The Oct. 3, 2017 column reviewed the new partnership level audit rules (New Rules) which are effective for tax years beginning after Dec. 31, 2017. See “Overview of the New Partnership Level Audit Rules,” N.Y.L.J. (Oct. 3, 2017). This column discusses considerations for existing or new partnership agreements under the New Rules. See The Bipartisan Budget Act of 2015, Public Law No. 114-74 (Nov. 2, 2015).
Summary of the New Rules. Under the New Rules, in the event that an item of partnership income or loss is adjusted in an IRS audit, the partnership will be liable for a partnership tax (plus interest and penalties, as applicable) equal to the amount of the adjustment multiplied by the highest marginal tax rate (Audit Tax). The partnership can then either pay the Audit Tax (subject to reduction, discussed below) or make an election, to push the audit adjustment out to the partners (Push-Out Election). See I.R.C. §6226. If the partnership decides to pay the Audit Tax, the partnership may be able to reduce the Audit Tax (1) by demonstrating to the IRS that a portion of its current investors either would be exempt from tax or taxed at lower rates, or (2) by having the applicable partners voluntarily agree to amend their tax returns to include their share of the audit adjustment. If the Push-Out Election is made, the audit adjustment would be “pushed out” to the partners that were partners during the Audit Year. Such partners would be liable for the tax (plus interest at a rate 2 percent higher than the regular underpayment interest rate and penalties) directly at their level, taking into account their other tax attributes. However, there is still uncertainty regarding whether an audit adjustment can be pushed out through partnership tiers.
Issues for Partners. The New Rules raise a number of issues for partners, many of which will need to be addressed through new provisions in partnership agreements including:
- Who will be the partnership representative?
- Who will determine whether the partnership pays the Audit Tax liability or whether the election is made to shift the burden to the partners?
- If the partnership pays an Audit Tax liability, how will the economic burden be shared among the partners?
- Will a partnership require its partners to provide information to the partnership or to file amended returns in order to reduce the amount of any Audit Tax liability?
- What rights will partners have regarding tax disputes? Absent contractual protections, the statute now gives full authority to the partnership representative.
Sheltered Income Could Become Taxable Income. As a result of the New Rules, partnerships are subject to a federal income tax that has historically been imposed on individual partners when there has been an understatement of income. This means that if partners were able to shelter their income from one partnership with losses from other sources on their individual returns, such partners might not be able to do so because the income would be taxed at the partnership level. Moreover, a partnership may have less capital because the partnership had to pay it to the government. Partnership agreements have never been drafted to deal with less capital because of tax payments. All partnership agreements are now going to have to anticipate such an event.
Another taxable income issue to consider is that for venture capital and real estate partnerships the income is typically capital gains currently taxed at a federal 20 percent rate. The New Rules levy the highest federal rate applicable to individuals (39.6 percent), which rate is almost twice as much. This means that partners will have to determine internally how they want to allocate the tax among themselves so as to ensure that each partner gets the economic outcome the partner had bargained for.
Liability May Exist for Past Partners’ Tax Decisions. When new members join a partnership or when an entity buys up a partnership during a merger or acquisition (M&A) transaction, the new partners could have tax liability for tax positions made before they become partners because adjustments stemming from an audit will apply to the year the adjustment is made rather than the tax year for which the partnership is being audited.
As discussed above, the New Rules give partnerships a Push-Out Election whereby the tax liability can be pushed out to individual partners through amended Schedule K-1s. Thus, partnerships have to deal with apportioning the adjusted income among individual partners for the audit year and draft the partnership agreement in such a way that the Push-Out Election and amended K-1s can be sent to former partners to make them responsible for imputed underpayments. Consideration should be including a mechanism to keep the former partners liable to repay the partnership should the partnership be audited in a particular year.
Partnership Representatives Have More Power. The new partnership representative is similar to the current laws tax matters partner, however the representative has greater authority to bind partnerships to settlements, extend statutes of limitations, and make decisions on whether to go to litigation. This means that partnerships will need to consider language to constrain what decisions the representative (who does not have to be a partner) will make without getting consent from a certain percentage of the partners.
Partnerships will also need to consider what kind of indemnification provisions are needed with regard to the role of the partnership representative. The authority of a partnership representative may also be implicated by former partners who may want to have a degree of control in an audit if they receive amended K-1s for new tax liabilities after they have left the partnership.
Opting Out Is Not Forever. Under the New Rules, partnerships with 100 or fewer partners can elect out of the New Rules to maintain the status quo. Note that the election does not become the default position for each year. Tax preparers must ask their clients every year if they want to opt out or not.
Partnerships that can and want to opt out should also review the transferability of their partnership interests. For example, since tiered partnerships are not eligible for opting out from the New Rules, a partner that makes transfers to a trust would automatically disqualify the partnership from opting out.
Former Partners May Escape Liability. If a partner transfers his or her interest before a partnership tax audit, the transferee will indirectly bear the burden of any tax liability paid by the partnership, even if the audit was in respect of a prior year. However, if the partnership agreement provides for its partners to pay the tax liability even after a transfer, the transferor will be liable.
The Push-Out Election Likely to Apply in Most Cases. Even assuming the IRS issues procedures permitting partnerships to reduce the applicable entity-level tax as described above, anticipate that many partnerships will instead opt to use the elective provisions. In the context of M&A transactions it is likely that many parties will require this approach contractually.
Transactions Involving the Purchase of Partnership Interests. Absent the choice to use the Push-Out Election provisions, the New Rules effectively allocate the tax liability associated with partnership items benefiting prior year partners to current year partners, even though prior-year partners may have benefited from prior year partnership earnings and income. It is likely that parties acquiring partnership interests or involved in M&A transactions with partnerships will in the first instance seek to use the elective provision for pre-closing periods. If the elective provision is not available, buyers will likely conduct enhanced due diligence and seek to negotiate detailed tax representations and warranties and tax indemnification provisions.
Partnership Governance. Under the New Rules, partners are denied notice, the ability to participate in an audit, and judicial standing to challenge the results of an audit. Furthermore, partners may not revoke a partnership representative’s authority to bind them. Partners with significant interests may seek to negotiate contractual partnership representative approval rights, audit notice rights, and audit settlement approval rights as a result of these changes.
Conclusion. As the above discussion demonstrates, affected taxpayers should consider practical steps to address the implications of the New Rules. From a transactional perspective, existing partnership agreements need to be reviewed and possibly revised to account for the New Rules. In addition, drafters of new partnership agreements and LLC operating agreements should consider including provisions such as those discussed above. Moreover, a determination will need to be made as to whether existing partnership and LLC operating agreements should be amended in light of the New Rules and, if so, how and with what implications (for example, in terms of required consents). In the context of M&A, potential purchasers of partnership interests are likely to require that the partnership commit to make the Push-Out Election in the event of an audit. The New Rules will have consequences to the business community for years to come.
The New Rules will make it easier for the IRS to audit partnerships and collect tax, penalties, and interest attributable to resulting adjustments. For that reason, the New Rules will likely lead to an increase in both the number of partnership audits and the amount the IRS ultimately collects from those audits.
Peter M. Fass is a partner at Proskauer Rose.