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TEFRA Update-Just When You Thought TEFRA Couldn’t Get Any More Complicated by Edward M. Robbins, Jr.

[On November 2, 2015, President Obama signed into law H.R. 1314, the Bipartisan Budget Act of 2015 (the “Budget Act”). This document outlines the key provisions (new procedural rules for partnership audits and adjustments, and amendments to sections 704(e) and 761(b)) relating to the determination of who is a partner in a partnership relating to TEFRA.]

REVISED PARTNERSHIP AUDITS AND ADJUSTMENTS RULES. The Bipartisan Budget Agreement (“Budget Act”) repeals the unified audit rules (TEFRA – Tax Equity and Fiscal Responsibility Act of 1982) and the special rules for electing large partnerships (“ELPs”).   The new partnership rules are intended to once again streamline partnership audits by replacing them with a single system of centralized audit, adjustment, and collection of tax for all partnerships.  Partnerships with 100 or fewer qualifying partners would be permitted to affirmatively opt-out of the new rules, electing to be subject to audits at the individual partner level.  The opt-out procedure is available provided that each partner is an individual, C corporation, foreign entity that would be a C corporation under U.S. law, an S corporation, or the estate of a deceased partner.

Since 1982, there have been numerous procedural and litigation issues raised regarding the implementation of TEFRA and over the years various proposal have been considered by Congress to overhaul the taxation of partnerships as TEFRA has been viewed as inefficient and complex.

As of today partnerships are audited one of the following three ways:

  • Partnerships with more than 10 partners are audited under the unified TEFRA procedures and binding on the partners;
  • Partnerships with 100 or more partners that elected to be treated as Electing Large Partnerships (ELPs) are subject to a unified audit. Any adjustments are reflected on the partner’s current return rather than on an amended return; and
  • Partnerships with 10 or fewer partners are audited as part of each partner’s individual audit.

The new Budget Act will apply to partnership returns filed for tax years beginning after December 31, 2017 and may allow a partnership to elect out of the new regime.  Specifically, the act replaces the current TEFRA partnership audit rules (Code sections 6221 through 6255).  It also repeals the current rules for electing large partnerships for electing large partnerships (sections 771 through 777).  In their place, the new rules are designed to assess and collect underpaid tax at the partnership level rather from the partners even though partnerships are flow through entities.

The new Section 6221 provides that:

Any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year (and any partner’s distributive share thereof) shall be determined, any tax attributable thereto shall be assessed and collected, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to any such item or share shall be determined, at the partnership level pursuant to this subchapter.

Certain partnerships with 100 or fewer partners can elect out of this provision.

For adjustments that result in tax underpayments the Service will be allowed to collect additional tax directly from the partnership in the year of an adjustment[i] and the tax could be collected at the highest individual tax rate.

The new section 6222 requires that a partner must treat “each item of income, gain, loss, deduction, or credit attributable to a partnership” consistently with how those item are treated on the partnership return.  Any underpayment resulting from a partner’s failure to treat an item consistently with the partnership return will be assessed as a math error on the partner’s return.  However, partners can avoid this provision if, before filing their return, they notify the IRS that there will be an inconsistency.

The new Section 6223 requires partnerships to designate a partnership representative, “who shall have the sole authority to act on behalf of the partnership in this subchapter.”  The partnerships and all partners will be bound by the actions of the partnership and by any final decision in a proceeding with respect to the partnership.  The Act also introduces new procedural rules regarding notices of proceedings and adjustment; assessment, collection, and payment; interest and penalties; judicial review of partnership adjustments; and the limitation period on making adjustments.

A Congressional Summary of the new provision explains that partnerships “would have the option of demonstrating that the adjustment would be lower if it were based on certain partner level information from the year under audit rather than imputed amounts determined solely on the partnership’s information in such year.”  However, the Budget Act also provides an elective mechanism by which a partnership could push out the payment of underpaid amounts in the current year to those who were partners in the year to which the adjustment relates.

The Service will need to develop regulation to reflect the repeal of the TEFRA and ELP rules and the enactment of its replacement regime.  On a positive note, Congress provided a delayed effective date (returns filed for partnership tax years beginning after 2017) giving taxpayers an opportunity to provide comments and allowing Treasury and IRS time to digest the changes and issue regulations, guidance and clarification. Already questions are being raised about the impact to multi-tier partnerships and impact on foreign and tax-exempt partners, as well as changes in partnership allocations and partners from year to year.  Also, it is unknown how state and local taxing authorities will respond to this new regime.

Reason for the Regime Change

Although, partnerships are among the fastest growing type of business entity, the Service audits very few large partnerships.  Most partnership audits resulted in no change to the partnership’s return or the aggregate change was small. According to the Service, the number of partnerships has grown at an annual rate of 3.9% since 2003. Almost two-thirds of large partnerships had more than 1,000 direct and indirect partners, had six or more tiers and/or self-reported being in the finance and insurance sector, with many being investment funds.

In recent years, there has been increased focus on problems the Service faces in auditing large partnerships. In July 2014, the U.S. Government Accountability Office (GAO) provided testimony before the Permanent Subcommittee on Investigations of the Senate Committee on Homeland Security and Governmental Affairs assessing the Service’s ability to audit “large” partnerships (defined for this purpose as partnerships with $100 million or more in assets and 100 or more direct and indirect partners). The GAO testified, among other things, that although the number of large partnerships more than tripled from tax years 2002 to 2011, the IRS audits few large partnerships. The GAO noted that, in 2012, the Service audited only 0.8% of large partnerships, compared to 27.1% for large corporations. Compare that to the amount of income that passed through partnerships.  In 2012, $1.4 billion in income was reported by partnerships – a 43.4% increase from 2011.

A few months later, the GAO issued a report recommending that Congress consider legislation requiring a large partnership to identify a partner to represent it during audits and to pay taxes on audit adjustments at the partnership level. The report’s findings concluded that under the existing TEFRA regime:

  • The Service audits few large partnerships, most audits result in no change to the partnership’s return, and the aggregate changes are small.
  • These audit results may be due to challenges—such as finding the sources of income within multiple tiers while also complying with TEFRA within specified time frames.
  • Service auditors said that it can sometimes take months to identify the partner that represents the partnership in the audit, reducing time available to conduct the audit.
  • Service officials stated that the process of determining each partner’s share of the adjustment is paper and labor intensive. When hundreds of partners’ returns have to be adjusted, the costs involved limit the number of audits the Service can conduct.

Subsequently, several similar legislative proposals were introduced to reform the partnership audit rules by, among other things, imposing a partnership-level tax in the case of audit adjustments. Prior to the Budget Act, the most recent of these proposals was H.R. 2821, the Partnership Audit Simplification Act.  However, numerous concerns were raised about aspects of H.R. 2821, including that it would have applied to more than the kinds of “large” partnerships addressed by GAO reports and would have imposed joint and several liability for the assessment of underpaid tax on the partnership and all its direct and indirect partners in both the year to which the adjustment relates and the year in which the adjustment finally is determined. H.R. 2821 also would have required past-year partners to file amended returns in many situations for the amount of the assessment to reflect the character of the income underpaid and the characteristics of the partners. In late October 2015, the partnership audit reform was added to the Budget Act but it included significant changes to the proposed H.R. 2821. It should also be noted that the modified version of the TEFRA provisions had not previously been made public.

The Budget Act’s partnership audit regime includes changes to the proposed H.R. 2821. The key changes are as follows:

  • It allows relatively more partnerships to elect out of the new regime,
  • It does not include the “joint and several” liability provision from H.R. 2821,
  • It allows the amount of an underpayment to be adjusted to better reflect the particular facts without requiring amended returns, and
  • It provides an elective mechanism by which those who were partners in the year to which the adjustment relates (rather than the partnership) can be responsible for payment of underpaid amounts in the current year.

 Partnerships Impacted by the Changes

The new audit and adjustment regime applies to all partnerships unless the qualifying partnerships affirmatively elect out for a tax year. A partnership can elect out of the new regime for a tax year only if:

  • It is required to furnish 100 or fewer statements under section 6031(b) (i.e., Schedules K-1) with respect to its partners for the tax year;[ii]
  • Each of its partners is an individual, a decedent’s estate, a C corporation, an S corporation, or a foreign entity that would be treated as a C corporation if it were domestic; and
  • Certain procedural requirements are met relating to the election.

In addition special rules apply for a partnership with an S corporation partner to elect out of the regime. The partnership generally must provide the IRS with the names and taxpayer identification numbers of the S corporation’s shareholders (in accordance with procedures prescribed by Treasury). If the partnership has an S corporation partner, then the Schedules K-1 furnished by the S corporation are treated as statements of the partnership for purposes of the “100 or fewer” rule. In addition, Treasury can issue rules similar to those applicable to S corporation partners to other kinds of partners.

To elect out, a partnership should consider whether any partners that are foreign entities would be treated as C corporations if domestic. Under the entity classification rules, the only domestic eligible entities that are classified as corporations for federal tax purposes are those that are either per se (such as incorporated entities or certain special taxpayers such as insurance companies and REITs) or those that elect to be classified as a corporation. Thus, it is unclear what is intended by referencing foreign entities that would be treated as C corporations if domestic.

Another challenge is the rules do not specifically address how a partnership interest that is owned by an entity that is disregarded as an entity separate from its owner will be treated. Generally, such an entity is disregarded, and its activities are treated in the same manner as a sole proprietorship, branch or division of the owner, for federal income tax purposes. The fact a disregarded entity owned by an individual or a C corporation holds a partnership interest seemingly should not disqualify the partnership from electing out of the new regime[iii]. However, 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.

 Opt Out or Not To Opt Out of the new Regime: Things to Consider

The opt-out procedure is available provided that each partner is an individual, C corporation, foreign entity that would be a C corporation under U.S. law, an S corporation, or the estate of a deceased partner (“eligible partnership”). In order to elect out of the new regime, an eligible partnership must file an election with its timely filed return for each year for which the election would apply, plus must disclose the name and taxpayer identification number of each partner in the partnership (unless the Treasury provides alternative identification for foreign partners). The partnership also must notify each partner of the election.

Partnerships that are eligible to elect out of the new regime will need to consider whether they want to elect out; an affirmative election will need to be made for each tax year that the partnership wants to elect out. Because the election is made with respect to a tax year, it appears that an eligible partnership could elect out of the regime for some years, but not for others.

One thing to consider is the impact of the assessment and refund statutes.  If a partnership elects out, the general “non-TEFRA” assessment and collection rules that were not modified by the Budget Act would apply.  In other words, the Service could still audit the partnership at the partnership level, but the partnership could not extend the statute of limitations for assessment for partnership 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 items under section 6501 and 6511, and the Service 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. In its place, the Service would need to enter into a separate settlement with each partner. For partners that do not resolve their partnership issues with the Service, the IRS would have to issue each partner a statutory notice of deficiency within the partner’s limitation period under section 6501. Each partner would have an option 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 for that partner 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 could occur at the same time.

One other thing to keep in mind is the impact of the timing of the adjustment.  Under the old TEFRA regime an adjustment would be made to the “reviewed year” partners return (year under examination) versus the current year partner’s return. Under the new audit regime, these items are taken into account by the partnership in the current year. The partnership’s ability to elect the alternative method, described below, to push back the payment of underpaid amounts to those who were partners in the year to which the adjustment relates appears limited to items that result in an “imputed underpayment.” Accordingly, any partnership that has not elected out of the new regime, and is eligible to, may be prohibited from sending any adjustment items related to net losses or net deductions back to the partners who were in the partnership during the reviewed year.

 Now What: Creative Adjustment and Collection Mechanisms

Under the new audit regime applies, the Service will audit items of income, gain, loss, deduction, or credit of the partnership (and any partner’s distributive share thereof) at the partnership level. The IRS likewise will assess and collect any taxes, interest, or penalties relating to an adjustment at the partnership level. This mechanism is provided to those partners in the year that is the subject of the adjustment and can pay their shares of the adjustment (instead of the partnership), as a result of a Schedule K-1 approach that does not involve the partners amending past year returns.

If the Service determines that adjustments are required for the partnership tax year being audited (the “reviewed year”), the partnership is required to pay any “imputed underpayment” with respect to the adjustment in the year in which the adjustment is finalized (the “adjustment year”). An adjustment that does not result in an imputed underpayment generally is taken into account by the partnership in the adjustment year as a reduction in non-separately stated income or an increase in non-separately stated loss (or, in the case of a credit, as a separately stated item).

  1. Amount of Imputed Underpayment


In the case of an underpayment, the imputed underpayment generally is determined by

  1. netting adjustments of items of income, gain, loss, or deduction for the reviewed year, and
  2. multiplying this net amount by the “highest rate of tax in effect for the reviewed year under section 1 or 11” (i.e., the highest individual or corporate rate). Thus, under the current rate structure, the 39.6% individual rate appears to be the “default” rate used for computing the imputed underpayment (even if there are C corporation partners). It is anticipated that Treasury will establish procedures under which the imputed underpayment amount can be modified to better reflect the amount properly owed to the government based on the character of underpaid income and the nature of the partners. In fact, the Budget Act directs the IRS to establish procedures that “shall” provide for:
  • Adjusting the amount of the underpayment to reflect amended returns filed by one or more partners for the tax year of such partners that includes the end of the partnership’s reviewed year.
  • Determining the amount of the imputed underpayment without regard to the portion thereof that the partnership demonstrates is allocable to a partner that would not owe tax by reason of its status as a tax-exempt entity (as defined in Code section 168(h)(2)).
  • Taking into account a rate of tax lower than the highest rate in effect under Code section 1 or 11 with respect to any portion of the imputed underpayment that the partnership demonstrates is allocable to a C corporation partner (in the case of ordinary income) or to an individual or S corporation (in the case of capital gain or a qualified dividend). If a portion of an imputed underpayment is subject to a lower rate, the portion is determined by reference to the partners’ distributive share of items to which the imputed underpayment relates. If it is attributable to more than one item, and any partner’s share of such items is not the same with respect to all such items, then the portion of the imputed underpayment to which the lower rate applies is determined by reference to the amount which would have been the partner’s distributive share of net gain or loss if the partnership had sold all of its assets at their fair market value as of the close of the reviewed year.

In addition, the Budget Act provides Treasury with authority to provide for additional procedures for modifying the amount of the imputed underpayment based on other factors, as appropriate. Things that should be considered include:

  • Clarification of the tax rate (35%) for the imputed underpayment.
  • Use of a “fair market value” sale approach may cause additional burdens by requiring a determination of fair market value.
  • Impact of tax attributes of the partners such as net operating losses (NOLs) or lower, treaty-based, rates that may be applicable for certain foreign partners.
  • Impact of the modification of the underpayment amount to reflect items included on the amended return of the partners for the reviewed year is limited if the adjustment is one that reallocates the distributive share of any item from one partner to another. In this case, the adjustment to the partnership’s underpayment amount to reflect items for which a partner filed an amended return is restricted to only those items for which all affected partners file amended returns.
  1. Payment of Imputed Underpayment by Partnership


As a general matter, the Budget Act requires a partnership to pay the imputed underpayment with respect to the adjustment by the due date of the partnership’s tax return (without regard to extensions of time to file) for the year for which the adjustment is finally determined (i.e., the adjustment year). Further, no deduction is allowed under the income tax title of the Code for any payment required to be made by the partnership. However, the non-deductiblity of the payment should reduce the partner’s tax basis in the partnership and the partner’s tax basis would be increased to reflect the partner’s share of the Service’s adjustment to the partnership’s income.

  1. Alternative Mechanism for Payment by Partners


Payment of the imputed underpayment by the partnership puts the economic burden of underpaid tax with respect to a past year on the current partners of the partnership. The Budget Act provides an elective alternative mechanism that puts the burden on the partners in the reviewed year. Specifically, a partnership that receives a notice of final partnership adjustment can elect to furnish to each partner in the reviewed year a statement of the partner’s share of the adjustment. In such case, each partner’s tax imposed for the tax year that includes the date the statement is furnished (i.e., the current tax year) is increased to reflect the adjustment amount, as well as any associated penalties or interest. The general rate of interest on underpayments is determined by adding three percentage points to the federal short- term rate. Significantly, however, under the new law, interest is determined by adding five percentage points, rather than three percentage points, to the federal short-term rate. Thus, there appears to be an interest “toll charge” to having the reviewed-year partners, rather than the partnership, pay the imputed underpayment. In addition, any subsequent year tax attribute that would have been affected if the adjustment had been taken into account in the reviewed year is “appropriately adjusted.”

In order to apply this alternative collection regime, the partnership will have to make an election no later than 45 days after the date of the notice of final partnership adjustment. Use of this alternative mechanism can be expected to be attractive to partnerships in which the partners, or the interests of partners, change from time to time because it allows the economic burden of the imputed underpayment to fall upon those who were partners in the year of the underpayment based on their interests in such year. Nonetheless, additional administrative costs, as well as higher interest calculations, would be involved in using the approach. To the extent that there is an adjustment to be taken into account by a reviewed year partner as a result of the use of the alternative mechanism, there will likely be an increased burden on the partner to determine the increase in tax liability not only for the reviewed year, but also for years subsequent to the reviewed year. For example, if a partner sells its interest between the reviewed and the adjustment year, the partner’s basis in the partnership interest may be affected by the adjustment amount. Other tax attributes, such as NOLs, passive activity losses, and other loss limitations, may need to be redetermined as a result of an adjustment amount.

Another question arises with respect to tiered partnerships. If a lower-tier partnership elects to use the alternative mechanism and furnishes an upper-tier partnership with a Schedule K-1 showing an adjustment for the reviewed year, can that upper-tier partnership in turn elect to use the alternative mechanism to pass the adjustment through to its partners (notwithstanding that it was not the partnership that received the notice of adjustment)? How would the “45-day” rule apply? Seemingly, the mechanism is intended to allow the adjustment to flow up tiers of partnerships. This is another area that clarity and guidance will be need before the new law begins to apply.

Although the alternative collection regime appears to only apply to “imputed underpayments” one would hope for consistency with an overpayment – resulting in an ordinary deduction to partners in the adjustment year (even though the partners of the adjustment year may be different than the reviewed year).


The new law imposes a substantially similar approach to payment of tax on an underpayment in the case of administrative adjustment requests filed by the partnership. When a partnership files an administrative adjustment request, the adjustment is taken into account for the partnership tax year in which the administrative adjustment request is made (i.e., the year of the filing, not the prior year). In addition, the payment of tax on an understatement is to be made generally using either the partnership level tax provisions, or under rules similar to the alternative method for payment by partners. When the adjustment would not result in an imputed underpayment, the partnership must use the alternative payment method for payments by partners.


Another area of difficulty with TEFRA involved the issue was who had the ability to represent the partnership.  Under the new law it will require each partnership that does not elect out of the new regime to designate a partner, or other person, with a substantial presence in the United States as the partnership representative (“Partnership Representative”). The Partnership Representative will have the sole authority to act on behalf of the partnership for purposes of the new regime. If the partnership does not make such a designation, the Service can select any person as the Partnership Representative. Further, the partnership and all its partners will be bound by actions taken under the new regime by the partnership and by any final decision in a proceeding brought under the new regime with respect to the partnership.


Under the new regime, no adjustment for a partnership tax year can be made after the latest of the date which is three years after the latest of the following three dates: (1) the date on which the partnership return for such tax year was filed, (2) the return due date for the tax year, or (3) the date on which the partnership filed an administrative adjustment request (AAR) with respect to such year.

There are also new rules that allow the period to remain open for adjustment: (1) in the case of any modification of the imputed underpayment, to a date that is 270 days after the date everything required to be submitted is submitted to the IRS; and (2) in the case of any notice of proposed partnership adjustment, to a date that is 270 days after the date of such notice.

The major change here is the impact of filing an AAR.  Under the new regime the Service is provided 3 years from the filing of an AAR to assess tax.  One wonders why the Service would need this additional time to keep the assessment statute open especially in a situation in which the partnership has paid the tax.  Like the Service taxpayers want finality and adding three years to the statute is a mystery.


The Budget Act strikes section 704(e)(1) and changes the heading of section 704(e) to “Partnership Interests Created by Gift” (instead of “Family Partnerships”). It also adds a new sentence to the end of section 761(b) providing that, in the case of a capital interest in a partnership in which capital is a material income-producing factor, whether a person is a partner with respect to such interest will be determined without regard to whether such interest was derived by gift from any other person. These amendments are effective for partnership tax years beginning after December 31, 2015. The section by section explanation of the budget agreement explains that:

The provision would clarify that Congress did not intend for the family partnership rules to provide an alternative test for whether a person is a partner in a partnership. The determination of whether the owner of a capital interest is a partner would be made under the generally applicable rules defining a partnership and a partner. In addition, the family partnership rules would be clarified to provide that a person is treated as a partner in a partnership in which capital is a material income-producing factor whether such interest was obtained by purchase or gift and regardless of whether such interest was acquired from a family member. The rule, therefore, is a general rule about who should be recognized as a partner. 


The Budget Act is effective for returns filed for partnership tax years beginning after December 31, 2017.  That said, a partnership could elect for the provisions to apply earlier.  It is anticipated that guidance will be issued and welcomed before the effective date.

EDWARD M. ROBBINS, Jr. – For more information please contact Edward M. Robbins, Jr. -EdR@taxlitigator.com  Mr. Robbins is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., the former Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal)  and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at www.taxlitigator.com

[i]   See the new Section 6225.

[ii] Note that the “100 or fewer” requirement is based on the requirement to furnish Schedules K-1 not the number actually furnished.  Partnerships that routinely provide a separate Schedule K-1 for each class of interest one partner may hold may want to revisit the potential implications of issuing the additional Schedules K-1 on whether that partnership is eligible to elect out. To the extent that there are multiple transfers of the same interest during the tax year, it appears that each transfer generally will be taken into account for purposes of the “100 or fewer” requirement.

[iii]  See, Rev. Rul. 2004-88, in which the Service 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 and such exception was not applicable.

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