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The Repeal and Replacement of the TEFRA Partnership Audit Rules

Jerald David August is a Partner in the law firm of Kostelanetz & Fink, LLP, New York, New York. Mr. August is a national authority on federal taxation and is a fre-quent lecturer throughout

the U.S. on federal tax matters, including corporate and partnership taxation, international taxation, wealth transfer taxation, tax controversy and tax liti-gation. Mr. August is past Vice-Chair (Publications) of the American Bar Association, Section of Taxation and past Editor-in-Chief of The Tax Lawyer, Vols. 58 & 59, which is the leading law review for tax practitio-ners in the U.S. He is Editor-in-Chief of the Journal of Business Entities, a leading national tax publication.

Mr. August has served as Chair of the S Corporation and CLE Committees of the ABA Tax Section and has served on the Task Force on Federal Wealth Transfer Taxes, Subcommittee on Carryover Basis and as Chair of the ABA Tax Section’s Task Force on Pass-Through Entity Integration. He is a long-standing member of the Advisory Board of the New York University Institute on Federal Taxation and has served as Chair of the Institute on Federal Wealth Taxation (2006-2011) and Chair of the NYU Annual Institute on Federal Taxation Closely-Held Businesses Session (2001-2011). He has chaired and participated in vari-ous national programs including the Graduate Tax Program of the NYU School of Law, ALI CLE, ABA Tax Section, and various state bar programs and institutes, including Pennsylvania Bar Institute and Florida Bar Tax Section. He is a member of the ABA Tax Section Committees on Government Submissions, Foreign Activities of U.S. Taxpayers, U.S. Activities of Foreigners & Tax Treaties, Partnerships & LLCs and S Corporations; Business Law Section, Mergers & Acquisitions Committee, International Mergers & Acquisitions Subcommittee; American College of Tax Counsel; the American College of Trust and Estate Counsel; American Tax Policy Institute; American Law Institute; and, member of the Consultative Groups on Restatement (Third) of Donative Transfers and Restatement (Third) of the Law of Trusts.

Jerald David August

THE BIPARTISAN BUDGET ACT of 2015, Pub. L. No. 114-74, Act § 1101 (the “Budget Act”), which the President signed into law on November 2, 2015, (as modified by the Protecting Americans from Tax Hikes Act of 2015, Pub. L. No.114-113 (the “PATH Act”)) makes fundamental changes in how the Internal Revenue Service (“Service”) will conduct audits of partnerships. The Budget Act repeals the partnership audit provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)1 and elect-ing large partnership regimes and replaces them with a new set of rules for partnership audits and judicial review of partnership audit adjustments under a new centralized or consolidated partnership audit regime.2

The new centralized partnership audit rules are gen-erally applicable to all partnerships. While the Service will audit the partnership under the revised entity-level audit rules, the default rule contained in Section 6225, will, for the first time, make the partnership responsible to make payment of any resulting imputed underpayment

1 Pub. L. 97-248. 2 See generally, Jerald David August and Terence Floyd Cuff, The TEFRA Partnership Audit Rules Repeal: Partnership and Partner Impacts, ALE CLE Video Webcast, July 17, 2016; August, The Good The Bad, and Possibly the Ugly in the New Audit Rules: Congress Rescues the IRS From Its Inability to Audit Large Partnerships, 18 Bus. Entities 4 (May/June 2016); August, Entity-Level Audit Rules Continue to Pose challenges for Partners, Parts 1 and 2, 16 Bus. Entities 4 (Nov./Dec. 2014), 17 Bus. Entities 4 (July/Aug. 2015). Section 1101, Pub. L. No. 114-74, the Bipartisan Budget Act of 2015. Section 1101 repeals the current rules governing partnership audits with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level. On the new audit provisions generally, see New York State Bar Association, Tax Section, Report No. 1347, Report on the Partnership Audit Rules of the Bipartisan Budget Act of 2015, (May 25, 2016). For background to the new legislation, see August and Cuff, supra.

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from one or more partnership adjustments for the reviewed year or years. There is a major exception, and that pertains to certain partnerships that have 100 or fewer partners. Under new Section 6221(b), a partnership having “100 or less” partners (actu-ally 100 K-1s or fewer) may elect out of the new audit rules for any tax year, provided that all part-ners are individuals, C corporations, foreign enti-ties that would be treated as C corporations were they domestic entities under the check-the-box reg-ulations, and S corporations having certain types of shareholders or estates of deceased partners. There are important notification provisions that must be made by the partnership representative to the IRS and the partners in qualifying for the election out of the partnership audit rules under SELA. The election out must be made annually.3 With respect to any tax year of the partnership where any part-ner is a partnership, trust, or even a single member LLC or defective entity, the election out provided in Section 6221(b) cannot be made.

When an eligible partnership elects out, the partners will be subject to the pre-TEFRA partner-ship audit rules with respect to such year, which will require that the IRS separately audit each partner as well as the partnership. It is somewhat ironic that the IRS’ motivation in obtaining the legislation was to enhance the audit and assessment of partner-ships but the legislation in fact opens the door for making auditing partners who reside in different states and countries even more difficult than before.

When an election out is not made or is other-wise ineffective, the new law requires that the part-nership will be subject to the general rule under

3 See new § 6231(a) (notices of audit (administrative pro-ceeding), proposed partnership adjustment and final partner-ship adjustment). Section 6231(a) (flush language provides that “[N]otice of a final partnership adjustment shall not be mailed earlier than 270 days after the date on which the no-tice of the proposed partnership adjustment is mailed. Such notices shall be sufficient if mailed to the last known address of the partnership representative or the partnership (even if the partnership has terminated its existence). The first sen-tence shall apply to any proceeding with respect to an admin-istrative adjustment request [or AAR] filed by a partnership under § 6227. See also § 6245(b)(1) (“notice of partnership adjustment”) which is deleted under the new rules).

Section 6221(a) and must directly bear the eco-nomic cost of proposed assessments in income tax resulting from the partnership audit in the year of adjustment, and not the “reviewed years” to which the partnership adjustments were attributable. The “partnership adjustment” is defined in new Section 6225. In such instance, the IRS will assess federal income tax against the partnership for the “imputed underpayment,” resulting from aggre-gate net increase in taxable income (or aggregate decrease in taxable loss) attributable to the part-nership adjustments with respect to the “reviewed” years. The imputed underpayment is calculated at the highest corporate or individual rate during the tax year(s) at issue.4 Appropriate guidance will be forthcoming on the computation of the imputed underpayment by IRS notice and then in final reg-ulations. The amount of the imputed underpay-ment can be mitigated by timely presentation of particular tax profiles of the partners to which the adjustments are allocable (for the reviewed years) or by reference to a particular tax provision in the Code, such as long-term capital gain, or qualifying dividend income, that will reduce part of the result-ing imputed underpayment. Indeed, the partners can reduce the imputed underpayment amount by timely remitting amended returns and making the required tax payments for their respective shares of the imputed underpayment amount.

A single partnership limitation period is set forth under a revised set of statute of limitations rules, in particular new Section 6235, replacing Section 6229. Under Section 6235, adjustments to the partnership cannot be made more than three years after the latest of: (a) the date on which the partnership filed its return; (b) the due date for the return; or (c) the date on which the partner-ship filed an administrative adjustment request. Of course, the law allows for the parties to agree to an extension or waiver of the statute of limitations. There are other important procedural rules set forth in the new provisions that again will be the subject of an extensive set of rules and exceptions to be published by the Service as guidance, pro-posed regulations, and then in final regulations. A

4 See new § 6225(b)(1).

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six-year period will apply for substantial omissions from the partnership’s gross income and, when no return is filed by the partnership or it involves civil fraud, there will be no statute of limitations.5

THE PARTNERSHIP AUDIT RULES PRIOR TO AND AS A RESULT OF TEFRA • Prior to the enactment of the TEFRA rules, all partnership audits were conducted at the partner level as part of the audit of one or more partners. The Service determined that this was an unsatisfactory method to audit partnerships although non-partnership issues would still be determined at the partner level.6

5 See new §§ 6235(c)(1)-(4). 6 Certain investment entities, joint extraction, or pro-duction arrangements that are joint undertakings for profit under may still elect out of partnership status in accordance with the regulations to § 761, in which case such enterprise is also not treated as a partnership under the TEFRA audit rules. Treas. Reg. § 1.761-2. See § 7701(a)(2); Powell v. Commis-sioner, 26 T.C.M. (CCH) 161 (1967); Rev. Rul. 68-344, 1968-1 C.B. 569; Rev. Rul. 82-61, 1982-1 C.B. 13. But see Bentex Oil Corp. v. Commissioner, 20 T.C. 565 (1953); Madison Gas & Electric Co. v. Commissioner, 633 F.2d 512 (7th Cir. 1980). See also, WB Acquisition, Inc. v. Comm’r, T.C. Memo 2011-36, aff’d, 803 F.3d 1014 (9th Cir. 2015) (profit cap found to be in-dicative of a contingent compensation arrangement); Historic Boardwalk Hall, LLC, v. Comm’r, 694 F.3d 425 (3d. Cir. 2012), rev’g and remanding 136 T.C. 1 (2011) (investor in vehicle to transfer historic tax credits not a bona fide partner); Chief Couns. Adv. 20124002F (Aug. 30, 2012) (applying participa-tion analysis to treat tax equity investor’s interest in partner-ship as debt). The regulations describe an “investing partner-ship” that may “elect out” of partnership status as one in which: (a) The partners own the property as co-owners (b) Each owner reserves the right to separately take or dispose of their shares of any property acquired or retained; (c) the own-ers do not actively conduct business or irrevocably authorize some person or persons acting in a representative capacity to purchase, sell, or exchange such investment property, al-though each separate participant may delegate authority to purchase, sell, or exchange his share of any such investment property for a period of up to one year. Under Treas. Reg. § 1.761-2(a)(3), a group may elect out of Subchapter K where the participants enter into an operating agreement for the joint production, extraction, or use of property in which: (a) the participants own the property as co-owners, either in fee or under lease or other form of contract granting exclusive operating rights; (b) the participants reserve the right sepa-rately to take in kind or dispose of their shares of any prop-erty produced, extracted, or used; and (c) the participants do not jointly sell services or the property produced or extract-

Some partnerships could elect out of TEFRA, such as a partnership with 10 or fewer eligible partners, in which case the IRS would have to audit each partner separately. There also were rules whereby electing large partnerships, i.e., partnerships with 100 or more partners, could elect into a special set of rules they would centralize the audit process.

The TEFRA entity level audit rules mixed both entity and aggregate theories into a complex web of procedural rules and protocols that were supposed to supersede the normal set of proce-dural rules applicable to taxpayers in general. This dual system for auditing partnerships had a well-intended design but generated much complexity and uncertainty in how the two sets of rules were to be applied. For example, there were different statutes of limitations applicable, one at the part-nership level and one at the partner level.7

In instances in which the TEFRA audit rules applied, the Service encountered administrative difficulties in timely locating the tax matters part-ner as well as all notice partners that the IRS was required to notify at the commencement of the audit and in issuing a final set of proposed partner-ship adjustments (FPAA). There were also thorny technical or legal issues generated from the two-track system of statutes of limitations, and in iden-tifying whether particular adjustments were to be labeled as “partnership items,” “affected items,”

ed. The election-out mechanics are contained in Treas. Reg. § 1.761-2(b). The election out would also negate application of the entity-level audit rules under TEFRA and presumably under the BBA, subject to the issuance of regulations. 7 See § 6229(statute of limitations for partnership audit does not expire until 3 years after the original due date of the partnership return or the date the return is filed, whichever is later). A 6 year period was possible for substantial understate-ments under the more than 25% rule as well as no statute of limitations for fraudulently reported partnership items. Each partner’s statute of limitation was to be determined as the lat-er in time of the normal statute of limitations on assessments under I.R.C. § 6501 or the partnership statute. See Rhone-Poulenc Surfactants & Specialties LP v. Commissioner, 114 T.C. 533 (2000) (reviewing the issue and siding with the Internal Revenue Service’s position); AD Global Fund LLC v. United States, 67 Fed. Cl. 657 (2005), aff’d, 481 F.3d 1351 (Fed. Cir. 2007) (discussing the interaction of §§ 6229 (TEFRA) and 6501 and the related case law).

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or “non-partnership items.” The case law under TEFRA reveals that the courts were somewhat ill-equipped to handle these unique and at times perplexing legal questions that had to be sorted out with judicial candor and clarity. This was not always easy.

The Service often had further difficulty dealing with complicated statute of limitation issues under TEFRA. There was added concern with the abil-ity to collect taxes from partners’ deficiencies after adjustments had been determined. Again, the multi-tiered partnerships having hundreds of partners (or more) in an investment fund situated in different parts of the U.S., as well as in foreign countries, posed formidable collection burdens for the IRS. 8

Congress Agreed with the Service and Treasury that Legislative Reform of the Partnership Procedural Rules and Collection Process Was Required

The IRS went to Congress for relief. Congress responded by enacting a new audit regime for large partnerships generally effective for partner-ship taxable years beginning after 2017. The new scheme also is intended to be a substantial source of increased revenues.9

8 See, however, §§ 1441 (non-resident FDAP), 1442 (for-eign corporation FDAP), 1445 (FIRPTA), 1446 (foreign ECI)), 1471-1474 (FATCA). 9 See August and Cuff, The TEFRA Partnership Audit Rules Repeal: Partnership and Partner Impacts, supra note 2; August, The Good, The Bad, And Possibly the Ugly In The New Audit Rules, supra note 2. See e.g., ABA Section of Taxation, Com-ments on Bipartisan Budget Act of 2015 Partnership Audit Proce-dures, June 6, 2016; Donald B. Susswein, Ryan P. McCor-mick, Getting the Partnership Audit Rules Up and Running, 151 Tax Notes 495 (Apr. 25, 2016) Monte A. Jackal, Partnership Audit Rules: Taxing at the Partner Level, Doc. 2016-8694, 2016 TNT 84-12 (May 2, 2016); Donald B. Susswein, Should the Partnership Audit Rules Be Broader in Scope, Doc. 2016-9710 (May 16, 2016). Cf. Tax Policy Advisory Committee of the Real Estate Roundtable, Improving the Partnership Audit Process (Sept. 2015); Susswein and McCormick, Fixing the Partner-ship Audit Process, 149 Tax Notes (Oct. 5, 2015): Viewpoint; Susswein and McCormick, Understanding the New Partnership Audit Rules, 149 Tax Notes 1171 (Nov. 30, 2015); New York State Bar Association, Tax Section, Report No. 1347, Report on the Partnership Audit Rules of the Bipartisan Budget Act of 2015 (May 25, 2016).

The general rule under the consolidated audit approach is that underpayments in prior years, i.e., reviewed years, with respect to partner income taxes in a partnership, would be borne by the part-nership. Under the new law, the audit would still focus on the prior tax years (the “reviewed year audits”). The proposed and resulting deficiency in tax would be assessed against and paid by the partnership in the “adjustment year.” The part-nership assessment becomes final, subject to a set of complex payment rules and exceptions. This fundamental change in federal tax procedure to assess and collect federal income tax in “open” years against the partnership entity appears to be a paradigm shift in treating a partnership for federal income tax purposes as a separate taxable entity instead of a flow-through entity, at least for assess-ment and collection purposes.10

The new partnership audit rules, which are generally effective for partnership taxable years beginning after December 31, 2017,11 replace both the TEFRA audit rules and the electing large part-nership rules. The hallmark of the new rules is that the partnership itself will be liable for any imputed underpayment in tax for one or more “reviewed year audits.” This is what the Treasury and the Service clearly wanted Congress to do in order to facilitate audits of large partnerships, includ-ing funds of funds and multi-tiered partnerships. The ability to elect out of the new centralized audit

10 As discussed below, in Notice 2016-23, 2016-13 I.R.B. 490 the IRS issued notice requesting comments under the new partnership rules in issuing guidance. The regulations projects will be quite important in understanding the scope and breadth of the new statutory language. The Congress, as it typically is prone to do in the area of tax legislation, left much of the detail on the new reforms to be defined by regulation and other forms of guidance. In fact, it has been reported that the IRS was not asked by Congress to report on the legislation prior to its enactment.11 Based on the obvious need for much published guid-ance from the Treasury and the IRS and the accumulating list of errors, inconsistences and perhaps unintended conse-quences attributable to the statutory language, it is possible that the Treasury may convince Congress to postpone the effective date of the new rules or otherwise promulgate, un-der rule-making authority, a delay in effective date. I.R.C. § 7805(b).