On November 2, 2015 – effective for tax years beginning January 1, 2018, new rules pertaining to the Internal Revenue Services ("IRS") tax examinations of partnerships (or other entities taxed as a partnership for U.S. federal income tax purposes) have entered into force (the "New Audit Rules"). Partnerships and partners that will be filing their 2018 tax return, should pay attention to the New Audit Rules, as such rules may have a material effect on them.
Partners are advised to carefully review and revise their partnership's operating agreement to address the New Audit Rules, as described below.
In general, until and including the 2017 tax year, partnerships' tax returns were examined by the IRS at the level of each partner with respect to each such partner's allocable share of the partnership income, deductions and credits. As of the 2018 tax year, the general rule is that partnership examinations shall be managed at the partnership level by a sole "partnership representative". Such "partnership representative" need not be a partner but must have the power to bind the partnership and all its partners before the IRS.
Although these general rules may subject the partnership to pay any tax deficiency, the New Audit Rules provide two potential elections, one election is to opt out of the New Audit Rules (the "Opt-Out Election"), applicable to "small partnerships" (defined below), and another election which is applicable to all partnerships, to re-allocate all or part of the partnership's deficiency obligations to the persons who were partners in the partnership during the relevant tax year that is under examination.
A partnership is classified as a "small partnership" if such partnership has 100 or fewer partners. Each partner needs to be an "eligible partner", i.e., either an individual, a corporation, a foreign entity that would be treated as a corporation if it were domestic, an S corporation, or an estate of a deceased partner. A partnership that one of its partners is a partnership or a trust, is, therefore, not qualified as a "small partnership".
The Opt-Out Election can be made annually and must be made on a timely filed tax return. Partnerships must notify their partners within 30 days of making the Opt-Out Election. Once the Opt-Out Election was made, with respect to a particular tax year, the IRS will collect from the partners of an electing partnership any deficiency obligations.
How this Should be Addressed in Your Partnership
Partnership agreements should establish whether to require and allow the "partnership representative" to make a timely Opt-Out Election. If desired, the partnership agreement should prohibit transfers of partnership interests to any third-party that is not an eligible partner, in order to make sure that the partnership will not be excluded from being a "small partnership."
The New Audit Rules essentially replaced the requirement for a "tax matters partner", i.e., a partner designated by the partnership to be the point of contact with the IRS on all issues related to tax with the "partnership representative" concept. A "partnership representative" is a person that has, under the New Audit Rules, sole authority to act for and on behalf of the partnership on all relevant matters with the IRS, including authority to (i) agree on settlements with the IRS, (ii) agree to extend the statute of limitations, (iii) appeal IRS decisions, and (iv) make a "push-out election."
The "partnership representative" should be designated annually on timely filed tax return (including extensions). Such representative must have substantial presence in the United States and may be a partner or a non-partner, including an entity, in which case the partnership must appoint a "designated individual" to act on behalf of the entity.
How this Should be Addressed in Your Partnership
Partnerships should amend their partnership agreements so to replace the previous requirements pertaining to a "tax matters partner" with the new requirements set forth under the New Audit Rules pertaining to a "partnership representative". Partnership agreements should also consider the qualifications of a potential "partnership representative".
Given that the "partnership representative" is the only point of contact between the IRS and the partnership, and that such representative has the authority to bind the partnership and partners during an audit, partnerships should consider adding a provision to their partnership agreement that requires the "partnership representative" to consult with the other partners, or persons that were partners in the year under audit, before any IRS-related decisions are made. Additionally, given that the underpayment is imputed on the partnership level and borne by the persons who are partners during the adjustment year, partnership agreements should include a provision, pursuant to which, persons that were partners during the year under exam will be required to indemnify persons that are partners in the year of adjustment (i.e., the year the exam concludes), and to amend their tax returns when requested to do so by the "partnership representative".
Partnerships can elect to "push-out" the underpayment to the persons that were partners in the partnership during the year under exam. Election must be made within 45 days of the date of the final notice of partnership adjustment. The election effectively pushes all potential tax liabilities from the partnership to the partners while allowing the partnership (i.e., not the partners) to preserve the right to contest all proposed changes.
How this Should be Addressed in Your Partnership Agreement?
The partnership agreement should allow the "partnership representative" to make a "push-out" election, but only after considering the total cost of tax on the partnership level as oppose to a "push-out" election. The partnership agreement should mandate a beneficial "push-out" election.
THE NEW RULES ARE MANDATORY FOR PARTNERSHIP YEARS BEGINNING ON OR AFTER JANUARY 1, 2018. CAREFUL PLANNING TODAY WILL HELP MITIGATE ANY UNFAVORABLE CONSEQUENCES.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.