Partnership Tax

Bradley Arant Boult Cummings, LLP, Mark Miller: “The Internal Revenue Service’s (IRS’) ability to audit partnerships1 will be greatly enhanced due to changes made by the recent Bipartisan Budget Act of 2015 (Budget Act). The new rules apply to tax years beginning after 2017, which may seem far away, but partnerships need to use this time to prepare for the changes by amending their governing documents (i.e., partnership agreements and operating agreements), selecting a new “Partnership Representative” (PR), and making decisions that will affect internal operations for years to come. Speaking at a conference on March 15, IRS Chief Counsel William Wilkins confirmed that the IRS will be ramping up its partnership audit efforts. Congress projects these new procedures to generate more than $9.3 billion in new revenue over a 10-year period.”

The article concludes with this statement:

“A final warning: Anyone that is either (1) contemplating a new . . . business that will be classified as a partnership for federal tax purposes (including an LLC or joint venture) or (2) needing to amend an existing agreement should strongly consider incorporating these changes into the new or revised agreement immediately“

Emphasis added.

The Journal of Passthrough Entities (CCH):  “This column has three focal points: S corporations (of course!), the new partnership audit procedures and Jeanne Dixon. Yes, that Jeanne Dixon—the self-professed psychic who claimed to have predicted the assassination of President Kennedy, met with Presidents Roosevelt and Nixon and for a time was one of Nancy Reagan’s astrologers.¹ What is Jeanne Dixon doing in this S Corporation Corner?  Well, it is about predicting the future. And it is about making enough predictions based on educated guesses that one or two of them may actually come true—or at least close enough to claim they came true.”

The author of this article makes three predictions.  His prediction number 2 deals with partnership agreements and operating agreements of LLCs taxed as partnerships.  He predicts:

“PREDICTION #2:

Some partnership agreements will be revised and some new ones drafted to require S corporation partners to provide annually to the partnership an accurate list of the names and TINs of the S corporation’s shareholders (i.e., the persons to whom the S corporation is required to issue Schedules K-1 for the year).

Corollary: Some partnership agreements will provide that S corporation partners must indemnify the partnership and its other partners against either: (i) partnership-level income taxes the partnership is required to pay but could have avoided had the S corporation provided the information necessary for the partnership to elect out of the entity-level audit provisions on a timely basis, or (ii) the costs to the partnership of making an election under new Code Sec. 6226.”

Paul Hastings LLP, Thomas S. Wisialowski , Erika Mayshar and Noah Metz: “Hedge funds, private equity firms, real estate companies, and other businesses structured as partnerships or limited liability companies are paying close attention to recent changes in IRS audit procedures. . . . This means that under the rules described above, if a partnership filed a tax return and paid its taxes in year 1 (the year 1 tax return), partner X sold its interest in the partnership to new partner Y in year 2, and the partnership was audited in year 3 in respect of its year 1 tax return, then partner Y would bear its share of any additional tax liability assessed on the partnership in year 3 in respect of the year 1 tax return, despite that partner X, and not partner Y, was a partner in the partnership in year 1.”

The article states one of the most important reason that operating agreement of all LLCs taxed as partnerships must be amended to deal with the new audit rules:

“Partnership and LLC agreements should generally be revised to provide for who will act as the ‘partnership representative’ because in the absence of an appointed person, the IRS has the discretion to pick a ‘partnership representative.’

Taft Stettinius & Hollister LLP, Todd C. Lady and Lourdes E. Perrino: “On Nov. 2, 2015, President Obama signed into law the Bipartisan Budget Act of 2015 (the “Act”). The Act dramatically changes the way the IRS will conduct partnership audits going forward and, in turn, likely will have far reaching implications on how partnerships, including funds, conduct operations in the future. . . . Although these rules have not yet taken effect, they should be taken into account when drafting new operating agreements or engaging in acquisitive transactions involving partnerships. Operating agreements should include procedures that address the option to elect to pass any adjustment on to the reviewed-year partners. Additionally, partners should clearly define their respective rights to notice and participation during an audit and carefully select the partnership representative that will have the authority to bind the partnership.”

Cozen O’Connor, Richard J. Silpe”If you are a partner of a partnership or a member of a limited liability company (LLC) taxed as a partnership, or are entering into a new partnership or LLC, you may have some important decisions to make in light of impending changes to the rules governing federal tax audits. . . . These new rules will lead to new provisions in partnership and LLC agreements and amendments of existing agreements to, among other things, designate a method for selecting a partnership representative and its rights and obligations of the partners, address whether certain tax elections will be made, and provide for indemnification and other contractual provisions (e.g., in the case of a withdrawing partner).

Kilpatrick Townsend & Stockton LLP, James E. Brown, Heather L. Preston, Lynn E. Fowler and Charles E. Hodges II “Congress has recently scrapped the existing procedures for IRS audits of partnerships. The new rules (the “BBA Audit Rules”1) are effective for partnership taxable years beginning on or after January 1, 2018. A partnership that fails to address key concepts of the BBA Audit Rules could make a partner indirectly liable for federal income tax of the partners assessed for a year prior to becoming a partner. Almost all partnership (and LLC operating) agreements will need to be amended at a minimum to clarify which partners will be liable with respect to audit adjustments asserted by the IRS.”

Holland & Knight LLP, William B. Sherman and Daniel L. Janovitz: “The Bipartisan Budget Act of 2015 (P.L. 114-74) includes a complete overhaul of the procedures that apply to Internal Revenue Service (IRS) audits of partnerships, including limited liability companies (LLCs) taxed as partnerships and their partners. . . . . Issues that Partnerships Need to Address . . . . 1. Existing partnership and LLC operating agreements should be reviewed, and amendments will need to be drafted to address aspects of the new rules, including:

• designating the partnership representative in place of the TMP
• determining the partner(s) that will control the decision to opt out of the new regime
• preventing assignments of partner interests to persons that would preclude the ability to opt-out
• addressing the payment of entity-level tax
• committing to making certain elections in the event of an audit adjustment
• addressing circumstances where partners agree to “adjusted information returns” in lieu of entity-level tax

2. Negotiations will be necessary to determine the appropriate partnership representative and the contractual limitations on the authority of such representative.

Dykema Gossett PLLC, Jeffrey A. Goldman, Steven E. Grob, Anthony Ilardi, Jr., William C. Lentine and Robert W. Nelson: “On November 2, President Obama signed the Bipartisan Budget Act of 2015 (the “Act”), which significantly changes the procedures for tax audits of partnerships. . . . The sweeping changes in the realm of partnership tax audits will likely require revisions to most partnership agreements and new considerations when entering or leaving a partnership.”

See the end of the article for a list of changes to make to operating agreements and partnership agreements.

Akerman LLP, Donald K. Duffy:  “Effective for partnership tax years beginning after 2017, the Bipartisan Budget Act of 2015 repealed the current partnership audit rules and replaced them with rules described in general terms below. Partnerships can also elect to apply the new rules sooner to partnership tax years beginning after the date of the Act’s enactment. In brief, the major change is that the partnership itself can be liable for federal income tax in the tax year the audit adjustments become final. The partners in that year bear the economic burden of the tax and not the partners in the earlier tax year under audit and with respect to which the adjustments are made. Since partnerships can elect to apply these new rules earlier than 2018, some extra diligence is needed now in the acquisition of partnership and LLC interests.”

This article lists eight partnership tax issues that should be addressed in partnership agreements and operating agreements of LLCs taxed as partnerships.  Bottom line:  If your existing or new LLC is or will be taxed as a partnership it must have an operating agreement that includes language that addresses the issues created by the Bipartisan Budget Act of 2015.

Drinker Biddle & Reath LLP, Stephen D.D. Hamilton, David Shechtman and Jonathan D. Grossberg: “Although the new rules under the Budget Act will first apply to returns filed during 2019 ( i.e., for a partnership’s 2018 taxable year), partnerships and their advisors need to plan now for these eventual changes. Anyone entering into a new partnership agreement or acquiring an interest in an existing partnership should focus on what tax audit rights, and what tax representations and covenants, to seek. Partners of “small partnerships” should consider whether to bind themselves to the election-out procedures and whether to adopt transfer restrictions that will insure that the election-out remains available. Existing partnerships should begin consideration of the procedures for designating the PR and whether to utilize the alternative regime for allocation of assessed tax liability back to the partners in the Audit Year.”

Kaye Scholer LLP, David A. Sausen, Willys H. Schneider and Zeno Houston:  “The Bipartisan Budget Act of 2015 (the Budget Act), which was signed into law on November 2, 2015, has dramatically reformed how the U.S. Internal Revenue Service (IRS) will assess and collect taxes from partnerships, including limited liability companies (LLCs) treated as partnerships for tax purposes. . . . Accordingly, absent the exercise of an election as described below, the New Audit Rules can result in the imposition of an entity-level tax on the partnership as a result of audit adjustments. This heralds a significant change from the existing partnership audit procedures”

The authors state:

“All partnerships will need to consider appropriate revisions to existing partnership agreements—preferably, long in advance of the Effective Date

Shearman & Sterling LLP, David S. Raab, Julie M. Marion and Thomas H. Halpern: “Existing partnerships should review operating agreements before new rules take effect.  The Bipartisan Budget Act of 2015 (the Act), which President Obama signed on November 2, upends the way the Internal Revenue Service (IRS) conducts partnership audits, with potentially far-reaching effects. . . . Small partnerships will have to decide whether they want to elect out of the new regime, thereby weakening the ability to control consistent partner reporting.  Partnerships that do not elect out or that are ineligible to elect out will need to ensure their operating agreements address the new procedural requirements, such as addressing whether the partnership is required to elect to pass-through audit adjustments to the partners or who will have the authority to make that decision.

Ropes & Gray LLP:  “On Monday, November 2, President Obama signed the Bipartisan Budget Act of 2015 (the “BBA”) into law, effecting sweeping changes to the rules governing audits of entities treated as partnerships for U.S. federal income tax purposes. The new rules can be expected to increase partnership audit rates by making audits and related tax assessments more efficient for the IRS, including by imposing an entity-level tax on the partnership on audit adjustments, absent an election (described below) to shift tax liability to partners. The new rules constitute a stark change from existing law“

The authors said the partners of a partnership and the members of an LLC taxed as a partnership should take the following action:

“Revision of partnership agreement provisions addressing the sharing among the partners of any partnership-level tax and related items.”

The authors described six other issues that partnerships and LLCs taxed as partnerships must consider.

Sutherland Asbill & Brennan LLP, Thomas A. Cullinan, Sheldon M. Kay , Daniel R. McKeithen, David A. Roby, Jr., Amish M. Shah and H. Karl Zeswitz: “On November 2, 2015, President Obama signed the Budget Act of 2015 (the “2015 Budget Act”), which makes significant amendments to the procedural rules governing federal income tax audits and judicial proceedings that apply to partnerships and other entities (such as limited liability companies or statutory trusts) classified as partnerships for federal income tax purposes. . . . existing partnerships and their partners will also need to consider the extent to which the new rules will necessitate amendments to their partnership agreements to preserve their existing arrangements.”