President Obama Signs Bipartisan Budget Act of 2015, Sweeping Aside Rules That Have Governed Tax Audits of Partnerships Since 1982

November 12, 2015

On November 2, 2015, President Obama signed the Bipartisan Budget Act of 2015 (the "Act"), which sweeps aside the rules that have governed the tax audits of partnerships since 1982.  Although the new rules generally will not be effective until 2018, because the changes to partnership audits and attendant tax liability are so dramatic, and because partnerships generally may elect to apply the rules before 2018,[1] it is important to ensure that both existing and future partnership agreements protect the interests of the partners and address the various alternatives available under the new rules.  In addition, disclosure documents and regulatory filings (including filings with the Securities and Exchange Commission) will need to be modified to reflect the new law.  Further, consideration should be given to the potential financial accounting consequences that may arise from the application of the new rules.

Current Law and Reasons for Change

Under current law, partnerships with not more than 10 partners (none of which may be a passthrough entity) are audited at both the partnership and the partner level.  For other partnerships, tax audits generally are conducted only at the partnership level.  Once all of the audit adjustments are agreed upon (or resolved through litigation), the adjustments are passed through to the partners; the IRS then is obligated to calculate each partner’s tax liability for the audited year.

There is a third audit regime that applies to partnerships with 100 or more partners that elect to be treated as "electing large partnerships."  Under these rules, partnership audit adjustments generally flow through to the partners for the year in which the adjustment takes effect, rather than the year under audit.  According to the IRS, very few partnerships have elected to apply this regime.

Government officials have repeatedly expressed concern that partnerships are difficult to audit, and that resulting audit adjustments often result in no additional tax being collected.  The Government Accountability Office issued a report in 2014 generally supporting these concerns,[2] which have also been broadly echoed by commentators.[3]

The New Rules – Summary and Observations

As noted above, the Act generally repeals the current rules effective for partnership taxable years beginning in 2018, although partnerships generally may elect to apply the provisions of the Act before then.[4] 

General rules.  The Act establishes three important general rules:

  • First, all partnership audits will be performed at the partnership level. 
  • Second, partnerships must appoint a "partnership representative" to represent the partnership in dealings with the IRS.  The partnership representative need not be a partner, but must have a "substantial presence" in the United States.   
  • Third, and perhaps most important, the partnership will be liable for any resulting tax liability (referred to as an "imputed underpayment"), as well as any interest and penalties.  The imputed underpayment is calculated by multiplying the netted adjustments of items of income, gain, loss or deduction by the highest rate of individual or corporate tax for the year under audit (known as the "reviewed year").[5]  As a result, except as described below, the partners in the year in which the imputed underpayment is paid will economically bear the burden of the payment.  In certain circumstances, partnerships will be permitted to demonstrate that their partners are subject to lower rates of tax to reduce the amount of any imputed underpayment.[6]  Also, partners generally will be permitted to file amended returns for the reviewed year and pay any resulting tax liability; this would reduce the partnership’s tax liability. 

Passthrough election.  Significantly, partnerships will be permitted to avoid having current year partners bear the cost of any imputed underpayment.  Instead, partnerships may elect to pass through to their partners any adjustments resulting from a partnership-level audit with respect to a given year by providing them with information statements (likely to be similar to Schedules K-1).  If this election is made,[7] the liability for any additional tax (as well as any interest and penalties) will be borne by the partners who were partners in the reviewed year.  Importantly, those partners would not be required to file amended tax returns for the reviewed year; instead, their tax liabilities for the current year (i.e., the year that includes the date the information returns were issued) would be adjusted and increased by the tax liability arising from the items passed through by the partnership, as well as by any applicable penalties and interest. 

Although this passthrough election would appear attractive to most partnerships, because the interest rate for deficiencies under this approach is higher than the rate for underpayments under the general rule, some partnerships may decide not to make the election and instead remain subject to the general rules.  For this reason, it will be important for partnership agreements to address specifically who has the power to compel the partnership to make, or the power to prevent the partnership from making, such an election.

Notably, this part of the Act suffers from some technical issues relating to tiered partnerships (i.e., partnerships that have other partnerships as partners).  Until these technical issues are resolved through the issuance of regulations or other IRS guidance, there will be uncertainty regarding the availability of this election for tiered partnerships.

Election out.  Certain partnerships with not more than 100 partners may elect out of the new rules entirely for any given partnership taxable year; that is, a partnership may elect out one year and not be bound by such an election for other years.  If a partnership elects out, the IRS would be required to audit both the partnership and the partners. 

For a partnership to elect out, all of the partners must be individuals, estates, domestic or foreign C corporations, or S corporations.  There are two important notes about the manner in which the number of partners is counted.  First, for purposes of counting the number of partners, each S corporation shareholder is treated as one partner.  Second, it is possible that if a partnership interest is sold during the year, both the buyer and seller must be treated as partners for this purpose. 

In addition, it appears that the drafters of the legislation intended to provide the IRS and Treasury with the authority to permit partnerships that have trusts or other partnerships as partners to elect out, but it is not clear whether or to what extent this regulatory authority will be exercised. 

Finally, it is important to note that the election out may be made only for partnership years beginning in 2018 or later.


Absent the passthrough election or the election out, for partnership tax years beginning in 2018 or later, partnerships will have entity-level liability for federal income taxes, and this liability may be economically borne by partners who were not partners in the year of the understatement giving rise to the tax liability.  As a result, care must be taken to ensure that the partnership agreement and any related documents clearly indicate the approach the partners want to take under the Act.



   [1]   Although the legislation permits a partnership to elect to apply the new rules immediately, the election may be made "at such time and in such form and manner as the Secretary of the Treasury may prescribe."  Therefore, it may be that, as a practical matter, partnerships may not make such an election until further guidance is issued.

   [2]   U.S. Government Accountability Office, GAO-14-732, "Large Partnerships:  With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency" (Sep. 18, 2014), available at

   [3]   See, e.g., Amy S. Elliott, "News Analysis:  Why It Matters That the IRS Has Trouble Auditing Partnerships," 143 Tax Notes 7 (Apr. 7, 2014).

   [4]   See note 1, above.  It seems likely that the IRS and Treasury will issue a substantial amount of guidance to address the many ambiguities in the operation of the Act.

   [5]   In the case of the reallocation of tax items among the partners, the imputed underpayment is calculated without taking into account any decrease in any item of income or gain or any increase in any item of deduction, loss, or credit. 

   [6]   For example, the partnership could demonstrate that certain of its partners are tax-exempt entities or individuals and therefore are not subject to tax or are subject to a lower rate of tax on particular types of income, such as capital gain or qualified dividend income.  The Act does not permit partner-level attributes, such as net operating losses, to be taken into account.  It is possible that future guidance may permit partnerships to take those attributes into account.

   [7]   The election must be made no later than 45 days after the date of the notice of final partnership adjustment. 

Gibson, Dunn & Crutcher LLP 

The following Gibson Dunn lawyers assisted in preparing this client alert:  Eric Sloan, Benjamin Rippeon, Paul Issler, Hatef Behnia, Jeff Trinklein, Kathryn Kelly, Nina Xue and Victor Lee.

Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these developments.  For further information, please contact the Gibson Dunn lawyer with whom you usually work or any of the following members of the Tax Practice Group:

Art Pasternak - Co-Chair, Washington, D.C. (+1 202-955-8582, [email protected])
Jeffrey M. Trinklein - Co-Chair, London/New York (+44 (0)20 7071 4224 / +1 212-351-2344), [email protected])
David B. Rosenauer - New York (+1 212-351-3853, [email protected])
Eric B. Sloan – New York (+1 212-351-2340, [email protected])
Romina Weiss - New York (+1 212-351-3929, [email protected])
Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, [email protected])
Hatef Behnia – Los Angeles (+1 213-229-7534, [email protected])
Paul S. Issler – Los Angeles (+1 213-229-7763, [email protected])
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
Scott Knutson – Orange County (+1 949-451-3961, [email protected])
David Sinak – Dallas (+1 214-698-3107, [email protected])    

© 2015 Gibson, Dunn & Crutcher LLP

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.