Partnership Audits | You Bought the Partnership. Now You Own Its Old Tax Problems.

You close on a partnership acquisition. The deal is done, the champagne is flat, and the integration is underway. Three years later, the IRS opens an audit of the partnership — covering a tax year when the sellers owned it. A year of losses the sellers took, deductions the sellers claimed, allocations the sellers structured.

And then the bill comes to you.

That's not a hypothetical. Under the rules that have governed partnership audits since 2018, that's the default. And most purchase agreements don't deal with it adequately.

Why partnerships get audited differently

Partnerships don't pay federal income tax themselves. They pass income, gains, losses, and deductions through to their partners, who report everything on their own returns. That structure creates an audit problem: if the IRS finds an error in the partnership's returns, it has to chase down every single partner — potentially hundreds of them — to collect the tax. For large funds and joint ventures, that was effectively unenforceable.

Congress fixed that in 2015 with the Bipartisan Budget Act, or BBA. The fix was simple and brutal: audit the partnership as a single entity, calculate any tax owed at the partnership level, and collect it from the partnership directly. No chasing partners. One bill, one payment.

The catch — and it's a significant one — is that the partnership pays the tax in the year the audit is resolved, not the year the error occurred. If the IRS audits tax year 2021 and closes the audit in 2025, the partnership writes the check in 2025. Whoever owns the partnership in 2025 funds that check, even if the underlying errors happened entirely on the sellers' watch.

Why this matters in M&A

When you buy a partnership interest, you're buying into an entity that carries audit exposure for every open tax year — typically three years back, sometimes six or more if the IRS suspects substantial understatement or fraud. Those years belong to the sellers economically. But under the BBA default, they belong to you legally.

The person in control of the audit is called the Partnership Representative, or PR. Under the BBA rules, the PR has sweeping, unilateral authority: to respond to the IRS, negotiate settlements, make binding elections, and — critically — decide whether to pursue the one mechanism that puts the tax burden back where it belongs. That mechanism is called the push-out election.

The push-out election — and why it's the key protection

The push-out election allows a partnership, when faced with an imputed underpayment from an audit, to essentially pass the tax burden back to the partners who were actually there during the audited year. Instead of the partnership paying a lump sum in the current year, the former partners receive adjusted information returns and pay the tax on their own returns — with some interest adjustments baked in.

For a buyer, this is the difference between funding a tax bill from years you didn't own the business and making it the sellers' problem. The election has to be made within 45 days of the IRS issuing its final adjustment. Miss the window and the default applies — the partnership pays.

Here's the problem: nothing in the law requires the partnership to make a push-out election. It's entirely discretionary. And whoever controls the PR controls that decision.

What a well-drafted purchase agreement does

This is where deal counsel earns their fee. A properly protected buyer needs two things in the purchase agreement: control over the partnership representative for pre-closing tax periods, and a binding covenant requiring the push-out election to be made if an audit adjustment covers a pre-closing year.

Without the PR designation covenant, a seller who remains as PR post-closing can settle an audit quietly, let the partnership absorb the imputed underpayment, and leave the buyer holding the economic cost. Without the push-out election covenant, even a buyer-controlled PR might face pressure — or simply fail — to make the election in time.

These aren't exotic protections. They're standard in well-negotiated deals. The problem is that they're frequently missing from purchase agreements drafted by counsel without deep tax M&A experience, and the gap doesn't surface until the IRS shows up.

In The Deep End below, we walk through the BBA mechanics in full — imputed underpayment calculations, the push-out election procedure under Section 6226, partnership representative authority and designation, and the specific purchase agreement covenants that provide real protection.

Prior to 2018, large partnerships were audited under the Tax Equity and Fiscal Responsibility Act (TEFRA) regime, which required the IRS to conduct partnership-level proceedings but ultimately assess and collect tax from individual partners. The TEFRA rules were administratively unworkable for partnerships with hundreds or thousands of partners — audit adjustments routinely became uncollectable as former partners dissolved entities, distributed assets, or simply couldn't be located.

The Bipartisan Budget Act of 2015 (BBA), effective for partnership tax years beginning after December 31, 2017, replaced TEFRA with a centralized audit regime under §§6221–6241. The core shift: the partnership itself is the default taxpayer for audit adjustments, and the imputed underpayment (IU) is assessed and collected at the partnership level in the adjustment year — the year the audit is resolved — rather than the reviewed year — the year under audit.

Partnerships with 100 or fewer qualifying partners may elect out of the BBA regime under §6221(b), provided all partners are individuals, C corporations, S corporations, estates of deceased partners, or certain foreign entities — and the partnership timely files the election with an eligible return. Partnerships with any partnership or trust partners, or with more than 100 partners, are generally ineligible to elect out. In M&A diligence, confirming whether a target partnership has validly elected out — and whether it remains eligible — is a threshold question.

When the IRS makes adjustments to a partnership's items of income, gain, loss, deduction, or credit for a reviewed year, it calculates an imputed underpayment (IU) under §6225. The default calculation:

The highest-rate default is intentionally punitive. It ignores the actual tax rates of the partners in the reviewed year, which may be significantly lower (tax-exempt investors, lower-bracket individuals, C corporations at 21%). The IU is therefore frequently higher than the aggregate tax that would have been owed if assessed directly against the reviewed-year partners — a deliberate design feature to incentivize settlements and elections.

Modification requests under §6225(c) allow the partnership to reduce the IU by demonstrating that specific partners in the reviewed year would have faced lower rates, were tax-exempt, or had tax attributes that would have offset the adjustment. Modifications require affected partners to file amended returns or take affirmative steps — creating coordination burdens that are practically difficult post-acquisition when sellers are dispersed or uncooperative.

The push-out election is the buyer's primary substantive protection against inheriting pre-closing audit liability. Under §6226(a), in lieu of paying the IU at the partnership level, the partnership may elect to push out the audit adjustment to the reviewed-year partners — the partners who held interests during the year under audit.

Procedural requirements:

The election must be filed with the IRS no later than 45 days after the date of the Notice of Final Partnership Adjustment (FPA) under §6231. The election is made on Form 8985, with corresponding push-out statements (Form 8986) furnished to each reviewed-year partner. Once made, the election is irrevocable, and the partnership is no longer liable for the IU. §6226(b).

Economic effect on reviewed-year partners:

Each reviewed-year partner receives a Form 8986 reflecting their share of the adjustment and must pay tax on the adjustment on their own return for the year in which they receive the statement (the reporting year). The tax is computed with an interest adjustment: the partner pays the tax as if they had reported the adjustment in the reviewed year, plus interest compounded from the reviewed year through the reporting year. This interest-on-interest mechanism means push-out elections are not economically neutral — reviewed-year partners bear a higher total cost than if they had simply filed correctly in the first instance. For sellers receiving Forms 8986 years post-closing, this is an exposure that purchase agreement indemnification provisions must address.

When push-out is unfavorable:

The push-out election is not always the optimal outcome from a tax efficiency standpoint. If reviewed-year partners are tax-exempt entities (pension funds, endowments), the push-out creates taxable income in their hands that would not have arisen under the IU default (which the tax-exempt partner effectively absorbs economically through a reduction in its partnership interest value rather than direct tax cost). Similarly, if adjustment-year partners can offset the IU against current-year losses or credits unavailable to reviewed-year partners, absorbing the IU at the partnership level may be economically preferable. This trade-off requires modeled analysis — and explains why the push-out election covenant in the purchase agreement must be carefully scoped rather than unconditional.

Under §6223, each BBA partnership must designate a Partnership Representative (PR) — a single individual or entity with the sole authority to act on behalf of the partnership in all BBA audit proceedings. The PR's authority is exclusive: other partners have no statutory right to participate in, receive notice of, or object to audit proceedings or settlements. §6223(b).

The PR's unilateral powers include:

In the M&A context, the identity and contractual obligations of the PR are as commercially significant as the indemnification provisions in the purchase agreement. A seller who retains PR authority post-closing can: settle a pre-closing audit on terms favorable to sellers (e.g., characterizing adjustments as capital rather than ordinary), decline to pursue modifications that would reduce the IU, and allow the 45-day push-out election window to lapse — all without buyer consent or recourse absent explicit contractual protections.

Changing the PR: The PR designated on the partnership's tax return can be changed by filing an updated designation with the IRS. In acquisitions of controlling interests, the buyer should ensure PR designation is addressed in the closing mechanics — not deferred to a post-closing amendment — since IRS audit contact may occur at any time.

The following provisions represent the core framework for buyer protection in acquisitions of partnership interests subject to the BBA regime:

1. Pre-Closing Period PR Designation Covenant

The purchase agreement should contain an affirmative covenant requiring the sellers (or the partnership, as applicable) to designate the buyer (or a buyer-designated entity) as PR for all pre-closing tax periods no later than the closing date, and to cooperate in filing any required IRS notifications. Where the target partnership's operating agreement restricts PR changes, amendment of the operating agreement should be a closing condition.

Drafting note: The PR designation should extend to all open tax years as of closing, not just the most recent year. The BBA statute of limitations under §6235 runs three years from the later of the date the partnership return was filed or the due date — meaning a closing in 2025 may leave 2022, 2023, and 2024 all open.

2. Push-Out Election Covenant

The purchase agreement should include a covenant obligating the buyer-controlled PR to make a timely §6226 push-out election with respect to any IU attributable to a pre-closing tax period, subject to a carve-out where the buyer reasonably determines (in consultation with outside tax counsel) that the push-out election would be economically disadvantageous due to the specific profile of the reviewed-year partners (e.g., predominantly tax-exempt LPs). The covenant should:

3. Seller Indemnification for Pre-Closing Tax Liabilities

Standard tax indemnification provisions should expressly cover: (i) any IU assessed against the partnership for a pre-closing tax period that the buyer is unable to recover through a push-out election (including where the push-out election is not made due to the tax-exempt partner carve-out); (ii) interest and penalties under §§6226(b)(2) and 6233; and (iii) costs incurred by the buyer in connection with IRS proceedings for pre-closing periods, including reasonable advisor fees.

The indemnification should survive closing for a period coextensive with the BBA statute of limitations — at minimum three years from the filing of each pre-closing return, extended to six years where substantial omissions are possible, and without limitation in cases of fraud. Standard 12- or 18-month survival caps on tax indemnities are inadequate in the BBA context and should be resisted.

4. Audit Cooperation Covenant

Sellers should covenant to: (i) provide reasonable access to books, records, and personnel relevant to pre-closing period audits; (ii) cooperate in connection with any §6225(c) modification requests; (iii) file amended returns if required as part of a modification; and (iv) not take any action (including transfers of interests to tax-exempt parties) designed to make a push-out election more burdensome or less effective. This last point addresses a specific post-closing risk: a seller who transfers its carried interest to a tax-exempt entity after closing but before an FPA can convert a straightforward push-out into a problematic one.