The New Partnership Audit Rules: Are You and Your Clients Ready?
Alabama Society of CPA's CONNECTIONS magazine
The effective date of the new federal partnership audit rules is fast approaching, and it’s clear that most of our Subchapter K clients (i.e., partnerships and multi-member LLCs) have taken a wait-and-see approach either because (a) they’re not convinced the new rules apply to them, or (b) they’ve heard that the rules might be delayed, or at the very least, altered by a technical corrections bill or by IRS “interpretation” principally through their 277 pages of proposed regulations. Tax practitioners are beginning to panic, as evidenced by the titles of several recent law firm newsletters, our favorite being “Holding the Bag: Update Your Operating Agreement or Face the (Tax) Consequences.”
We have taught mini-seminars on this topic to various CPA firms around the state and at the Alabama Society of CPA’s 2017 annual meeting, and from those experiences here are some FAQ’s (without our typical footnotes and caveats) that we hope will be quick reading and that you can cut and paste into a newsletter or merge-text letter to your Subchapter K clients, soon. We’ll use “partnership” and “partners” throughout this article, but that includes multi-member LLCs classified as partnerships and their members where appropriate.
1. Why should my partnership clients (and I) be concerned about the new rules?
You’ve probably already heard that the Bipartisan Budget Act of 2015 created a comprehensive new partnership audit regime. Well, this is what “repeal and replace” actually looks like. The current tripartite regime, meaning the TEFRA audit rules, the elective large partnership audit procedures, and the default rules, is repealed effective for tax years beginning after December 31, 2017. There will be no such thing as a tax matters partner or the fundamental principle that partnerships are not taxpayers for income tax purposes. The partnership audit will be performed by the IRS (and perhaps by the states) at the partnership level, and by default, the partnership will be liable for any income tax deficiency, interest and penalties. Worse yet, at least from the perspective of us lawyers, the partners LLC members will have no statutory right to participate in the audit or any resulting appeal. A new creature, called the “partnership representative,” will have sole authority to speak for the partnership and its partners.
Congress has been told that the new rules will raise approximately $9.3 billion over the next 10 years and a substantial amount of revenue will likely be generated for the often cash-starved states. For those states with an income tax, this will be like found money.
2. To which entities do these new rules apply?
Obviously, traditional partnerships and multi-member LLCs are covered, but here’s the first surprise: so are joint ventures and other arrangements that the IRS will try very hard to classify as partnerships for federal income tax purposes. For example, many co-investment funds and special purpose vehicles set up to hold particular assets could be covered. On several recent occasions, Treasury officials have told bar and CPA groups they want these new rules to apply to as many arrangements as possible. Notably, the rules do not apply to disregarded entities such as single member LLCs (regardless of whether they have elected to be treated as corporations, or S corporations, or trusts). However, as we mention below, single member LLCs and trusts can be problematic.
3. What do you mean my partnership is covered by the new rules? We only have 3 partners!
As mentioned above, we expect many clients will be surprised that their partnership is even covered by the new rules. That could result from either having one or more ineligible partners, or having failed to make the annual opt-out election by filing the Form 1065 (with the new opt-out box) one day late.
Most tax advisers will suggest that if your client can opt out, do it. Your client’s lenders may require that, too. The new rules provide relief from the entity-level tax for partnerships that (a) issue 100 or fewer Schedules K-1 annually, (b) are owned by some combination of individuals, estates of deceased partners, C corporations, and S corporations, and (c) as mentioned above, timely file their Form 1065 and check the correct box. In the case of S corporation partners, each shareholder is considered a partner for purposes of headcount. As mentioned above, Treasury has indicated there will be no grace in terms of expanding the pool of eligible partners/members. For example, if even one member of the LLC is itself another LLC or a trust – even a single member LLC or a grantor trust –the opt-out election is not available. (Our estate planners are not happy.) And any complex or tiered LLC structure won’t be permitted to opt-out. Note that the partnership representative must make the annual election, not the president, CFO, managing member or the CPA.
4. Who controls the audit? Which partners will have a say-so?
Under the new rules, the partnership must designate a “partnership representative” (PR) for each tax year, and that individual or entity will control the audit and any appeal. By statute, the PR is the only person empowered to work with the IRS, and based on the proposed regulations, it’s going to be difficult to fire the PR, at least externally. If the PR is an entity, the proposed regulations require the partnership (not the PR) to designate a live human being, otherwise known as a “designated individual,” who’ll be the only person authorized to deal with the IRS. The PR, or the designated individual of an entity PR, need not be a partner in the partnership, and we can foresee a new cottage industry of “professional” PRs springing up to represent multiple partnerships, akin to registered agents for corporations but with some tax expertise.
Under the new rules, the PR (or the designated individual, if the PR is an entity) controls all partnership audit proceedings with the IRS, and according to the proposed regulations, the partners may not participate, and there is absolutely no requirement that the IRS inform the partners of the audit proceeding in any circumstances. But here’s where the partnership agreement comes in: the agreement may require the PR to provide notice of and updates on audit proceedings, to obtain partner votes on various issues, and otherwise restrict the activities of the PR. A breach of an obligation under the partnership agreement by the PR may be pursued under contract law, or in some states, possibly as a breach of fiduciary duty since the PR arguably acts somewhat like a trustee. Obviously, it’s extremely important to appoint a qualified PR (and a designated individual if the PR is an entity). Failing to do so will allow the IRS to appoint one – sort of like a court-appointed attorney. Thankfully, the proposed regulations impose some restrictions on that selection process.
5. Who pays the audit adjustment?
Generally, the partnership itself will be responsible for paying any income tax, interest and penalties that arise from an IRS audit, post-2017 tax year. Thankfully, there are 2 mechanisms (3 if the 2016 Tax Technical Corrections Bill is reintroduced and enacted), that can mitigate the damage but can put the PR in a quandary, as discussed below. The BBA and proposed regulations provide a mechanism to reduce the impact of an audit adjustment by, for example, allowing the PR to prove that certain partners filing amended returns are in a tax bracket lower than 39.6% (e.g., C corporations) or are tax-exempt organizations. And even after the proposed adjustment is reduced in that manner, the PR has the election to “push-out” the final audit adjustment to the persons or entities who were the partners during the so-called “reviewed year.” The proposed regulations clarify that if the PR makes that election, the partnership is off the hook for the audit adjustment and the liability shifts to the reviewed year partners, or perhaps by that time, their estates. With the PR possessing that power, somebody will not be happy, whether that will be the reviewed year partners or the current (“adjustment year”) partners who will indirectly, or perhaps directly, bear the brunt of the tax liability.
6. So what do we do now?
First and foremost, CPAs should promptly contact their partnership clients (and document those efforts) to be sure each is aware of the impending rules and is examining their ownership structures. For example, if a family LLC or LP has a grantor trust or a single member LLC as a member, the client should consider transferring those membership interests away from ineligible members. This must be done by December 31, 2017 since eligibility will be determined as of January 1, 2018, and throughout the years thereafter.
This suggestion leads to the next one: Every partnership agreement must be reviewed – soon. Since every Subchapter K entity (big or small) should have a PR, preferably appointed this Fall or next Spring, the client needs to consider who would be the best PR, and our next word of advice is: Not you. Depending on who you represent in this matter, you may suggest that the client build a high wall of protection around the PR and any actions he or she may take in that capacity. On the other hand, your client(s) may wish to impose strict reporting obligations on the PR and require them to seek partner input on major decisions, e.g., whether to extend the statute of limitations, or to appeal or settle, and whether to make the push-out election described above. On the other hand, there is a tradeoff with imposing strict duties – the more burdens placed on the PR, the more difficult it will be for your client to convince a trustworthy and competent individual to serve in that capacity.
There are a number of items that need to be addressed in any new or amended partnership agreement, and this article only scratches the surface. Our July 2017 Federal Tax Alert posted on the ASCPA website provides a long list of items that should be considered for inclusion in any new or amended agreement. When should these amendments be made? Now. And obviously, any new partnership or LLC agreement should address these issues. Although the proposed regulations have yet to be finalized as of this date, and we expect more guidance in the next few months, there is little chance the rules will be delayed or materially changed in the near future. Explaining all of this to your many partnership clients will take time. It might take multiple meetings and telephone conferences, the input of a competent tax attorney, and perhaps some courting of the individual your client hopes will agree to serve as the PR. Remember, almost all partnership agreements require unanimous consent to be amended for fundamental changes like we’re suggesting here, and yes, they need to be reviewed by experienced tax and partnership counsel.
7. That’s just the federal rules?! What about the states?
Your co-authors chair a Task Force of the American Bar Association Tax Section’s SALT Committee on the state implications of these new rules. We have been involved in drafting a model act that we hope will be adopted by every state with an income tax, plus Texas (who isn’t quite sure whether they have an income tax, depending on the circumstances). For more information on the proposed model act and related state-level issues, see the following articles: “MTC, Business Groups Respond to Federal Partnership Audit Rules,” State Tax Notes (Jan. 9, 2017); “Tax Pros Float State Law Model for Partnerships,” Law 360 (Jun. 8, 2017); and “Parties Unveil Model State Statute for Partnership Audit Law,” Bloomberg BNA (Jun. 9, 2017). Links to each of those articles are available on our website: www.bradley.com.
If we can assist you or any of your clients in this regard, please don’t hesitate to contact us at email@example.com or firstname.lastname@example.org, or Stuart Frentz at email@example.com, our Nashville tax partner, Mark Miller, at firstname.lastname@example.org, or our Jackson tax partner, Steve Wilson at email@example.com.
Republished with permission. This article originally appeared in the September/October 2017 issue of the Alabama Society of CPAs’ CONNECTIONS magazine.