Page 4 - Partnership Audit Rules - Drafting Partnership Agreements: The New Partnership Representative And The Outgoing Tax Matters Partner

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fected items” by executing a part- nership-level extension agreement, which is effective for all partners even if the partners do not individu- ally agree to an extension for their individual tax return year(s).5 Still, the partners have their separate stat- ute of limitations for assessment purposes. The tax matters partner may also select the forum for litiga- tion of partnership items.6
These ten essential characteristics of TEFRA partnership audits have been replaced by the centralized au- dit rules. One remarkable difference is that the partnership may be sub- ject to pay federal income tax, pen- alties, and interest on partner-level taxes attributable to adjustments to taxable income or loss from a prior year. Another major change is that only the partnership representative, who replaces the tax matters part- ner, has sole and exclusive authority to settle tax issues on behalf of the partnership with the IRS. There is no notice partner idea and no right of a partner to intervene. That is why it will be critically important for partnership agreements to “reign in” to the extent possible, the pow- ers and authority of the partnership representative.
Calls for Reforms or Repeal of the TEFRA Rules
As previously discussed, the TEFRA entity-level audit rules were originally adopted in response to the increasing number of tax shelter syndicators who were marketing tax shelter transactions, which in many cases were abusive and offered or presented to high-income individu- als in an effort to eliminate and/or defer an anticipated tax gain or one that was already realized earlier in the same tax year. The inherent characteristics of such shelters were low cash payments in relation to tax
5 See Section 6229(b)(1)(B).
98D*points, Next 830D, Vjust JC2:1
savings generated from leveraged transactions. Many of the deals did not have economic substance with- out taking tax savings into account and promoters used inflated values that taxpayers-investors used to claim cost recovery expensing and tax credit amounts. The Service wanted to audit such tax shelters in a single proceeding that would bind all affected partners.
Over thirty years have passed since the TEFRA entity-level audit rules were enacted, it has been re- ported that a large segment of the tax shelter industry directed toward eliminating and/or deferring large taxable gains or income of individu- als has “retired.” Still, the corporate tax shelter phenomenon got into full swing with the use of “basis plays” and “foreign tax credit splitting techniques” and other tax-avoidance transactions from the mid-1990s for a ten-year or more period. Most of the strategies involved the use of partnerships, such as in “Son of Boss” promotions, which necessa- rily involved the application of the partnership audit rules. This is at- tributable to the flexibility afforded
example, IRS auditors have said that it can sometimes take months to identify the partner that represents the partnership in the audit, reduc- ing time available to conduct the audit. TEFRA does not require large partnerships to identify this partner on tax returns.
Also under TEFRA, unless the partnership elects to be taxed at the entity-level (which few do), the IRS must pass audit adjustments through to the ultimate partners. IRS offi- cials have stated that the process of determining each partner’s share of the adjustment is paper and labor intensive. When hundreds of part- ners’ returns have to be adjusted, such as for investors in hedge funds or private equity funds, i.e., so called “large partnerships,” the costs involved limit the number of audits that the IRS can conduct. Adjusting the partnership return instead of the partners’ returns would reduce these costs (but, without legislative action, the IRS’s ability to do so was lim- ited). The noble goal of a single-en- tity audit and proceeding was com- promised by increasing awareness that the rules were overly complex and at times counterintuitive, led to unfair results, and could hardly be said to have resulted in administra- tive efficiencies.
Over the years the Service has became increasingly frustrated in auditing partnerships subject to the TEFRA rules. Many in Congress were concerned that “large partner- ships” may not be subject to the proper level of audit review, fueled in some part by the complex entity- level audit provisions, and that re- form was needed. Over the past sev- eral years, various commentators, including professional groups and organizations, have called for major reforms, if not the outright repeal of the entity-level audit rules, as well
partnerships for ation as a blend gate-level rules.
federal income tax- of entity and aggre-
Presently, as
recent GAO report, the Service au- dits few large partnerships. Even when audited, adjustments, if any, are small. Although internal control standards call for information about effective resource use, the IRS has not defined what constitutes a large partnership and does not have codes to track audit results. According to IRS auditors, the audit results may be due to challenges such as finding the sources of income within multi- ple tiers, while meeting the adminis- trative tasks required by TEFRA within specified time frames. For
acknowledged in a
4
Corporate Taxation
6 Section 6226.