Partnership Audits - The partnership audit procedures have dramatically changed in favor of the Internal Revenue Service, and amendments to your Operating Agreement or Partnership Agreement are required now.
There is a new party involved in partnership audits on your behalf starting on New Year’s Day 2018. The old audit regime using the “Tax Matters Partner” (“TMP”), with its retained notice and appeal rights for the partners, is now history for most partnerships, limited partnerships (“LPs”), limited liability partnerships (“LLPs”) and limited liability companies (“LLCs”). The new party replacing your TMP is your “Partnership Representative” (“PR”), and one must be appointed by you to be effective as of January 1, 2018. There is a significant difference between the two types of tax representatives, and you must be aware and take appropriate steps to protect yourself as a partner or member (both “partner” in this letter and for tax purposes), as well as understand your obligations and liabilities if you become a PR.
Most of the details regarding the new laws and regulations are of interest to lawyers and accountants, but you need to be aware of the new audit regime which was enacted by the Bipartisan Budget Act of 2015 (“BBA”) and set under a new regulatory structure from the Treasury Department published on June 13, 2017. It is generally effective on January 1, 2018.
The New Partnership Representative
The IRS will now look solely to your new PR instead of the former TMP, and notice rights you formerly had regarding the audit process will be held solely by the new PR. The IRS will work only with the PR in all matters regarding an audit, and your PR will have rights formerly held individually by the partners to take actions - such as to bind the partnership (and all partners) and to appeal a tax underpayment, unless changes are made to your controlling partnership or operating agreement.
Previously, the TMP handled the audit matters with the IRS, but the individual partners retained certain notice rights, appeal rights, the ability to extend statute of limitations, and other rights. The new PR now holds all of those rights instead of the partners. Moreover, it is possible for the PR, unless otherwise contractually bound to the partners, to receive notice of an audit commencement, manage an audit, enter into a settlement, and have a tax bill issued to the partners where they had no prior notice and no right to appeal. The PR has the power, in part, to:
- Be the sole contact at the partnership for the IRS.
- Make all communications with the IRS during the audit and agree to a settlement of the total tax liability of all the partners.
- Waive the statute of limitations or other defenses to tax liability for the partnership and all partners.
- Determine whether to challenge or contest all or part of a Final Partnership Audit by filing a judicial proceeding.
- Elect out of partnership treatment (if criteria are met).
- Enter into a closing agreement with the IRS.
- Make elections, once a tax liability is imposed and agreed to by the PR and IRS, to either:
- Allocate the tax liability between the partners for the IRS collection activities (a new “push out” power), or
- Pay the tax lability on each partner’s share at the partnership level (this is a new concept of actual partnership liability created by the new law).
The PR is allowed to take all these actions without notice to the partners under the new law and regulations, unless the partners enter into other contractual agreements relating to the appointment and authority of the PR before January 1, 2018.
The tax audit will begin in a year called the “audit year” and will cover years at the IRS determination which are called the “review years.” Without prior agreements in the partnership or operating agreement of the entity, the audit year is the year in which the tax liability is assessed and its then current partners are responsible for payment of all taxes due from all review years, even if they were not partners in those review years. The tax due resulting from the audit’s “imputed underpayment” (as it is named in the new law) will be charged at the highest rate applicable, which is currently 39.6%. Thus, this new rule actually creates the potential that a prior long-term capital gain or qualified dividend income event could be taxed at the highest ordinary income rates. The IRS will not independently take steps to collect against prior partners that left the partnership before the audit year. Only amendments to your partnership or operating agreement will provide the ability for the PR to send demand notices to partners from the review years for payment of the resulting taxes, penalties and interest. Prior tax liabilities will follow the partnership and not the partners from the IRS perspective. This also creates a tax risk to consider when acquiring interests in existing partnerships.
Limited Opt Out Election
Some partnerships, LPs, LLPs, and LLCs will be allowed to opt out of the new audit regime and continue to be audited under the prior audit procedures. This is a limited sub-group of entities. If the partnership has less than 100 partners and those partners are all either an individual, estate of a deceased partner, C corporation, S corporation or a foreign entity that meets particular criteria, then the partnership may make an election to opt out. The entities that can make this election are, under the BBA, called “small” partnerships. There is no regulatory allowance in this opt-out or small partnership procedure for a partnership that has a trust, a partnership, or an LLC as a partner. As of January 12, 2018, trusts, sole member LLC’s, and partnerships as partners or members of the top level partnership will cause it to be ineligible to make the opt-out election. No tiered partnerships or LLC’s will be able to elect out of the new tax regime.
New Provisions in your Partnership or Operating Agreement
Initially, all entities taxed as partnerships must make amendments to their controlling agreement to appoint a PR effective January 1, 2018. If the appointment is not made by the partnership or LLC, and the IRS begins an audit process, the IRS has the sole right to appoint a PR for the entity and it can be any eligible person or entity it chooses, including itself. You should assume this choice will not be to the benefit of the partners.
In making the decision to appoint a PR, or one to accept the designation of PR, there are significant factors to consider. One concern with the PR choice is that once appointed the partnership may not revoke the PR designation and designate a successor unless it follows IRS rules for filing an administrative adjustment request (AAR). Where a PR is not willing to step aside and tender a resignation to the IRS when a proposed successor is desired, the partnership must follow new regulations providing for a successor and notify the IRS in writing along with the PR whose designation is being revoked. Once a notice of administrative proceeding is initiated by the IRS, except in connection with an AAR, the partnership may not revoke the partnership representative designation. One situation where this revocation will be important is where a PR has changed its own circumstances and it no longer is aligned with the best interests of the partners, such as where it has exited the partnership (the PR is not required to be a partner) prior to an IRS action. It is recommended to have the procedure in place in the controlling agreement to provide for this situation, even if the PR cannot be removed.
As a result it is important to both (1) carefully select a PR, and (2) provide contractual controls on a partner PR in the partnership or operating agreement, or in a separate contract for services from a third party PR. The controls created in a partnership or operating agreement must adequately protect the partners and allow them control over major decisions the PR must make, but also provide for a structure that will be acceptable to a proposed PR. There should be mutual indemnities and, potentially, errors and omissions insurance protection for both the partnership and the PR.
All clients are advised to have their partnership or operating agreements reviewed regarding the amendments required to appoint and properly control the rights and obligations among your PR and your entity. DUGGAN BERTSCH is available to work with you to make recommendations for amendments to your documents and the appointment process for your Personal Representative, and complete all of your documentation. Since this new tax law takes effect on January 1, 2018, we will be following this newsletter with an amendment proposal in short order. Please do not hesitate to contact DUGGAN BERTSCH with any questions you may have.