Time to Review Your Operating Agreements - New Partnership Audit Rules Enacted
A new federal law has changed the way that the IRS audits and collects underpayment of tax (and interest and penalties) from partnerships (“Underpayments”). Referred to as the Consolidated Partnership Audit Regime (“New Audit Regime”), the new law allows the IRS to audit, assess and collect Underpayments directly from the partnership itself. Previously, if the IRS questioned the tax reporting from a partnership, it had to assess and collect Underpayments from each individual partner in separate proceedings. This piecemeal approach led to a very low nationwide audit rate for partnership-related taxes, which the IRS is now looking to correct.
There are three significant changes under the New Audit Regime:
- Every entity that is taxed as a partnership (i.e., filing a Form 1065), must designate a “Partnership Representative” in its operating agreement and on tax filings beginning for calendar year 2018 (i.e., returns due April 2019);
- The IRS will now assess and collect tax Underpayments at the entity level with the coordination of the Partnership Representative, rather than at the individual partner level, and
- Underpayments are paid by the partnership in the year an audit is finally completed and not in the year that the Underpayment actually occurred.
Without proper planning, the New Audit Regime could significantly impact the economics of your partnership and fellow partners. Underpayments assessed to the entity will be taxed at the highest individual income tax rate and certain types of losses will not be deductible for the purpose of determining the Underpayment. This could create a substantially higher liability for the entity than it otherwise would for the individual partners. Additionally, where an Underpayment will be collected from the entity in the year the audit closes, partners in the year of audit, rather than the partners that existed in the year of the actual Underpayment, will be forced to pay an Underpayment that could be unrelated to them. We recommend reviewing your current entity operating agreements with your attorney and accountant to address the issues we discuss further below.
The “Partnership Representative”
Every entity taxed as a partnership must now designate a “Partnership Representative” (“PR”) on its timely filed partnership income tax return. Partners will want to think carefully about who is nominated to serve as PR for the entity. The PR may, but need not be, a partner in the partnership. Note that if an entity is named as the PR, then a “Designated Individual” will need to be named for that entity-type of PR. The designated PR will be the only party with the authority to talk to the IRS on behalf of the partnership, and to bind the partnership and the partners in matters with the IRS. The IRS is not required to provide notice to partners or to permit other partners to participate in the audit process. The designation of a PR will remain effective until it is validly terminated, revoked, or the PR resigns, which all require adherence to strict IRS rules regarding the timing and method of action. In addition, if the entity fails to name a PR, then the IRS will arbitrarily select a PR from among the partners.
Can the New Audit Regime Be Avoided or Mitigated?
The IRS has created a few limited procedures to allow some partnerships to avoid assessment of Underpayments at the entity level. Only the PR will have the authority to make the following elections for the partnership.
- Elect Out: Eligible partnerships may elect out of the New Audit Regime entirely by making an election on the entity’s tax return. The election must be made each tax year and may not be made for entities who have (1) more than 100 partners or (2) partners who are trusts (including grantor trusts), partnerships, or disregarded entities (i.e., single-member or community property LLCs). If a partnership does “elect out” of the New Audit Regime, then the IRS must use the old audit rules and audit each individual partner separately.
- Push Out: Partnerships that are not eligible to “elect out” of the New Audit Regime, may want to make a “push out” election to force the Underpayment to all of the individual partners who were partners in the audited year. This election must be made within a short period of time from the end of audit. The benefit of the election is that each individual partner computes and pays his or her own Underpayment and can take advantage of more deductions than the partnership would be able to at the entity level. In addition, partners that joined the partnership in years after the year being audited are not impacted economically by the Underpayment.
We generally recommend that eligible partnerships should “elect out” of the New Audit Regime. We also recognize that many partnerships, including entities that are routinely established for estate planning or business succession purposes, will not be eligible to “elect out” because of the common use of tiered entities or trusts in those matters. We therefore generally recommend a secondary preference for the partnership to file a “push out” election under IRC §6221. However, because each partnership is different, only you can determine what elections may be appropriate for your entity.
Changes to Operating Agreements
We recommend that partners review their operating agreements to determine how to handle the New Audit Regime. In general, you may want to consider the how the following issues should be addressed in your entity’s operating agreement:
- Who should serve as the PR, and how should succession of the PR and compliance with IRS-required succession procedures be handled?
- How and when must the PR provide notice of an audit to the entity partners? How should communication among the partners during an audit be handled?
- Should the PR be required to obtain advance consent from the affected partners (and former affected partners) regarding any proposed audit settlement?
- Should your partnership express a direction or preference for elections to “elect out” of the New Audit Regime or to “push out” an Underpayment? Or should the PR have the ability to exercise complete discretion when resolving how to pay an Underpayment?
- Should the PR be obligated with state law fiduciary duties, including a duty of loyalty to other partners? Are there any potential conflicts of interest of the PR when making audit decisions for the entity (and other partners)?
- Should the entity’s transfer provisions address the obligations of a former partner after a transfer or preclude transfers that would make the partnership ineligible to “elect out” of the New Audit Regime?
Keep in mind that while the IRS is not bound by the terms of an entity’s operating agreement, carefully incorporating provisions related to the PR and the New Audit Regime will at least provide partners state law remedies against a rogue PR or a former partner.
If you have any questions regarding how the New Audit Regime impacts your entity, please contact an attorney in our Estate Planning Group or our Business Group.