Partnership audit rules

Partnership audit rules determine how the IRS conducts tax audits of partnerships, including hedge funds that are organized as partnerships. These rules represent a major change in tax compliance requirements for hedge funds structured as partnerships. The rules fundamentally changed when Congress passed the Bipartisan Budget Act of 2015Federal legislation that fundamentally reformed partnership audit procedures, shifting tax liability and collection from individual partners to the partnership entity level for tax years beginning after 2017., which transformed how partnership entities handle tax audits.

Before the 2015 reforms, partnerships operated under audit procedures created by the Tax Equity and Fiscal Responsibility Act of 1982Federal tax legislation that established the previous partnership audit framework (TEFRA rules), which was replaced by the Bipartisan Budget Act of 2015's centralized audit procedures.. Under that earlier system, when the IRS audited a partnership's tax return, the government determined the proper tax treatment of the partnership's income and deductions at the partnership level. However, any resulting tax deficienciesAdditional taxes owed as a result of an IRS audit or examination that identifies underreported income or disallowed deductions. were collected from the individual partners who owned interests during the year being audited.

This old system created significant administrative challenges. The IRS often had to track down numerous individual partners to collect taxes, and partners could dispute audit findings separately. This process was time-consuming and complex for both the IRS and the partnerships involved.

The Bipartisan Budget Act of 2015 became law on November 2, 2015. It completely replaced the previous audit framework for partnership tax returns filed for tax years beginning after 2017. This new system shifts the focus from collecting taxes from individual partners to handling everything at the partnership level.

Under the new rules, tax adjustments and payments are handled directly by the partnership entity rather than flowing through to individual partners. This centralized approach simplifies the process for the IRS and creates more predictable procedures for partnerships.

When the IRS conducts an audit under the current system, tax liability calculations typically use the highest applicable federal tax rates for U.S. taxpayers. However, partnerships may qualify for reduced rates if they can demonstrate that certain partners are tax-exempt.

For example, foreign partners and other tax-exempt entities who would not normally owe taxes on specific types of income can provide certification of their exempt status. They do this by filing IRS Form 8983IRS form used by tax-exempt entities and foreign partners to certify their exempt status and support reduced tax rate calculations during partnership audits. or other designated forms to support calculations using lower tax rates. This process helps ensure that the partnership does not pay more tax than would have been owed if the audit adjustments had been handled at the partner level.

Partnerships have an alternative option called a "push-out election." Instead of paying audit adjustments at the partnership level, the partnership can elect to distribute these adjustments to the partners who participated during the tax year being examined. This transfers responsibility for any resulting tax deficiency from the partnership to those individual partners.

When partnerships choose this option, each affected partner becomes responsible for including their proportionate share of the adjustments on their own tax return for the audited year. The partners must pay any resulting taxes alongside their return for the year when the deficiency determination occurs. However, partnerships that make this election face interest charges computed at rates two percentage points above the standard underpayment interest ratesIRS interest rates charged on unpaid tax obligations, used as a baseline for calculating penalty rates on various tax compliance failures..

This election gives partnerships flexibility, but it comes with costs and administrative complexity. The partnership must track down all relevant partners and ensure they properly report their share of the adjustments.

The push-out election mechanism works through multiple levels of partnership ownership, which is common in hedge fund structures. Each partnership entity in an ownership chain can choose between paying directly or distributing the adjustments further down to their own partners.

For example, consider a structure where individual investors invest in a domestic feeder fund Feeder fund A feeder fund is a type of investment fund that collects money from investors and then invests nearly all of that money into a larger "master fund." This structure allows different types of investors—such as U.S. taxpayers, tax-exempt organizations, and foreign investors—to all participate in the same investment strategy while using the fund structure that works best for their specific tax and regulatory needs. , which then invests in a master fundThe central investment vehicle in a master-feeder structure where multiple feeder funds pool their capital for consolidated investment management.. If the master fund faces an audit, it can push out adjustments to the feeder fund. The feeder fund can then choose to either pay the resulting taxes or push the adjustments out again to the individual investors.

This tiered approach accommodates complex hedge fund structures while maintaining appropriate allocation of tax obligations. It provides operational flexibility while ensuring that someone ultimately pays the required taxes.

Current regulations require partnerships to designate a "partnership representative" who has exclusive authority to act for and bind both the partnership and all partners throughout audit and adjustment proceedings. This role replaces the previous "tax matters partnerThe former designation under TEFRA rules for a partner who represented the partnership in audit proceedings, replaced by the broader 'partnership representative' role under current law." position and has broader authority.

The designated representative must maintain substantial presence within the United States. This requirement may force partnerships with offshore management to engage domestic service providers for this role. The representative's authority is binding on all partners, and individual partners have no separate recourse options.

This centralization of authority streamlines the audit process from the IRS perspective but requires partnerships to choose their representative carefully. The representative can make decisions that bind all partners, including decisions about whether to contest audit findings or accept proposed adjustments.

The current audit framework eliminates individual partner rights to separately contest audit results. All decision-making authority is concentrated in the partnership representative. This consolidation requires careful consideration when drafting partnership agreements Partnership agreement A partnership agreement is the primary governing document for a hedge fund structured as a limited partnership. It establishes the relationship between general partners and limited partners. The agreement details rights, obligations, economic terms, and operational provisions for all parties involved. and selecting partners.

Unlike the previous system, where individual partners could challenge audit findings independently, partners now must rely entirely on the partnership representative to protect their interests. This change can create potential conflicts of interest, especially in partnerships with diverse partner bases that may have different preferences about how to handle audit disputes.

Partnerships with 100 or fewer partners may opt out of these centralized audit rules, but they must meet strict requirements. All partners must consist of individuals, C corporations, S corporations, estates of deceased partners, or foreign entities that would face C corporation tax treatment if they were domestic entities.

However, this exception offers limited utility for most hedge fund structures. Funds typically include at least one partner entity that is itself a partnership or disregarded entityA business entity that is ignored for federal tax purposes, with its activities treated as those of its owner, commonly used for single-member LLCs. for federal tax purposes. This disqualifies them from using the small partnership exception.

Partnership audit rules create several significant operational considerations for hedge fund management companies. First, the partnership representative requirement with substantial U.S. presence may require funds with offshore management structures to establish additional service provider relationships.

Second, concentrating audit authority in a single representative requires careful analysis of potential conflicts of interest. Funds must establish appropriate governance frameworks to address situations where the representative's interests may not align perfectly with all partners' interests.

Third, the partnership-level tax liability under current rules may require funds to maintain cash reserves or develop procedures for addressing potential audit adjustments. Unlike the previous system, where tax deficiencies were collected from individual partners, partnerships may now face immediate entity-level tax obligations that they must be prepared to pay.

Finally, the complexity of the push-out election mechanism requires careful planning and documentation. Partnerships must maintain detailed records of partner ownership during audited years and have procedures in place to locate and communicate with former partners if they choose to use the push-out election.

Recent regulatory developments include updated IRS forms effective December 2024. The revised Forms 8985IRS form used to report partnership audit adjustments and related information under the centralized partnership audit regime. and 8986IRS form used by partnerships to make push-out elections, transferring audit adjustments and resulting tax liability from the partnership to the affected partners. feature modified column headings and additional reporting requirements for partnerships subject to audit procedures.

Additionally, state-level conformity with federal partnership audit rules remains inconsistent across jurisdictions. Many states are still developing frameworks to handle federal audit adjustments, creating potential compliance challenges for partnerships that operate in multiple states.