Page 2 - Partnership Audit Rules - Drafting Partnership Agreements: The New Partnership Representative And The Outgoing Tax Matters Partner

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ners, the IRS would have to audit each of the eight individual partners separately to collect the aggregate deficiency in income tax. Of course, it did not legally have to audit all eight.
Where one of the partners, for ex- ample, was a pass-through entity, the audit would ultimately have to focus on the individual partners or partner-taxpayers directly subject to reporting and payment of federal in- come tax. Where the partners re- sided in different geographical areas and therefore resided in different venues for determining governing precedent, inconsistent treatment of the same item was always more than simply a theoretical possibility.
As a matter of effective tax ad- ministration, the individual audit ap- proach handicapped the Service from effectively auditing partner- ships. The tax administration diffi- culties were compounded by an awareness on the part of the Service that the hybrid tax system under Subchapter K was being exploited by tax shelter promoters who pro- duced and marketed tax shelter part- nerships designed to generate tax savings for investors at a multiple over invested cash or cash at-risk. Right offs at ten to one or more in non-credit deals and five to one or more in tax credit deals were com- monly being “pushed” to high-end individuals realizing large gains or having high levels of taxable in- come. The promotion of these abu- sive tax shelters through partner- ships to individuals reached their peak during the 1970s and early 1980s. Since this activity occurred prior to the adoption of the TEFRA entity-level audit rules in 1982, the IRS was forced to search out each partner and make timely tax assess- ments (or proposed assessments) on an individual basis. In many cases, the Service may have been unable to timely issue notices of deficiency.
60D*points, Next 120D, Vjust J2:1
Moreover, where audits were con- currently conducted in different ju- risdictions or IRS districts, there was always the chance that the audit results, settlements, and litigation outcomes would not be consistent among the partners. The potential for inconsistent outcomes increased substantially where the tax shelter promotion involved many individual investors, or was warehoused in large investment partnerships, mak- ing the audit under pre-TEFRA rules a challenging, uphill climb for the government. In fact, since many partners challenged the proposed as- sessments that were timely issued, abusive tax shelter partnership liti- gation clogged the dockets of the Tax Court and posed numerous bur- dens and challenges for the Service and its lawyers. The IRS Chief Counsel’s Office would invariably attempt to pick a “lead” case, e.g., the earliest filed case, and require other investors filing a petition with the Tax Court to agree to be bound by its outcome.
The TEFRA partnership entity- level audit rules were designed to alleviate the costs associated with multiple audits involving a single partnership or tiered partnerships and to achieve uniformity of out- come for partnership-level items through a single unified procedure. As set forth in Sections 6221 through 6234, the TEFRA entity- level audit rules provided a separate framework for conducting the audit, administrative appeal, and tax litiga- tion of a TEFRA partnership, in- cluding claims for refund and re- fund suits. The entities subject to the TEFRA audit rules include: (1) any partnership, including a foreign partnership, as defined in Section 761(a), and which is required to file a partnership return under Section 6031; and (2) all other entities that file a partnership tax return and meet the definition of a partnership
in Section 6231(a)(1)(A) . It is therefore important to identify whether the relationship between the parties to an economic undertaking is a “partnership” so that the TEFRA audit rules generally will apply.
Eligible Small Partnerships Not Subject to TEFRA Entity-Level Audits
Under the TEFRA rules, Section 6231(a)(1)(B) provides that a part- nership having ten or fewer part- ners, each of whom is an individual (other than a nonresident alien), a C corporation, or an estate of a de- ceased partner is not subject to the entity-level audit rules No election is required to be filed to qualify under the “small partnership” excep- tion. Alternatively, a partnership may “opt-in” or otherwise meet the definition of a partnership subject to TEFRA under Section 6231(a) by filing an election statement (or Form 8893) with the partnership re- turn signed by all persons who are partners during the partnership tax year. Once this opt-in election is made, it is permanent unless re- voked with the consent of the IRS.
No pass-through entity may qual- ify to be a partner under the elec- tion out. The small partnership ex- ception is not available where at least one of the ten partners is a ju- ridical body, such as a limited lia- bility company or corporation. Thus, having a single member LLC own- ing a partnership interest would eliminate the partnership from quali- fying for the small partnership (election out) exception. The same result applies where a qualified Sub- chapter S subsidiary owns a partner- ship interest or a partner is organ- ized as a grantor trust. Such outcomes pose a danger for the partner who is not aware that the tax matters partner will have sub- stantial control and authority of in-
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Corporate Taxation