September 19, 2017
Tax Law Alert
Author(s): Kenneth H. Silverberg
We have all seen the client alerts and newsletters from lawyers and accountants explaining the new IRS audit regime for partnerships. Busy people tend to forward those things to their tax advisor and assume that the tax advisor will deal with it. They may think of these new rules as “routine housekeeping.”
This time it requires attention from the owners of every existing and new business taxed as a partnership. Here is what could happen if you fail to take appropriate action and address the new rules in Operating or Partnership Agreements:
These are just some of the bad things that can happen when the IRS audits a partnership for 2018 or later years. You can head off all of these and other bad scenarios by getting the partners to agree now on how tax audits will be handled in the future.
The IRS has lobbied for these changes for years to make it easier to audit partnerships and to eliminate the individual appeal rights of partners. Now that the changes are set to go into effect, the IRS has announced it will be able to conduct more partnership audits without asking Congress for additional resources. So the chance of a partnership getting audited will increase beginning next year.
The new rules apply to audits of 2018 and later years for most partnerships and for most LLCs and LLPs that are taxed as partnerships. Unless the partnership elects otherwise, future tax deficiencies will be imposed on the partnership and will be computed as if every partner is subject to the maximum tax rates (generally 39.6% for individuals and 35% for C corporations.)
In most cases, attorneys can draft the necessary amendments to address the new rules in the governing agreement in short order. What is likely to take time and effort is educating partners about the changes and helping them make the necessary decisions.
The “fix” for these new rules will depend on the situation. Here are a few situations we are already commonly encountering:
If there are fewer than 100 partners and all of them are individuals, C corporations or one of a few other categories, the partnership may elect-out of the new centralized audit procedures. If it does, any future IRS audit assessments will still be made against the individual partners, as under present law. The partners will also continue to have individual appeal rights. These eligible partnerships may want to amend their governing agreement to require the election-out, and add an amendment to prevent partners from transferring their interests to a partner that would destroy continued eligibility for the election-out.
In harmonious partnerships where the managing GP makes all the business decisions, it probably makes sense for that person to be the “partnership representative” or “PR” (i.e., the individual who has sole authority for dealing with the IRS. (See our previous Tax Alert “ Who Should Be the Partnership Representative, and why it Matters to Investors.”) For these partnerships, it may be sufficient to add provisions dealing with:
Some partnerships have a tradition of making all their important decisions by voting—either plenary votes of the partners or votes taken by a managing body composed of representatives of the partners. For these partnerships, it’s normally best to convene a special meeting at which each taxpayer’s rights-decision is explained. When partners expect to have a voice in the partnership’s business decisions, they almost always want to have a voice in how their own tax liability is determined.
The new law requires the PR to make decisions that are binding on all partners, and provides strict timetables for making various elections, without regard to how long it may take to call a partnership meeting or get a vote of the partners. Individual partners have lost many of their “due process” rights under the new IRS regime, and they should be made aware of the changes.
An additional set of issues arises when one or more partners transfer their interests during or after the year being audited. The current partners will probably not want to pay their former partner’s additional tax bill, so they will probably want to require the PR to make the “push-out” election. That means within 45 days of receiving the auditor’s adjustment notice, the PR must give the IRS an election form plus a list of how much should be collected from each partner and former partner. The IRS then uses its formidable collection resources to collect the tax directly from the partners, and imposes an additional interest rate of 2% on all the partners’ assessments for the additional “collection service.”
If the partners are at odds, or if the original agreement was heavily negotiated, the “fix” to address the new tax rules might be more complicated. Communicating with partners about the necessary tax changes may be the occasion that opens up the other discussions, which may not be unanimously desired. Nevertheless, delay or inaction will create risks if there is an IRS audit.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.