New US Partnership Tax Audit Rules

Publication August 9, 2016

The U.S. Congress has recently enacted legislation (H.R. 1314, the Bipartisan Budget Act of 2015) [1] that changes the rules governing the IRS’s tax audits of partnerships, whether US or foreign, subject to certain exceptions. These rules also apply to non-partnership entities that are treated as partnerships for US federal income tax purposes (e.g., a US multi-member LLC). The new rules are generally effective for the IRS’s US federal income tax audits of partnership taxable years beginning after December 31, 2017. [2]

Effect of new US partnership audit tax rules. In general, the new rules provide for the IRS’s tax audit adjustments to be made at the partnership level and paid by the partnership. As an exception to this general rule, the partnership may elect to have the partners who were partners in the partnership taxable year that is under audit (including former partners who were partners in the partnership taxable year that is under audit and are not partners when the audit is conducted) take into account the adjustments made by the IRS with respect to the partnership and pay any tax due as a result of those adjustments in the year in which the IRS adjustment is made (instead of holding the partnership liable for such tax due). The new rules also provide exceptions for certain partnerships with no more than 100 partners and certain exceptions allowing for the reduction of an IRS partnership-level tax adjustment by having the partners file amended tax returns for the taxable years that are being audited.

“Partnership representative” designation requirement. The new rules also provide for a designation by the partnership of a “partnership representative” who shall have the sole authority to act on behalf of the partnership in respect of IRS tax audits and related proceedings and who can bind the partners in respect of any such audits or proceedings (including binding former partners who were partners in the partnership taxable year that is under audit and are not partners when the audit is conducted). The “partnership representative” can be an entity or an individual but such entity or individual must have a substantial presence in the United States. The “partnership representative” does not necessarily have to be a partner of the partnership (for example, it can be a third-party US law firm).

Recommended steps for private equity funds, hedge funds or other investment vehicles. As a result of the new rules, private equity funds, hedge funds and other investment vehicles that are formed as partnerships or as other entities that are treated as partnerships for US federal income tax purposes (e.g., a US multi-member LLC)should consider:

Amending their limited partnership agreement (or other applicable governing documents) to address these new rules, including, but not limited to:

  • Designation and authority of a “partnership representative”;
  • The partnership’s authority to make the elections or procedures available under the new rules that may minimize any obligations of the partnership itself to pay taxes, interest and/or penalties in connection with any IRS tax audit of the partnership; and/or
  • Cooperation by the partners in connection with the foregoing.
  • Amending their limited partnership agreement (or other applicable governing documents) to add a partner clawback provision covering IRS tax adjustments that are made at the partnership level under the new rules that are allocable to former partners who were partners in the partnership taxable year that is under audit and are not partners when the audit is conducted.
  • Including in offering documents (e.g., PPMs) a description of the new rules and their effect on potential investors.

[1] Please refer to https://www.congress.gov/bill/114th-congress/house-bill/1314/text for the full text of H.R. 1314.

[2] The IRS’s tax audits of partnership taxable years up to 2017 are still subject to the current tax audit rules.

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