Private fund investors and managers are hearing a clear message from Washington: Partnerships that until now have received little attention from the IRS could soon face a new audit regime, with more to come.
New audit rules enacted by Congress are a small move, “but it's part of a larger shift in Washington's regulation” of general partners, said Christopher Ailman, chief investment officer of the $181.3 billion California State Teachers' Retirement System, West Sacramento. “It's part of the desire by many to tax general partners as income rather than capital gains.”
When President Barack Obama signed the Bipartisan Budget Act on Nov. 2, he noted some of it would be “paid for in a balanced way ... (by) ensuring investors in hedge funds, private equity funds and other large partnerships pay what they owe in taxes.” The new partnership audit rules, which were included in the act as a revenue raiser, could bring in $9.3 billion over 10 years, according to the Joint Committee on Taxation.
Along with the added revenue, a White House blog said current audit practices needed to be streamlined to better detect partnerships that have been “at the forefront of aggressive tax avoidance schemes.” Even for law-abiding partnerships, the White House said current audit rules enacted in 1982 have prevented the Internal Revenue Service from effectively auditing large partnerships such as hedge funds, private equity firms or oil and gas partnerships. “Unlike with corporations, the IRS cannot simply assess tax against the partnerships — it has to find each of the individual partners, pull their tax returns, compute the tax adjustment and send every one of them a notice,” the White House blog noted.
The new rules, which apply to partnership taxable years beginning in 2018, will allow the IRS to examine a partnership's income, gains, losses, deductions and credits, with the partnership responsible for adjusting any of those items.
Any additional taxes due would be collected directly from the partnership at the top individual rate, unless some income can be allocated to a tax-exempt partner.
“The shift in liability resulting from any income adjustments to the partnership rather than individual partners is a significant departure from the historic treatment of a partnership as a pass-through entity that is not subject to federal income tax,” said David Roby, a tax attorney and partner with Sutherland Asbill & Brennan LLP in Washington who works with partnerships.
Tax experts also caution that because tax assessments and collections now will be made at the partnership level instead of on individual partners, any assessment costs could shift to the partners present in the year of the assessment, rather than to partners who benefited from underpayment in earlier years. Partnerships might be able to have an assessment made against the partners who benefited at the time under certain conditions that the IRS will have to spell out in the implementing rules and procedures.
Entities with 100 or fewer partners may opt out of the new rules, but that does not apply to investment funds that have other partnership investors, such as a fund of funds. Investment funds with domestic and offshore feeders may need special allocation rules to ensure tax assessments are handled equitably.
In 2014, a Government Accountability Office study found the IRS audited just 0.8% of large partnerships vs. 27.1% for similar-size corporations. Large partnerships, defined as those with 100 or more direct and indirect partners and $100 million or more in assets, have increased dramatically in recent years, and in 2012 held $7.5 trillion in assets. Almost two-thirds had more than 1,000 direct or indirect partners, six or more tiers and were in the finance or insurance sectors, the GAO found.
“The IRS was shying away in large measure because they don't know what to do with partnerships,” said Steven Rosenthal, a tax lawyer and visiting fellow at the Tax Policy Center in Washington. “There's a lot of crazy stuff going on and the IRS feels overwhelmed. Clearly the partnership audit regime is broken, so something had to be done,” he said.