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The Florida Bar Journal
December, 2017 Volume 91, No. 10
New Partnership Audit Regime: Opt-Out, Push-Out, or Pay-Up?

by Mitchell I. Horowitz and Gregory M. Marks

Page 55


On November 2, 2015, Congress passed the Bipartisan Budget Act of 2015 (BBA),1 which enacted a new centralized audit regime (regime) that applies to all entities taxed as a partnership for taxable years starting after December 31, 2017. The most important feature of the regime is that it refocuses all audit activities on the partnership itself instead of the partners, including requiring assessments of tax deficiencies and collections at the entity level. The BBA identified several issues for which the Treasury Department and Internal Revenue Service (IRS) were to promulgate regulations to carry out the statutory objectives. This was a significant undertaking for Treasury and IRS, as the BBA flipped partnership taxation from a “flow-thru” construct to one in which the partnership would be primarily liable for any additional income tax due after audit. The congressional goal was to reduce the administrative burdens placed on IRS for audits of partnerships, and move that burden to the partnerships themselves.2

After passage of the BBA, many comments on the new law were submitted,3 including by the Section of Taxation of the American Bar Association4 and the American Institute of CPAs.5 Treasury and IRS maintained an open dialogue with these and other adviser groups as the comments were being submitted and requested comments on specific topics with which they were struggling in the drafting process.6 The comments pointed out many flaws in the BBA language, so much so that on December 6, 2016, Congress introduced the Tax Technical Corrections Act of 2016,7 which addressed a number of those problems, but that legislation did not pass.8 On January 18, 2017, Treasury finally issued 277 pages of proposed regulations and commentary on the new regime (regs),9 but their publication in the Federal Register was postponed by the Trump regulatory freeze and the regs were not reissued until June 14, 2017 (with minimal changes).

Due to space constraints, this article deals with only the “opt-out” and “push-out” elections available under the regs and a variation of the “pay-up” default rule that applies when a partnership does not make one of those two elections. To learn more about the other significant changes made by the BBA and regs not covered in this article, there are many other articles and resources.10 Practitioners need to review these other resources to fully appreciate the critical role of the “partnership representative” under the new regime, how imputed underpayments and proposed assessments can be modified, making administrative adjustment requests, and how operating and partnership agreements should expressly address these issues and the elections described in this article.

Opt-Out Election
Because the partnership is now primarily liable for tax deficiencies under the new law, this historical burden has been effectively transferred from reviewed year partners11 to audit year12 partners. When the partners and their profit and loss percentages are the same, this may not be an unwelcome result. However, that will often not be the case. If a partnership can opt-out of the regime altogether, any audits and assessments involving partnership items will be made at the partner level instead of the partnership level, such that those burdens would be “retained” by the reviewed year partners as under current law.

This approach is intuitively fair and preserves the historical “pass thru” consequences of matching owners with the operations that occurred while they were owners. Also, it may be a natural reaction to the regime’s complexity and lack of reliable guidance at the present time. However, many factors need to be considered when choosing to opt-out rather than letting the partnership simply “pay-up” the imputed underpayment. For example, some partners may not want IRS reviewing partner-level items unrelated to partnership operations. Some situations may be more efficiently or better addressed by having the partnership items resolved under the regime, such as when ownership changes are infrequent or when the reviewed year partners and audit year partners are otherwise the same (as in closely held or family-owned businesses). There may also be cases in which the partners want all tax matters involving the partnership to be resolved at the same time and in a more predictable and consistent manner. If the partnership were to opt-out, IRS could still audit the partnership, but the partnership could not extend the statute of limitations for assessment for flow-thru items for the partners. Rather, each partner’s period for assessment and refunds for partnership items would correspond to the partner’s individual limitation period for other audit items and IRS would need to enter into a separate agreement to extend the period with each partner. Likewise, the partnership could not settle partnership items on behalf of the partners, so that each partner would have to negotiate a separate settlement upon receiving a timely issued notice of deficiency from IRS. Each partner would then have to decide whether to petition the deficiency to the U.S. Tax Court or to pay the deficiency and seek a refund in the appropriate federal district court or the U.S. Court of Federal Claims. The result could be more than one case on the same issue or issues from the partnership at the same time, with possible inconsistent treatment coming from different courts or an appellate conferee.

Creditors and other stakeholders may also have an interest in whether the partnership opts-out, as the election shifts the tax and penalty liability away from the debtor entity and back to the partners. Likewise, a purchaser of a partnership interest may want assurances that the seller will remain liable for assessments relating to review years. Similar considerations would apply in mergers, divisions, and other organic transactions. Since an opt-out election must be made for each tax year, a partnership may like the flexibility of opting-out depending on the pros, cons, and other factors facing the partnership or its partners on a “wait-and-see” basis.

Making the Opt-Out Election
The regs make clear that IRS wants to increase audits for all partnerships, including those that opt-out of the regime. IRS will closely review a partnership’s opt-out election in order to ensure it is not being used to frustrate IRS compliance efforts. The eligibility for opting out will prompt analysis and discussion about restructuring the ownership of partnerships in order to meet the opt-out conditions, causing the IRS to consider whether a partner has been accurately identified or is merely a nominee or agent of a beneficial owner, or recasting a business arrangement or other contractual relationship as a constructive or de facto partnership. If IRS recasts an arrangement as a partnership, that entity will be subject to the regime, because it will not have filed a partnership return and, therefore, will not have made a timely opt-out election.13

In order to elect out of the regime, a partnership must have 100 or fewer partners during the year (as measured by the number of Schedule K-1s that are issued to partners); and each partner must be an “eligible partner,” which includes: 1) an individual; 2) a deceased partner’s estate; 3) a C corporation (allowed to be a RIC or REIT); 4) a foreign entity that would be required to be a C corporation if it were domestic; or 5) an S corporation (if certain informational requirements are met) — with each shareholder counting as one partner.14 Treasury and IRS chose not to expand the list of eligible partners in the regs, which expressly disallow a partner that is another partnership,15 trust, disregarded entity, or nominee or similar person holding a partnership interest on behalf of another person, because of the perceived additional burden this would place on auditors. Arguably, single member LLCs and grantor trusts, whose direct owner’s taxpayer ID number appear on the Schedule K-1, should not be excluded as this should not increase the IRS’s audit burden.16

Interestingly, the regs17 permit the use of an S corporation with otherwise noneligible partners for the opt-out. This will be of limited utility because of the limitations upon owning shares in an S corporation, but provides a way to do indirectly what cannot be done directly for disregarded entities and qualified trusts. For instance, a disregarded entity remains an ineligible partner under the regs regardless of whether the ultimate owner is an eligible entity. However, a disregarded entity, trust, or other noneligible entity partner could transfer its partnership interest into an S corporation to get around this limitation.

A partnership must elect out on a timely filed tax return (including extensions). A late return precludes the election out.18 A partnership must notify each of its partners within 30 days of electing out.19 If no election occurs, the regime applies to all partners in the partnership, including a partnership-partner that has made a valid election out on its return.20

Push-out Election
A second method by which the partnership can avoid liability for audit assessments under the regime is the “push out election” (POE) under I.R.C. §6226. In a POE, the partnership shifts or pushes the obligation to pay the imputed underpayment (and any penalties, interest, additions to tax, and other audit payments) to the reviewed year partners, who must then include their allocable share of the adjustments in their income tax returns for the adjustment year (not the reviewed year). It is critical to note that the reviewed-year partners have no right to challenge the adjustments, which occur at the partnership level. Once the POE is made, the partnership is no longer liable for the imputed underpayment, unless the POE is determined to be invalid. The POE will likely be of great interest to partnerships that cannot opt-out of the regime’s pay-up default rule or which are looking for a means to minimize the risk of current owners being indirectly liable for tax costs that should have been borne by the reviewed year partners.

Surprisingly, the regs do not require the partnership to notify the reviewed year partners that it has made a POE, only that it send a statement to the reviewed-year partners after the adjustments are final. Operating and partnership agreements should require partners to receive notice at or about the same time that the POE is made. The partnership is required to make the POE within 45 days of the date the notice of final partnership adjustment (FPA) was mailed by IRS (with no permissible extensions). The regs provide that the partnership must furnish statements to the reviewed-year partners no later than 60 days after the date the partnership adjustments become final, which is the later of 1) the expiration of the time to file a petition under §6234 (which is 90 days after the FPA is mailed); or 2) if a petition is filed under §6234, the date when the court’s decision becomes final).21 The regs contain a detailed list of the information that must be in the statements furnished to the reviewed-year partners. Under the POE, the reviewed-year partner is liable for the interest on any additional tax, penalties, additions to tax, or additional amounts calculated from the due date (without extension) of the reviewed year partner’s return for the first affected year until the amount is paid.22

The regs allow the partnership to push out one or more specific imputed underpayments to one or more partners (who would be responsible for payment of the tax liability), while making the partnership liable for the remaining general imputed underpayment. However, any defense to any penalty, addition to tax, or additional amount may be raised only by the partnership, regardless of whether the defense relates to facts and circumstances of a person other than the partnership (including a particular partner).23

One of the most important and complex issues to sort out is the effect, if any, that a POE will have on the adjustment-year partners’ outside bases and capital accounts, and the partnership’s basis and book value in property. While it is the reviewed-year partners who pay additional tax when the partnership has made a POE, it is still necessary in many instances to adjust the adjustment-year partners’ outside bases and capital accounts, as well as the partnership’s basis and book value in property, in order to subsequently ensure these numbers are essentially what would have resulted had there been no need for partnership adjustments. The regs reserve a section for guidance on adjustments to partners’ outside bases and capital accounts, as well as partnership basis and book value in property. Treasury and IRS have requested comments on the technical issues that arise when trying to provide guidance on these adjustments.

Partnership’s Responsibility to Pay Up
If the partnership cannot or does not opt-out and does not exercise the POE, then it must pay the imputed underpayment. Thus, current partners will effectively pay the taxes, penalties, interest, etc., that should have been apportioned only among those persons who were partners during the reviewed year. Agreements should squarely address this burden, with indemnities of audit-year partners or the partnership by reviewed-year partners as a starting point. Escrows, reserves, and other hold-backs and set-off capability should also be considered by the partners, particularly in the case of distributions from sales of assets and other capital transactions, and when partnership interests are sold by reviewed-year partners (either to: other persons, other partners, or the partnership itself).

Unfortunately, we cannot address in this article all of the considerations and issues in the calculation of the imputed underpayment for which the partnership is liable, including netting of adjusted items (and accompanying grouping rules), bifurcation of underpayments into general and specific underpayments for facilitating partner allocations (some of which may be subject to the POE while the partnership retains liability for others), and the very important rules for seeking modification of the imputed underpayment. What is important to know is that the payment of this underpayment is calculated on a default basis at the highest federal income tax rate in effect (for individuals or corporations, as applicable) in the reviewed year. That payment is not deductible, but will reduce the basis of partnership interests held by adjustment-year partners. The serious consequences of this underpayment liability and the complexity of these rules further demonstrates why these elections, along with the designation of the partnership representative, deserve very careful planning and negotiation by the partners, and should be expressly addressed by every operating and partnership agreement.

Reducing Partnership’s Underpayment — Amended Return Modification
The regs provide that a partnership may request modification of an imputed underpayment if a reviewed-year partner (or indirect partner) files an amended return that takes into account all or a portion of a partnership adjustment. If coordinated properly by the partnership and all reviewed year partners, this provision in the regs could effectively shift the tax burden back to the reviewed year partners.24 This would also enable the partners to compute their tax liability using the actual tax rates, deductions, losses, and other factors unique to their situations, rather than using the higher default rate. There are several conditions that need to be satisfied for this modification, including the actual and timely filing of amended returns, payment of all tax and other amounts due by that partner when filed, all reallocation adjustments must be taken into account by them, and the partnership representative must present an affidavit to the IRS showing these conditions have been met. There are also several limitations and waivers that apply to future adjustments involving the amended returns and flow-thru items covered by them.

A partnership that receives a notice of administrative proceeding may want to discuss with reviewed-year partners the possibility of agreeing to extend their respective limitations period for the reviewed year prior to its expiration under §6501 to keep open the possibility of using the amended return modification process. The regs provide an alternative to the amended return process in the form of a closing agreement, which a reviewed-year partner may be able to take advantage of (with IRS consent) if the limitations period on filing an amended return has expired.

Drafting Considerations: Partnership and Multi-Member Operating Agreements
It is imperative that partnership and multi-member operating agreements expressly address the changes made by the regime. Should the agreement mandate any of the elections discussed above, or should it be left to the discretion of management or the partnership representative on a wait-and-see basis? In some cases, the partners’ collective tax liability may be significantly different at the partner level than the indirect burden of paying the tax at the entity level, so it may be unwise to mandate one approach versus another. In some cases, it might be advantageous to require the pay-up over the POE approach depending on a predetermined dollar level or other rule of convenience. If the election decision is deferred, it would be expected that some level of owner approval be required (e.g., majority in interest, super-majority, unanimity, a particular investor, etc.) depending upon the bargaining positions of the parties. If the parties to the agreement wish to mandate the annual opt-out election, then the agreement should contain not only customary transfer restrictions but also limitations on the usual “permitted transferee” carve-out for estate planning purposes since these transferees will typically be ineligible owners (e.g., trusts or family partnerships).

Consideration should be given to how the owners may enforce the obligations of the manager or partnership representative regarding these elections and approaches. This will be complicated by the immensely broad swath of authority conferred on a partnership representative as a matter of tax law regardless of any inconsistency with the agreement or state law governing the agency authority of the representative.25 It may be that the only practical way of controlling the process from an enforcement standpoint it to have mechanisms in place for revoking the representative’s designation and appointing a successor, in which case the very specific requirements and limitations in the regs for doing this must be satisfied. Perhaps other penalties could apply (indemnity for incremental tax costs, liquidated damages, etc.). Similarly, the agreement might specify penalties for an owner’s failure to comply with the partnership representative’s decisions. Should the agreement contain express exculpatory indemnity provisions benefiting the partnership representative (e.g., similar to those that would customarily apply to a manager or general partner)?

There should be consistent reporting and taking-further-action covenants in the agreement to assure that all owners comply with the pre-agreed elections or approach allowable under the regime. This may extend to the obligation to file amended returns and pay tax and other amounts on a timely basis or prior to another agreed deadline.

The parties to the agreement will want to address specific audit process matters, such as being notified of IRS communications and significant developments involving the audit process, or updates from time to time or upon request, or having a say in the hiring of tax professionals for the audit. There are many other considerations that need to be evaluated and addressed when drafting a partnership or multi-member agreement under the regime that go beyond the scope of this article. Fortunately, there are many articles, CLE materials, and other resources now readily available for this purpose.


1 Pub. L. No. 114-74, 129 Stat. 584.

2 Staff of the Joint Committee on Taxation, General Explanation of the Tax Legislation Enacted in 2015 (JCS 1-16 (2016), 58 (The Bluebook).

3 At the invitation of Notice 2016-23, 2016-13 I.R.B. 490.

4 Section of Taxation, American Bar Association, https://www.americanbar.org/groups/taxation.html.

5 American Institute of CPAs, http://www.aicpa.org.

6 Alison Bennett, More Partnership Audit Activity to Follow Guidance: Wilkins, 51 DTR (Mar. 16, 2016).

7 H.R. 6439, 114th Cong. (2016); S. 3506, 114th Cong. (2016) (Tax Technical Corrections Act).

8 As of the writing of this article, no replacement technical corrections bill has been introduced.

9 82 Fed. Reg. 27334, REG-136118-15; RIN: 1545-BN77.

10 Christian Brause, New Partnership Audit Rules: Concepts and Issues – Parts 1 and 2, Tax Notes (May 2 and May 9, 2016); Terence Cuff, Finding the Path, Los Angeles Lawyer (Dec. 2016); Kean, Tax Notes, Vol. 156, No. 4, p. 471, What to Know and Do About the New Partnership Audit Rules Now, Los Angeles Lawyer (Dec. 2015); PWC, Tax Insights from Mergers and Acquisitions (June 16, 2017); New York State Bar Tax Section, Report on the Partnership Audit Rules of the Bipartisan Budget Act of 2015 (May 25, 2016).

11 In other words, the partnership’s return for the year that is being audited.

12 This is called the adjustment year in the BBA and regs.

13 82 Fed. Reg. 27344.

14 Section 6221(b).

15 Including a limited liability company taxed as a partnership.

16 Note that in Rev. Rul. 2004-88, the IRS concluded that the disregarded entity itself, and not its owner, was treated as the owner of a partnership interest for purposes of the small partnership exception from TEFRA.

17 Prop. Reg. §301.6221(b)-1(b)(3).

18 Prop. Reg. §301.6221(b)-1(c)(1).

19 Section 6221(b)(1)(E); Prop. Reg. §301.6221(b)-1(c)(3).

20 Prop. Reg. §301.6221(b)-1(d)(1).

21 Prop. Reg. §301.6226-2(b) (The regs provide that if a statement is returned to the partnership as undeliverable, the partnership is required to undertake reasonable diligence to identify a correct address for the reviewed year partner.).

22 Prop. Reg. §301.6226-3(d)(3).

23 Prop. Reg. §301.6221(a)-1(c).

24 Prop. Reg. §301.6225-2(d)(2).

25 Prop. Reg. §301.6223-2(c) (note that the regs specifically provide that the partnership agreement may not limit the partnership representative’s authority).


Mitchell I. Horowitz is a shareholder in the Tampa offices of Buchanan Ingersoll & Rooney, P.C. He is a former chair of the Tax Section (2005-2006), and has served in a variety of capacities for The Florida Bar and the ABA Tax Section.

Gregory M. Marks is a partner in the Sarasota office of Shumaker, Loop and Kendrick, LLP, and has served in various leadership capacities within The Florida Bar Tax Section and as chair or reporter for Florida partnership and LLC statute drafting committees.

This column is submitted by the Tax Law Section, Joseph B. Schimmel, chair, and Christine Concepcion, Michael D. Miller, and Benjamin A. Jablow, editors.

[Revised: 11-29-2017]