Page 2 - Repeal of the TEFRA Entity Level Audit Rules Under the Bipartisan Budget Act of 2015

REPEAL OF THE TEFRA ENTITY LEVEL AUDIT RULES
additions to tax, with respect to the “reviewed year” or reviewed years, which are to be assessed on the year of the adjustment (“adjustment year”). There are important exceptions to this principle the effect of which directly shifts the burden of payment of additional income taxes to those persons who were partners for the reviewed year (or years) and had received the tax benefits from erroneous omission from gross income and/or erroneous expensing in reducing tax in such prior years.5
While the new partnership audit rules do not apply until partnership tax years beginning after 2017, draftsmen of partnership agreements should take the new audit rules into account in drafting current partnership and limited liability company (LLC) agreements.6 We now have three “old” audit regimes in effect at this time and two more (and a hybrid approach) under the “new audit” regime. During the period of time under the new rules take ef- fect, the current rules continue in place. This includes the elective small partnership audit rules outside of TEFRA where audits are conducted on a partner-by-partner basis, the actual TEFRA entity level audit rules and the substantially ignored elective audit regime applicable to large partnerships. Under the new rules, the electing out of the consolidated audit rules, as discussed below, has been greatly expanded. If a partnership is not eligible to elect-out or otherwise decides not to “elect-out,” then the partnership audit rules under the Bipartisan Budget Act of 2015 apply. The “hybrid” approach is a partnership level audit but the taxes attributable to the partnership level adjustm are paid at the partner level.7
Congress Repeals the TEFRA ELA Rules for Tax Years Commencing After 2017
As part of the Bipartisan Budget Act of 2015, which the President signed into law on November 2, 2015, Congress repealed the complex and much-criticized TEFRA part- nership ELA rules including the electing large partnership rules. The TEFRA ELA provisions (which were enacted in 1982) were replaced with a set of SELA rules.
Prior to the TEFRA rules, all partnership audits were conducted at the partner level as audits of partners. The IRS determined that this was an unsatisfactory method to audit partnerships although nonpartnership issues would still be determined at the partner level.8 Generally, TEFRA audit rules apply to a partnership with 11 or more partners at any one time during the partnership’s tax year. Many partnerships with 10 or fewer eligible partners are able to elect out of consolidated TEFRA audit rules and be
subject to audit on a partner-by-partner basis provided there is no “ineligible partner.”
The TEFRA rules mixed both entity and aggregate theories that proved to be difficult if not unwieldy. For example, there were different statutes of limitations ap- plicable, one at the partnership level and one at the partner level.9 The TEFRA ELA rules also required the IRS to identify the partners in the partnership which could be quite difficult in multi-tiered partnerships particularly where large pools of funds are invested by fund managers. In some instances locating the partnership’s “tax matters partner” was difficult.
For years in which the issue was one of the proper allocation of income, for example, the adjustments would yield no positive revenue to the IRS. These years would simply yield a refund for those partners receiving an excessive allocation of income for a particular year and a deficiency in tax for those partners required to pay tax on the underpayment in tax to account for the erroneous allocation of income.10 The IRS collected tax at the partner level. The IRS would have to pursue each partner’s several liability for the years that resulted in an assessment in tax. For multi-member partnerships, this could prove to be a multi-jurisdictional collection project. TEFRA, while resolving some of the problems under the “open audit” approach of partners in partner- ships, still suffered defects from a tax administration standpoint. This was primarily attributable to the fact that even under the unified audit rules, any resulting assessments in tax were not payable at the entity level, only at the partner level. The partnership TEFRA audit could yield no “tax revenue” fruit if the IRS cannot collect the resulting tax liability.
TEFRA, however, had many issues in practice. The IRS often had difficulty dealing with complicated statute of limitation issues under TEFRA. There was added concern with the ability to collect taxes from partner’s deficiencies after adjustments had been determined. Again, the multi- tiered partnerships having hundreds of (or more) partners in an investment fund situated in different parts of the United States as well as in foreign countries posed formi- dable collection burdens to the IRS.11The IRS encountered administrative difficulties under TEFRA when working with large partnerships with many partners and when working with tiered partnerships. The IRS notoriously audits a very small proportion of large partnerships (about 0.8 percent annually). The IRS presumably will have to increase its audit activity for partnerships if the new audit rules are to realize their promised potential of dramatically raising revenues.12 The new rules “streamline” the unified partnership audit rules by replacing the TEFRA provisions
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56 JOURNAL OF TAX PRACTICE & PROCEDURE
AUGUST–SEPTEMBER 2016