The number of businesses in the United States that include at least one partnership (or limited liability company (“LLC”) taxed as a partnership) in their ownership structure has exploded since LLCs became popular in the 1990s1.It is safe to say, however, that very few of the owners of those businesses understand the way in which the IRS audits partnerships. And for the most part it is not necessary for them to know – the lawyers and accountants take care of such things. Except when the rules change so significantly, as they have here, that business owners have to decide how to amend their partnership agreements not only to reflect changes that the new rules make in the audit process itself, but also to avoid potential pitfalls and take advantage of potential benefits associated with the changes. While the “tax press” is full of articles by and for tax professionals, very few have tried to explain what is going on at a level that is relevant to the average business owner. This article is intended to give business owners a sense of the importance of dealing with the impact that the new rules will have on their partnership agreements.
The Bipartisan Budget Act of 2015 (the “Act”) repeals the procedures the IRS has used since 1982 for auditing partnerships and replaces them with new procedures effective for taxable years beginning January 1, 2018. Don’t let that date fool you. Even though the new law does not go into effect until 2018, it will impact not only the audit procedure itself, but also how some partnership interests are transferred and how the economics of a partnership are shared among both existing and former partners. Amending a partnership to comply with and manage these changes is not simply a matter of lawyers inserting boilerplate provisions into the agreement. These are issues that require serious consideration by the partners and should be dealt with long before the effective date arrives.
The core of the changes is relatively simple – adjustments made as a result of a partnership IRS audit are not only determined at the partnership level, but the underpayment of tax associated with the adjustments is also paid at the partnership level and is based on the highest individual or corporate tax rate regardless of the partners’ actual tax rates, with a few exceptions.
This article presents business owners with a brief explanation of the primary aspects of the new rules and the issues they raise that need to be addressed through amendments to their partnership agreements.
1. The Partnership Representative. The audit process must be managed by a “partnership representative” (individual or entity) that has a substantial presence in the United States. The partnership representative need not be a partner and has the sole authority to act on behalf of the partnership. If a partnership fails to appoint a representative, the IRS is authorized to appoint one. To comply with and manage the impact of these changes, partnership agreements should be amended to include provisions regarding:
- Appointment and removal of a partnership representative
- Restrictions on the partnership representative’s powers
- Partner participation in the partnership representative’s decisions
- Providing indemnification for the partnership representative’s actions
2. Electing Out of the Partnership Level Tax. The new rules apply to all partnerships regardless of size, but partnerships with 100 or fewer partners can elect out as long as the partners are individuals, C corporations, certain foreign entities, S corporations, or estates of deceased partners. If any of the partners is another partnership or a trust, the partnership cannot elect out. Further, if a partner is an S corporation, each of the S corporation’s shareholders is treated as a partner for the purposes of determining whether the partnership has 100 or fewer partners, and the IRS has stated that if a partner is a disregarded entity, both the disregarded entity and the owner of such entity are each counted as separate partners for purposes of the 100 partner test. The process of electing out requires that the partnership (i) elect out on its partnership return each year, (ii) inform each partner of the election and (iii) submit the names and taxpayer identification numbers of each of its partners, including S corporation shareholders treated as partners for purposes of the 100-partner test. To comply with and manage the impact of these changes, partnership agreements should be amended to include provisions regarding:
- Whether a qualifying small partnership should be allowed, or perhaps required, to elect out of the new rules
- Information-sharing provisions to allow partnerships to satisfy the requirements of the election out
- For partnerships that want to have the option to elect out each year, transfer restriction provisions preventing partners from transferring their interests to “ineligible” partners
3. Payment of the Partnership Level Tax. Payment of the tax is made by the partnership at the highest individual or corporate tax rate, but the IRS can issue regulations that provide some relief (e.g., with respect to partners that are corporations, tax-exempt entities, or individuals entitled to lower capital gain and dividend tax rates). To comply with and manage the impact of these changes, partnership agreements should be amended to include provisions regarding:
- If the partnership would generally have sufficient cash to pay a tax assessment, how the economic effect of a tax assessment paid at the partnership level would be shared among the partners
- If the partnership generally would not have sufficient cash to pay a tax assessment, whether it would be permitted to make a capital call to pay a tax assessment and how that capital call would be managed (e.g., how the burden would be shared and how failures to comply with a capital call would be dealt with)
- Information-sharing provisions to allow partnerships to determine if their ultimate owners are corporations, individuals entitled to lower capital gain and dividend tax rates, tax-exempt entities, etc.
4. Alternatives to Paying Tax at the Partnership Level. Partnerships that cannot or do not elect out, can avoid being liable for the partnership level tax by choosing between two alternative methods. Under the first alternative, if the partners who were partners during the year under audit amend their returns for the year under audit to reflect their shares of the audit adjustments made at the partnership level and pay the tax, the partnership will be relieved of those partners’ shares of the partnership tax liability. Under the second alternative, a partnership may avoid being liable for the partnership-level tax by electing to push this tax liability out to its partners. To do so, within 45 days of getting a final notice of partnership adjustment from the IRS, the partnership must issue statements to the partners reflecting the distributive share of partnership items as adjusted by the IRS. If this election is made, the partners pay tax in the year that the statements are issued, but the interest charged on the underpayment of tax is at a rate that is 2% higher than the regular underpayment rate. To comply with and manage the impact of these changes, partnership agreements should be amended to include provisions regarding:
- For the first alternative, authorizing the partnership to issue appropriate tax information statements to the reviewed-year partners even if they are no longer partners at the time the statements are issued and establishing whether and, if so, how to encourage each partner to actually file an amended return and pay the associated taxes, and how to deal with partners who do not file and pay
- For the second alternative, authorizing the partnership to elect to have the audit adjustments taken into account in the current year of the partners who were partners during the year that is under audit and establishing whether and, if so, how to encourage each partner to actually report and pay the tax with its current year return and how to deal with partners who do not file and pay
- Managing the alternatives can present many complexities that may not be readily predicted, e.g., what happens if the partnership has different partners in the year of the assessment from the reviewed year, or the partners are the same but the ownership percentage has shifted among the partners, or if the tax rates have changed between the reviewed year and the year of the assessment?
5. Notification of Audit and Consent to Settlement. The new rules do not require the partnership to notify the partners of a partnership audit nor do the rules require partner consent for any settlements with the IRS. To comply with and manage the impact of these changes, partnership agreements should be amended to include provisions regarding:
- A process for notifying partners when an IRS audit begins, keeping them informed about the progress of the audit and any proposed and final IRS adjustments, and providing for partner involvement in final decisions
6. Liability for Tax from Years when Not a Partner. The new rules can result in partners at the time of the conclusion of an audit bearing the impact of the tax incurred with respect to a year in which they were not a partner. To comply with and manage the impact of these changes, partnership agreements should be amended to include provisions regarding:
- Determining what, if any, escrow and indemnification provisions will be required when partners sell their interests to take care of tax liabilities arising with respect to years when they were a partner
- Having partners’ liabilities for taxes survive beyond the life of the partnership
If the explanation above does not convince you that it is important to amend your partnership agreements, consider what would happen if a partnership were to ignore the new rules and make no effort to amend its agreement.
- The IRS could appoint a partnership representative, which because of the significant powers of the representative could effectively undermine arrangements that the partners thought they enjoyed among themselves
- The partnership even though qualifying to elect out of the new rules, could fail to do so having taken no steps to ameliorate the potentially punitive consequences of an audit under the new rules
- The partnership could fail to elect an alternative method that would have alleviated consequences that are unacceptable to some or all of the partners, resulting in strained relations and perhaps litigation among the partners.
Finally, in addition to addressing these issues for existing partnerships, whenever new partnerships are formed, or partnership interests are sold, the parties will need to focus on these new rules. Anyone planning to acquire a partnership interest will need to consider their potential share of the partnership’s liability with respect to any of the partnership’s previously filed tax returns if the partnership is not able to elect out of the new regime.
Even a brief explanation like this shows that there are many business decisions that partners will need to make in the process of amending partnership agreements to incorporate the new rules. These are changes that can affect how the economics of a partnership are shared among both existing and former partners. It is not simply a matter of lawyers inserting boilerplate provisions into the agreement. We have analyzed the rules in depth and are prepared to assist partnerships in reviewing the general rules and alternatives and determining how the partnership would prefer to operate under the new rules. If you are interested in a more technical discussion of the new partnership audit rules, please see our recent Practitioner Tax Alert.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass & Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.