By: Damian Hovancik, Arnall Golden Gregory LLP
Damian is a Partner with AGG and is a member of AGG’s Tax Practice Group.
On November 2, 2015, the Bipartisan Budget Act of 2015( Budget Act) was signed into law. The Budget Act essentially repeals the current rules regarding federal income tax audits of partnerships and replaces them with those discussed below. These changes are a departure from how partnerships are currently required to resolve audit adjustments and pay any deficiencies in tax that are assessed by the IRS. Currently partnerships are treated as flow through entities and are not subject to federal income tax and any audit adjustments are made with respect to each partner in the partnership. The new rules impose the tax liability at the partnership level. These new audit procedural rules will have a significant effect on partnerships holding low-income housing tax credit (“LIHTC”) projects.
Federal income tax audit or judicial proceedings will continue to be conducted at the partnership level, but any tax liability, including penalties and interest, resulting from a federal income tax audit or judicial proceeding will be imposed directly on the partnership and not on the partners individually (a so called “ imputed underpayment”). The imputed underpayment is calculated by applying either the highest individual or corporate tax rate that was in effect for the reviewed year. An imputed underpayment for a particular year that is being audited (called the “reviewed year”) are taken into account by the partnership in the year that the federal income tax audit or judicial proceeding is completed (called the “adjustment year”). This change shifts the ultimate tax liability to the partnership and the partners who are partners in the adjustment year. Under the current rules the individual partners in the reviewed year would be responsible for such tax liability. Certain elections can be made so that the tax liability from any audit is imposed on the partners in the reviewed year (and not the partnership). There is also an election out of these rules for small partnerships as described below but it is unlikely to apply to most LIHTC projects. Therefore, these rules must be considered when drafting project partnership agreements.
Transferring the Liability for the Imputed Underpayment
There are methods to essentially transfer the imputed underpayment to the partners of the partnership which would be substantially equivalent to the current rules. One way to reduce the imputed underpayment is by the partners filing amended tax returns and paying the related tax liability for the reviewed year. After the proposed partnership adjustment is mailed, the partnership has 270 days to submit the necessary information and documentation to the Internal Revenue Service (IRS) for modification of the imputed underpayment using this method. The IRS must approve all modifications to the imputed underpayment of the partnership.
Another alternative is to have the partnership elect, within 45 days of receiving an IRS final notice of partnership adjustment, to issue statements to the partners who were partners in the reviewed year for their share of any audit adjustment. The partners receiving these statements will be required to take the adjustments into account on their individual tax returns for the reviewed year and any affected subsequent tax years. In addition, those partners will owe interest and penalties, if applicable, but the interest will be two percent higher than the normal rate on tax underpayments; which is one disadvantage of this approach.
Another major change in the partnership audit rules is that the “tax matter partner” designation for federal income tax audits or judicial proceedings was repealed and replaced by the “partnership representative.” The partnership representative is the only person that will receive notice of any audit that has been initiated and any IRS notices including any final partnership adjustment. The partnership representative has the sole authority to act on behalf of the partnership during a federal income tax audit or judicial proceeding.
Given the broad power of the partnership representative, developers and investors have been negotiating to clarify what authority the partnership representative can exercise in conducting and settling any audit matters, such as providing notice to the other partners of any proceedings and requiring the partnership representative’s actions to be subject to investor consent or the agreement of all the partners.
Small Partnership Exception
As indicated above, there is an exception for small partnerships to elect out of these new partnership audit rules. During each tax year, if the partnership has 100 or fewer partners and all of the partners are either; individuals, a C corporation, any foreign entity that would be treated as a C corporation if it was domestic, a S corporation, or an estate of a deceased partner, then the partnership may elect this exception on its partnership tax return. Currently, a partnership that has a partnership or a single member limited liability company as a partner is not eligible for the small partnership exception. So in a tiered partnership structure, like most LIHTC projects, the lower tier project partnership will be subject to the new partnership audit procedures and, in many cases, the partners may want to use the methods described above to transfer the tax liability.
These new partnership audit procedure rules are effective for partnership taxable years beginning after December 31, 2017.
The IRS is still in the process of issuing guidance in this area. There have also been technical correction bills introduced into Congress to alleviate some of the uncertainties in the law generated by these new audit rules. When negotiating the terms of partnership agreements it is important to make sure that the partnership agreement reflects the intent of the partners and the alternative methods that can be used to transfer the tax liability to the partners are made available in the partnership agreement.