This article originally appeared in Wisconsin Lawyer, October 2017 issue.
Significant changes to the way entities taxed as partnerships are audited and the tax from audit adjustments is collected generally become effective for returns filed for taxable years beginning after Dec. 31, 2017. Such entities include limited partnerships, limited liability partnerships (LLPs), and multi-member limited liability companies (LLCs) that have not elected to be taxed as corporations.1 Law firms will need to consider the effects of these changes not only on clients but also potentially on the entity in which the firm conducts business.
History of Partnership Tax Audit Process
Before the enactment of partnership audit rules in 1982, Internal Revenue Service (IRS) examinations of entities taxed as partnerships were conducted at the partner level. If the IRS wanted to examine the activity of a partnership, it was required to audit and collect tax from its partners.
The approach to auditing many partnerships changed significantly in 1982. Under statutes enacted then (hereinafter the TEFRA rules),2 the IRS was allowed to audit the partnership and then apply the results to the returns of each partner.3 The amount of tax due from the partner depended on the partner’s other tax attributes (that is, the partner’s other items of income, gain, loss, deduction, and credit), and the IRS collected the resulting tax from each partner.
Reasons for Change
Over time, the IRS found application of the TEFRA rules difficult or otherwise unsatisfactory. The process is labor and paper intensive. The TEFRA rules require notices to partners of the commencement of proceedings, proposed audit adjustments, and subsequent calculations of the tax due from each partner. In addition, while the TEFRA rules allowed the IRS to deal with a single “tax matters partner,” the IRS sometimes found it difficult to identify that person or to react to the permitted intervention of other partners in the examination process.
Given these problems, the significant number of business enterprises now taxed as partnerships, and the complexity of some ownership structures, Congress concluded that the TEFRA rules contributed to fewer partnerships being audited, particularly when compared to the number of examinations of similarly sized corporations. Congress also seems to have concluded that audits of tax partnerships were, in practice, more limited and resulted in fewer adjustments and less tax being collected when compared to examinations of enterprises operating in other tax forms.
Opting Out of the New Partnership Tax Audit Rules
Certain entities taxed as partnerships may opt out of the new audit rules. The election to do so for any year must be included in a timely filed partnership tax return for that year.
The election is only available to entities having fewer than 100 partners (including, generally, indirect owners of the entity in the case of an S corporation partner). Further, the opt-out election is not available if the entity has owners other than individuals, C corporations, foreign entities meeting certain requirements, S corporations, or estates of deceased partners.
The authors expect many owners will want the entity to make this annual election. They may wish to include provisions in partnership, operating, and other governance agreements to require that qualifying entities include the election in the partnership tax return each year.
New Partnership Tax Audit Rules
New rules for the examination of entities taxed as partnerships were enacted by the Bipartisan Budget Act of 2015 (the BBA),4 and proposed regulations followed.5 The new rules are generally effective for returns filed for partnership tax years beginning after Dec. 31, 2017.6
While partnership-level examinations will continue under the new rules,7 the IRS will for the first time be entitled to collect tax, based on the results of the audit, directly from the partnership, rather than from the partners.8 The tax payable by the partnership under the new rules is referred to as the “imputed underpayment.” The imputed underpayment in most cases will be due from the partnership in the year the audit adjustments are finalized, referred to as the “adjustment year” in the new statutory regime.9
Moreover, instead of a tax calculation based on the other tax attributes of each partner, the imputed underpayment will be calculated by applying a single tax rate to, essentially, the net amount of the audit adjustments for the year under review.10 That tax rate will be the highest rate of tax in effect under I.R.C. § 1, which sets the tax rates applicable to individuals, or I.R.C. § 11, which sets the tax rates applicable to corporations.11 It is currently 39.6 percent, the highest tax rate applicable to individuals.12
The new statutory provisions, however, contemplate that the amount of the imputed underpayment due from the partnership can be reduced. For example, the BBA directs the Treasury Department to establish procedures under which the imputed underpayment is to be determined without regard to the portion the partnership demonstrates is allocable to a tax-exempt partner. In addition, the tax rate used to compute the imputed underpayment is to be reduced with respect to any portion of it that the partnership demonstrates is allocable to a partner that is a C corporation or, in the case of a capital gain or qualified dividend, is an individual. The procedures are also to provide that the imputed underpayment is to be determined without regard to adjustments properly taken into account for the year under audit (the reviewed year) on amended returns filed by partners for that year (and other tax years affected by the adjustments), if the partners pay any tax due on those returns and other requirements are met.13
Thus, while the imputed underpayment will first be calculated as if all partnership adjustments constitute income taxed at the maximum rate applicable to any individual or corporate taxpayer, the BBA contemplates that the partnership will be able to seek reductions that move the amount closer to the total amount that would have been paid over time had the partners reported consistently with the results of the audit on their initially filed tax returns. There is a time limit for submissions by the partnership seeking reductions to the imputed underpayment, and the modification of the imputed underpayment is subject to approval by the IRS.14
Audits under the new rules will make adjustments to the reviewed year, and the resulting imputed underpayment will not be collected from the partnership until the adjustment year. However, over time, ownership interests might change hands, ownership percentages might change, and new owners might be added and existing owners redeemed. Therefore, the ownership structure in the adjustment year may differ from the ownership structure in the reviewed year, and the new system might produce results considered unfair by many partners.
Fortunately, the BBA permits the partnership to make certain elections that would have the effect of aligning the burden of audit adjustments with the reviewed year partnership ownership. First, certain partnerships having, generally speaking, fewer than 100 partners may “opt out” of the new audit regime. The opt out is an annual election that must be made by the partnership on a timely filed return.15
This election is available only to partnerships in which each partner is an individual, a C corporation, a foreign entity meeting certain requirements, an S corporation, or an estate of a deceased partner.16Thus, the opt-out election is not available to the partnership if any one of the partners is a trust, another partnership or, perhaps, a tax-disregarded entity (such as a single-member LLC). Further, for purposes of determining the 100-partner limit, each shareholder of an S corporation partner is essentially treated as a partner.17
Second, even if a partnership did not make the opt-out election on the partnership tax return, it will be permitted to shift the responsibility for tax relating to the audit adjustments to the reviewed year partners (which will eliminate the partnership’s obligation to pay the tax). However, to do so, the partnership will need to affirmatively make an election, within 45 days after the IRS notice of final partnership audit adjustment, that the partners are to take the adjustments into account and pay the associated tax.18
The election has been referred to by some as a “push out” election. If made, the partnership must furnish to each partner of the partnership for the reviewed year and to the IRS a statement of the partner’s share of each adjustment made in the audit. Each partner’s tax for the reviewed year, and potentially other affected years, will be increased by taking its share of the audit adjustments into account, and each partner will then be responsible for paying the resulting tax.19
Under the new rules, the person authorized to act for the partnership will be called the “partnership representative.”20 Unlike the “tax matters partner” under the TEFRA provisions, the partnership representative will not need to be a partner of the partnership. The partnership representative will be required to have a substantial U.S. presence.
The partnership representative will have the sole authority to act on behalf of the partnership with respect to the audit.21 The partnership and all partners will be bound by the actions undertaken under the new rules by the partnership and any final decision in a proceeding brought under the rules.22
Suggestions for Business and Tax Lawyers
As suggested above, owners of interests in entities taxed as partnerships will likely find the potential calculation and collection of tax at the partnership level inequitable, particularly in light of long-standing tax principles that generally apply an aggregate, not an entity, theory to the determination and collection of tax on partnership activity.23 As a result, they might want to adopt, implement, or provide standards for deciding how to adopt and implement the alternative treatments of audit results allowed under the new rules. Existing instruments, including partnership agreements, operating agreements, buy-sell agreements, and other contractual arrangements, likely will need to be modified. New documents will need to be drafted in light of these rules.
For example, though there are exceptions, the authors expect many owners will want to make an election each year to opt out of the new rules. As a result, partnership, LLC operating, and other governance agreements should be amended, and provisions in new agreements drafted, to require that qualifying entities include the election in tax returns each year.
Such entities might also want to consider prohibiting issuance or transfers of ownership interests to trusts, partnerships, or tax-disregarded entities if ownership of interests in the entity may preclude the making of an opt-out election. On the other hand, such a prohibition may be impractical, given owner objectives, business needs, and succession, estate, and other planning goals.
Owners may also wish to agree that if the opt-out election has not been made for a particular tax year and the procedures contemplated by the BBA are in place modifying imputed underpayments in cases in which partners file returns and pay tax by taking into account the audit adjustments properly allocable to them, that the partners so file returns and pay the tax. An advisor should evaluate, in drafting the agreement, the expected future ability of the owners to satisfy those obligations and whether some provisions to secure performance should be included.
In addition, if owners conclude the burden of partnership audit results should always fall on each partner based on its particular tax attributes (as opposed to falling on the partnership under the general rules described above), the owners may also wish to require that if an audit results in adjustments, a “push out” election must be made. Or, the owners might conclude the making of a “push out” election should be optional, in which case applicable agreements might be modified to provide standards and factors to be considered in deciding to make the election and how the decision is to be made (including who is to participate in making the decision).
If these or other provisions will not always make partners separately responsible for the tax resulting from partnership audit adjustments, the partners may want to address, in applicable agreements, how current and former owners will share in the payment of any imputed underpayment that the partnership pays.
Given that examinations of partnership activity might be completed years after the tax year(s) under review and the identity of or relative ownership percentages of the partners may change between the reviewed year and the year the audit concludes, the owners might want to provide for appropriate indemnifications among themselves or obligations to reimburse the entity for the amount of any imputed underpayment. Such agreements should bind all owners of the entity for the year under audit. Again, the expected future ability of partners to satisfy indemnification obligations should be evaluated, and means to secure performance might be considered.
Tax distribution provisions commonly present in entity agreements might also require review and modification. Such provisions will need to be consistent with the parts of the agreement addressing the new audit rules.
Governing documents should also be modified or drafted to address issues relating to the partnership representative, including how the representative will be selected, standards for those occupying the position, duties to the partnership and partners with respect to the exercise of the representative’s decision-making power under the statute, duties to keep partners and former partners informed regarding proceedings, and, potentially, indemnification of the representative.
Because the general rule imposes on the entity the obligation for tax on adjustments of items reported on prior partnership tax returns, the effect of the new rules must also be considered if a person purchases or acquires by contribution interests in an entity that is taxed as a partnership, owners are redeemed, entities taxed as partnerships merge, or other transactions involving the entity or its owners occur. For example, those acquiring interests in the entity will want protection against the potential indirect economic effect they might suffer if the IRS audits and adjusts the results of entity activity for years before the acquisition transaction occurred. Due diligence checklists should be modified so this issue is considered, and acquisition and indemnification agreements among the parties in such transactions must include provisions regarding potential partnership tax examinations.
While enactment of the new partnership audit rules may have been motivated in part to address difficulties examining larger enterprises, the new audit regime applies to all entities taxed as partnerships, including most multi-member LLCs. The new rules apply to returns filed for tax years beginning after Dec. 31, 2017. Thus, Wisconsin lawyers and business advisors must promptly consider and advise clients and recommend amendments to applicable governance, buy-sell, and other documents regarding the effect of the new rules on client businesses.
Lawyers representing clients in transactions involving the acquisition or disposition of interests in entities taxed as partnerships must also consider the new rules. Parties will need to consider and properly address responsibilities in representation, warranty, indemnification or holdback arrangements or provisions, for adjustments to tax returns for periods before the closing.
Wisconsin lawyers may also want to consider the effect of the new rules on the law firms with which they are associated. As with all other enterprises, owners come and go. If taxed as a partnership, the lawyers should amend agreements to allocate responsibility for tax obligations that may be asserted after applicable transfers of ownership interests.
1 Such entities may be referred to simply as “partnerships” below.
2 See Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97–248 (TEFRA).
3 Certain partnerships having 10 or fewer partners were not subject to the TEFRA rules, unless an election was made to be covered by the rules. See I.R.C. § 6231(a) as in effect for partnership tax years beginning before Jan. 1, 2018. Rules regarding “electing large partnerships” were later enacted. See I.R.C. §§ 6240-6255 as in effect for partnership tax years beginning before Jan. 1, 2018.
4 Pub. L. No. 114-74.
5 The proposed regulations (REG-136118-15) were released by the Treasury Department on Jan. 18, 2017, but withdrawn Jan. 20, 2017, in response to President Trump’s directive freezing issuance of federal regulations. The proposed regulations were reissued in June 2017.
6 An election to apply the rules to earlier years exists.
7 But see rules for “electing large partnerships” referred to above.
8 I.R.C. § 6221(a) and I.R.C. § 6225(a), each as added by section 1101 of Pub. L. No. 114-74, effective as provided in section 1101(g), for returns filed for partnership taxable years beginning after Dec. 31, 2017. All subsequent references are to I.R.C sections as amended or added by Pub. L. No. 114-74.
9 I.R.C. § 6225; I.R.C. § 6232.
10 I.R.C. § 6225(b).
11 I.R.C. § 6225.
12 At the time of this writing in May 2017, the prospect of significant tax reform or tax rate modification looms. This highest rate, now in effect for many years, may change.
13 I.R.C. § 6225(c)(2), (3), (4).
14 I.R.C. § 6225(c)(7), (8).
15 I.R.C. § 6221(b).
16 I.R.C. § 6221(b)(1)(C).
17 I.R.C. § 6221(b)(2).
18 I.R.C. § 6226(a).
19 I.R.C. § 6226(b).
20 I.R.C. § 6223.
21 I.R.C. § 6223(a).
22 I.R.C. § 6223(b).
23 Some have asked if the new rules may prompt businesses to structure themselves as entities that will not be taxed as partnerships. The authors expect that other factors affecting entity selection will continue to be more important and thus believe entity-selection decisions made based on the changes to the audit rules will be rare.