In November 2015, President Barack Obama signed the Bipartisan Budget Act of 2015 (the “Act”) into law. Under the Act, after December 31, 2017 and earlier if so elected by a partnership or LLC, new audit procedures will govern partnerships and LLCs. The recently announced public notice and comment period for regulations implementing the new rules expires April 15, 2016.
The biggest change under the new audit rules is that adjustments made at the partnership level are assessed against the partnership — not against the partners. These adjustments are assessed in the year in which the audit is completed (the “adjustment year”) rather than in the year under audit (the “review year”), meaning that new partners might bear the burden of tax attributable to years before they became partners. Fortunately, solutions are available to partnerships that prefer to have adjustments assessed at the partner level, as discussed below.
Tax deficiencies resulting from a partnership-level adjustment generally are taxed at the highest income tax rate in effect for the review year, although the partnership may modify these adjustments under certain circumstances. For example, the partnership may modify the adjustment if it can demonstrate the adjustment would be lower if it were based on individual partners’ tax rates in the review year. This is particularly important if any partner is a tax-exempt entity. Furthermore, if a partner files an amended return for the review year taking into account its allocable share of the partnership adjustment, then the partnership’s imputed underpayment is reduced by that partner’s share of the adjustment. Partnerships generally have 270 days following receipt of a notice of proposed partnership adjustment to modify an imputed underpayment by submitting individual partner information to the IRS.
Two Solutions to the Entity-Level Tax: Opting Out and Issuing Adjusted K-1s
Partnerships that have 100 or fewer partners consisting solely of individuals, C corporations, S corporations or the estates of deceased partners may elect out of the new rules in their entirety. Any partnership having another partnership or a trust as a partner is not eligible for such an election. An electing partnership must notify all partners of the election and provide the name and TIN of each partner to the IRS. If a partner is an S corporation, then this information must be reported for each of its shareholders, with each shareholder counting toward the 100-partner limit. A partnership that elects out will be audited under the rules applicable to individuals.
Partnerships that are not eligible to elect out of the rules may avoid an entity-level tax by electing to issue adjusted K-1s to each person who was a partner in the review year. Those partners are required to take the adjustments into account in the adjustment year on their own tax returns. The partnership must make this election within 45 days after the notice of final partnership adjustment.
The “Partnership Representative” Replaces the “Tax Matters Partner”
The new rules also require partnerships to designate a “partnership representative,” which replaces the role of the “tax matters partner” and differs in several respects:
- The partnership representative has the sole authority to act on the partnership’s behalf. Its partnership-level determinations are binding on the partnership and its partners.
- The partnership representative is not required to provide notice of audit developments to the partners.
- Unlike the tax matters partner, the partnership representative need not be a partner but must have a substantial presence in the United States.
- If the partnership does not designate a partnership representative, then the IRS may choose anyone to act in this role.
Partnership Agreements: Considerations Under the New Rules
- Because new partners might bear the burden of tax attributable to previous years, they might seek indemnities from current partners in order to offset this risk. Furthermore, partnerships that have lost review-year partners may wish to consider how to allocate the costs of previous years’ taxes among current partners. To avoid issues among the partners, qualifying partnerships may wish to revise their partnership agreement to mandate that the partnership elect out of the new rules. Partnerships not eligible to elect out of the new rules may wish to adopt provisions mandating that adjusted K-1s be issued to review-year partners.
- Partnerships that do not opt out of the new rules will need to determine how the partnership’s tax liability will affect current partners. The partnership agreement may specify whether the partners’ share of the deficiency will be funded by the partners through capital contributions or by offsets against distributions. Additionally, the partnership may wish to consider provisions allowing it to hold back distributions in the event of an audit or an expected audit.
- Partners should carefully consider who should fill the role of the partnership representative and whether and how they should restrict the partnership representative’s decision-making powers. Partners should also consider to what extent individual partners should be allowed to influence an audit. The partnership agreement should mandate that the partnership representative notify the partners of audit-related developments to keep investors apprised.
State Law Developments
Real estate professionals should be aware of state law developments addressing the new rules. Most states have partnership tax rules that closely follow the old partnership audit rules. It remains to be seen whether states will enact new laws to adapt to the new audit rules. It is possible states will keep their current rules, at least temporarily, thereby placing the burden of complying with disparate state and federal tax regimes on the partnerships themselves.
The new rules prompt a number of questions that real estate professionals should contemplate with respect to new partnership and LLC agreements. Real estate professionals should also consider whether existing partnership agreements should be amended in light of the new rules.
To discuss your partnership and LLC agreements, contact Christine McGuinness in Schiff Hardin’s Real Estate Group.