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.