On Monday, November 2, 2015, the Bipartisan Budget Act of 2015 (the “Budget Act”) was enacted. This is especially significant for partnerships because it completely replaces the Tax Equity and Fiscal Responsibility Act (TEFRA) and the Electing Large Partnership (ELP) rules governing IRS examination of partnerships.
Current Law
Three different regimes are currently in use for auditing partnerships:
- Ten or fewer partners: For partnerships with 10 or fewer partners, the IRS generally applies the audit procedures for individual taxpayers, which entails auditing the partnership and each partner separately.
- More than 10 partners: For most partnerships with more than 10 partners, the IRS conducts a single administrative proceeding under the TEFRA rules. This process is used to resolve audit issues that are more appropriately determined at the partnership level rather than at the individual partner level.
- One hundred or more partners: A partnership with 100 or more partners can elect to be treated as an Electing Large Partnership (ELP) for reporting and auditing purposes.
TEFRA and ELP
Congress passed TEFRA in 1982 to establish unified audit rules for partnerships with more than 10 partners. It required that the tax treatment of all partnership items be determined at the entity level for these partnerships. In 1997, Congress adopted rules to allow partnerships with more than 100 partners to elect into a simplified reporting regime (Electing Large Partnership, or “ELP”), including streamlined audit and adjustment procedures.
Under TEFRA, adjustments resulting from the audit lead to an IRS recalculation of the tax liability of each partner who participated in the partnership during the tax year under examination.
In contrast, under the ELP rules, any partnership adjustments generally flow through to the partners for the year in which the adjustment takes effect, and adjustments generally do not affect prior-year returns of any partners.
Changes to Partnership Audit Rules
President Obama had proposed mandating the ELP rules in several administration budget proposals. House Ways and Means Committee Chairman Dave Camp (R-MI) also proposed streamlining the audit process by mandating rules similar to the ELP rules for partnerships with more than 100 partners in his February 2014 draft comprehensive tax reform plan. In June of 2015, Rep. James Renacci (R-OH) and Rep. Ron Kind (D-WI), both members of the Ways and Means Committee, introduced the Partnership Audit Simplification Act, which was similar to the Camp proposal. The Budget Act provision is based largely on the Renacci bill. The purpose behind all of these proposals remains the same - to respond to IRS difficulty in assessing tax owed at the partnership level, particularly in cases of complex and multi-tiered partnership arrangements.
The New Rules
The Budget Act repeals these provisions and reduces the number of audit procedures for partnerships from three to two:
First, similar to the TEFRA rule excluding small partnerships, the provision would permit partnerships with 100 or fewer qualifying partners to opt out of the new rules. In this case, the partnership and partners would be audited under the general rules applicable to individual taxpayers. Unlike current law, the onus is on the partnership to opt out of the rules rather than either automatically being excluded under TEFRA or being offered the opportunity to opt in under ELP. The election to opt out must be made on an annual basis and is available only to partnerships that do not have other partnerships or trusts as partners.
Partnerships that do not opt out will be subject to the new streamlined audit approach. Under the new rules, the IRS will examine the partnership’s items of income, gain, loss, deduction, credit, and partners’ distributive shares for the year under audit and any adjustments will be assessed directly to the partnership (rather than the individual partners) in the year that any audit adjustments are finalized. Partners will not be subject to joint and several liability for any liability determined at the partnership level. The partnership may shift the liability to the individual partners, but it is up to the partnership rather than the IRS to issue adjusted information returns (i.e., adjusted Form K-1s).
Effective Date
In order to allow sufficient time for implementing regulations to be promulgated and to give taxpayers and the IRS time to adjust to the new rules, the effective date of the new provisions is delayed and will begin with returns filed for tax years beginning after December 31, 2017. However, a partnership may elect to apply the new rules for earlier tax years beginning after the enactment date. The Congressional Budget Office (CBO) estimates that the new rules will raise approximately $9 billion over the next ten years.