As discussed in a recent blog post¹, a new partnership audit regime that was enacted as part of the Bipartisan Budget Act of 2015 (the “Partnership Audit Rules”) will have significant, wide ranging effects on the taxation of income from partnerships. Under the Partnership Audit Rules, the general result (the “General Method”) is that the tax liability resulting from an Internal Revenue Service (“IRS”) audit adjustment to a partnership’s income will generally be assessed and collected directly from the partnership. See I.R.C. § 6221 (2018). This is obviously a significant departure from the result under the partnership audit rules that are currently in place through year-end 2017 (the “TEFRA Rules”), under which an adjustment is made at the partnership level, but the resulting tax liability is assessed and collected from the partners of the partnership.
The Partnership Audit Rules are effective for partnership tax years beginning after December 31, 2017. A partnership, however, may elect to apply the Partnership Audit Rules for any partnership tax year beginning after November 2, 2015.
As discussed below, the Partnership Audit Rules involve significant issues regarding: (i) which partners will ultimately bear the economic burden of the tax resulting from a partnership adjustment; and (ii) who will have the authority to negotiate with the IRS on behalf of the partnership and its partners. Because these issues will potentially have a significant impact on each partner’s rights and obligations, it is a good idea for partners to address them now by amending their partnership agreement. The following is a summary of three issues that will arise under the Partnership Audit Rules and potential amendments to partnership agreements that should be considered now to address those issues.
1. Potential Adverse Interests Among Different Partners.
a. Summary of Potential Issues.
The General Method requires a partnership to directly pay “in the adjustment year” the tax liability resulting from a partnership adjustment. I.R.C. § 6225(a) (2018). The “adjustment year” is basically the partnership tax year in which the IRS audit is finally resolved (the “Adjustment Year”). See I.R.C. § 6225(d)(2) (2018). In contrast, the “reviewed year” is the partnership tax year that is the subject of the audit and to which the partnership adjustment relates (the “Reviewed Year”). See I.R.C. § 6225(d)(1) (2018).
If the composition of the partners has changed over time, the General Method creates a potential mismatch between the Reviewed Year partners who enjoyed the tax benefit that gave rise to the IRS adjustment and the Adjustment Year partners who must bear the economic burden of paying the tax liability resulting from the IRS adjustment. This potential mismatch is illustrated by the following example.
Assume that two individuals, “A” and “B,” each own a 50% interest in a partnership. That partnership reports a $1 million deduction for its 2018 tax year, A and B are each allocated $500,000 of that deduction, and A and B each report and enjoy the benefit of the $500,000 deduction on their 2018 income tax returns. In 2019, A sells her interest in the partnership to another individual, “C.” In 2020, the IRS issues a notice of final partnership adjustment in which the IRS disallows the $1 million deduction that the partnership reported on its 2018 tax return. Under the General Method, the partnership is liable to pay the tax liability resulting from the $1 million adjustment for its 2020 tax year, when B and C are partners, notwithstanding that the tax benefit of the $1 million deduction was enjoyed by A and B. Thus, under the General Method, C effectively must bear the economic burden of tax liability relating to the disallowance of prior benefits that were enjoyed by A.
In contrast to the General Method, the Partnership Audit Rules provide two exceptions through which the economic burden of the partnership adjustment is better matched with the tax benefit that gave rise to the adjustment. First, a partner of the partnership for the Reviewed Year may file an amended return to report and pay the tax resulting from that partner’s allocable share of the partnership adjustment (the “Amended Return Exception”). See I.R.C. § 6225(c)(2) (2018). To the extent a partnership adjustment is reported, and the related tax is paid, by a Reviewed Year partner under the Amended Return Exception, the amount of the partnership’s liability relating to that partnership adjustment decreases. See id. It is reasonable to assume, however, that a person who is no longer a partner in the partnership in the Adjustment Year may not cooperate in filing an amended return to incur additional liability for the benefit of the Adjustment Year partners.
Second, the partnership may timely elect to shift the tax liability resulting from the partnership adjustment to the Reviewed Year partners (the “Alternative Method”). See I.R.C. § 6226(a) (2018). The partnership must elect the Alternative Method within 45 days after the date of the notice of final partnership adjustment. See id. If the Alternative Method is elected, each Reviewed Year partner’s tax liability for the Adjustment Year is increased by the amount by which that Reviewed Year partner’s tax liability for the Reviewed Year and any subsequent year would have increased if the partnership adjustment had been made for the Reviewed Year. See I.R.C. § 6226(b) (2018). Thus, if a person is no longer a partner in the partnership for the Adjustment Year, that person generally will not have any say whatsoever regarding whether the partnership will elect under the Alternative Method to shift to the Reviewed Year partners the tax liability that otherwise would be owed by the partnership under the General Method.
Thus, the former and current partners of a partnership may have adverse interests regarding whether a partnership should incur the tax liability under the General Method or elect to shift that tax liability to the Reviewed Year Partners under the Alternative Method. If there is any chance that the composition of the partners of a partnership may change, the partners should start considering today how they would like to address in their partnership agreement these significant issues regarding who may bear the economic burden of the liability that may result in the future from tax benefits allocated from the partnership.
b. Summary of Potential Partnership Agreement Solutions.
There are multiple arrangements that partners may choose to implement into their partnership agreements to address the aforementioned issues. For example, the partners could amend the partnership agreement to provide that the partnership generally must elect the Alternative Method, unless a required threshold of Adjustment Year partners vote for the partnership to forego making that election. There are many factors, however, that must be taken into account regarding whether to elect the Alternative Method, and thus the partners therefore may not want to make the Alternative Method the default regime that would apply to their partnership.
Alternatively, the partners could amend the partnership agreement to provide an indemnification obligation through which a partner who was allocated a tax benefit from the partnership that is later disallowed would be obligated to indemnify the partnership for that partner’s allocable share of the liability resulting from the IRS’s disallowance of that tax benefit. In this manner, the partners could seek to ensure that the economic burden associated with a partnership adjustment is borne by the same party who enjoyed the tax benefit that was adjusted.
Conversely, the partners could decide that, if they withdraw from the partnership, they should have no continuing obligation to that partnership. If that is the agreement among the partners, they could amend the partnership agreement to provide that the partnership and its partners would release a withdrawing partner from any liability in connection with any tax liability arising in the future.
The appropriate revisions to make to a partnership agreement in a specific situation will depend on the nature of the agreement between the partners of that partnership. Different potential approaches will have differing effects on the rights and obligations of the partners, and it is therefore important that the partners consult with their tax professionals in determining the manner in which they would like to address the issues arising from the Partnership Audit Rules.
2. The Partnership Representative.
a. Summary of Potential Issues.
Under the Partnership Audit Rules, the partnership must designate a “partnership representative” (the “Partnership Representative”) to handle tax matters with the IRS. I.R.C. § 6223(a) (2018). The Partnership Audit Rules provide that the Partnership Representative is the only person who has authority to act on behalf of a partnership in connection with an IRS partnership audit. See id. In addition, the Partnership Representative’s actions are binding on all former and current partners. See I.R.C. § 6223(b) (2018). Thus, the Partnership Audit Rules provide that a Partnership Representative has sole and unilateral authority to make decisions on behalf of the partnership and its partners, such as: (i) whether the partnership will elect to utilize the Alternative Method; (ii) whether the partnership will continue to contest an IRS audit; (iii) whether the partnership will seek judicial review of the IRS’s audit adjustments; and (iv) whether the partnership will enter into a settlement with the IRS. As a result of the Partnership Representative’s unilateral authority, the selection of the individual who will act as Partnership Representative will be extremely important.
The partnership has a lot of latitude in selecting its Partnership Representative. The Partnership Audit Rules merely require that the person selected as Partnership Representative must have a “substantial presence in the United States.” I.R.C. § 6223(a) (2018). The Partnership Representative is not required to be a partner of the partnership.
It is very important that the partnership actually designate its Partnership Representative. If it fails to do so, Treasury may select “any person” as the Partnership Representative. See I.R.C. § 6223(a) (2018). The Partnership Audit Rules do not contain any limitations on whom Treasury might appoint as Partnership Representative. See id.
The Partnership Audit Rules also make changes regarding the notices that the partners of the partnership are entitled to receive in connection with an IRS partnership audit. The Partnership Audit Rules merely require that Treasury mail to the “partnership and partnership representative” notice of any administrative proceeding initiated at the partnership level, notice of any proposed partnership adjustment, and notice of any final partnership adjustment. See I.R.C. § 6231(a) (2018). The Partnership Audit Rules, however, do not contain any statutory obligation on the part of any party to provide notice to the partners of the partnership or otherwise keep them informed of the partnership audit. This is in contrast to the TEFRA Rules, which provide that Treasury generally must provide notice to each partner regarding the beginning of an administrative proceeding at the partnership level and the final partnership administrative adjustment resulting from that proceeding. See I.R.C. § 6223(a). The TEFRA Rules also provide that the Tax Matters Partner “shall keep each partner informed of all administrative and judicial proceedings” relating to the adjustment at the partnership level. I.R.C. § 6223(g).
b. Summary of Potential Partnership Agreement Solutions.
Clearly, much is at stake in ensuring that the right person is designated as Partnership Representative. As a result, partners should consider amending their partnership agreement now to identify or provide a framework for determining who will be the Partnership Representative in the future.
If the partners can agree on who is the best individual to represent their interests in an IRS matter, they may wish to appoint that person by name in their partnership agreement, along with provisions specifying how that person’s successor would be determined. If there is no specific individual who the partners agree should serve as Partnership Representative, the partners may wish to amend the partnership agreement to provide a criteria for selecting a Partnership Representative in the future. For example, the partnership agreement could provide that the Partnership Representative would be selected based on a specific order of preference (assuming that the person selected has a substantial U.S. presence), such as: (i) a partner who has management authority over the partnership’s operations or activities; (ii) the partner with the largest profits interest in the partnership; (iii) a non-partner who has authority to sign the partnership’s tax return; (iv) a non-partner who has management authority over the partnership’s operations or activities; or (v) an outside professional advisor of the partnership. The particular criteria for selecting the Partnership Representative will depend on each partnership’s particular circumstances.
The partners should also consider amending the partnership agreement to require that the Partnership Representative meet a certain standard for keeping the partners informed of the status of the partnership’s IRS matter. For example, the partnership agreement could provide that the Partnership Representative must forward to each partner a copy of each notice that is received from the IRS in connection with the partnership audit.
Because the Partnership Representative has the sole authority to act on behalf of the partnership in connection with the IRS partnership audit, the partners may wish to amend the partnership agreement to include provisions that would give the partners more authority in connection with the IRS audit. For example, the partnership agreement could provide that a majority vote of the partners is required for the Partnership Representative to take certain actions, such as: (i) agreeing to settle the IRS audit; (ii) filing a Tax Court petition in connection with the IRS audit; (iii) electing the Alternative Method; and (iv) engaging the tax professional who would advise the partnership in connection with the administrative and any judicial proceeding relating to the IRS audit.
The partners may also recognize that, due to potential conflicting interests among different partners, it may be important to provide legal protections in order to encourage a desired individual to serve as Partnership Representative. The partners could therefore agree to amend the partnership agreement to provide for a release (and possibly an indemnity) of the Partnership Representative from any claims or liabilities asserted in connection with the Personal Representative’s conduct.
3. The Election Out.
a. Summary of Potential Issues.
The Partnership Audit Rules provide that a partnership may elect out of the application of the Partnership Audit Rules (the “Election Out”), provided that: (i) each of its partners is either an individual, C corporation, foreign entity treated as a C corporation, S corporation, or estate of a deceased partner; and (ii) the partnership has 100 or fewer partners, which is determined based on the number of Schedules K-1 issued by the partnership. See I.R.C. § 6221(b)(1) (2018). A partnership must elect the Election Out separately for each partnership tax year by including the appropriate designation on its timely filed tax return for the tax year for which the Election Out is elected. See I.R.C. § 6221(b)(1)(D) (2018). If a partnership elects to avail itself of the Election Out, the IRS would not conduct any audit at the partnership level, and the tax liability from a partnership would be determined in a separate deficiency proceeding for each partner of that partnership.
b. Summary of Potential Partnership Agreement Solutions.
If a partnership is eligible for the Election Out under the aforementioned restrictions, the partners may decide that they wish to avoid altogether the complications that could result from the Partnership Audit Rules. The partners could therefore amend the partnership agreement to require the Partnership to make the Election Out for each partnership tax year, unless a majority of the partners vote not to do so.
In addition, the partners may want to take steps to ensure that the partnership will continue to qualify for the Election Out in the future. In this regard, the partners could amend the partnership agreement to impose transferability restrictions to protect against any partner transferring their interest in the partnership to a person who is not an eligible partner under the Election Out requirement.
For the reasons discussed above, it is important that partners address in their partnership agreement the manner in which they will share the burden of liability resulting from a partnership adjustment and who will have the authority to make decisions on behalf of the partnership during the IRS audit. Due to the significance of these issues and the potential differing interests of various partners, it is a good idea for the partners to go ahead and work through these issues in advance of the applicability of the Partnership Audit Rules.
There are many potential approaches through which partners can address in their partnership agreement the issues implicated by the Partnership Audit Rules. Each approach will have its own set of advantages and disadvantages. Whether a particular approach is beneficial may differ for different partners. As a result, it is important that the partners consult with their tax professionals in determining their preferred approach for amending the partnership agreement. If anyone has questions or would like to discuss further the issues arising under the Partnership Audit Rules and the manner in which partnership agreements can be amended to address those issues, please contact Stephen Beck at 214-749-2401.