The new partnership tax audit rules enacted by Congress on November 2, 2015 could have a dramatic impact on partnerships and their partners (including limited liability companies taxed as partnerships (“LLCs”) and their members). The new rules will apply to audits of tax returns for tax years beginning after December 31, 2017.
The “tax matters partner” provision found in virtually all partnership and LLC operating agreements will not work for tax years when the new partnership audit rules will automatically apply. Thus, this provision will have to be amended at some point. The only question is when. Partnerships and LLCs should not wait until the commencement of an audit to amend their partnership or operating agreements.
We would be glad to discuss your particular situation. We recommend the following:
- In general, partnership and LLC agreements should not be amended until the IRS issues more detailed guidance;
- If an existing partnership and LLC agreement is being amended for other reasons (whether to admit a new investor or otherwise), a revised partnership audit provision should be included with the amendments;
- In the case of new partnership and LLC agreements, an updated partnership audit provision should be included; and
- If an existing partnership or LLC desires to qualify for the “opt-out” election (which is described in more detail below), it is important to make conforming amendments now. In general, only partnerships and LLCs that have solely individual or corporate members can qualify for this election.
(This alert henceforth will refer only to partnerships, their partners, and partnership agreements. However, any such references also apply equally to LLCs that are taxed as partnerships, their members, and LLC operating agreements.)
Currently, partnerships are subject to audits at the partnership level, and any adjustments are passed through to the partners, who end up paying any additional tax (plus interest and any penalty). The Internal Revenue Service had difficulty, however, auditing and processing adjustments in cases of multiple-tiered partnerships and where there were numerous partners. These difficulties led to the enactment of the new partnership audit rules on November 2, 2015.
Under the amended statutes, and in a departure from the normal “flow through” treatment of partnerships, the default rule is that the partnership itself must pay the tax on any additional income imposed as a result of a tax audit. Further, the tax is assessed to the partnership in the year that the audit or judicial review is completed. Thus, the partners in the year that the audit or judicial review is completed will bear the economic burden of the adjustment.
This default rule can have adverse financial results. First, the economic burden of the tax may be borne by current partners who were not partners in the year under tax audit, or may be borne by partners in different amounts than if the tax had been passed through to partners for the “reviewed” year under tax audit. Second, the partnership must pay at the highest maximum tax rate (which is currently 39.6%) applicable to the reviewed year (although new rules should provide the ability for partnerships to lower their tax bills by establishing that some of their partners would be entitled to lower rates or tax exemption). Third, if a partnership adjustment reallocates income between partners, only increases in income or decreases in loss, and not the offsetting adjustments, are taken into account. Fourth, the partnership may not deduct interest paid to the IRS. Some partners, particularly corporations and other taxpayers engaged in business, would otherwise generally be entitled to deduct interest expense.
The new partnership audit rules contain an “alternative method”—partnership can elect to push out its taxable income adjustment to the partners of the reviewed tax year. This “push-out” election, which must be made within 45 days of the notice of final partnership adjustment, has gained the interest of many taxpayers and their advisors. It allows partners to include the adjustments on their returns in the year in which the adjustments become final but to calculate the tax triggered by the adjustments based on their actual tax rates for the reviewed year and offset any increase with any other tax benefits (such as a net operating loss carryover). Furthermore, partnerships that make the election are not liable if a partner fails to pay its share of the adjustment (this should be of particular interest to general partners, who would otherwise bear potential liability for unpaid tax assessments). Moreover, the interest on the assessed tax may be a deductible business expense for some partners. The push-out election may be used where the interests of the partners have changed over time, so that the burden falls on those who were partners in the reviewed year. Also partnerships that lack sufficient available cash to pay the tax may need to make this election.
While this election can be helpful, it comes at a cost. For one, the interest rate on the payments under this election is 2% greater than the normal rates on tax deficiencies paid by partners. In addition, the 3.8% net investment income tax would be taken into account under the push-out election, but not if the partnership pays the tax. Furthermore, the push-out election requires partners to take adjusted items into account not only in the reviewed year, but in any subsequent year that would increase the partner’s tax due; years that would lower the partner’s tax would not be taken into account. Moreover, how the push-out election works in multiple-tiered structures is currently unclear. This election could also entail significant administrative and compliance burdens on the partnership, particularly where a number of partners have multiple-tiered structures. Thus, for any or all of these reasons, it may be desirable for the partnership to pay the additional tax.
The new rules do permit the partnership to elect for the partners to file amended returns for the tax years at issue. In that case, those who were partners in the reviewed tax year at issue will bear the burden of the tax. The partners can pay tax using their actual tax rates, including individuals paying tax at favorable capital gains and dividends rates and tax-exempt partners paying no tax. Partners may be able to offset the additional income with attributes at the partner level, such as net operating losses; and partners may be entitled to deduct interest. But the partners filing amended returns would not be subject to the additional interest charge, as is the case under the push-out election.
If a partner files an amended return and pays the associated tax, the partnership’s tax assessment is determined without regard to the portion of the assessment taken into account on the amended return. Thus, if all applicable amended returns are filed, the partnership’s tax assessment should be reduced to zero. While a partnership agreement can require partners to file amended returns, it may be difficult to enforce if a partner is a subsidiary in a multiple-tiered structure. If some partners (and their direct and indirect owners) do not file amended returns, the partnership would still owe some tax and the partners that did file amended returns may wind up bearing more than their proper share of the tax assessment. In addition, just as the IRS found it burdensome to handle amended returns, so might partners of partnerships (and their direct and indirect owners).
Unless an existing partnership agreement is otherwise being amended, we recommend that such agreements not be amended at this time to reflect the new partnership audit rules, for two reasons. First, the new rules apply only to tax returns for tax years beginning after December 31, 2017. Accordingly, there is some time left before the new rules kick in. Second, the IRS is in the process of writing new regulations and other guidance under the new rules. The statute provides the IRS with a broad grant of authority to make rules under the new regime. Given this broad grant of authority and questions and uncertainties surrounding the push-out election, filing amended returns, and some other matters, it is advisable to wait until such guidance is issued.
As discussed in greater detail below, if an existing qualifying partnership desires to “opt-out” of the new partnership rules, or “opt in” early into the new partnership audit rules, we recommend that it amend its partnership agreement to reflect the new partnership audit rules.
If an existing partnership agreement is otherwise being amended prior to the issuance of new guidance by the IRS (whether to admit a new investor or otherwise), we recommend that the partnership tax audit provision of such agreement be amended as well to reflect the partnership audit rules. In this case, the burdensome effort is already being made to go to partners to approve amendments to the partnership agreement. In such a case, it also makes sense at the same time to draft and obtain approval for a new partnership audit provision. Such provisions are sufficiently developed at this time to address many of the issues raised by the new partnership audit rules. If, after the IRS issues its regulations or other guidance, it becomes advisable to revise the partnership audit provision, such revision may not be a substantial one that would create tensions among the partners or members.
We strongly recommend that provisions addressing the new partnership audit rules be added to all future partnership agreements.
A well-drafted provision taking into account the new partnership audit rules should address the following topics:
- The partnership must designate a “partnership representative.” Unlike the current “tax matters partner,” a partnership representative does not have to be a partner of the partnership, but does have to have a substantial U.S. presence. There should also be provisions providing for replacing a partnership representative, the reimbursement of the partnership representative when incurring expenses related to this role, and indemnification of the partnership representative against claims related settling tax audits and litigation proceedings;
- The partnership representative will have the sole authority to act for the partnership in an audit or litigation proceeding. The partners may want to limit such authority by requiring board approval, majority vote, or satisfying some other threshold. The extent to which partners are entitled to notification of partnership audit developments should also be addressed;
- The partners need to agree on, in the event the partnership is assessed tax in the future, whether or not it is to be expected or how it is to be determined for the partnership to make the push out election or elect to have partners file amended returns;
- The partners should be required to cooperate in the event the decision is made to make the push-out election or to amend returns;
- In the event the decision is made not to make the push out election or file amended returns (perhaps because the partners cannot agree or it is determined that any such election would be administratively burdensome), and the partnership is therefore required to pay the assessed tax (and any interest and penalty), a mechanism is needed to insure that the partners of the partnership for the tax year under review bear the burden of the tax in the proper proportions consistent with the partnership agreement, including any former partners; and
- If the partnership pays the assessed tax, it will likely have the opportunity to demonstrate that its tax rate should be lower—for example, because of the presence of tax exempt partners. Partnerships need to work out how to compensate a partner whose exemption or lower rate disproportionately reduced the tax bill for the partnership. To date, few partnership audit provisions, even in new partnership agreements, address this compensation issue. Similarly, if any partner files an amended return and pays tax on such partner’s share of the adjustment, that payment will reduce the partnership’s tax bill. Such partner should not have to bear any further portion of the tax assessment.
The new partnership audit statutes provides for an “opt-out” election for partnerships with 100 or fewer partners. For a partnership to qualify for the election, each of its partners must be an individual, S corporation, C corporation, foreign entity that would be treated as a C corporation were it domestic, or an estate of a deceased partner. Accordingly, unless future guidance permits it, the opt-out election is not available to partnerships with another partnership or many types of trusts as a member. This is an annual election and is made on a timely filed partnership tax return.
An eligible partnership may want to make the opt-out election in order to avoid the risk of suffering from some of the adverse consequences of having the partnership pay the tax assessment (i.e., paying tax at the highest rates) or making the push out election (i.e., the additional interest charge). Partnerships that elect out would not be subject to the current TEFRA partnership audit rules; instead, each partner will be entitled to litigate its own position separately. This could present opportunities, but could also result in inconsistent results for different partners and higher costs in defending the audit.
If a partnership seeks to make the opt-out election, it should consider amending its existing partnership agreement now to restrict the transfer of a partnership interest to a new partner that would preclude the partnership from making the opt-out election. If such restrictions are not in place now, a future transfer could result in the partnership being ineligible to make the election once the new partnership audit rules apply. The transfer restriction rules would be similar in nature to the transfer restriction rules currently found in many shareholder agreements that are intended to prevent the transfer of stock to holders that are not eligible S corporation shareholders. The partnership agreement should also require partners to provide the information necessary to confirm that the partnership qualifies to make the opt-out election.
While the new partnership audit rules apply to partnership tax years beginning after December 31, 2017, in limited circumstances partnerships can elect to apply them to returns filed for partnership tax years beginning after November 2, 2015 and before January 1, 2018. Not many partnerships will want to elect-in early. A partnership may want to elect in early because it would be administratively burdensome for it to prepare numerous amended K-1 forms and annoying for partners to pay the additional tax. In such a case, a partnership with sufficient funds might welcome the ability to pay the additional tax itself.
Under temporary regulations recently issued, a partnership cannot elect-in unless it receives an IRS notice that the partnership has been selected for examination. The partnership must make the election within 30 days of receiving the notice of selection for examination and the election cannot be revoked without IRS consent. Given this short time frame, partnerships expecting to be audited and desiring to elect-in may want to amend their partnership agreements now to lay the groundwork for the opt-in election.
An exception to the general rule allows a partnership to elect-in if the partnership wants to file an administrative adjustment request under the new regime. But the election cannot be made before January 1, 2018.
The temporary regulations close a loop-hole by providing that any partnership that elects-in early cannot then make the opt-out election. It appears that a partnership opting in early can make the push-out election.
To make the opt-in election, the partnership must represent that it is not insolvent, does not anticipate going into bankruptcy, and has sufficient assets to pay any tax assessment. The IRS does not want to allow partnerships to avoid their tax obligations by opting-in and then declaring bankruptcy.