By Blake D. Lewis
Well, 2019 is finally here, which means the time has come to update your partnership agreements to address the new partnership tax audit rules that were passed as part of the Bipartisan Budget Act of 2015. These new rules will replace the Tax Equity and Fiscal Responsibility Act of 1982 (TEFFA) and are effective for tax years beginning after December 31, 2017.
In general, the new audit rules require adjustments of items of income, gain, loss, deduction or credit to be made at the partnership level and impose any imputed underpayment of tax on the partnership at the higher of the highest marginal individual or corporation tax rate.
Because it is the partnership that bears the financial responsibility of paying the underpayment, it may be necessary for the partnership to make a capital call in a very limited amount of time in order to timely satisfy the lability. As a result, partnership agreements should address how capital calls will be made in such instances. In some cases, the partnership may find that it is appropriate for one particular partner to ultimately bear the financial responsibility of an underpayment as the underpayment relates to an item unique to the partner such as a guaranteed payment. Therefore, the partnership may want the discretion to impose the cost of the audit and the imputed underpayment on an individual partner. In such cases, the partnership may also want the ability to net a partner's share of the imputed underpayment against distributions that are otherwise owed to the partner. Accordingly, partnerships need to evaluate whether their partnership agreements are sufficient to address the economic issues presented by the new rules.
As a default, the new partnership rules apply to all partnerships. However, eligible partnerships may elect out of the application of the rules. An eligible partnership is a partnership that issued 100 or fewer Form K-1s for the taxable year with each of its partners being a C corporation, an S corporation, or an estate of a deceased partner. Thus, if the partnership has as a partner another partnership, a trust (including a grantor trust), or a disregarded entity, it may not elect out. The election must be made on the partnership's timely filed tax return for each year the partnership decides to make the election. In addition, the partnership must notify each of the partners that the election has been made and supply the IRS with the names, tax identification numbers, and tax classification of each partner and, in the case of a partnership with an S corporation partner, each S corporation shareholder. If the partnership elects out, the partnership will be subject to the pre-TEFFA audit procedures under which the IRS must separately asses tax with respect to each partner. Consequently, partnership agreements should address whether or not the partnership will elect out of the rules. Moreover, partnerships currently eligible to make the election may desire to place transfer restrictions on partnership interests to prevent partners from making transfers that would affect the partnership eligibility to elect out.
Under the new rules, partnerships that do not elect out may still shift their tax liability to the individual partners by electing to "push out" any imputed underpayments of tax to those individual and entities who were partners during the year in which the underpayments relate (the "reviewed year partners"). In order to make a valid election, the partnership must make the election within 45 days after the date the final partnership adjustment is mailed, and the election must include, among other items, the name, tax identification number, and address of each reviewed year partner. Accordingly, it would be wise for the partnership agreement to address how the decision to make the push election will be made. Moreover, in order to ensure that the partnership has the required information to make the election, partnerships should consider including provisions in their partnership agreements requiring partners to provide the partnership with the required information in a timely manner and such provisions should survive a partner's status as a partner. Otherwise, partners who were not partners in the year for which imputed underpayments relate may end up bearing the financial responsibility of such underpayments.
The new audit rules also replace the tax matters partner with the "partnership representative" (PR), which unlike the tax matters partner, does not have to be a partner of the partnership. Under the new audit rules, the partnership is required to designate a PR on each of its timely filed tax returns for years ending after December 31, 2017. From the standpoint of the IRS, the PR has absolute authority in making decisions on behalf of the partnership during an audit. However, this does not mean that the partnership is prevented from imposing contractual obligations on the PR to obtain consent from or consult with the partners prior to making decisions on behalf of the partnership. While imposing contractual obligations on the PR does not limit his decision-making authority in matters before the IRS, the PR's breach of such contractual obligations could result in the PR's civil liability to the partnership and partners. Accordingly, at the very minimum, the partnership agreement should address how the partnership will decide who to designate as the PR each year; whether, when and, how the PR is required to notify the partners of developments in an audit; and whether, when, how the PR must obtain the consent of the partners prior to making decisions on the partnership's behalf. Additionally, a PR will likely require the partnership agreement to indemnify the PR for actions taken on behalf of the partnership to the extent those actions were not in violation of the partnership agreement.
Ultimately, as a result of the imposition of the new partnership audit rules, partnerships are now faced with many new decisions on how to approach audits. At the very minimum, partnership agreements should address the following items: How imputed underpayments will be financed and allocated; whether the partnership will elect out; how the partnership will approach the decision to make a push out election; and how the designation of the PR will be determined and what duties the PR will owe the partnership.
The information provided above is written by Attorney Blake D. Lewis of Friday, Eldredge & Clark, LLP. Blake is an associate in the firm’s Mergers and Acquisitions Practice Group. Blake's practice focuses on taxation, mergers and acquisitions, real estate transactions, tax controversies, entity formation and governance, and franchising.
This is not a substitute for legal advice and should be considered for general guidance only. For more information or if you have further questions, please contact one of our Mergers and AcquisitionsAttorneys.