For decades, a bedrock principle of federal income taxation has been that partnerships are not subject to federal income tax on current income. Instead, a partnership’s current income flows through to its owners and those respective entities are taxed. Further, even if the Internal Revenue Service (IRS) later audits a partnership’s tax return, the IRS typically cannot hold the partnership itself liable for the payment of any additional tax liability.
On November 2, 2015, Congress enacted legislation that fundamentally changes this landscape.
With the enactment of the Bipartisan Budget Act of 2015, the IRS will be able to impose liability at the partnership level if it determines, after an audit, that tax was paid on too little income—unless the partnership is eligible to elect, and properly elects, to be subject to a different set of rules. As a result, an understatement of previous partnership income ultimately could burden the partnership’s assets and current owners.
Although the new partnership audit rules won’t apply for a few years (unless a partnership elects to apply them earlier), partnerships and their creditors are currently evaluating whether they should change legal agreements in anticipation of the new rules. How a partnership responds could affect issues of critical importance to companies that own interests in partnerships, are considering investing in partnerships, or lend to partnerships. And the directors of these companies will need to be aware of how a partnership’s response to the new law may affect their company’s’ potential liability exposure. For example:
A partnership’s decisions with regard to the new law can affect which partners will bear the burden if the IRS determines income was understated in an audited year—current partners or only partners from the audited year. If a company decides to invest in a partnership, it could, in some circumstances, end up bearing the burden of a liability that stems from partners in previous years not having paid tax on the “right” amount of income. As a result, the company may want to consider what additional “due diligence” measures should be required when evaluating acquisitions of partnership interests.
In addition, a partnership’s assets could be at risk in cases in which the IRS assesses a partnership-level tax. Thus, companies that own interests in or lend to partnerships will need to evaluate how the new rules will apply to the particular partnerships to determine to what extent the values of their investments or security interests could be diminished.
More generally, directors of companies that own partnership interests, are considering acquiring partnership interests or lend to partnerships may need to ensure that adequate procedures are in place to evaluate and mitigate risks associated with the new regime.
The new partnership audit rules are extremely complex and there are many significant, unanswered questions regarding how the rules will apply. Congress has already enacted one round of clarifications, and it’s possible that other changes will be made to the rules before the law becomes widely applicable.
Watch for administrative guidance to be issued in the coming years that will affect due diligence, risk management, creditor and investment relationships, and other significant issues associated with partnership investments. Directors of companies that own interests in or lend to partnerships may want to start thinking now about how to manage risks posed by the new law and should stay tuned for further developments.
Carol Kulish Harvey, Deborah Fields, and Harve Lewis in KPMG's Washington National Tax office contributed to this Board Perspective.