Tax Strategy: Partnership agreements need to reflect the new audit regime, now
With an estimated 1 million-plus partners under the U.S. tax system, the importance of the Bipartisan Budget Act of 2015’s controversial centralized partnership audit regime cannot be underplayed.
Mandatory implementation of the new audit regime kicks off for audits of partnership tax years starting on or after Jan. 1, 2018. Perhaps because of a slow response from the Internal Revenue Service and the administration on issuing much-needed guidance, or because audits of tax years starting in 2018 are not likely until well into 2020 at the earliest, partners and their partnerships have been slow in preparing for these changes. Unfortunately, both because the tax liability and, therefore, the responsibility of its payment start less than six months from now, on Jan. 1, 2018, and because a key instrument in settling these responsibilities among partners, the partnership agreement, is usually hard to amend due to simple logistics, time is running out for partnerships to devise an initial strategy in response.
The new audit rules generally allow the IRS to assess and collect tax directly at the entity level, from the partnership itself at the time of the audit, rather than chasing down its individual partners as of the audited year. In doing so, the new rules especially impact partnerships in which any change of ownership occurs between the year being audited and the year of assessment. Purchasers of partnerships or partnership interests may find themselves liable for a prior year’s deficiency under the new audit rules.
All in all, the IRS itself fares just fine in the changeover from the rules centered on the Tax Equity and Fiscal Responsibility Act of 1982. The new centralized partnership audit rules likely will accomplish exactly what Congress intended: a streamlined, efficient system to examine complex partnership structures and to collect deficiencies from them. Unlike under the TEFRA rules, the IRS no longer must keep each partner’s liability for partnership operations separate, which forced the IRS to find and then chase down each individual partner for payment in most cases. With the new audit system, the partnership, not the partners, pays the tax, interest and any penalties resulting from the IRS’s audit adjustment at the partnership level. That “imputed underpayment” is computed based upon the highest income tax rate applicable to an individual, but with a reduction available upon the partnership’s initiative for the tax status of each partner and the character of the income being recognized.
The liability for the prior-year taxes, therefore, is placed on the partnership as it exists at the time of the audit, so that the IRS effectively collects from existing partners. Whatever agreement the partners have among themselves for allocating the liability, especially in connection with the partners existing for the tax year being audited, is not the IRS’s concern.
Nevertheless, under the new regime, many partnerships will be able to elect to “push out” the tax deficiency to the partners in the tax year being audited. However, even that concession is governed by how streamlined the process will be for the IRS. A “push-out” election goes through an IRS approval process under which the IRS must be assured of the identity and the location of those audit-year partners.
Relatively little guidance
When compared to the detailed rules under TEFRA, gaping holes currently exist in the guidance surrounding how to apply the new audit rules as enacted by Congress. Enacted on Nov. 2, 2015, under the BBA, the new audit rules were considered to be hurriedly put together, with many of the “finer points” left to the IRS and Treasury to fill in with regulations and other guidance. So far, proposed and temporary regulations were issued in August 2016 to cover “early elections-in” for partnerships with tax years starting after Nov. 2, 2015, and before 2018 (an LB&I Memorandum was also issued to examiners on June 29, 2017, to cover these early elections). Other than that, to guide us for now on post-2017 tax years we only have the proposed regulations, released in January and then withdrawn until this past June due to the Trump administration’s moratorium on regulations.
What is a partnership?
The definition of a partnership for purposes of the audit rules is as broad as the tax concept itself. Post-2017, however, the urgency in identifying any entity treated as a partnership under federal tax law carries the additional need to respond to liability issues associated with the new audit rules. LLCs without an additional contrary check-the-box election will generally be governed by the new partnership audit regime. In any case, however, reliance on default check-the-box rules should be avoided. Form 8832, Entity Classification Election, should be filed now more than ever as a matter of course, since an incorrect assumption of non-partnership status can have significant wider implications under the new audit regime — as will certain structured joint ventures such as joint marketing sales agreements, whose parties may be surprised to discover shared liabilities under the new audit regime.
At least for the time being, until rules become more settled, most partnerships should elect out of an audit of a post-2017 year under the new regime if eligible to do so. Eligibility requires passing two tests: The partnership must have fewer than 100 partners, and all partners must be eligible partners. Current agreements for many partnerships should provide for an outcome under which it unintentionally fails one of these tests.
Creeping toward the 100-partner mark based upon the way partners are counted presents one danger. More common, however, will be a partnership that takes on a partner that is not considered “eligible.” Ineligible partners are defined by exclusion, being anyone that is not an individual; an estate of a deceased partner; a C corporation; or a foreign entity which, if domestic, would be treated as a C corporation; or an S corporation. Also important in some situations is the fact that partnerships, trusts and disregarded entities are not eligible partners.
The new audit regime introduces the concept of “partnership representative,” which is different from a “tax matters partner” under the TEFRA regime. Generally, the partnership representative has broad powers to bind the partnership and its partners and has the exclusive authority to resolve any partnership audit. The representative need not be a partner.
With broad powers may come unexpected liabilities cutting both ways: An existing partner may be accused of self-interest, or, as a non-partner, an independent advisory firm, for example, may find itself in between an intra-firm squabble with no solution amenable to everyone and its reputation. In any case, the partnership representative should be designated on the partnership’s tax return for each applicable tax year. Having the IRS select the representative under a default option generally will give partners too little time to negotiate among themselves.
The new regime enables a partnership representative to elect to “push out” the liability from current partners to those partners existing during the year under audit — the “reviewed year” partners. Key to allowing a push-out is providing to the IRS and each reviewed-year partner a statement that identifies each reviewed partner’s share of the partnership adjustments. This preserves the purpose behind the new partnership regime: to minimize the IRS’s task of finding each responsible partner. In the case of multi-tiered partnership arrangements, the proposed regulations reserve guidance on push-outs beyond first-tier partners, but promise them in the near future.
A proposed technical correction (HR 6439) that would create a procedure under which imputed underpayments may be flowed through the tiers is another alternative being considered. Although an indemnification agreement among the partners may lead to the same result, a push-out elected by the partnership representative is usually the cleaner and more flexible option.
Partnerships should place provisions in their agreements to cover both audits under the old regime and those under the new rules. Under each, decisions on push-outs and other liability should be made within the agreement, rather than addressing them ad hoc with the tax matter partner or partnership representative at the outset of an audit.
Questions remain, too, as to the impact of such latter agreements on the powers of the partnership representative. While there may be recourse against the partnership representative by the partners, the IRS need only look to the decisions of the partnership representative since the IRS is not a party to the partnership agreement; having the partnership representative live up to the duties and responsibilities within the partnership agreement is not its problem. Fiduciary duties of the partnership representative need to be spelled out in the partnership agreement. Indemnifications may be required to get someone to serve as a partnership representative.
Many questions remain concerning implementation of the new audit regime. Some are acknowledged in “reserved” sections within the proposed regulations and/or requests for comments. Questions remain on the impact of the new rules on inside basis and book value of partnership assets, as well as the capital accounts and adjusted basis of partners.
Problems with the current partnership paying an assessment based on a prior year also include what income might be generated for tax purposes on the former partners who otherwise escape the payment of tax on activity in that prior year. Terminated partnerships or partnerships with insufficient assets to pay a tax liability represent still another problem. The proposed regulations attempt to address this situation by putting any partnership adjustments on the shoulders of the partners at the time the partnership ceases to exist. This again presents a circumstance in which partners must turn to the partnership agreement in order to resolve liability among themselves by way of indemnifications. And adaptation of state audit procedures to the new federal regime is generating its own set of issues.
Word on the street is that many partnerships have been waiting for more guidance from the IRS before amending agreements. With an IRS hearing on the proposed regulations not scheduled until September 18, however, it appears that help will not be on the way soon. Others have pointed to the additional time that the IRS will require to generate forms once the proposed regulations are approved, a process that itself usually takes many months.
The American Institute of CPAs and other groups have asked Congress and the IRS to delay the Jan. 1, 2018, start date. Nevertheless, the new audit regime is good for revenues and efficiencies at the IRS, two strong budgetary reasons for moving forward with the effective date without further delay.
At present, then, partnerships have little choice but to assume a 2018 start date, with income and expenses generated within calendar-year partnerships after that date subject to the new rules when an audit is finally performed. Partnership agreements should be amended sooner than later to set out partner liabilities for the initial year, as well as to designate partnership representatives who will control the audit conversation with the IRS. While amendments to those agreements can always be made to reflect further guidance, as a practical matter it may be difficult for existing partners to agree on tax allocations in the first place, so that the sooner the process is begun, the less likely problems will arise when a future audit occurs.