The Bipartisan Budget Act of 2015 (the Act) modified the partnership* audit rules, which affects private equity funds and their portfolio companies taxed as flow-through partnerships. These new rules are effective for tax years beginning on or after January 1, 2018, and are intended to allow the IRS to more easily audit and assess taxes against large entities taxed as partnerships. Therefore, an increase in partnership audits is expected.
While this article doesn’t cover the intricacy of the new audit procedures, it does contain a brief overview of how they affect mergers and acquisitions (M&A). The most significant effects are to make the partnership responsible for the federal income taxes resulting from audit adjustments and designate the partnership representative as the sole authority to act on the partnership’s behalf with the IRS. Unless an alternative procedure is elected, the partnership’s liability for federal income taxes may shift the burden to taxpayers who didn’t receive the benefit of the deductions.
The new default procedures mean the buyer of a partnership interest indirectly assumes any pre-acquisition income tax liabilities that may arise during an audit with respect to that interest.
This change will complicate the sale of partnership equity in several ways. The buyer likely will need to conduct more due diligence on the partnership’s income tax reporting. Negotiating the contract provisions governing each party’s rights and obligations in the event of an audit also will become more complicated. Buyers and sellers may want to investigate whether the partnership can choose to elect the alternative procedures and their rights to participate in the audit proceedings.
The Act states that where the partnership ceases to exist, responsibility for audit adjustments reverts to the former partners. Recently proposed IRS regulations make it clear a technical termination doesn’t constitute a partnership ceasing to exist; however, when a partnership becomes a disregarded entity and continues to exist for state law purposes, it does cease to exist under the partnership audit rules.
The proposed regulations offer additional guidance on the new audit procedures, but significant questions that affect M&A remain. Tiered partnerships still have no clarity on whether they’ll have any options for electing out of the default procedures. Foreign partners await clarity on the effect of certain elections.
Although the IRS won’t conduct audits under these new procedures for a few years, partnerships should start planning now. All partnerships should consider amending their partnership agreements to address these new rules. Check out our November BKD Thoughtware® article for a list of questions to consider when amending your agreement in light of these new rules. Entities involved in M&A using partnerships also should consider updating their due diligence procedures as successor liability is now a consideration.
*In this article, the term “partnership” includes all entities taxed as a partnership, including a limited liability company. The term “partner” includes all partners/members of such an entity.