In late 2015, Congress passed the Bipartisan Budget Act of 2015 (the “BBA”)1 as amended by the PATH Act of 2015. The BBA established a new partnership audit and assessment regime and repealed prospectively the current TEFRA partnership audit rules.2 As discussed below, the BBA greatly enhanced the Internal Revenue Service’s ability to audit partnerships (including multimember LLCs). As a result, the new federal partnership income tax audit rules, which are scheduled to take effect on January 1, 2018, will have significant implications for the taxation of partnerships and their partners.
Currently, very few partnerships are audited, generally because the IRS cannot directly assess partnerships, but instead must pursue each partner for its share of the assessment, often through multiple tiers. The BBA repealed the existing rules regarding partnership audits and replaced them with fairly radical new procedures, which are codified under Sections 6221 to 6231 of the Internal Revenue Code. The new regime is designed to alter the burden of sifting through myriad assortments of partnership structures, saving time and expense for IRS revenue agents who the GAO notes are often not conversant with the intricacies of Subchapter K.
Under the new rules, the IRS will audit a partnership’s tax items and the partners’ distributive shares for a particular year (the “reviewed year”), and any audit adjustments will be made at the partnership level and taken into account by the partnership in the year the audit or judicial review is completed (the “adjustment year”). If an audit results in a tax deficiency, the “imputed underpayment” presumptively will be assessed against and collected from the partnership rather than the individual partners. Unless the partnership timely elects out of the new regime, or unless certain elections are made as described below, the adjustment year partners will therefore bear the audit assessment, including interest and possibly penalties, even if some or all are different than the partners in the reviewed year. Thus, under the new rules, partners can be on the hook for someone else’s income tax liability.
The January 1, 2018 effective date of the new federal partnership audit rules is fast approaching, and it is clear that most of our (and likely your) Subchapter K clients (i.e., partnerships of all stripes and multi-member LLCs) have taken a wait-and-see approach. That’s either because (a) they are not convinced the new rules apply to them or (b) because they have 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.”
From our involvement in the ABA Tax Section’s Task Force on the State Implications of the New Federal Partnership Audit Rules and from speaking to various CPA and attorney groups over the past year or so, we have developed some frequently-asked questions that we hope will be quick reading for non-tax lawyers. We will use the terms “partnership” and “partners” throughout, but that includes multi-member LLCs classified as partnerships and their members where appropriate.
Why should my partnership clients be concerned about the new rules?
You may have heard that the Bipartisan Budget Act of 2015 created a comprehensive and radically new partnership audit regime. 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, will be repealed effective for tax years beginning after December 31, 2017. Going forward, 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 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 also likely be generated for the often cash-starved states, like Alabama. For those states with an income tax, this will be like found money.
To which entities do these new rules apply?
Obviously, traditional partnerships and multi-member LLCs are covered, but here is the first surprise: so are joint ventures and other arrangements that the IRS Worse yet, at least from the perspective of us lawyers, the partners will have no statutory right to participate in the audit or any resulting appeal. will try very hard to classify as partnerships for federal income tax purposes. For example, many coinvestment 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 or to S corporations or to trusts or IRAs. However, as discussed below, single- member LLCs and trusts can be problematic.
What do you mean my partnership is covered by the new rules? We only have five partners!
As mentioned above, we expect that 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 they or their CPA 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, they should. Your client’s lenders may begin to 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 to opt out. In the case of S corporation partners, each shareholder is considered a partner for purposes of headcount. As mentioned above, so far the Treasury Department has indicated there will be no grace in terms of expanding the pool of eligible partners. For example, if even one member of the LLC is itself another LLC or a trust–even a disregarded single-member LLC or a grantor trust–the opt-out election is not available. And any complex or tiered LLC structure won’t be permitted to opt out. Note it appears that the partnership representative must make the annual election, not the president, CFO, managing member or TMP.
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 is 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, oddly) 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 who possess 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 in the audit, and there is absolutely no requirement that the IRS inform the partners of the audit proceeding in any circumstances. Here is where the partnership agreement comes in, though: 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. Obviously, it is 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. Fortunately, the proposed regulations impose some restrictions on that selection process.
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 two mechanisms (three 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 percent (e.g., C corporations) or are taxexempt organizations. And even after the proposed adjustment is reduced in that manner and issued in final form, 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 absent a push-out election.
So what do we do now?
First and foremost, attorneys should promptly contact their partnership clients (and document those efforts) to be sure that each is aware of the impending rules and is examining their ownership structures. If, for example, a family LLC or limited partnership has a grantor trust or a single-member LLC as a partner, 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–and you should be sure that the client’s CPA is in the loop. Because every Subchapter K entity (big or small) should have a PR according to the proposed regulations, who must be officially appointed and in place before the 2018 tax return must be filed, the client needs to consider who would be the best PR.
Depending on who you represent in this matter (the partnership? the managing partner? the minority partner[s]? the proposed PR?), 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 him or her 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 pushout election described above. There is a tradeoff with imposing strict duties, however–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 related to the new partnership audit rules that need to be addressed in any new or amended partnership agreement. For example, any partnership agreement (new or existing) should consider the following:
- the designation and removal of the partnership representative;
- the designation and removal of the individual who must be appointed under the proposed regulations if the partnership representative is an entity;
- the requirements for the partnership representative and partners to obtain and provide information that may reduce the partnership’s liability for the imputed underpayment;
- partner consent required, if any, for making elections or settlements by the partnership representative, including the election out and the push-out election;
- the potential for filing amended returns by those who were partners in the reviewed year(s);
- terms and conditions for amending the partnership agreement to deal with changes or updates to the new rules;
- restrictions on transfers of partnership interests to entities that are ineligible partners;
- partners’ notice and participation rights in connection with IRS or state audits;
- appropriate indemnifications for and duties of the partnership representative; and
- how to ensure that the appropriate partners and former partners bear the actual costs of imputed underpayments, including cooperation requirements for former partners.
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, 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 partnership clients will take time and patience. It might take multiple meetings and telephone conferences, the input of their CPA and an experienced tax attorney and perhaps some courting of the individual your client hopes will agree to serve as the PR. Remember, most 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.
That’s just the federal rules?! What about the states?
As mentioned above, the American Bar Association Tax Section’s SALT Committee has created a task force on the state implications of these new rules. As co-chairs of the task force, we have been involved in drafting a model act that we hope will be adopted by every state with an income tax.3
Copyright September 2017. All views expressed in this article are those of the authors and not necessarily those of their law firm, the ABA Tax Section or other associations with which they are affiliated.
1. Bipartisan Budget Act of 2015, Pub. L. No. 114-74, 129 Stat. 584 (to be codified as amended at IRC §§ 6221– 6241) (2015).
2. The current audit rules were enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324, and are typically referenced, using the legislation’s acronym, as the “TEFRA” rules.
3. 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 all the articles cited in this article are available on our website (https://www.bradley.com/practicesand- industries/practices/tax/state-and-localtax? tab=insights-events).
This article originally appeared in the November 2017 issue of The Alabama Lawyer and is posted here with permission.