Since the beginning of tax time, the key distinction between a partnership and a corporation has been its ability to “pass-through” U.S. federal income tax¹ liability to its partners. Pass-through taxation is a notoriously difficult concept to implement. The complications of partnership tax multiply when the Internal Revenue Service (IRS) later decides to audit a partnership’s prior tax period. Many questions arise in that situation, including who pays tax liability resulting from the audit – should it be the partnership or the partners, and which partners? These questions become especially thorny when changes in capitalization have occurred since the tax year under audit.

Before the 1980s, the IRS generally audited and assessed partnership tax at the partner level – not at the partnership level. The IRS, however, contended such an approach was unworkable in practice. As a result, in 1982, legislation known as “TEFRA” essentially authorized the IRS to conduct partnership audits at the partnership level; however, the resulting tax liability was still separately assessed and collected from each partner. Consequently, the IRS contended effective enforcement of partnership audits remained elusive. In response, a new legislation referred to as the Bipartisan Budget Act (BBA) audit regime became effective for partnership tax years beginning after Dec. 31, 2017 – assuming no early adoption election was made. This legislation permits the IRS to generally conduct partnership audits and collect resulting tax liability directly from the partnership.

At the outset, the BBA audit regime creates an unusual dynamic: a partnership that properly reports its taxes each year will never pay income tax – consistent with pass-through taxation – but the second that partnership is audited, the tax year under review shifts to an entity-level tax regime, similar to a C-corporation. This dynamic can result in an “unfair” shifting of tax liability among former and current partners of the partnership if partnership equity ownership has changed between the tax year subject to audit “reviewed year” and the year the partnership is assessed tax resulting from such audit.

BBA Audit Regime Example One

AB is a partnership owned, 50% by A and 50% by B. In 2024, B sells 100% of its equity to PE and A sells 60% of its equity (i.e. “rolls over equity” by retaining a 20% interest in ABC). In 2025, the IRS audits AB for the 2022 taxable year, resulting in an adjustment of $1 million in additional partnership taxable income. Had AB properly reported its taxes for 2022, A and B each would have borne $500,000 of additional taxable income and paid the resulting tax on their individual tax returns. Instead, as a general rule, AB must pay the additional income tax arising from the $1 million adjustment – which will be indirectly economically “borne” 80% by PE and 20% by A.

Recognizing the potential for “unfairness,” as illustrated in the example above, Congress provided mechanisms to avoid this result – perhaps the most prominent being the “push-out election.” The push-out election refers to an election under Code Section 6226(a) that allows a partnership to “push-out” the tax liability resulting from audit adjustments to those persons and entities who were partners during the partnership in the reviewed year – as opposed to the year in which the assessment arises.

BBA Audit Regime Example Two

Let’s use the same scenario as example one, but AB timely and properly makes a push-out election. As a general matter, AB is no longer responsible for any income tax liability arising from the audit adjustment; instead, that tax burden falls on those persons and entities who were partners of AB during 2022 – A and B will each bear 50%.

Impact of Push-Out Election on RWI

The impact of the push-out election on representations and warranties insurance (RWI) cannot be understated. The following tax obligations exist with and without push-out elections for RWI.

• Without the push-out election: under the buyer’s control, the target partnership generally bears the burden of tax liability arising from a pre-closing tax period.
• With the push-out election: the pre-closing partners should bear the burden of income taxes arising from a pre-closing tax period.

Stated in insurance terms, the push-out election should shift the vast majority of tax losses arising from a pre-closing tax period out of the policy.

Absent RWI, the push-out election is zero-sum between buyer and seller. The buyer typically addresses its risk by requesting the unilateral right to effect a push-out election for pre-closing tax periods, which is usually backstopped by the sellers’ pre-closing tax “line item” indemnity – in the event the push-out election was not properly made, there is leakage, etc. RWI removes the zero-sum element by insuring the tax representations and the synthetic pre-closing tax “line item” indemnity. Knowing the buyer has effectively “insured” its risk already, savvy sellers may push for silence in the purchase agreement with respect to a push-out election matter – or, more aggressively, push to prohibit a push-out election.

The Diligence Gap

Insureds – and some brokers – may argue that insurers were getting a free ride on partnership tax issues pre-BBA. The argument usually goes like this, “You would have insured this if it were a C-Corporation, so why the inconsistent position for partnerships?” Like all good arguments, it starts with an element of truth. Insuring pre-closing tax risks of a C-Corporation is table stakes for the RWI industry. Of course, the simplification of the matter glosses over a few fundamental points:

• Taxation of partnerships is substantially more complicated than corporations.
• Buyers typically conduct fulsome corporate tax diligence.
• Historically, buyers of tax partnerships pre-BBA conducted minimal partnership tax due diligence.²

Ultimately, we see partnership tax as no different than any other subject area where a buyer seeks RWI coverage. If the buyer has conducted comprehensive due diligence on a matter – the level it would conduct had no RWI existed – then the RWI policy should cover that matter, with narrowly tailored exclusions for any known material issues. Buyers who conduct pre-BBA “light” diligence should expect insurers to demand the purchase agreement contain a push-out election or prepare for a broad partnership tax exclusion. Insurers who receive tax due diligence reports that cover partnership tax in detail should expect to cover the risk regardless of what the purchase agreement says on push-out elections.

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¹ All references to “tax” or taxes,” are to U.S. federal income tax liability unless otherwise noted.

² Typically, partnership tax due diligence conducted by a buyer focused on issues relevant to the buyer on a post-closing basis.