FIRPTA Investors Face Important Choices Under New Partnership Tax Audit Rules
Beginning in tax year 2018, IRS partnership tax audit adjustments will be assessed at the partnership level, not the partner level, and the partnership will owe the tax, penalties and interest. This can result in an inequitable result in the typical FIRPTA blocker structure since the blocker corporation typically accumulates NOL carryforwards which could offset their share of an IRS audit adjustment. Fortunately, the IRS has issued favorable regulations to address this scenario. However, the rules are complex and must be implemented correctly to get the desired tax result.
Partnership Audits of Tax Years Predating 2018
Traditionally, the IRS generally has audited partnerships, not particular partners, under the so-called TEFRA rules, dating from 1982. But, over the years, the IRS has complained to Congress that the TEFRA rules haven’t worked well in part because the IRS, after auditing a partnership, then has had to try to collect resulting amounts due (“deficiencies”) from partners. Sometimes the partners from whom the IRS sought to collect have proven elusive.
Partnership Audits Starting Tax Years 2018
In 2015, Congress responded to the IRS by adding to the tax law a new Centralized Partnership Audit Regime, replacing the TEFRA rules. Subject to exceptions we’ll explain, the new regime basically transfers from the IRS to partnerships themselves the responsibility to collect amounts due the IRS resulting from an audit.
Under these new rules, the IRS generally will continue to audit at the partnership level. Unless a partnership can and does elect another approach, the partnership itself must pay the IRS any resulting deficiency plus interest and any penalties. The partnership and its partners then must decide how the partners will bear the economic burden of the partnership’s having paid the IRS.
Under this new regime, a “partnership representative” rather than the traditional “tax matters partner” controls the IRS audit. A partnership representative can be but need not be a partner and has more authority than a tax matters partner.
These new partnership audit rules generally apply to partnership tax years beginning after December 31, 2017. For example, the IRS will audit calendar-year partnerships under the new regime starting as soon as 2018 tax years.
Some states may follow these new federal tax audit rules. However, many issues at the state level remain unresolved.
Example of How New General Audit Rule Can Affect a FIRPTA Partnership Owning USRPIs
Assume that a partnership (“Property LLC”) directly owns United States Real Property Interests “USRPIs.” The members of Property LLC consist solely of three Blocker Corps. The Blocker Corps directly own their interests in the Property LLC and are subject to federal income tax at 21% of taxable income. (Typically, Blocker Corps own their interests in Property LLC through intervening entities such upper tier LLCs. We’ll address those more complicated scenarios later.)
The IRS audits the Property LLC. It determines that the Property LLC understated rents, capital gain, or some other income. The IRS asserts a deficiency (tax on the understated income).
Under the new general rule, the Property LLC must pay the IRS tax on the understated income, interest, and any penalties. The additional tax due equals 21% of the underpayment, the highest stated Federal tax rate to which the partners (the Blocker Corps) are subject.
Alternatives to Partnership’s Paying the IRS Under General Rule
Partnerships should consider two possible alternatives to the general rule of the partnership’s paying the IRS. First, some partnerships can “elect out” of the new audit rules. Second (alternatively), a partnership instead of itself paying the IRS can elect to “push out” audit adjustments to its partners who themselves then settle up with the IRS. Let’s consider each of these opportunities.
Opportunity No. 1: Partnership Elects Out of General Rule
If a partnership qualifies to elect out of the new Centralized Partnership Audit Regime and successfully elects out on a timely filed tax return, the IRS cannot audit the partnership itself. Instead, it must audit each partner individually. Assume that in the preceding example the Property LLC elects out. The IRS then must audit each of the Blocker Corps individually and collect from each of them separately tax (plus penalties and interest) on their shares of the Property LLC’s audit adjustments.
Not all partnerships, however, may elect out of the new rules. The partnership must have no more than 100 partners. That threshold sounds like it covers many partnerships. However, the partners can consist only of particular types of persons. Each partner must be an individual, a corporation (including a Blocker Corp), and limited other special kinds of partners.
In the preceding example, Property LLC has only three partners, and its partners consist solely of corporations (three Blocker Corps). Consequently, Property LLC could elect out of the new rules. In that instance, the Blocker Corps could offset their share of an audit adjustment with their NOL carryforward and other current year deductions.
In that simple example, the Blocker Corps directly own the Property LLC. Typically, however, Blocker Corps own their interests in USRPIs indirectly through tiers of partnerships; the bottom tier, Property LLC, directly owns the USRPIs.
In that typical tiered structure, a Property LLC having other partnerships as partners cannot elect out. For example, a Property LLC may have two partners: an upper tier LLC of equity investors, and another upper tier LLC of individuals who have received carried interests in the deal for performing services. In this situation, the Property LLC cannot elect out of the partnership audit rules.
Opportunity No. 2: Partnership Elects to Push Out Audit Adjustments to Partners
Instead of itself paying an audit deficiency, an audited partnership may elect with the IRS to “push out” audit adjustments to partners. Electing push out may reduce the tax assessment of an audit if:
- the partnership cannot elect out or has not elected out;
- the partners (including Blocker Corps) have favorable unused tax attributes; and
- those partner tax attributes could offset their shares of audit adjustments.
If a partnership elects to push out, then the partnership itself does not pay the IRS. Instead, the partners on their own tax returns take into account their shares of the adjustments the IRS has asserted in auditing the partnership.
Pushout may help when partners can offset their own tax attributes against partnership audit adjustments. Blocker Corps generally do not generate much taxable income until the year the property is sold by the LLC. Until then, they tend to generate tax losses not usable (if at all) until a Blocker Corp has taxable gain or other income.
Assume, for example, that the IRS audits Property LLC and determines the partnership understated its income. Assume also that indirect partners (Blocker Corps) have unused net operating losses (“NOLs”). If Property LLC and any upper-tier partnerships elect to pushout audit adjustments to partners, then the Blocker Corps on their own tax returns can offset their shares of Property LLC’s understated income with their NOLs. The Blocker Corps in the aggregate may pay the IRS less compared to the partnership’s paying the IRS under the general rule. If there is a significant audit adjustment in the year of the sale, the partnership would pay significant taxes. However, if the blocker has NOLs to offset most or all of the adjustment, significant taxes could be avoided by a push out election. For example, if the adjustment is $10 million at the partnership level and no push election is made, the partnership would pay $2.1 of Federal tax, plus interest and penalties. Assume the blocker corporation has a 50% interest in the partnership, no taxable income for the year, and has an NOL carryforward of $15 million. Without a pushout election, it’s share of the partnership level tax would be $1.05 million ($2.1 x 50%). With a push out election, it would be allocated $5.0 million of taxable income from the audit adjustment. Under the TCJA, the blocker corporation can offset 80% of its current year taxable income with an NOL carryforward, or $4 million ($5 million x 80%) in the example. Thus, under the push out election only $1.0 million of the increase in income would be taxable resulting in a tax of $210,000. In this example, the push out election reduced the blocker’s tax by $840,000 million, plus interest and penalties.
If a partnership is audited, then it can wait until it receives the final adjustments before deciding whether to elect to push the adjustments out to the partners. However, the partnership must elect to push out audit adjustments within 45 days of receiving the IRS’s final partnership audit report. If the case goes to US Tax Court and the taxpayer loses, they have 60 days to elect to push out.
When Blocker Corps own USRPIs through tiers of entities, each partnership in the tiered structure must elect to push adjustments to the next tier. The top tier must elect to push out the adjustments to its direct partners including Blocker Corps.
To elect pushout, a partnership must satisfy various procedural requirements. Each partnership must file an election statement with the IRS and notify the partners that the partnership has elected push out. The partnership also must issue each direct partner an amended Schedule K-1. Finally, each electing partnership must provide its partners various information which the partnership also must send the IRS.
The direct partners must amend their own income tax returns for the partnership tax year audited. They must take into account their shares of the audit adjustments the partnership has pushed out to each of them.
A partnership that validly elects to push out adjustments to its partners is not itself liable for any deficiencies. The IRS legally cannot try to collect the deficiency, penalties, or interest from the partnership itself. Instead, each partner of an electing partnership is liable for the partner’s share of the deficiency, penalties, and interest. The IRS must collect that share from each partner. Partners do not have “joint and several” liability; the IRS legally cannot try to collect a non-paying partner’s share from any other partner.
An upper tier partnership that does not make the push out election must pay the tax and interest. Thus, it is crucial in a blocker structure with a NOL carryforward that the push out election is made on a timely basis.
If an IRS adjustment is immaterial, the push out election will be an administrative burden. This burden would outweigh the cost of the partnership paying the tax.
Other Points to Consider
Funds should insist that LLC operating agreements or partnership agreements of entities in which the Fund directly or indirectly has invested adequately address the consequences of the IRS’s auditing the entity. An agreement should designate the partnership representative. It also should address whether the partnership will elect out of the new rules if eligible or, alternatively, explain how the partnership will decide whether to elect out. An agreement should address whether the partnership will elect to push out audit adjustments to partners or at least explain how the partnership will decide whether to elect push out.
Underpayments of tax bear a higher interest rate if a partnership elects to push out audit adjustments compared to the partnership itself satisfying them under the general rule. The interest rate at the partner level is 2% higher than at the partnership level. However, other tax benefits of pushing out adjustments may more than offset this disadvantage.
A partnership’s electing push out does not solve inequities that can occur when partners have changed between an audited year and the year in which the IRS asserts adjustments. Under either the general rule or push out, recently joining partners may end up bearing audit adjustments from years before they were partners or years before their partnership interests increased. Lenders also do not want to be subordinated to the IRS if the LLC owes taxes under the new audit rules. The loan agreement may require the LLC to elect out or push out to avoid this issue. However, operating or partnership agreements can address these situations. For example, audit-year partners can agree to indemnify adjustment-year partners for the audit-year partners’ shares of tax deficiencies (the financial burdens the audit-year partners effectively would have borne had they stayed in the partnership). Accordingly it is important to have your attorney review you operating agreement to ensure that appropriate language is added to take into account the new rules under the new partnership audit rules.