Recently issued legislation completely replaces and transforms the IRS’s partnership audit procedures. Under existing IRS rules, the partners of a partnership are generally responsible for the payment of any tax deficiency for the taxable year being audited. Therefore, the acquirer of a partnership interest currently does not bear the risk of pre-closing federal income tax deficiencies. However, under the new rules, the IRS will collect any additional tax, interest and penalties from the partnership itself (and not from the individual partners) unless the partnership makes an alternative election.
The new default procedure has the effect of shifting the economic burden of any tax deficiency to the partnership’s current partners, which may be different, or have different ownership percentages than in the year under audit.
The new partnership audit rules are effective for the tax years beginning on or after January 1, 2018, although existing partnerships may opt for early adoption of the new audit rules. It should also be noted the new rules apply to all entities treated as partnerships for federal income tax purposes.
Options for Avoiding the New Rules
Partnerships are eligible to elect out of the new IRS audit rules under a “Small Partnership Election” if the following criteria are met:
- Each of the partners is an individual, a decedent’s estate, a C-corp or an S-corp
- The partnership has fewer than 100 partners (including pass-through owners of an S-corp partner)
- Certain procedural requirements are satisfied
The above criteria may be difficult for private investment vehicles to meet in typical tiered partnership structures.
The new IRS audit rules also allow a method (referred to as the “6226 Election”) by which the obligation to pay the tax deficiencies may be shifted away from the partnership (and thus away from the partners at the time the audit is finalized) and back to the partners who owned the partnership during the year under audit. Certain procedural and reporting requirements must be met for the partnership to utilize the “6226 Election.”
Another notable change under the new rules is the requirement for all partnerships to appoint a “Partnership Representative.” The “Partnership Representative” will have sole authority to act on behalf of the partnership in connection with audits or judicial proceedings. Furthermore, the new audit rules eliminate the right of partners to participate in or even receive notices relating to IRS audits. It should be noted the “Partnership Representative” does not need to be an owner of the entity, which can be useful for private equity management companies. Great care should be taken in appointing the “Partnership Representative.”
Impact on Private Equity and M&A Transactions
The new IRS audit rules described above are certain to have a significant impact on all partnerships, including private equity funds and other private investment vehicles. Relevant considerations for the purchase and sale of partnership interests include:
- Buyers should ensure the partnership either meets the requirements of the “Small Partnership Election” or can utilize the “6226 Election”
- Buyers of partnership interests should request an indemnity from the seller for any losses suffered as a result of an IRS audit covering a pre-closing period
- Buyers of partnership interests should request a representation from the seller that no “6226 Election” has been made or will be made prior to the transaction closing
- Partners in existing partnerships, or those considering formation of new partnerships, should consider opportunities to use the “Small Partnership Election” or utilize the “6226 Election”
- Partners in existing partnerships should consider adding strict control or notice provisions in partnership governing documents with respect to the actions of the Partnership Representative
The recently enacted partnership tax audit rules will make it much easier for the IRS to collect taxes, penalties and interest as a result of conducting an income tax audit. It should be expected that the rate of federal income tax audits of partnerships, including investment funds and other private investment vehicles will increase significantly.
While the revised IRS rules are not effective until 2018, consideration should be taken now to adapt to the new regulations when reviewing existing or drafting new partnership agreements. Care should also be taken when negotiating M&A transactions involving entities treated as partnerships for federal income tax purposes.
Tad N. Render, CPA, leads the M&A practice at Miller, Cooper & Co., Ltd., a Chicago-based accounting and consulting firm.