To address this difficulty for the IRS, the Bipartisan Budget Act of 2015 provided that where a fund (whether organized in the U.S. or an offshore fund with U.S. investors) is audited for a tax year beginning after 2017 and it is determined that additional taxes are owed by the investors, the IRS may generally collect those taxes directly from the fund. The law also gives the "partnership representative" designated by the fund extremely broad authority to bind the fund and the investors in connection with the audit, with limited obligations to consult with or even notify the investors.
Why is this change significant for tax-exempt investors? Because once even a dollar of tax is collected from the fund itself as opposed to its investors, the economic burden of that tax, like that of any other expense of the fund, will be borne by all of those who are partners in the fund (including tax-exempt investors) in the year the audit is completed and the tax is paid, unless the fund's governing documents say otherwise.
Worse still, unless otherwise addressed in the documents, the fund may allocate tax audit liability across its current investors rather than only those who were investors in the prior year under audit. This might arise, for example, in a hedge fund where investors come and go over time. Naturally this compounds the risk for tax-exempt investors — they may be liable not only for the current taxable investors' tax but also for the tax of former taxable investors who have since left the fund.
And if the fund cannot obtain reimbursement from a current or former taxable partner of the partner's share of a tax audit adjustment because, for example, the partner is bankrupt or cannot be located, absent a prohibition in the fund's contract, the fund typically can "socialize" the liability among the other taxable and tax-exempt partners.
For these reasons, unless one or more of the possible solutions described below are employed, the new partnership audit rules seem inherently unfair to investors who are exempted from most taxes due to their public-interest missions. In addition, they are inconsistent with the traditional concept that an investor's liability to the fund is limited to its capital account and may well be applied in a manner that is inconsistent with the institutions' fiduciary duties.
This puts the tax-exempt investor and its counsel in the uncertain position of having to quantify, in advance, the magnitude of its potential future tax liability. To date, most counsel to the funds' general partners appreciate the risk this creates for tax-exempts but do not wish to add language to the fund documents that would reduce or limit the GP's options to make and recover tax payments in the event the fund is ever audited and underpayments are determined. Indeed, it is currently the market standard for funds to have no duty even to inform investors of a tax audit or to allow tax-exempt or other investors to be heard.