What Is a Restricted Interest in a Partnership Audit?
Explore the BBA partnership audit concept of a restricted interest, which mandates how tax adjustments must flow through tiered pass-through entity structures.
A restricted interest is a term created by the Bipartisan Budget Act of 2015 (BBA), which established the current centralized partnership audit rules. These rules shifted the liability for audit adjustments from the individual partners to the partnership entity itself. The term restricted interest is unique to this tax audit framework and is defined by the structure of a partnership’s ownership, not by any limits on the sale or transfer of the interest.
Identifying a Restricted Interest
A restricted interest is any partnership interest held by a pass-through entity. The classification is based on the nature of the owner, as the Internal Revenue Service (IRS) seeks to identify the ultimate taxpayer. When a partner is an entity that passes its income and losses to its owners, special rules apply to trace tax adjustments.
Pass-through entities include other partnerships, S corporations, and trusts. For example, if Partnership A’s partners include an individual, a C corporation, and another partnership (Partnership B), the interest held by Partnership B is a restricted interest. This is because Partnership B passes its share of adjustments on to its own partners. Disregarded entities, like single-member LLCs, also create a restricted interest.
Implications of a Restricted Interest in an Audit
The existence of a restricted interest has direct consequences when a partnership chooses to “push out” audit adjustments to its partners. Under Internal Revenue Code Section 6226, a partnership can make this election to pass the tax liability to those who were partners during the audited year. This avoids having the partnership pay the tax, which would be calculated at the highest applicable rate.
When a push-out election is made, the audited partnership gives each partner a statement with their share of the adjustments. While an individual or C corporation partner would then pay the resulting tax, a partner with a restricted interest cannot. Instead, it must continue the push-out process by passing the adjustments to its own partners. It acts only as a conduit, ensuring the audit adjustments are properly allocated down the ownership chain.
Required Information and Notifications
If an audited partnership makes a push-out election, it must collect information from any partner holding a restricted interest. The pass-through partner must provide the full name, current address, and taxpayer identification number (TIN) for each of its own partners. This requirement continues down every tier of a multi-level ownership structure. This data is used to complete Form 8986, Partner’s Share of Adjustment(s) to Partnership-Related Item(s), which details each partner’s share of the audit changes. The audited partnership prepares a Form 8986 for each direct partner, using the provided information to populate the statements.
Procedural Steps for Pass-Through Partners
After receiving a Form 8986 from an audited partnership, a pass-through partner must take two procedural steps within a set timeframe. First, it must furnish its own completed Form 8986 statements to its direct partners, officially passing the audit adjustments to the next tier of owners. The deadline for this is generally tied to the extended due date of the audited partnership’s return for the adjustment year.
Second, the pass-through partner must file a package with the IRS. This submission includes Form 8985, Pass-Through Partner’s Transmittal of Tax Adjustment, which serves as a cover sheet, along with copies of all the Form 8986 statements it issued to its own partners.