The so-called "TEFRA" audit provisions for large partnerships have long confounded the IRS, taxpayers, and the courts. The recent bipartisan budget agreement will bring some long-needed reforms to a complex area of the tax code. The reforms simplify and streamline the procedures for auditing all partnerships and address concerns raised by Congress by requiring the partnership to designate a representative to act on its behalf, by providing for payment of taxes at the partnership level, and by defining large partnerships.
The new rules repeal and replace the three separate regimes in place under the current audit provisions. The new rules generally apply to returns for partnership tax years beginning after December 31, 2017. However, a partnership may elect to apply the new rules to any partnership return for partnership tax years beginning after November 2, 2015 and before January 1, 2018. Certain partnerships with 100 or fewer partners will be able to elect out of the application of the unified rules for a tax year on a timely filed return.
Under the new streamlined audit approach, the IRS will audit the partnership's items of income, gain, loss, deduction, credit and partners’ distributive shares for a particular year of the partnership (the "reviewed year"). Any adjustments will be made at the partnership level and taken into account by the partnership in the year that the audit or any judicial review is completed (the "adjustment year").
The general rule is that an imputed underpayment is assessed and collected at the partnership level. This represents a significant departure from current rules. An adjustment that does not result in an imputed underpayment generally will be taken into account by the partnership in the adjustment year as a reduction in non-separately stated income or an increase in non-separately stated loss, or in the case of a credit, as a separately stated item.
Partnerships will have the option of reducing the imputed underpayment under procedures established by the Secretary of the Treasury. A partnership generally will have 270 days to submit information to the IRS to modify the imputed underpayment amount following receipt of a notice of proposed partnership adjustment unless the IRS consents to an extension. The new rules provide that if one or more partners file amended returns for the reviewed year that take into account the adjustments allocable to the partner(s), and include payment of any tax due with the amended return, the imputed underpayment will be determined without regard to the portion of adjustments taken into account by the partner(s)' amended return(s). In addition, the existence of tax-exempt partners, as well as the proper application of lower tax rates to certain partners, may be taken into account to reduce the imputed underpayment.
As an alternative to the general rule that an imputed underpayment is assessed and collected at the partnership level, a partnership may elect to send adjustment statements to all reviewed-year partners. The partnership must make this election no later than 45 days after the date of the notice of final partnership adjustment. If the partnership makes this election and sends the required adjustment statements to reviewed-year partners and the IRS, the imputed underpayment is paid by the reviewed-year partners.
Under the new rules, a partnership can initiate an administrative adjustment, which it may want to do if it believes that an overpayment has been made. The adjustment would be taken into account in the adjustment year.
A quick analysis suggests that while the new rules address many longstanding challenges to the IRS’s ability to effectively audit large partnerships, they also generate new challenges as a result of the choices available to partnerships to modify imputed underpayments, and to elect to pass the liability for payment of the adjustment year tax to the review year partners. Absent an election, these provisions operate to shift the economic burden for past years’ tax liability to the adjustment year, so partners may bear the economic burden for tax attributable to years in which they did not have an ownership interest. Partnerships will need to take these provisions into account and make appropriate revisions to their partnership agreements.
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