New Partnership Audit Rules: Should the Partnership Agreement be Amended?

New Partnership Audit Rules: Should the Partnership Agreement be Amended?

In November 2015, as part of the Bipartisan Budget Act (BBA) of 2015, Congress enacted a new centralized Partnership Audit Rules (PAR) to replace the TEFRA partnership rules. The PAR applies to all partnerships  and, like TEFRA, IRS examinations and adjustments will be made at the partnership level.  However, unlike TEFRA, the IRS will assess and collect tax from the partnership. 

The PAR is generally effective for partnership tax years beginning after December 31, 2017.  As a result, for most partnerships, the 2018 tax return will be the first tax return filed under the new regime.   In prior blog posts, we discussed designating a partnership representative on the 2018 tax return (HERE) and opting out of the new audit regime on the 2018 tax return (HERE).  In this blog post, we will discuss potential additions and amendments to the partnership agreement to address the new audit regime.

The following is a non-exhaustive list of issues that will need to be considered in drafting new partnership agreements and amending existing partnership agreements:

1.   Partnership Representative (PR).  If the partnership agreement does not include provisions addressing the PAR, the PR and the partnership’s professional advisors are placed in a difficult position for purposes of implementing and complying with the PAR.

a.   Who will be designated the PR and what vote of the partners is required to appoint and to remove this person?

b.   What is the power and authority of the PR in acting in that capacity and in representing the partnership in an IRS examination, considering that the PAR designates the PR as the “czar” in tax matters?

c.    For those actions that are elective under the PAR, such as Opting In, Opting Out, Administrative Adjustment Request, Push Out, Pull In, Judicial Review, and Modifications, what is the power and authority of the PR to elect to take these actions?  Does the PR need partner approval and if so, which partners (i.e., Adjustment Year partners or Reviewed Year partners or both) are required to approve an action and how is the vote of the partners to be determined?  Each of these elective actions requires an affirmative act and if not taken within a prescribed time period, the ability to take the elective act is forfeited.

d.   Can a partner require the PR to elect one of the Modification procedures to reduce a partner’s share of tax liability or penalty (ie, amended return penalty defenses; lower tax rate)?

e.   Is the PR required to consult with the partners, and if so, does that include both the Adjustment Year partners, and the Reviewed Year partners and how much information and detail is the PR required to share?

f.    Is the PR indemnified by the partnership or the partners and released from all liability arising out of any act or omission of the PR subject to certain agreed carve outs, i.e., gross negligence, willful misconduct, fraud?

2.   Partners.

a.   What are the rights and obligations of the partners regarding PAR?

b.   Is a partner required to comply with the requirements of an election made by the PR when the partner had no participation in the making of the election, such as a Push Out Election that imposes the tax on the Reviewed Year partner or filing Amended Returns under Modification?

c.    Do the partners have an obligation to indemnify the PR and, if so, which partner group (ie, Reviewed Year partners or Adjustment Year partners), and how is the indemnification obligation shared among the indemnifying partners?

d.   If Push Out Election is not made, do the Reviewed Year partners have an obligation to the partnership or the Adjustment Year partners to indemnify them for any taxes, penalties and interest arising out of the Partnership Adjustments and, if so, how is the tax, penalty and interest allocated among the Reviewed Year partners?  Does the indemnity extend to state taxes?

e.   Do the partners have a right to participate in any IRS proceeding with the PR or have the right to attend meetings or receive notice of the proceeding or meeting?

f.      Do the partners have the right to receive periodic updates from the PR and, if so, is that both the Reviewed Year partners and the Adjustment Year partners?

g.    Can the Reviewed Year partners compel the PR to seek judicial review of a Partnership Adjustment?  Same question regarding any calculation of the Imputed Underpayment or any modifications.

h.   Do the partners have the right to participate in selection of counsel in connection with the tax audit and proceedings, if so, which partner group and how are costs shared?

i.      If a partner fails to take an action, such as filing an amended return or providing necessary information to the PR, what is the remedy that the partnership or other partners can seek against that partner?

j.      Do the partners have the right of access to the books and records of the partnership in the event of an IRS proceeding under an Opt Out Election?

k.    Do the partners have the right to transfer an interest in the partnership if a transfer would prevent the Partnership from making an Opt Out Election?

l.      Do the obligations and liabilities of a partner relating to the provisions of the partnership agreement addressing the PAR survive the partner’s ceasing to be a partner?

3.   Other Affected Agreements.

a.   Partnership Interest Buy-Sell Agreements need to include provisions covered by the PAR, including indemnification by the seller in favor of the buyer in the event of a Partnership Adjustment for a presale year, and whether the buyer can vote in favor of a Push Out Election, Pull In or any other elective act that could adversely affect the selling partner.

b.   Agreements Incident to Divorce and Divorce Decrees need to address the PAR issues if a partnership interest is involved in the division of property for the year of divorce and how the economic consequence of an audit under the PAR will be shared by the parties.

c.    Loan agreements need to be reviewed for covenants and representations that could be affected by the PAR and whether the lender will require an Opt Out Election or a Push Out Election.

d.   Tenancy in Common Agreements (TICA) need to be reviewed to determine the consequences of the IRS determining that the arrangement is actually a partnership and whether the TICA needs to contain provisions addressing the PAR in such event.

e.   Wills and estate planning need to be reviewed, especially the power of executor or trustee to participate in elections under the PAR or for estate or trust to indemnify heirs and beneficiaries from taxes arising under the PAR.

For any questions on this or any other tax-related matter, please feel free to contact Joel Crouch at (214) 749-2456 or jcrouch@meadowscollier.com.