The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) established a unified procedure for determining the tax treatment of partnership items at the partnership level rather than the partner level. Although these rules addressed a serious and real administrative problem in the assessment of partnership level deficiencies, they also created a complex process with many new problems and potential traps. One particularly unique set of challenges arises in the context of multi-tiered entities.
Multi-tiered entities are partnerships that have a partnership or other pass-through entity as a partner. The pass-through partner is commonly referred to as a “tier,” and the partnership in which it holds its interest is the “source” partnership. The partners who hold an interest in the source partnership through a pass-through partner are “indirect partners” of the source partnership. TEFRA procedures apply to all partners, whether direct partners, pass-through partners, and indirect partners. Pass-through partners and indirect partners face unique issues in navigating the TEFRA rules. This article highlights some common issues.
The Internal Revenue Service (IRS) provides notices of the beginning of an audit to the partnership and “notice partners,” generally those partners identified on the partnership’s return. Pass-through partners are required to pass the information along to their partners, but any partnership proceedings and adjustments apply to indirect partners even if they did not receive notice of the proceedings. Indirect partners therefore may wish to follow the special procedure to become notice partners and therefore receive notifications directly from the IRS. This may be particularly important if the pass-through partner is in bankruptcy or the indirect partner holds less than 1% interest in a large partnership.
All partners have a right to participate in certain administrative proceedings. However, some rights are limited to notice partners, such as the right to file a protest to a notice of final partnership administrative adjustment (FPAA) or the right to file a petition for redetermination in Tax Court. Further, the tax matters partner (TMP) can reach a settlement with the IRS that binds all partners who are not notice partners, while notice partners can accept the settlement or not. Thus, indirect partners may wish to protect these rights by follow the special procedure to become notice partners.
Finally, the statute of limitations for assessment of taxes attributable to partnership items is longer for “unidentified partners”; it does not expire until one year after the unidentified partner is identified to the IRS. Becoming a notice partner may therefore prevent an indefinite extension of the statute of limitations for indirect partners. This is particularly important if the indirect partner, whether knowingly or unknowingly, takes a position on its tax return that is inconsistent with the partnership’s return.
In many ways, TEFRA reduced the procedural burden on partners by streamlining the process and reducing overall audit costs. In exchange for this benefit, TEFRA’s procedures in many cases shift the notice burden to pass-through partners and limit an indirect partner’s right to control the resolution of its tax liability. Pass-through partners and indirect partners should approach a TEFRA audit with caution. A pass-through partner should take care to comply with TEFRA’s notice requirements to avoid potential liability to its partners. Likewise, indirect partners should protect their rights to participate in partnership-level proceedings and to control the resolution of their own tax liability.
W G & L Financial Reporting & Management Research
Mary A. McNulty, Robert D. Probasco & Lee S. Meyercord,
Navigating TEFRA Partnership Audits in Multi-Tiered Entity Structures,
Available at: https://scholarship.law.tamu.edu/facscholar/1231