As part of their ongoing implementation of the partnership audit system created by 2015's Balanced Budget Act, the IRS has again released guidance on how partnerships can pay adjustments after an audit.
On February, 1 the IRS proposed rules detailing how to re-align partners’ capital accounts after an adjustment, if the partnership elects to pay the liability at the entity level. The goal is to find a way to put partners in the same place after an adjustment that they would have been if the tax had been paid correctly in the first place.
The regulations create a concept called a notional item that is allocated to partners and adjusts their capital accounts based on the amount of tax the partnership paid on their behalf. The rules instruct partnerships on how to allocate those notional items to partners and how to deal with scenarios when partners have sold their interest prior to the conclusion of an audit. The new partner who bought their interest will get the old partner's basis, with an exception for cases where the old-year partner was a tax-exempt partner.
The proposed rules, however, could create serious problems for master limited partnerships (MLPs), whose units trade on public markets, where new partners don't know from whom they are buying. Additionally, MLP units have to be treated the same so the MLP can't adjust the capital account of one unit without making adjustments on all interests.
Additionally, the IRS released regulations in December that specify that partnerships can push tax adjustments out to the ultimate partner in a tiered structure. Both the entity level tax and the push-out will require the partnership to collect information from partners and send data back out. As a result, many partnerships will simply opt for the push-out option so that they don't also have the responsibility of cutting the check to the IRS.
Publicly traded partnerships (e.g. MLPs), however, may often decide to pay the adjustment at the entity level because pushing it out to the partners would create a big inconvenience for investors. As a result, the IRS' February guidance could create problems for MLPs: the mechanism to adjust a partner’s basis after a tax adjustment paid at the partnership level (notional item) will apply imperfectly to the partnerships most likely to use it (MLPs).