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IRS Publishes Regulations to Apply the New Post-2017 Audit Rules

Published by Forrest D. Milder on Monday, July 10, 2017

Journal cover July 2017   Download PDF

Once upon a time, the Internal Revenue Service (IRS) audited partnerships (and LLCs, which are generally taxed as partnerships) by auditing the individual partners. This was full of difficulties–the individual partners didn’t necessarily have access to the relevant data, audits of different partners might yield different results (or even no audit for some), with multiple costs to do much the same investigation multiple times.

So, in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Congress adopted a new entity-level procedure that applied to a broad range of partnerships. Most readers are likely familiar with the terms “TEFRA audit,” and “tax matters partner” (or TMP), the person responsible for representing the partnership in a TEFRA audit. These terms and the entity-level procedure associated with partnership audits date back to 1982 and the adoption of TEFRA.

More than 30 years later, the IRS continued to feel outgunned in partnership and LLC audits. This led to the adoption of the Bipartisan Budget Act of 2015, as well as certain technical amendments in the Protecting Americans from Tax Hikes Act (PATH Act) of 2015 (I’ll call the audit rules of these two laws the BBA), which gave us a new partnership audit regime, effective for tax years after 2017. After adoption of the new law, but before any interpretations had been published, we provided an overview of the new rules in the January 2016 issue of The Current, (“New Audit Rules Could Have Broad Impact.”) 

Then, this past January, the IRS prepared to publish regulations that would flesh out some of these rules and its draft even appeared in some tax publications. However, when President Donald Trump took office, the draft was pulled before reaching the official status of “proposed” or “temporary regulation,” with the result that taxpayers now had a sense of how the rules would likely apply, but not the confidence of being able to point to published authority.

And, this brings us to June 2017 and the IRS actually issuing proposed regulations to apply the audit rules. The new regulations still aren’t the end of what you need to know about the new audit process. That’s because (i) the IRS has still declined to give guidance on some important aspects of the new rules, and (ii) statutory amendments proposed at the end of 2016 make it clear that the law could still change in material ways.

Here’s a brief summary of the new statutory provisions, as augmented by the recently published regulations:

  • Partnerships with 10 or more partners, or which have partnerships or LLCs taxed as partnerships as partners, are subject to the new rules and they may not elect out of entity-level audits. So, if the developer-affiliated managing member of a tax-equity LLC is a partnership, two-or-more member LLC or an S corporation, or if the investor invests in a particular project’s partnership or LLC through a fund that has more than one partner or member, then the new rules will apply. Stated differently, to avoid an entity-level audit, a tax equity investment would have to be structured as direct ownership or through a partnership or LLC whose only members were individuals and/or C corporations. 
  • The person who deals with the IRS is now called a “partnership representative” (PR). Unlike the TMP, a PR needn’t be a partner. This is important–under the new rules, the PR has very broad authority to deal with the IRS, and there are no longer statutory rules requiring the IRS or any person on behalf of the partnership to notify or involve any partners. A couple of considerations :

Once appointed, the PR cannot be changed unless and until an examination begins. Another rule provides that if an entity is named as the PR, then an actual individual must be named to deal with the IRS. These rules appear remarkably burdensome to taxpayers. Apparently, the IRS can still claim to have notified the partnership by sending correspondence to this individual, even if the individual has retired, left the country or died. In other words, being able to change the person after an audit commences can be meaningless if the partnership never hears about the audit in the first place.

With the new rules no longer requiring the IRS to send notices to the entity’s partners and the PR responsible for making the entity’s elections, as well as settling with the IRS and filing a petition in the U.S. Tax Court, it is important to ensure that the PR has a contractual obligation to keep the partners in the loop and participating in the audit. Similarly, partnership and LLC agreements will need decision making provisions, a procedure for replacing the PR, where appropriate, as well as cost sharing, and indemnity mechanisms.

With the change in law, if a nonpartner (or even the investor) becomes the PR, it’s important to carefully review how the term “tax matters partner” is used throughout the agreement and not simply substitute PR for TMP each place it appears. For example, many agreements give the TMP other tax-related duties (such as filing tax returns), but that’s not because TMPs have that responsibility by statute. Merely subbing one term for the other might result in someone other than the general partner or managing member becoming responsible for other tax duties that are unrelated to audits. 

  • The provision getting the most attention relates to who actually pays any tax liability. The new rules create a presumption that taxes will be paid at the entity level, with the amount generally computed by multiplying net underreported income by the highest marginal income tax rate for the year in which the affected item was reported. However, the rules provide a second election, enabling the partners for the year under audit to pay the liability (i.e., just like old law). This election is made by making the election and providing a statement to the IRS and each partner for that year that shows the partner’s distributive share of liability. Note:
    • Even if the tax liability is paid by the entity, it can demonstrate that a lower tax bill is appropriate based on the partners’ tax rates. 
    • The decision to elect out of entity-level tax liability has a small window, just 45 days. Partners must ensure that they plan ahead for this decision.

Lenders and others often want the partnership to elect out of entity-level liability so as to maximize the continued credit worthiness of the obligor.

Electing out is not necessarily prudent: the interest rate that applies to an electing partner’s tax liability is 2 points higher than when the tax liability is paid by the entity. Thus, an investor could assert, in “good faith,” that it wants the tax liability paid at the entity level simply to minimize the bill. And, of course, if a developer affiliate has the greater share of the entity’s residual value (say, because the partnership or LLC has a “flip” provision), then paying the liability at the entity level facilitates making the developer liable for the risk of an unfavorable audit, rather than making the investor pay the bill and then seek reimbursement.

It is not clear where the ability to pass the liability up a level ends. The IRS has indicated that it thinks that the liability can only be passed up one level, but the law is unclear on this point. For example, suppose “investor” invests in “fund,” and fund invests in operating partnership (OP); the IRS examines OP’s return and determines a liability and OP elects to have the liability paid at the partner level. Under current law, it is not clear whether this liability can only be passed to fund (one level up) but not to investor (which is two levels up). 

What if the person responsible for payment has insufficient assets? The regulations provide that the IRS can go after the partners, even if no election was made out of entity treatment. This and the previous point seem to establish a one-way street for liability–the IRS asserting that the taxpayer can only pass the liability one level from the audited entity, while the IRS can go as many tiers as it thinks necessary. The IRS position seems to reach beyond the plain wording of the new statute, which presumes entity-level liability unless the partnership specifically elects otherwise. 

The Congress is aware of these issues. Legislation proposed at the end of 2016 would permit the liability to be passed up to higher level partnerships, and it would also allow the IRS to go after the partners of a nonelecting partnership or LLC, if assets were insufficient at a lower level. This suggests that the IRS cannot go after the individual partners without an election out, but the IRS undoubtedly disagrees. 

Comments may be made on the proposed regulations not later than 60 days after publication, i.e., 60 days after June 14. 

Forrest David Milder is a partner with Nixon Peabody LLP. He has more than 30 years’ experience in tax-advantaged investments including the tax credits that apply to affordable housing, energy, new markets and historic rehabilitation, as well as the tax treatment of partnerships and LLCs, tax-exempt organizations, and structured financial products. He can be reached at (617) 345-1055 or [email protected]
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