Attention Investment Partnerships: New IRS Audit Rules Going Into Effect Soon
The Bipartisan Budget Act of 2015 included provisions that fundamentally alter the manner in which partnerships, including hedge funds and private equity funds, are audited by the IRS. The so-called “TEFRA” rules were replaced with a Centralized Partnership Audit “CPA” regime that allows the IRS to make assessments at the partnership level, subject to certain elections to either opt out of the law or push out the assessments to partners. The law is scheduled to be effective for tax years beginning in 2018.
The CPA rules were enacted as a result of the IRS’ challenges in auditing partnerships. The IRS had resource constraints that affected their ability to effectively audit partnerships under the TEFRA rules, which date back to the early 1980s. One of the big challenges the IRS faced was that once the audit was done at the partnership level, the tax needed to be assessed and collected at the partner level. The heart of the new CPA rules is that they allow the IRS to assess and collect the tax at the partnership level.
While these rules are intended to alleviate the administrative burden on the IRS, they create many issues and challenges for fund sponsors that manage investment partnerships such as hedge funds, private equity and venture capital. Some of these are outlined below.
Issues and Challenges
Prior Tax Liabilities
One of the major challenges will be how to address concerns from new investors in funds about buying into someone else’s tax liability from an earlier year. For example, tax year 2018 could be subject to audit in the year 2021. If an assessment is made in 2021, the investor base could be very different from the audited year, 2018. This issue is more pronounced in the hedge fund industry, where there is more capital movement and liquidity, as opposed to private equity or venture capital, where the investor base is more static. If the tax is assessed at the fund level in 2021, as envisioned by the CPA rules, it would negatively impact the NAV of current investors, some of which were not partners in 2018. This is a real business and operational challenge for fund managers.
Financial Reporting Issues
Another important consideration is that the CPA regime could create a financial reporting issue under ASC 740, a.k.a. FIN 48. Funds may need to book reserves for uncertain tax positions that could result in a fund level assessment. The scope of uncertain tax positions could expand to include areas such as wash sales, straddles, and the application of long-term capital gains rates to transactions. In the past these items were not within the scope of FIN 48 since they could only have a partner level, as opposed to fund level, impact. There is some debate over whether assessments under the CPA rules should be considered a tax paid on behalf of the partners, and thus outside the scope of FIN 48.
Eligibility Rules Surrounding the “Opt-Out” Mechanism
The CPA rules do provide for mechanisms to avoid these issues, but unfortunately they will not be available to most funds, especially where tiered structures are employed. One mechanism allows partnerships to “opt out” of the CPA rules, but only if the partnership has 100 or fewer eligible partners. Partners that are themselves partnerships are not eligible partners. For example, a partner that is a fund of a funds investor or even a General Partner entity that is formed as an LLC would disqualify a fund from opting out.
Issues With the “Push-Out” Election
Another mechanism is a “push out” election, which enables the partnership to have the partners from the audited year (e.g. 2018) pay the tax assessment. This election would also allow the partnership to avoid any potential entity level tax assessments and related FIN 48 reserves. The push out election does not work well in the context of tiered partnerships, such as master-feeder structures, which are common in the fund industry. In a tiered partnership structure, the upper tier partnership cannot pass through the push out and is actually treated as an individual taxpayer. There was an attempt to fix this problem legislatively through a technical corrections bill, but it never materialized and such a fix was not included in the tax bill that was released in November. Recently proposed regulations also do not address this problem. Even if the push out election is available there are some other considerations. One such consideration is that there is an additional 2% interest charge on the tax liability. In addition, there are limits on the ability to net positive adjustments with negative adjustments, resulting in the risk of a tax assessment on gross income.
Partnership Agreements Need to Be Altered
Fund managers can expect the CPA rules to affect fund governance matters. For example, some prospective investors may request a side letter or language in the partnership agreement committing the fund to the push out election, assuming it is available. Another governance matter to be addressed is the selection of a “partnership representative,” who will be the point person in the event of an audit. Note that the partnership representative must be a partner with a “substantial presence” in the United States to be eligible.
Again, the law is scheduled to be effective for tax years beginning in 2018. The IRS has indicated that more guidance may be released before year end to address some of the challenges inherent in the new rules. MFA is closely monitoring the progress of these rules and will apprise our clients of further developments. In addition, we are available to assist clients in addressing and implementing these rules.
See our Oct 2017 MFA Insight, Urgent Business Matter Affecting Partnerships, LLPs and LLCs for additional information on the matter. To discuss what your partnership should be doing now, contact MFA today.
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