Hedge fund managers and those involved with private equity investment should take note of the new partnership audit rules which were enacted as part of the Bipartisan Budget Act of 2015. It is anticipated that the new audit rules will likely have a large impact on investment partnerships, including hedge funds, private equity funds and other private investment vehicles.
One of the considerations driving the rule changes is the Internal Revenue Service’s desire to make it easier for the agency to audit hedge funds and private equity funds. Ultimately, the changes put into place should enable the IRS to collect more money. Currently, only about one percent of large partnerships are audited by the IRS. The new rules, which are effective for taxable years beginning after December 31, 2017, are anticipated to generate over $10 billion over the next 10 years for the government.
What’s Changing and Who will it Impact?
When it comes to IRS audits of hedge funds and private equity funds, the rules historically have been difficult to apply. The collection of taxes as a result of the audits has been a challenge as well. The new law repeals the partnership audit rules of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the electing large partnership rules.
TEFRA generally applies to partnerships with 10 or more partners or any size partnership with one or more partners that are pass-through entities. Under the current TEFRA rules, the IRS conducts a single administrative proceeding to resolve audit issues regarding partnership items – issues that are more appropriately determined at the partnership level rather than the partner level. After the audit is completed and resulting adjustments are determined, the IRS recalculates the tax liability partner by partner for the particular audit year. Because tax is ultimately collected and assessed from each partner, the TEFRA rules have made it administratively quite difficult for the IRS to actually audit partnerships and then collect additional taxes resulting from audit adjustments.
Simplified audit procedures currently apply to large partnerships with 100 or more partners who elect to be treated as “electing large partnerships” for reporting and audit purposes. In reality, few funds have elected to be subject to the electing large partnership rules. The majority of hedge funds and private equity funds currently are subject to the TEFRA rules.
Under the new act, the partnership itself will be liable for any additional tax imposed as a result of a partnership audit adjustment. The new rules are designed to shift the administrative burden of audits to the partnership, at the entity level, and away from each partner.
Under this new streamlined audit approach, any adjustment to items of income, gain, loss, deduction or credit of a partnership for a partnership tax year (and any partner’s distributive share of such adjustment) is determined at the partnership level. Similarly, any tax attributable to such adjustment is assessed and collected from the partnership. In addition, the applicability of any penalty, addition to tax or additional amount that relates to an adjustment to any such item or share is determined at the partnership level. This change is expected to make it easier for the IRS to audit large funds and actually collect additional taxes.
The IRS will examine the partnership’s items of income, gain, loss, deduction or credit and partners’ distributive shares for a particular year of the partnership termed the “reviewed year.” Furthermore, any adjustments will be taken into account by the partnership in the “adjustment year,” and not the year to which the adjustments relate. This means that current investors could be allocated expense for taxes that relate to previous years — whether or not the current investor was a partner in the partnership during the year to which the adjustment pertains.
Partnerships must pay tax equal to the “imputed underpayment,” which generally is the net of all adjustments for any reviewed year multiplied by the highest individual or corporate tax rate. The tax is included on the partnership’s tax return for the adjustment year.
The imputed underpayment may be lowered if the partnership demonstrates the following:
- The income is allocable to foreign persons and tax-exempt persons.
- A lower rate should apply because one or more partners is a C-Corporation, or because the adjustment is made to a qualified dividend or a long-term capital gain.
- The partners file amended tax returns for the reviewed year, reflecting the pass-through of the adjusted items. (They would also file amended tax returns for later years, reflecting adjustments to tax attributes for years after the reviewed year).
Any items required to be submitted to the IRS with respect to decreased imputed underpayments must be submitted no later than 270 days after the partnership’s receipt of the notice of a proposed partnership assessment.
Opt-out Election for Small Partnerships
Partnerships with 100 or fewer partners can elect out of the new audit rules only if the partners are all individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic, S corporations, or estates of deceased partners. If any of the partners is another partnership or a trust, the partnership cannot elect out. This eliminates tiered funds and master funds from being able to make the opt-out election. Furthermore, if the partner is an S corporation, each of the S corporation’s shareholders is treated as a partner for purposes of determining whether the partnership has 100 or fewer partners. In reality, the majority of hedge funds will not meet these criteria.
Even if the criteria for electing out of the new audit rules is met, additional administrative burdens exist and include the following:
- The partnership must elect to opt-out on its return each year.
- The partnership must inform each of its partners of the election.
- The partnership must provide the names and tax ID numbers of each of its partners, including S corporation shareholders treated as partners for purposes of the 100 or fewer partners test.
Alternative Elections for Large Partnerships
For large partnerships that cannot elect out because they have more than 100 partners, or for those with disqualifying partners, an alternative to the default rule exists. As an alternative to taking the adjustment into account at the partnership level, new IRC Section 6226 allows a partnership to make an election (within 45 days after a notice of final partnership adjustment) to issue adjusted information returns to the reviewed-year partners, reflecting the distributive share of partnership items as adjusted by the IRS. If this election is made, the partners take the adjustment into account on their individual returns in the adjustment year through a simplified amended-return process. Under the Section 6226 election, the partnership must issue a statement of the partners’ share of adjustment to income, gain, loss, deduction or credit (i.e. an adjusted Schedule K-1) to the IRS and to each partner of the audited year (or partnership taxable year that is under audit, to which the item being adjusted relates). Each of these partners, in turn, is required to pay the adjusted tax with their current return (determined by the calendar year the adjusted K-1 is issued). The election must be made in the time and manner prescribed by the IRS, and once made, it can be revoked only with the IRS’s consent.
Under this election, the responsibility is on the partnership to identify and to ensure that each partner of the audited year pays the tax underpayment. The adjusted Schedule K-1 is included with each partner’s return for the year it is issued and not for the audited year.
Preparing for and Communicating the Upcoming Changes to Investors
A number of changes will need to be made to fund documents as a result of the new audit rules. Partnership operating agreements will need to be amended to designate a “partnership representative,” instead of a “tax matters partner.” The partnership representative has the sole authority to act on behalf of the partnership in an examination, and decisions made by the partnership representative are binding on the partnership and all of its partners. The partnership representative does not have to be a partner in the fund. The partnership representative can be any person who has a “substantial presence in the U.S.” If a partnership fails to designate a representative, the IRS may select any person as the partnership representative.
Even though the new rules are not effective until the 2018 tax year, there are several considerations that funds should take now in preparation to ensure the appropriate actions are taken and to disclose the potential impact to investors.
Partnership agreements will need to include the following:
- Address what kind of notice and inspection rights partners will reserve.
- Specify rules for electing a partner level assessment.
- Designate the Partnership Representative.
- Include tax-sharing provisions which set forth how taxes or adjustments are shared or are to be allocated among the partners.
Any fund which has investors whose interests will (or could) change over time should consider adding indemnification provisions regarding taxes paid. In addition, offering memorandums will also need to be updated to disclose the new audit rules and their impact.
Further guidance is expected from the IRS, but the rule changes will likely impact other areas including the following:
- Allocation adjustments between partners
- Amended return mechanism
- Passthrough election
- Tiered structure
- Tax liability for new or exiting members in the fund
We Can Help
Time will tell whether the new partnership audit rules will accomplish the goals that the IRS hopes. Significant guidance is expected to be issued before the new audit rules become effective so it is possible that the rules will be changed and/or that technical corrections will be enacted to revise the new rules. Partnerships should start planning early and consult with attorneys and tax advisors to ensure their interests are protected. Elliott Davis Decosimo’s tax team is following these changes closely, and we can help you address the issues generated by the new rules. Contact your Elliott Davis Decosimo tax advisor or a member of our Investment Companies practice at firstname.lastname@example.org.