The BBA rules are coming

The upcoming New Year may present some nasty surprises to oil and gas partnerships that have not prepared for the new partnership tax audit rules. Entirely new Internal Revenue Service (IRS) audit procedures will become effective for partnership taxable years beginning after Dec. 31, 2017. These new rules drastically change the way the IRS will assess additional tax on partnership income. Moreover, the new regime will make partnerships directly liable to pay any additional taxes, not the individual partners.

The new partnership audit rules were enacted as part of the Bipartisan Budget Act of 2015 (BBA). The BBA adopted a streamlined set of rules designed to make it easier for the IRS to audit and collect tax from large partnerships, particularly hedge funds, private equity firms, and oil and gas partnerships. To accomplish these goals, the BBA authorizes the IRS for the first time to assess and collect tax adjustments at the partnership level, effectively imposing taxes directly on entities taxed as partnerships. In effect, partnerships will no longer be taxed entirely as pass-through entities.

Congress expects to raise $11 billion in revenue as a result of these rules, so oil and gas partnerships should expect the IRS to be aggressive in using its new tools. Fortunately, there are actions tax partnerships can take now to reduce the potential for negative consequences in the coming years.

Oil and Gas Partnerships

The term "partnership" is broader than most folks expect. The Internal Revenue Code (IRC) defines "partnership" extremely broadly to include almost any unincorporated joint business operation. This definition is broad enough to cover most types of joint operations in the oil and gas industry, from formal partnerships to contractual joint ventures that have not elected to opt out of partnership treatment under IRC Section 761 (e.g., by striking paragraph IX of the AAPL Model Form 610 Joint Operating Agreement). For tax purposes, "partnership" also includes other entities, such as limited liability companies, that have elected to be treated as a partnership for federal income tax purposes in order to obtain the benefits of a single level of income tax.

Oil and gas partnerships also include a significant number of master limited partnerships (MLP), which combine the tax benefits of a partnership and the liquidity of a publicly-traded corporation. Because MLP units are publicly-traded, MLPs must satisfy specific requirements not imposed on other tax partnerships. For example, MLP units must be "fungible," meaning they must have identical tax and economic characteristics in the hands of a buyer, leaving MLPs exceptionally sensitive to the entity-level tax envisioned by the BBA.

Understanding The New
Partnership Audit Rules

For more than thirty years, tax partnerships have been subject to audit under the procedures established in the Tax Equity and Fiscal Responsibility Act of 1982, commonly referred to as TEFRA. TEFRA created a unified audit procedure for most partnerships, which allowed the IRS to examine partnership items at the partnership level, rather than opening an audit into the personal return of each individual partner. Although the TEFRA rules encouraged a partnership to name a "tax matters partner" to help coordinate the audit, partners had significant rights to notice and participation. In the event the IRS determined adjustments to partnership items, the adjustments flowed through to the partners, with the separate partners having the responsibility to pay their allocable shares of any assessed tax, penalties, or interest.

The BBA rules radically change both the partnership audit procedures and the collection of additional taxes from partnerships. Most importantly, the new rules shift the burden of paying any tax adjustments directly to the partnership. The BBA authorizes the IRS to assess any "imputed underpayment" of tax at the partnership level, generally at the highest individual rate of tax (currently 39.6 percent), rather than at the separate partners' individual tax rates, and then to collect any tax underpayments, penalties, and interest directly from the partnership.

The BBA rules also severely limit partners' rights with respect to the examination of the partnership's return. Unlike under the TEFRA rules, partners will no longer have the right to receive notice of a partnership audit, participate in the audit, or raise partner-level defenses. Instead, the IRS will only deal with a single designated "partnership representative" who will have the sole authority to act on behalf of the partnership. If the partnership fails to designate a partnership representative on its return for the year under review, the IRS may select a partnership representative to act on behalf of the partnership. Unlike the tax matters partner under TEFRA, the BBA partnership representative does not have to be a partner of the partnership, but can be any person with a substantial presence in the United States.

Relief Provisions

The BBA rules are extremely favorable to the IRS, but they do provide taxpayers with a few avenues for relief. For example, under IRC Section 6221, small partnerships of 100 or fewer qualifying partners are eligible to opt out of the new procedures. Qualifying partners include individuals, C corporations, foreign entities that would be taxable as C corporations under US law, S corporations, and the estates of deceased partners. These qualifying partner rules mean that some small partnerships will not be eligible to opt out of the BBA rules. For example, if one of the partners is a partnership, a disregarded entity, or a trust, the partnership cannot opt out.

If an eligible small partnership wants to opt out of the BBA rules, it must do so annually on its tax return. The partnership cannot wait until an IRS audit to decide; it must elect out of the BBA procedures when filing the tax return.

For partnerships that are too large (i.e., more than 100 partners) or too complicated (e.g., with another partnership as a partner) to elect out of the BBA, there are two other options to reduce the burden of the partnership-level tax. First, a partnership can make a "push out" election under IRC Section 6226. To do so, the partnership provides each of its reviewed-year partners with a revised Schedule K-1 reporting such partner's allocable share of any partnership-level adjustments within 45 days of receiving notice of a final partnership adjustment (FPA) from the IRS. This shifts (or "pushes out") the burden of payment from the partnership to those who held an interest in the partnership during the taxable year under review. However, the election comes at the price of paying an additional two percent interest on any underpayment.

Alternatively, a partnership can seek a modification of the imputed amount of the tax under IRC Section 6225. These provisions allow adjustment of the partnership tax liability if the reviewed-year partners voluntarily amend their own returns or if the partnership can show that the individual partners would have been taxed at a rate lower than the maximum individual marginal rate. For example, a partnership can seek a reduction in the imputed underpayment amount where at least one of its reviewed-year partners voluntarily files an amended return, taking into account the partner's share of the adjustments in the FPA and remitting the corresponding tax due.

A partnership can also request a modification to the extent an adjustment is allocable to (1) a tax-exempt partner, from which no tax should be due, (2) a C corporation, subject to tax at a lower maximum rate (35%), or (3) in the case of capital gain or qualified dividend income, an individual, as such income is taxable at preferred rates (23.8%). MLPs can also request a modification to the extent its partners have "specified passive activity losses," or losses from the MLP suspended under IRC Section 469(k).

Potential Consequences of Inaction

Oil and gas partnerships, big and small, need to prepare for the BBA rules. Failing to do so will lead to complications and potentially increased costs. For example, if a partnership does not consult with its tax advisors about designating a partnership representative each year on its return, it potentially leaves the selection of a partnership representative in the hands of the IRS. Similarly, a small partnership eligible to opt out under IRC Section 6221 must be proactive in making such an election on its tax return each year or be subject to the general BBA rules upon audit.

Thoughtful planning also is essential to avoid unnecessary disputes among partners. By imposing an entity-level tax, the BBA effectively shifts the tax burden from the partners who owned partnership interests in the taxable year under review to the current year's partners, regardless of whether the current partners owned any interest in the partnership during the reviewed year. Under the BBA, the partnership's current partners will be subject to capital calls or reduced distributions to pay any tax demanded from the partnership.

Moreover, oil and gas partnerships face peculiar additional complications from an entity-level tax. For example, the Internal Revenue Code treats a joint venture that has not elected out of partnership treatment as a separate entity, despite being a purely contractual arrangement. A joint venture is not a state-law entity, and it is unlikely to have a bank account with funds that it could use to pay an "entity" level tax. Accordingly, the joint operating agreement for any tax partnership should address this issue specifically, either by making a particular party (e.g., the operator) responsible for paying any tax assessed against the joint venture under the BBA, or requiring the partnership representative for the joint venture to make a push-out election.

An entity-level tax will also cause unique difficulties for MLPs. Because of the fungibility requirement for MLP units, MLPs generally cannot make special tax allocations or distributions to a particular group of public unitholders or call for additional capital from some public unitholders but not others. An MLP thus cannot allocate the burden of the partnership-level tax to partners according to the interests they held in the MLP in the reviewed year. Further, given that a tax liability will likely drive down the trading price of an MLP's public units, it would be difficult to raise capital to pay the tax by selling additional equity units. Instead, to pay the tax, the MLP would need to use cash on hand - potentially resulting in reduced distributions - or debt. An MLP could also pursue a push-out election to avoid these consequences and push the liability out to the reviewed-year partners. But the average MLP has approximately 40,000 unitholders, so an MLP would struggle to make a push-out election within the tight timeframe in which to issue adjusted Schedule K-1s to all the partners.

Recommendations

The good news is that oil and gas partnerships still have several months to prepare for the new BBA rules. During that time, partnerships should review their governing documents and amend any tax matters provisions. At a minimum, partnership agreements should be revised to:

Refer to the BBA rules, rather than the soon-to-be-outdated TEFRA provisions;

• Designate a partnership representative or establish a procedure to select the partnership representative for each taxable year;

• Provide checks and balances on the partnership representative's authority, including notice procedures in appropriate partnerships;

• In a small partnership, address whether to elect out of the BBA rules and include transfer restrictions to ensure the partnership remains eligible to elect out; and

• Determine whether all partners should indemnify the partnership for their allocable share of any partnership tax adjustment.

In addition, oil and gas partnerships concerned about the potential impact of the new BBA rules should consult with their tax advisers about other measures necessary to prepare for these new rules.

About the authors

Larry Campagna is a shareholder and former chair of the Tax Controversy Section of the law firm of Chamberlain, Hrdlicka, White, Williams & Aughtry. Jessica Cory is an attorney in the Tax Section of Chamberlain Hrdlicka.