By:
Michael E. Kar
Associate, New York
Date: December 27, 2017
Entities that are taxed as
partnerships enter 2018 with fresh concerns in relation to due diligence and
contract drafting, in reaction to changes in the statutory regime impacting
audit procedures for taxable years starting after December 31, 2017.
By way of background, in the early 1980s a series of statutes,
consolidated as the Tax Equity and Fiscal
Responsibility Act of 1982 (TEFRA), changed the way partnerships were audited
by the IRS. Where previously each partner was individually audited and then
collected from, TEFRA supposedly streamlined the process by auditing the
partnership as a whole, and then applying the results to each individual
partner, taking into account his or her specific tax attributes. This meant
that these adjustments were based in part on each individual partner’s taxable
rate. Now, however, new rules will alter that statutory regime, regulations
that follow the Bipartisan Budget Act of 2015. The rules of the BBA are
effective for partnership returns for tax years beginning after December 31,
2017.
TEFRA was deemed in need of improvement for a collection of
reasons. One such reason was who exactly the IRS would deal with in regard to
the partnership. There was difficulty in ascertaining who the single ‘tax
matters’ partner was. Sometimes, this was an unofficial coalition of
partners who would deal with the IRS, creating conflicting information and
procedural confusion. Along with a series of other inefficiencies, it was
determined that TEFRA resulted in fewer tax-eligible partnerships being audited.
Following the new rules at hand, the most immediate consideration imposed upon
partnerships is the necessary designation of a “tax partnership
representative”. This is a
designated individual (or entity) with whom the IRS interacts. Unlike the ‘tax
matters partner’, the tax partnership representative does not have
to be a member of the partnership; the only statutory requisite is a
substantial presence in the United States.
Although requisites are minimal, this tax partnership representative is given
substantial power in regard to potential audits. This representative of a
partnership has the sole authority to act on behalf of the partnership with
respect to auditing, including any settlement, and can make certain unilateral
Internal Revenue Code elections. All partners are bound by this
representative’s decisions as well as any final IRS determination relating to
the pertinent audit. Drafting tip: a partnership representative should
be chosen before 2018 because if there is no designation, the IRS will make the
selection. In addition to the benefit of autonomy of choice due to this
increased power, partnerships should select their own representative because
IRS consent is needed to revoke any IRS-made designation.
The second and far more substantial consideration is that the new rules allow
the IRS to collect directly from the partnership, not just from the individual
partners therein. This has been termed the “imputed underpayment”, and this
adjustment is applied to the year in which the audit was centered, the “review
year.”
In terms of tax rates, in contrast to TEFRA and the prior statutory regime
which utilized the tax attributes of individual partners, the new rules would
apply one rate to the entire partnership. It is important to note that this
rate would not be based on the traditional aggregate method of
determining tax on partnerships.
For this reason, among other potential considerations, partnerships may wish to
avoid these changes. For qualifying partnerships, there are two options
available.
The first option is an opt out, exercisable each year by partnerships that
furnish less than 100 required (not possible) K-1s.
Partnerships can qualify to opt out, generally, as long as there are no owners
that are: trusts; tax-disregarded entities; or other partnerships not meeting
certain requirements. These qualifications may and should factor into the
acquisition and disposition decisions of a partnership, both today and in the
future.
The second option, a sort of retroactive opt-out, is the election of a “push
out.” If an audit tries to collect based on a previous review year, the
partnership can push out the tax responsibility to the partners in that
reviewed year, removing the tax responsibility of the partnership as a
whole. Drafting tip: in consideration of possible adjustments that may
be made under these rules, partnerships may want to impose an obligation on the
partnership to push out in the event of an imputed underpayment.
Pushing out requires (i) a timely election within 45 days of IRS notice of
final audit adjustment, and (ii) that the partnership provides to each partner
during that reviewed year their share of the adjustment. The latter share
adjustment must also be sent to the IRS. If executed properly, each notified
partner is thereafter responsible for payment. Drafting tip: a
partnership may want to secure these obligations contractually with owners,
either during the relationship or during the sale or transfer of that owner’s
interest. This drafting consideration works both ways.
Alternatively, owners who are releasing their interest may seek contractual
indemnity for any future audits being done under these new rules, particularly
for possible review years in which that owner held interest.
Although this article addresses just a portion of the changes under the new
rules, two obvious changes are needed moving forward for most impacted
partnerships. First, existing tax distribution provisions should be reviewed in
light of these developments, even if a partnership plans on systematic opting
or pushing out. Second, new agreements to acquire or transfer interest should
consider these rules and inject potential indemnities, preceded by new
due diligence as to the partnership’s previous tax and ownership
circumstances.
These changes to the statutory regime may and should result in global
considerations for acquisition and disposition of partnership interests, as
well as a multitude of amendments to operating agreements, partnership
agreements, contracts, and other instruments. Some of these changes, especially
the designation of a tax partnership representative, demand immediate attention.
NOTE: This is not tax advice.
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