Budget Deal Has Implications for Tax Credit Partnerships

Published by Michael Novogradac on Friday, October 30, 2015 - 12:00am

The Bipartisan Budget Act of 2015 signed Nov. 2 by President Barack Obama includes revenue generating provisions that are intended to streamline the Internal Revenue Service (IRS) partnership audit process by eliminating multi-tier audits and determinations at the partner level. Similar provisions were included in the president’s fiscal year (FY) 2016 budget and a bill introduced by Rep. Jim Renacci, R-Ohio. While these provisions may initially sound appealing, the changes could be problematic for those in the tax credit communities who primarily use partnerships as the business regime to invest in affordable housing, community development, historic preservation and renewable energy. The good news is the delay in the mandatory application of the new rules. The new rules generally apply to partnership taxable years beginning after Dec. 31, 2017, though a partnership may elect to apply the new rules to any partnership return filed for partnership taxable years beginning after Nov. 2, 2015.

The intent of the new law is to make it easier for the IRS to audit partnerships composed of many partners by determining adjustments and assessing taxes at the partnership level, rather than the partner level. Any adjustments resulting from tax determinations made at the partnership level under audit would be taken into account in that year by the partnership. Partners would not be subject to joint and several liability for any liability determined at the partnership level. It’s also important to note that an election exists to allow the tax due to be paid at the partner, not the partnership, level. The rules and regulations regarding the implementation of this election will be one of many matters on which the IRS will need to issue guidance.

Under previous law, a partnership designates a tax matters partner (TMP) who is a current partner to represent the partnership in audit proceedings. The TMP generally enters into settlements with the IRS and notifies all the partners of the audit. Ultimately, partnership level adjustments flow through to each partner and taxes and penalties are paid at the tax paying partner level. The newly enacted law eliminates the TMP and instead has a partnership representative that does not have to be a partner in the partnership. The partnership representative works with the IRS in the audit proceedings and has the power to bind the partners on the determination. There are provisions that allow partnerships with 100 or fewer partners to opt out. Under the new law, as enacted, a partnership that has another partnership as a partner is not generally eligible to elect out. This could be problematic because multi-tier partnerships are common in numerous tax credit investment structures.

So while this simplified approach initially sounds like a good thing, it’s clear there are many questions left to be answered and further explored. For example:

  • When tax is determined and assessed at the partnership level, there are numerous issues, including:
    • What is the impact on the calculation of the tax due if the partnership has tax exempt partners?
    • What is the impact on the calculation of tax due when you have corporate and individual partners with differing ordinary income and/or capital gains tax rates?
  • If a partner did not claim a pass through loss on its tax return due to basis limitations, how is the partnership level tax determined?
  • What if a partner has an overall net operating loss and is not subject to tax in a particular year?
  • How are the partners’ Section 704(b) capital accounts affected by payments of federal income tax at the partnership level?

Another potential threat to the tax credit community lies in the way liability will be assessed. If the liability is assessed at the partnership level in the current year (as opposed to the year under audit), there is risk to new investors who wish to acquire tax credit investments from existing investors. This provision could discourage secondary market transactions because of potential audit risk on tax positions taken on tax returns prior to when the new investor becomes a partner. Could this cause investors to delay or even stop some secondary transactions from closing? Or if they do close, would investors ask for larger guarantees and escrows to protect against potential tax liability?

Certainly, further analysis is needed on the effect of the provisions, but it’s clear that, as enacted, changes to existing partnership agreements are likely needed, and will certainly affect the structuring of future investments and related legal agreements.

Fortunately, as noted above, tax credit communities have some time, as the provisions generally do not go into effect until 2018, giving Treasury time to write regulations and guidance implementing the new law. The Novogradac LIHTC Working Group will write to Treasury to urge it to draft appropriate guidance to address these concerns.

In the comment section below, we encourage blog post readers to share additional questions, concerns and observations regarding this new regime for auditing partnerships.