Practical Implications of New Partnership Audit Rules
The Experts: Michael Hauswirth, Todd McArthur, and Adam Feuerstein

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Ignore the new partnership audit rules at your own peril. Absent an election of earlier application, they take effect for tax years beginning in 2018. Under the new rules, the Internal Revenue Service (IRS) generally will collect tax at the partnership level on adjusted partnership items at the highest corporate or individual rate in effect for the audit year. This tax will often be the “wrong” amount and will often be borne by the “wrong” partners. The statute offers partners limited ways to right these wrongs (or possibly opt out entirely), but partners need to understand these exceptions well before an audit—even before acquiring an interest in a partnership—to avoid the potential pitfalls of the new rules.

What issues should be considered in response to the new partnership rules?

Answer: The partnership audit and adjustment rules enacted as part of the Bipartisan Budget Act of 2015 and amended by the Protecting Americans from Tax Hikes Act of 2015 (the “BBA audit rules”) revolutionize the manner in which partnerships will be audited and related taxes will be assessed and collected for tax years generally beginning after December 31, 2017.

Beginning in 2018 (except with respect to partnerships electing earlier application), the TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) partnership audit rules are repealed. Partnership audits and the assessment and collection of related taxes will be centralized at the partnership level, and partners will have no statutory right, as they generally do under the TEFRA partnership rules, to receive notice of, or to participate in, any partnership audit, appeal, or judicial review.

Any tax assessed will be collected at the partnership level and borne indirectly by the persons who are partners during the year of the partnership adjustment (not the year under review), unless the partnership is able to “push out” the adjusted partnership items to the persons who were partners in the year under examination (the “push-out election”). A decision to pay tax at the partnership level or to push out adjusted partnership items can materially affect the total amount of the tax and which partners bear the burden of the additional tax liability.

BBA changes

The BBA’s significant changes to partnership audit and adjustment procedures will affect how partnerships and partners assess and allocate the risk of uncertain partnership tax positions. The BBA audit rules were enacted to streamline IRS audits of large and tiered partnerships and to reduce the IRS’ administrative burden with respect to assessing and collecting underpayments determined as a result of partnership audits. These factors and others will likely result in an increase in partnership audit activity as the rules are phased in.1

Complicating matters further are numerous unanswered questions that will have to be resolved by administrative guidance or statutory changes.2 Well before 2018, partnerships, partners, future partnership representatives, and prudent advisors will want to monitor those developments and begin to consider the impact of the BBA audit rules on the terms of partnership agreements and the due diligence and negotiation strategies of all parties involved.

Elevated Role of Single Person: The Partnership Representative

Every partnership subject to the BBA audit rules will have a “partnership representative.” Any person (even a non-partner) with a “substantial presence in the United States” may be the partnership representative. If a partnership fails to designate its partnership representative, the IRS is empowered to do so.

The partnership representative has the sole and exclusive authority to act on behalf of the partnership and to bind all partners with respect to partnership matters subject to the BBA audit rules. This authority includes representing the partnership during an audit, negotiating and agreeing (or disagreeing) to settle with the IRS, and seeking judicial review of an IRS adjustment. The BBA audit rules, unlike the TEFRA rules, do not provide partners with any rights to be notified at key stages during a partnership audit or to participate in the audit, appeal, or later judicial review.

Choices Under BBA Audit Rules

How the BBA audit rules will affect a partnership and its partners will depend, in large part, on choices the partnership, the partnership representative, and the partners make or fail to make. Choosing not to address the BBA audit rules is in fact a choice to apply the default rule to adjusted items. This choice could lead, for example, to partnership-level taxation at the highest effective tax rate without reduction. The choices presented by the rules include: (1) electing into the BBA audit rules for tax years beginning after November 2, 2015, (2) electing out of the BBA audit rules if the partnership is eligible, (3) paying tax on the adjusted items at the partnership level (i.e., the default rule), (4) reducing the tax owed under the default rule by providing information about the partners’ tax attributes to the IRS, (5) reducing the tax owed under the default rule by causing affected partners to amend their own tax returns, and (6) avoiding the default rule by electing to “push out” the adjusted items to the persons who were partners in the reviewed year (i.e., the push-out election).

For partnerships subject to the BBA audit rules, the rules do not require partnerships to choose an approach to addressing the BBA audit rules until the partnership year under audit (i.e., the adjustment year, as discussed below). That timing permits the partnership representative, at its discretion or as guided by terms negotiated with partners, to weigh the relative benefits and disadvantages of the available alternatives at that time.

Electing Into BBA Audit Rules

For taxable years beginning after November 2, 2015, and before January 1, 2018, a partnership can elect into the BBA audit rules by providing a written statement to the IRS within thirty days of being notified, in writing, that a partnership return for an eligible taxable year has been selected for examination. Procedures are available if a partnership has not received a notice of selection for examination but wishes to file a request for administrative adjustment under the BBA rules.3

Election Out of BBA Audit Rules

A partnership that issues no more than 100 Schedule K-1s in a given tax year can elect out of the BBA audit rules for the tax year, provided that its partners are only individuals, C corporations, S corporations, estates of deceased partners, or foreign entities that would be C corporations if they were domestic (collectively, “permitted partners”). The election out of the BBA audit rules is made with a partnership return filed on time for each qualifying tax year. Electing out of the BBA audit rules may be a desirable option with respect to strategic and other corporate joint ventures consisting of a few corporate or individual partners. While electing out may be desirable, partners should consider that this might allow the IRS to delve into other partner-level items that are unrelated to the partnership.

The default rule: IRS examines, assesses, and collects tax at the partnership level

Under the default rule, the IRS examines a partnership’s items of income, gain, loss, deduction, or credit for a partnership year (the “reviewed year”). Adjusted items are netted, and the partnership must pay tax in the “adjustment year,” which generally is the year in which the IRS sends the notice of final partnership adjustment (or, in the case of an adjustment under judicial review, the year in which the court’s decision becomes final).

The tax is imposed on the net adjustment at the highest rate currently in effect for individuals or corporations. Partners in the adjustment year effectively will bear the tax costs resulting from adjustments to the reviewed year, even though those partners may not have been partners in the reviewed year. The statute refers to the partnership-level tax amount determined under the default rule as the “imputed underpayment.”

The manner in which the imputed underpayment is calculated and taken into account (and the approach taken with respect to overpayments) can result in an overall tax liability that materially differs from what would have resulted had the partnership properly included the adjusted items on its partnership tax return for the reviewed year (the “correct return position”).4 The imputed underpayment also does not automatically take into account other partner-level tax attributes and statuses, such the tax-exempt status of a partner, which could reduce the overall tax liability.

In short, the default rule can change the amount of tax and shift the economic burden of the tax to different partners. These problems may outweigh the convenience of the default rule, but circumstances may favor choosing the default rule. For example, it may be preferable when the imputed underpayment is relatively small or the partner group is relatively stable and the imputed underpayment does not materially differ from the tax calculated under the correct return position.

The default rule with adjustments to account for partner tax attributes

Under procedures to be established by the IRS, a partnership will be able to reduce the imputed underpayment under the default rule to the extent the partnership can demonstrate that an adjusted item is allocable to a partner that is tax exempt or a C corporation, or is a capital gain or qualified dividend income allocated to an individual.

The IRS also has the authority to consider other factors that would reduce the imputed underpayment. Therefore, partnerships may want to require direct and indirect partners to provide sufficient information necessary to take full advantage of any future guidance and to apportion the cost of failing to do so only to partners who refuse to supply such information.

The default rule with adjustments to account for amended partner returns

The payment due from a partnership under the default rule also can be reduced if one or more partners file amended returns for the year under examination, if the returns take into account all adjustments properly allocable to such partners, and if any tax due is paid with the amended return.

Partnerships seeking to benefit from this alternative should consider the practical implications. For example, convincing or contractually obligating direct and indirect partners to file amended returns and to satisfy any resulting tax liability may be a challenge. The 2016 Technical Corrections Bill proposes an alternative procedure (the “pull-in”) that allows partners to substantiate the tax that would be due if they file an amended return, pay the tax, and make adjustments to attributes for subsequent years without actually filing an amended return for the reviewed year.

Push-Out Election

As an alternative to having the partnership pay the imputed underpayment under the default rule, a partnership may elect to flow through or “push out” items adjusted at the partnership level to the persons who were partners in the reviewed year (the “push-out election”). The push-out election generally prevents adjustment-year partners from bearing tax liability for reviewed years unless they also were reviewed-year partners.

If a partnership makes the push-out election, the partnership will report the adjusted partnership items to the persons who were partners in the reviewed year, regardless of whether they remain partners in the adjustment year. The reviewed-year partners will calculate any additional tax due for the year under examination and the years from the year under examination to the year of the adjustment by reference to their individual tax attributes. Any additional tax must be reported and paid in the year the persons are notified by the partnership of the adjusted items. No amended returns are filed.

It is not clear whether adjustments pushed out by a lower-tier partnership can be pushed out by an upper-tier partnership. The BBA audit rules address only the statement to be provided to direct partners and do not address how an upper-tier partnership should treat any such statement. The 2016 Technical Corrections Bill proposes to require any upper-tier partnership that receives a push-out statement from a lower-tier partnership to file a “partnership adjustment tracking report” with the secretary, containing such information as the secretary may require (e.g., information about the partners of the upper-tier partnership), and either pay the imputed underpayment or provide push-out statements to its partners.

The push-out election mitigates potential distortions caused by the default rule by requiring the reviewed-year partners to bear the tax liability for the reviewed year and to determine tax liability by taking into account their actual tax attributes. The election, however, has a cost. The underpayment interest rate for the tax deficiency is increased by two percentage points. In addition, the reviewed-year partners will have to account for additional tax liability for the years between the reviewed year and the adjustment year that result from adjustments to tax attributes in the years that stem from the pushed-out items.

Consider Potential Amendments to Terms of Partnership Agreements

The threat of entity-level taxation and the possibility of increased IRS auditing should encourage partnerships and their partners to reconsider tax matters provisions in a partnership agreement. Tax matters provisions negotiated under the TEFRA rules may need to be reconsidered given the exclusive authority granted to the partnership representative, without any notice or participation rights given to other partners, under the BBA audit rules. At a minimum, existing partnership agreements should be amended to identify the partnership representative for taxable years beginning no later than January 1, 2018.

Partnerships and their partners will have to balance preserving discretion that frequently is afforded in tax matters to partners in current partnership agreements and more detailed rules that may be desired to address the new regime. Topics that may be desirable to address in partnership agreements are as follows.

Choosing How BBA Audit Rules Are Applied

Partners and partnership representatives may want to specify, in advance, the manner in which the BBA audit rules will be applied, the scope of discretion afforded the partnership representative, and participation and consent rights of the partners. For example, provisions might:

  • Address whether and when an eligible partnership elects out of the BBA audit rules and, in that event, establish ground rules for cooperation and information sharing between the partnership and its partners;
  • Require the default rule to be applied for imputed underpayments under a specified dollar amount and the push-out election to be made for imputed underpayments at or over that amount;
  • Address the level of diligence the partnership representative must exercise to identify partner tax attributes that can reduce an imputed underpayment;
  • Address whether and when partners are required to file amended returns and how compliance can be substantiated to effectively reduce an imputed underpayment;
  • Establish timing and diligence requirements for partners to respond to the partnership representative’s reasonable requests for information;
  • Assign responsibility for partners who fail to cooperate within agreed parameters; and
  • Preserve the ability to elect out of the BBA audit rules by restricting transfers of partnership interests to ineligible partners.

Funding and Allocating Partnership Tax Liability

Address the manner in which partnership tax liability under the default rule will be funded, and allocate that liability, by indemnification or otherwise, among the partners in various circumstances, including circumstances in which:

  • Some adjustment-year partners were not partners during the reviewed year;
  • Some but not all partners have tax attributes that reduce an imputed underpayment;
  • The partnership has insufficient assets to pay the tax (or, if additional contributions from the partners are anticipated, some partners have insufficient assets);
  • The partnership ceases to exist before partnership-level tax is due; and
  • The partnership tax liability is caused by one or more partners failing to file amended returns to account for adjusted partnership items or failing to pay the tax liability resulting from amended partner returns or a push-out election.

Consider extending any indemnification obligation to survive for a period of time (perhaps taking into account relevant statutes of limitation) after a partner retires from the partnership or sells its partnership interest.

Procedural Matters

Consider establishing qualifications for the partnership representative and terms for removal of, and resignation by, the partnership representative.

Address the obligations of the partnership representative and the partners (including indirect partners) to seek or provide partner tax attributes or other information that can reduce the partnership’s imputed underpayment under the default rule.

Address the obligations of former partners, the partnership representative, and partnerships to cooperate (e.g., by providing notice to partners and former partners at key stages of partnership proceedings, sharing information, filing amended returns, and accounting for pushed-out adjusted partnership items) with respect to reviewed years in which the former partners were partners.
Consider limiting the ability of the partnership representative to make relevant elections, to settle issues, or to have unfettered discretion in pursuing judicial review without partner participation.
Consider providing authority to amend the BBA audit rules provisions, and require the partnership representative and partners to cooperate in good faith when the IRS issues additional guidance or when Congress amends the BBA audit rules.

Address potential complications arising in tiered partnership structures.

Other Considerations

In addition to, or in lieu of, more detailed provisions, consider generally requiring the partnership representative and partners to take action (including accepting responsibility for their shares of tax liability) that would reach the correct return position to the extent possible. Consider also requiring the partnership representative to file an administrative adjustment request to pursue a material, aggregate reduction of the partners’ federal income taxes.

In anticipation of heightened IRS audit activity and the risk of partnership-level tax, partners may want to agree on some degree of diligence regarding material, uncertain partnership tax positions, including, for example, a minimum level of documentation or a minimal level of comfort (e.g., substantial authority, more likely than not).

Due Diligence When Entering or Exiting Partnerships

Participants in merger and acquisition (M&A) transactions and other acquirers of partnership interests should add to their due-diligence list the potential liability for prior-period income taxes and execute that review similarly to the manner in which prior-period taxes are scrutinized in corporate M&A transactions. Corporations are, and partnerships may be, exposed to uncertain, entity-level tax positions.

Issues for Buyers

The mere fact that a partnership representative is contractually obligated to make a push-out election (to avoid entity-level taxation) but fails to do so does not absolve the partnership from entity-level taxation under the default rule or the buyer from indirectly bearing a portion of the resulting tax. Even if a partnership representative makes the push-out election, tax distribution or similar provisions in a partnership agreement may cause buyers to indirectly bear a share of taxes for prior periods. In short, risks for prior-period liability, and the potential for partnership-level taxes, presumably will become a standard topic of negotiation between buyers and sellers of partnership interests.

A buyer also may want to review the partnership agreement to identify how the BBA audit rules will be applied, taking into account the various considerations outlined above and the practical impact they could have on the buyer. For example, if a partnership agreement requires partners to file amended separate returns to reduce an imputed underpayment, the buyer may want to internalize that risk before buying the partnership interest.

Issues for Sellers

A seller has similar concerns. In particular, for tax years beginning in 2018, a seller needs to understand who controls the push-out election for any year in which it was a partner. If a seller cannot prevent the partnership from making the push-out election for a reviewed year during which the seller was a partner, the seller may want to negotiate for notice and participation rights for those reviewed years.

Here are some special considerations.

Tax-exempt partners. Tax-exempt partners presumably want to be no worse off under the BBA audit rules than under the existing regime. They may want, for example, to require the partnership representative to make the push-out election for all material adjusted partnership items. For adjusted partnership items that are not pushed out, they may want to ensure they realize the benefit of any reduction in the imputed underpayment attributable to their tax-exempt status.

Potential increase in partnership audit activity and the economic and accounting impact of uncertain tax positions. Partnerships may want to reconsider uncertain tax positions taken in the past in light of the cash flow and potential accounting implications of entity-level taxation. Although the issue is not clear and will depend on the outcome of future legislative and administrative actions, partnerships subject to the BBA audit rules may need to consider tax accounting, including the accounting treatment of uncertainties. Some partnerships therefore may wish to revisit and document material tax positions in anticipation of possibly increased IRS audit activity.

State and local taxes. State and local income tax rules often, but not always, mirror federal income tax rules. Some states already have passed, or are considering, legislation to “piggyback” off the federal BBA audit rules. The Multistate Tax Commission has opened a project to address the conformity issues.

Conclusion: Waiting for Final Guidance May Not Be Best Option

As noted above, the government’s interpretation of the BBA audit rules and possibly even the statute itself could change significantly before the rules become mandatory. Nevertheless, informed partnerships, partners, future partnership representatives, and prudent advisors will not wait for the government and will start considering the risks and benefits associated with the BBA audit rules.

Todd McArthur is a principal and Mike Hauswirth is a director in PricewaterhouseCooper’s National Tax Services M&A Group. Adam Feuerstein is a principal at PwC and is PwC’s national real estate tax technical leader.


  1. Cf. Staff of the United States Government Accountability Office, Report to Congressional Requesters—LARGE PARTNERSHIPS—With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency (GAO-14-732, Sept. 2014).
  2. The Tax Technical Corrections Act of 2016, introduced on December 6, 2016, in the House of Representatives as HR 6439 and in the Senate as S 3506 (hereinafter the “2016 Technical Corrections Bill”), proposes extensive clarifications and technical corrections to the BBA audit rules.
  3. See T.D. 9780, 81 Fed. Reg. 51,795 (2016) (providing procedures and conditions for electing into the BBA audit rules).
  4. The correct return position concept was developed by the New York State Bar Association Tax Section in its Report on the Partnership Audit Rules of the Bipartisan Budget Act of 2015 to illustrate the BBA audit rules and their implications. See New York State Bar Association Tax Section, Report on the Partnership Audit Rules of the Bipartisan Budget Act of 2015 (May 25, 2016), available at 89-93 (advocating the correct return position to minimize distortions that can arise under the BBA audit rules).

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