Bipartisan Budget Act of 2015 Changes Partnership Audit Rules

Ellen S. Brody, JD, CPA, and Vivek Chandrasekhar, JD
Published Date:
May 1, 2016

On Nov. 2, 2015, Congress enacted the Bipartisan Budget Act of 2015 ("BBA"), repealing the previous audit regime in effect for partnerships that had been around since the Tax Equity and Fiscal Responsibility Tax Act of 1982 ("TEFRA"). The new BBA audit regime is designed to apply partnership returns for taxable years beginning after Dec. 31, 2017, although the BBA provides that a partnership may elect to have the new rules apply for earlier years if it so desires. The audit rules also provide for increased centralization of audits at the partnership level and create a new mechanism for partnership-level payment of additional tax owed. 

Under TEFRA, partnerships are generally subject to one of two sets of rules, the TEFRA regime of centralized audit, or the "small partnership" exemption that provides for partner-level audit. While there was also a special regime that certain partnerships with 100 or more partners could opt into, relatively few partnerships did so, and it has been repealed as part of the BBA.

In order to be considered a small partnership and eligible for the exemption from TEFRA, a partnership must have no more than 10 partners and must have only eligible partners under IRC section 6231(a)(1)(B)(i). Individuals, C corporations, and estates are eligible partners, but flow-through entities - including partnership, S corporations, and disregarded entities - are ineligible partners under 26 CFR section 301.6231(a)(1)-1(a)(2) and Rev. Rul. 2004-88. For such small partnerships, any IRS audit is conducted at the partner level, and each partner is subject to the normal audit and litigation rules for taxpayers. Under IRC section 6231(a)(1)(B)(ii), an eligible small partnership is automatically exempt from TEFRA unless such partnership actively elects into TEFRA treatment for a taxable year; once such an election is made, however, it is applicable for all subsequent taxable years unless revoked with the consent of the secretary.

Partnerships ineligible for the small partnership exception are covered by TEFRA, which provides for centralization of the partnership audit in the hands of the "tax matters partner," the designation of which is governed by a complicated set of regulations, including IRC section 6231(a)(7) and 26 CFR section 301.6231(a)(7). Although the audit is centralized under the control of the tax matters partner, TEFRA provides various notice requirements and procedural powers that safeguard the rights of the other partners. For example, IRC sections 6223(a) and (b) contain listing notice rules and IRC section 6226(b) allows other partners to initiate litigation on behalf of the partnership if the tax matters partner chooses not to.

Under the BBA, partnerships are again subject to one of two sets of rules. The new regime preserves and expands the exemption from partnership-level proceedings for small partnerships, increasing the limitation on the number of partners from 10 to 100, and adding S corporations to the type of eligible partners, with the S-corporation-partnership shareholders counting toward the 100-partner limit under the new IRC section 6221(b) (the "new" designation refers to the post-BBA IRC sections). The new rules also give the IRS authority to add other entities to the list of eligible partners in the future, providing flexibility that did not exist under the TEFRA statute.

For example, a recent Joint Committee on Taxation report suggests that the IRS could use this authority to allow partnerships with disregarded-entity partners to be eligible for the exemption. While the BBA, however, liberalizes the parameters of the exemption in many ways, it also creates a burden for exemption-eligible partnerships by changing the default rule: Under the new IRC section 6221(b)(1)(D), eligible partnerships must now affirmatively opt out of partnership-level audit treatment with their tax return for each taxable year.

All other partnerships (including small partnerships that do not affirmatively opt out) are subject to the BBA rules, which continue the centralization of audit at the partnership level. The BBA eliminates the tax matters partner concept as well as the complicated rules associated with appointing one, and instead uses a designated "partnership representative." Under the new IRC section 6223(a), the partnership representative can be any person, including a non-partner, with a substantial presence in the United States. The partnership representative has sole control of the audit, including choices with respect to extension of the statute of limitations, whether or not to litigate, and the choice of forum. Both the partnership and all of the partners are bound by the actions taken by the partnership representative on behalf of the partnership.

Most significantly, the BBA departs from the underlying federal income tax concept that a partnership is not a taxpayer, and provides for a default partnership-level collection of additional tax owed under the new IRC sections 6225(a) and 6232(a). At the conclusion of the audit, the partnership itself has liability for the "imputed underpayment," which is generally computed by netting all adjustments and multiplying by the highest applicable rate under the new IRC section 6225(b). The partners of the partnership in the year of the adjustment will bear the burden of this tax liability despite the fact that the audit relates to an earlier reviewed year when the composition of the partnership might have been very different. Under the new IRC section 6221(a), penalties and interest are also determined at the partnership level.

To avoid this potentially harsh "partnership pays" default rule, the BBA provides two collection alternatives. First, under the new IRC section 6225(c)(2), the partnership can reduce its imputed underpayment liability to the extent that the partners who were partners in the partnership for the reviewed year voluntarily take into account their allocable share of the imputed underpayment. A partner must file an amended return for the reviewed year which takes into account its allocable share of the adjustments and pay any tax due in order for the reduction to occur. If all reviewed year partners act under this provision, the partnership's imputed underpayment should be reduced to zero. However, under the new IRC section 6221(a), penalties and interest are still determined at the partnership level.

Under the second alternative, the partnership itself may elect to require the reviewed year partners to have to take their share of any partnership adjustment into account. Under the new IRC section 6226, in order to make this election, after the partnership receives its final partnership adjustment, it must furnish to the reviewed year partners and to the IRS a statement of each partner's share of any partnership adjustments. Penalties will continue to be determined at the partnership level, although interest is determined at the partner level and is assessed at a higher rate with an additional two percentage points, although penalties will continue to be determined at the partnership level.

Given the radical nature of the "partnership pays" default rule, many partnerships are likely to elect into one of these two alternatives. However, many of the rules - including the early election in, the new small partnership exemption, and the two alternatives to "partnership pays" - require the IRS to issue guidance. Although the IRS has not yet done so, these are items that accountants should add to their checklists when preparing partnership tax returns in the future.

Ellen S. Brody, JD, CPA, is a partner and Vivek Chandrasekhar, JD, is an associate at Roberts & Holland LLP. Ms. Brody can be reached at 212-903-8712 or Mr. Chandrasekhar can be reached at 212-903-8747 or

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