Complex Partnerships Under New Review

by Edward R. Jenkins Jr., CPA, CGMA | Nov 30, 2017
Pennsylvania CPA Journal
The Bipartisan Budget Act of 2015 (BBA) was passed Nov. 2, 2015. It was then modified by the Protecting Americans from Tax Hikes Act on Dec. 18, 2015. Those new laws substantially changed how partnerships will be audited by the IRS. The statutes will take effect in a few weeks, on Jan. 1, 2018. This article explains why Congress made the changes and what the changes to the audit regime are; identifies some traps in the new rules; and provides you with tips for compliance. 

The Rationale
A September 2014 U.S. Government Accountability Office (GAO) Report to Congressional Requesters (GAO-14-732) provided Congress with some raw data and trends regarding partnerships. That report indicated that the number of large partnerships – those with 100 or more direct or indirect partners and more than $100 million in assets – grew by 257 percent in the 10 years from 2002 to 2011. Part of that rapid growth was due to the Sarbanes-Oxley Act significantly increasing the cost of being a C corporation. Another driver of the proliferation has been the settling of limited liability company (LLC) law throughout the states: with the use of the LLC for limiting owners’ liability and the ability to be taxed as a partnership/pass-through entity, the LLC has become the business entity of choice. 

During this time, a disintermediation of sorts was occurring. Institutional investors’ influence in the stock market grew, initial public offerings slowed to a drip, the Federal Reserve Board’s managed interest rate environment (a discount rate at nearly 0 percent in December 2008 and the purchase of over $4.5 trillion worth of collateralized mortgage obligation and U.S. government debt known as quantitative easing) created essentially no yield on debt instruments, and piles of available cash that pushed stocks to overvalued highs all influenced a fleeing of capital to private equity and hedge funds. So, there was a substantial growth in the number of partnerships that have a lot of assets, and those partnerships often had tiers of ownership. 

That level of complexity made audits of partnerships exceedingly difficult. Under the 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) rules, elements of partnership income were determined at the partnership level, but adjustments/assessments occur at the individual partner level. The tracking of capital accounts, partner allocations, and partnership basis has become incredibly complex. The IRS didn’t have the capacity to locate, chase down, and collect from all of the direct and indirect partners.

This was the general rationale for why a change was perceived as necessary. Essentially, the new laws are intended to streamline the audits of complex partnerships.

Changes and Considerations

Here are eight considerations that arise from the mind-numbing complexity of the new audit rules.
Let Me Level with You – The BBA throws out the TEFRA partnership audit rules. Now, the IRS will conduct an audit of a partnership and assess tax at the partnership level (not the individual partners anymore), pursuant to IRC Section 6221, at the highest partner tax rate. So, if the partner is an individual, that tax rate is 39.6 percent at the moment. The rate could be 35 percent for a corporate partner. Under the new rules, the partnership has to pay that tax instead of the partners. Even worse, the partners lose the ability to contest the adjustment as IRC Section 6222 requires partners to follow the partnership tax treatment of an item of income or expense.

Partner Disconnect – A second big issue is the fact that the partners who now bear the burden of the audit adjustment in the year the audit is finalized (adjustment year) may be different from the partners who owned the partnership and paid tax on the income in the year under audit (reviewed year). 

The Opt-Out – The composition of the partners may be important because small partnerships, those who issue fewer than 100 Form 1065 Schedules K-1, have the opportunity to elect out of the new IRS audit treatment. Care must be exercised in counting K-1s. For instance, if a Subchapter S corporation is a partner, you must count the S corporation plus all of its shareholders in that K-1 count. The caveat is all of the partners must be “eligible” partners for every day of the tax year in which the partnership wants to opt out. Other partnerships and most trusts are ineligible partners for the opt-out provision. 

The Push-Out – There is a provision to avoid the highest tax rate assessment under IRC Section 6226. The new statutes create an election to “push out” the audit adjustments to the review year partners instead of the adjustment year partners. That irrevocable election is due within 45 days of the final partnership adjustment report from the IRS. That push-out will avoid the highest-rate tax treatment, but will incur a higher interest rate calculation in determining the amount of interest on adjustments. Again, the partnership agreements should reflect selected governance for that election, and appropriate internal controls must be in place for tracking partners’ whereabouts, capital accounts, basis, and so on.

The Partnership Representative – There is a new partnership responsibility created under BBA called the partnership representative (PR). The PR has the authority to bind all of the partners with respect to the elections and conduct of the audit. The PR replaces what used to be a “Tax Matters Partner.” The PR must have substantial presence in the United States, and the PR has sole authority to act on behalf of the partners pursuant to IRC Section 6223.

Regulation – The regulations needed to implement BBA were on hold for some time. The Trump administration froze issuance of new government regulations in January 2017, so the partnership regulations were in limbo until they were published in the Federal Register this summer. The proposed regulations were issued in June, with comments due in August. PICPA’s Federal Tax Committee was on top of the deadline, and the PICPA did submit a comment letter that raised concern over several issues. The AICPA is advocating a delay in implementation of the regulations, but Congress would have to change the statute to delay the effective date. Treasury is now revising the regulations.

Accounting Standards Codification (ASC) 740 for Partnerships – ASC 740 may require partnerships to accrue taxes for financial reporting purposes. Doing tax provisions on partnerships hasn’t been an issue because taxes were always paid by the individual partners in the past. Under the new audit rules, partnerships have to pay the tax. Absent the ability to use opt-out or push-out elections, tax will be imposed at the partnership level. Check out examples 35 and 36 from ASC 740-55-226 and ASC 740-55-227 for how ASC 740 works in this circumstance.

State Conformity – Kudos to the Multistate Tax Commission! It has been diligent in its work to guide member states into adopting conforming state statutes. They have done a great job analyzing partnership filing data and state-by-state impacts. Check out the April 5, 2017, Partnership Work Group Staff Report that is available at The report does a fantastic job at spotting the state conformity issues. You can also see their recommendations for model state legislation. 

The AICPA issued a paper regarding state conformity that is available as well. The PICPA has been active in providing input to the state, but at this point the conformity issues likely require the Pennsylvania General Assembly to change state statutes. 

Big changes are coming very soon for partnerships and LLCs taxed as partnerships. Here are a few tips to consider now if you haven’t already done so.
  • Some partnerships may wish to restructure their ownership to be eligible to elect the opt-out each year.
  • Partnership agreements will need to address how the partners’ capital accounts, basis in the partnership interest, and potential basis in debt will be calculated.
  • Partnership agreements will need to address how former partners will indemnify future partners with respect to both positive and negative tax adjustments. Restorations of basis in the partnership interest can also be affected. Those calculations will likely be affected by new proposed regulations that address the allocation of partnership liabilities that were issued on Oct. 4, 2016.
  • Partnership agreements will need to be updated to reflect the new role of the PR and to establish governance/internal controls over the conduct of the PR. 
  • Conflicts of interest may arise from the choice of the PR, and the partnership agreement should reflect how those conflicts are expected to be resolved. 
  • Individuals considering fulfilling the responsibility of the PR may want some type of indemnification from the partnership for all acts completed in good faith in fulfilling the PR responsibilities on behalf of the partners and partnership. Some PRs and partnerships may want insurance coverage to fund those indemnifications.
You will definitely need to update your partnership agreements, so now is the time to get to work! You don’t want to get caught without your partnership or LLC Member Operating agreement (partnership agreements) and legal/tax structure up to date.

Edward R. Jenkins Jr., CPA, CGMA, is an instructor of accounting at Pennsylvania State University in University Park, a tax consultant for Boyer & Ritter LLC in State College, and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at
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