A TEFRA partnership is a partnership that was subject to the centralized audit procedures created by the Tax Equity and Fiscal Responsibility Act of 1982. Those procedures governed how the IRS examined partnership returns for about 35 years before Congress replaced them, and they still apply to partnership tax years that began before January 1, 2018. If you are dealing with an old audit, an older partnership agreement, or a partnership interest purchased from someone who held it years ago, the TEFRA rules can still reach you.
Which Partnerships Were TEFRA Partnerships
Before 1982, the IRS had to audit every partner individually when it found a problem on a partnership return. Fifty partners meant fifty separate proceedings and potentially fifty different outcomes. TEFRA fixed that by moving the examination to the partnership level, where a single proceeding could resolve the partnership’s tax reporting for everyone.
Most partnerships fell under TEFRA automatically. The main carve-out was the small partnership exception, and it was narrow. A partnership qualified only if it had ten or fewer partners and every one of those partners was an individual (other than a nonresident alien), a C corporation, or the estate of a deceased partner. A married couple filing jointly counted as a single partner. One trust, LLC, S corporation, or other partnership on the roster disqualified the whole partnership, no matter how small. Small partnerships were examined partner by partner under the traditional process. Everyone else went through TEFRA.
How a TEFRA Audit Worked
TEFRA’s organizing concept was the “partnership item,” defined as any tax item more appropriately determined at the partnership level than at the partner level. That covered income, gains, losses, deductions, credits, guaranteed payments, contributions, distributions, and the other items reported on Form 1065.1Internal Revenue Service. IRS Internal Revenue Manual 8.19.1 – Procedures and Authorities The IRS resolved these questions once, at the partnership level, and the result flowed through to every partner’s individual return.
When the examination produced proposed changes, the IRS issued a Final Partnership Administrative Adjustment, or FPAA, which functioned as the partnership equivalent of a notice of deficiency. The FPAA went to the Tax Matters Partner and to every “notice partner” who had not already agreed to the adjustments.2Internal Revenue Service. IRS Internal Revenue Manual 8.19.12 – Final Partnership Administrative Adjustment
Here is where TEFRA ran into trouble. The audit happened at the partnership level, but the IRS could not collect from the partnership. Any resulting tax, penalty, and interest had to be assessed against individual partners, which meant separate partner-level proceedings to deal with “affected items” on each partner’s own return. For a partnership with hundreds of partners, or a tiered structure where one partnership was a partner in another, the follow-up work became so costly that the IRS sometimes abandoned adjustments it had already won.
The Tax Matters Partner
Every TEFRA partnership needed a Tax Matters Partner (TMP) to serve as the point of contact with the IRS. The TMP notified the other partners about the audit, negotiated settlements, and could extend the statute of limitations on behalf of the partnership. If the IRS issued an FPAA, the TMP had the exclusive right to file a petition challenging it in Tax Court, federal district court, or the Court of Federal Claims within 90 days. If the TMP did not file, other partners who were notice partners or who held at least a 5% interest could file during the next 60 days.2Internal Revenue Service. IRS Internal Revenue Manual 8.19.12 – Final Partnership Administrative Adjustment
The partnership agreement usually named the TMP. If it did not, the role defaulted to the general partner with the largest profits interest at the close of the tax year in question. The TMP’s authority was real but not absolute. Partners kept the right to participate in the proceeding and, in some circumstances, to challenge the TMP’s decisions or settle separately with the IRS.
What Replaced TEFRA
The Bipartisan Budget Act of 2015 (BBA) scrapped the TEFRA framework and installed a new centralized partnership audit regime. The BBA took effect for partnership tax years beginning after December 31, 2017, with an optional early election available for tax years beginning after November 2, 2015.3Internal Revenue Service. Centralized Partnership Audit Regime
The headline change: under the BBA, adjustments are determined at the partnership level and the tax is assessed and collected from the partnership itself.4Office of the Law Revision Counsel. 26 U.S. Code 6221 – Determination at Partnership Level A partnership can request modifications that reduce the amount owed, or it can elect to push the adjustments out to the partners who held interests during the audited year, but the default is that the partnership writes the check. The TMP role was replaced by a “partnership representative” with sole authority to act for the partnership; no partner can participate in the IRS proceeding without consent, and every partner is bound by the representative’s decisions.5Office of the Law Revision Counsel. 26 U.S. Code 6223 – Partners Bound by Actions of Partnership That authority runs considerably broader than anything the TMP held.
Why TEFRA Still Matters
Repealed is not the same as gone. The TEFRA rules continue to govern real situations.
Timing is the most direct reason. The BBA applies only to partnership tax years beginning after December 31, 2017. Any return from a tax year starting before that date remains under TEFRA’s procedures if the partnership was subject to them.3Internal Revenue Service. Centralized Partnership Audit Regime Because statutes of limitation can be extended by agreement and litigation stretches on, some TEFRA-era audits and court cases are still active. A partner who held an interest during a pre-2018 year can still face an assessment under the old rules.
Legacy partnership agreements are the second reason. Thousands of operating agreements and limited partnership agreements drafted before 2018 include provisions built around the Tax Matters Partner, FPAA notice rights, and TEFRA audit procedures. Those provisions no longer line up with current law. An agreement that gives the TMP power to extend the statute of limitations does nothing when the statute requires a partnership representative instead. An agreement that preserves partner participation rights grounded in TEFRA may create expectations the BBA will not honor, because the partnership representative’s authority is far more absolute than the TMP’s was. Partnerships that have not updated their agreements since 2017 are carrying language that does not match the regime they now operate under.
The third reason reaches buyers of partnership interests. Under TEFRA, audit adjustments were assessed against the individual partners who held interests during the audited year. Under the BBA, the partnership pays, so a buyer can end up absorbing a share of tax liability for positions taken years before the purchase. Knowing which regime applies to which tax year is a necessary piece of due diligence any time a partnership transaction involves pre-2018 returns.