By: Barry E. Haimo, Esq.
November 17, 2017
New Partnership Audit Rules: Amend Your Partnership Agreements Now
The audit rules relating to partnerships undergo an important change starting January 1, 2018. It does not apply to all partnerships. However, for the partnerships that it does affect, it affects them in a material way that must not be ignored. This post will give you a high level overview of the changes so you can minimize the consequences of failing to address them.
The old rules were governed by the Tax Equity and Responsibility Act of 1982 (TEFRA) and Electing Large Partnerships (ELP) rules. Under TEFRA and ELP, the government — particularly, the Internal Revenue Service (“Service”) and the United States Treasury (“Treasury”) — would audit various partnerships. The Service would impute liability and make an assessment of tax liability due from the partnership at the partnership level. That means that the partnership would be responsible for a payment of taxes due. However, collections were done by the Treasury at the partner level not the partnership level. In the case of large partnerships, it was difficult and inefficient for the Treasury to identify and chase down partners in nested partnership structures; for example, a partner made up companies owned by trusts and other individual. Smaller partnerships were able to avoid this audit procedure but others, particularly, larger ones, were not.
The new partnership audit rules take effect on January 1, 2018 under the Bipartisan Budget Act of 2015 (BBA). The new rules were designed to make collections easier for the Treasury; mainly, they still assess tax liability at the partnership level but they may collect from the partnership level instead of the partners. As a result, they no longer need to hunt down partners in complicated nested structures. It’s objectively very smart and long overdue for them to have figured this out. Nevertheless, it’s important to understand to whom the new rules apply and the implications of these new rules.
Qualifications to Opt-Out Under Section 6221(b) of the Internal Revenue Code
Qualified partnerships may opt-out of these rules. The requirements depend on the number and type of partners. For example, large partnerships over 100 partners are not be permitted to opt-out of these new rules. Likewise, grantor trusts would disqualify a partnership from opting out. Importantly, shareholders of a partner are counted towards the threshold of 100 partners. For example, a two-partner partnership with one partner that is a s-corporation comprised of 100 shareholders would be disqualified from opting out because it is deemed to have more than 100 partners.
The Pushout Election Under Section 6226(a) of the Internal Revenue Code
Fortunately, all is not lost if your partnership is disqualified or otherwise not permitted to opt-out. The Partnership Representative may make an election to push out the tax liability to the partner level; mainly, to enable the partners to engage and negotiate with the Service and Treasury to reduce their respective portion of the tax burden and make necessary amendments to their returns as necessary.
The Partnership Representative Under Section 6223(a) of the Internal Revenue Code
Whether you opt-out or not, the new rules created a new role for the partnership called the “Partnership Representative”. This replaces the “Tax Matters Partner” under the old rules. The Partnership Representative will be designated on the income tax return each year if not earlier allowed by the Service. The Partnership Representative’s role is critical and impacts all partners in a material and potentially adverse way. While he or she will likely try to opt-out, if the partnership is not permitted to opt-out, the Partnership Representative is the sole person designated to represent the partnership with the Service and the Treasury. Importantly, no other partners are permitted to engage or negotiate with the Service or the Treasury even though their rights as partners may be adversely affected. In addition, the Partnership Representative’s actions are binding on the partnership and its partners! Further, without taking necessary elections, the current partners may end up being liable directly or indirectly for tax liabilities arising from prior years’ (review year) before they became partners in the partnership! The only protect from these potential dangers lies in the contractual obligations memorialized in the partnership agreement. Therefore, you absolutely want to address the duties and responsibilities of the Partnership Representative to the partnership and its partners in the partnership agreement (operating agreement in the limited liability company).
Important issues to address in your partnership agreement or operating agreement:
The partnership agreement should address the Partnerships Representative’s powers and duties with respect to the partnership and the partners. For example, the Partnership Representative should cooperate with management and follow agreed-upon procedures in the event of notice of deficiency or partnership proceedings from the Service. Conversely, the partnership agreement should also identify the partners’ duties and obligations to the partnership and the Partnership Representative in such proceedings. The partnership agreement should ensure that the partners understand the implications of the new rules. Among other important provisions, it should provide that review-year partners remain liable for such year’s tax liability even they are no longer partners in the audit year. Here’s a list of other important considerations to insert into a partnership agreement or operating agreement (LLCs).
- Appointment of Partnership Representative and successor Partnership Representative and qualifications thereto
- Duties to disclose and inform partnership and partners
- Decision to pay tax or push-out and who makes such decisions
- Transfer and ownership restrictions to preserve qualification
- Tax due diligence in acquiring partnership interests
- Establish the procedures for push-out elections
- Indemnification of the Partnership Representative
- Preserve the ability to amend the partnership agreement as guidance is issued by the Service or Treasury
As you can see, there’s a lot to consider and the implications can be significant. The treasury wised up and shifted the burden of collections to the partnership and partners so it’s important to ensure your partnership agreements addresses how this new burden will be addressed.
Here’s a helpful flow chart courtesy of the American Bar Association:
THE INFORMATION CONTAINED HEREIN IS INTENDED FOR INFORMATIONAL PURPOSES ONLY. EACH SITUATION IS HIGHLY FACT SPECIFIC AND REQUIRES A CONSULTATION TO UNDERSTAND SUCH FACTS AND THE CLIENT’S NEEDS AND GOALS. ACCORDINGLY, NOTHING CONTAINED HEREIN CONSTITUTES LEGAL ADVICE.
Barry E. Haimo, Esq.
Strategic Planning With Purpose