A TEFRA partnership was any partnership subject to the centralized audit rules created by the Tax Equity and Fiscal Responsibility Act of 1982. Those rules governed how the IRS examined partnership returns for roughly 35 years before the Bipartisan Budget Act of 2015 replaced them. They still matter today because partnership tax years beginning before January 1, 2018, remain under TEFRA, and many partnership agreements drafted during the TEFRA era still contain provisions that no longer fit the current law.
Which Partnerships Were Subject to TEFRA
Before 1982, the IRS had to audit each partner individually when it found a problem on a partnership return. A partnership with 50 partners could mean 50 separate proceedings and 50 different outcomes. TEFRA fixed that by moving the audit to the partnership level, so the IRS could resolve disputes about the partnership’s reporting in a single proceeding.
Most partnerships fell under TEFRA automatically. The main way out was the “small partnership” exception. A partnership qualified only if it had ten or fewer partners and every partner 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 one partner. If even one partner was a trust, an LLC, another partnership, or an S corporation, the exception did not apply regardless of headcount.
Partnerships that met the small-partnership test were audited the old-fashioned way, partner by partner. Everyone else went through TEFRA’s unified procedures.
How a TEFRA Audit Worked
The core concept was the “partnership item.” These were tax items more appropriately determined at the partnership level than at the partner level: the partnership’s income, gains, losses, deductions, credits, guaranteed payments, contributions, distributions, and other items reported on Form 1065.1Internal Revenue Service. IRS Internal Revenue Manual 8.19.1 – Procedures and Authorities The IRS resolved questions about those items in one proceeding, and the results flowed through to every partner’s return.
When the IRS finished its examination, it issued a Final Partnership Administrative Adjustment, or FPAA. The FPAA was the partnership equivalent of a notice of deficiency. It was mailed to the Tax Matters Partner and to every “notice partner” who had not agreed to the proposed adjustments.2Internal Revenue Service. IRS Internal Revenue Manual 8.19.12 – Final Partnership Administrative Adjustment
Here TEFRA got awkward. The audit happened at the partnership level, but the IRS could not collect from the partnership. Tax, penalties, and interest had to be assessed and collected from the individual partners. That often required separate proceedings at the partner level to address “affected items” — items on a partner’s personal return that changed because of the partnership-level adjustments. For a large partnership, that could mean hundreds of follow-up actions, and the IRS sometimes chose not to pursue all of them.
The Tax Matters Partner
Every TEFRA partnership needed a Tax Matters Partner (TMP) to serve as its point of contact with the IRS. The TMP notified 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 challenge 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 held at least a 5% interest could file during the following 60 days.2Internal Revenue Service. IRS Internal Revenue Manual 8.19.12 – Final Partnership Administrative Adjustment
The partnership agreement usually named the TMP. If no designation was made, the role defaulted to the general partner with the largest profits interest at the close of the tax year in question. The TMP had real authority, including the power to extend the assessment period and bind the partnership to a settlement, but partners kept the right to participate in the proceeding and, in some circumstances, to settle separately with the IRS.
Statute of Limitations Under TEFRA
The IRS generally had three years from the later of the filing date or the return due date to assess tax on partnership items. That window stretched to six years when there was a substantial omission of income, and it disappeared entirely if the partnership never filed a return or a partner signed a fraudulent return. The TMP could agree to extend the limitations period on behalf of every partner, which is a large part of why the TMP’s authority mattered so much and why it still matters in any pre-2018 audit that remains open.
What Replaced TEFRA
TEFRA improved on the pre-1982 system, but its central design flaw was never fixed: the IRS audited at the partnership level and then still had to chase down individual partners to collect. For partnerships with hundreds or thousands of partners, or tiered structures with partnerships inside partnerships, collection became impractical enough that the IRS sometimes walked away from adjustments it had already won.
The Bipartisan Budget Act of 2015 (BBA) replaced TEFRA with an entirely new centralized audit regime for partnership tax years beginning after December 31, 2017. Partnerships could elect the new rules early for tax years beginning after November 2, 2015.3Internal Revenue Service. Centralized Partnership Audit Regime The biggest change is that the IRS now assesses and collects directly from the partnership itself. When the IRS finds an underpayment, it calculates an “imputed underpayment” by applying the highest individual or corporate rate to the net adjustments, and the partnership pays.4Office of the Law Revision Counsel. 26 U.S. Code 6221 – Determination at Partnership Level The partnership can request a modification to reduce that amount, or elect to “push out” the adjustments to the partners who held interests during the reviewed year.5Internal Revenue Service. BBA Partnership Audit Process
The BBA also replaced the Tax Matters Partner with a “partnership representative,” and the change is not cosmetic. The partnership representative has sole authority to act for the partnership in an audit, and every partner is bound by that person’s decisions.6Office of the Law Revision Counsel. 26 U.S. Code 6223 – Partners Bound by Actions of Partnership No other partner can participate in the IRS proceeding without the IRS’s consent. Settlements, extensions of the statute of limitations, and the push-out election are all final when the representative makes them. Unlike the TMP, the partnership representative does not need to be a general partner; it can be any person or entity with a substantial U.S. presence.7Internal Revenue Service. 4Office of the Law Revision Counsel. 26 U.S. Code 6221 – Determination at Partnership Level Partnerships with partners that are trusts or LLCs taxed as partnerships cannot opt out. The election is annual and is made on a timely filed Form 1065.8Internal Revenue Service. Elect Out of the Centralized Partnership Audit Regime
Why TEFRA Still Matters
TEFRA is repealed, but it is not gone. Three situations keep it in play.
First, timing. 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 if the partnership was subject to it.3Internal Revenue Service. Centralized Partnership Audit Regime Because statutes of limitation can be extended by agreement and litigation takes years, some TEFRA-era audits and court cases remain active. A partner who held an interest during a pre-2018 tax year can still face a TEFRA assessment.
Second, legacy partnership agreements. Thousands of operating agreements and limited partnership agreements drafted before 2018 still contain TEFRA-era provisions on the Tax Matters Partner, audit procedures, and partner notification rights that tracked the old statute. Those provisions no longer match the law. An agreement that gives the TMP authority to extend the statute of limitations does nothing useful when the law now requires a partnership representative. An agreement that describes partner participation rights based on TEFRA can create expectations the BBA does not honor, because the partnership representative’s authority is broader and more absolute than the TMP’s ever was.
Third, buying into a partnership. Under TEFRA, audit adjustments were assessed against the partners who held interests during the audited year. Under the BBA, the partnership itself pays, so a buyer of a partnership interest can end up bearing a share of tax liability for positions taken years before the acquisition. Knowing which regime applies to which tax year is basic due diligence for any partnership transaction involving pre-2018 returns.