If One Musician Plays A Wrong Note, the Entire Orchestra Now May Pay the Price -- Be Aware of New Partnership Tax Audit Rules

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In 1985, the “participatory journalist” George Plimpton worked as a temporary percussionist, playing sleigh bells, triangle, bass drum, and most notably, gong, with the New York Philharmonic.  During a performance, he once struck the gong so hard and created such an overwhelming sound that Leonard Bernstein, who was conducting at the time, burst into applause.  Although one of the world’s most famous orchestras was playing, it was Plimpton, not the orchestra that received the credit or blame for the huge gong sound.

Likewise, most of the time, if one musician in an orchestra misses a note, it doesn’t impact the orchestra as a whole. Certainly, if a musician misses a note in one performance, it should not impact a future performance of the orchestra or musicians who join the orchestra in the future.  Until now, the same as been true of partnerships, limited liability companies, and other entities taxed as partnerships under federal tax law. 

Partnerships are considered “pass-through” entities under federal tax law.  Partnerships have to file a tax return on Form 1065, but partnerships do not have to pay federal income taxes.  Instead, the partnership issues a Form K-1 to each partner allocating partnership income and expenses to that partner.  The partner puts the information from the Form K-1 onto the partner’s tax return and pays any taxes attributable to the partnership income. 

In this way, partnership taxation is not unlike musician responsibilities an orchestra.  The orchestra manager or conductor provides each orchestra member with his/her part.  However, it is up to the individual orchestra members to play the part. 

Just as an orchestra may sometimes have critics passing judgment on its performance, sometimes the Internal Revenue Service (IRS) may audit a partnership tax return.  Under the current rules (referred to as the TEFRA rules), when the IRS adjusted partnership income in an audit, it was up to the IRS to collect any tax deficiency, interest, and penalties from the taxpayer.  Since the partners, not the partnership, are the taxpayers, the IRS, then, collected any amounts due after an audit from each individual partner.  This is akin to a critic commenting adversely on the orchestra’s performance but then attributing the “blame” for the performance on the individual musicians who failed to perform their parts.

Just as it may be difficult to name every musician who failed to perform his/her part as well as expected, it is a hassle for the IRS to collect amounts for several different partners.  Therefore, the Bipartisan Budget Act of 2015 replaced the TEFRA rules effective January 1, 2018 the IRS adopt new rules (I will call the new rules the post-TEFRA rules).  The post-TEFRA rules allow the IRS to collect any amounts due after a partnership tax audit from the partnership, itself, but allow the partnership to pass those amounts on to individual partners.  The post-TEFRA rules also provide that any additional taxes determined upon audit are to be computed at the maximum rate, even though the rate paid by the partners, who are the taxpayers, may be lower.  If the post-TEFRA rules were applied to music critics, they would allow music critics to blame the orchestra for a poor performance and leave it to the orchestra to allocate blame to individual musicians.

At first glance, this sounds reasonable.  However, unlike a music critic’s article, which typically will be published the day after a performance, a partnership tax audit typically will occur years after the tax year in question.  Just as orchestra personnel may change from year-to-year, the partners in a partnership also may change over time.  So, under the post-TEFRA rules, a partnership is left in the unenviable position of paying taxes for a previous tax year and either allocating those taxes to partners who weren’t even part of the partnership in the tax year in question or tracking down former partners to get reimbursed for the taxes, interest, and penalties the partnership must pay.

As the IRS undoubtedly experienced in trying to collect these taxes, interest, and penalties, this is easier said than done.  The partnership may not be able to find its former partners.  If a former partner is an individual, he/she may have moved, changed names, or even died.  If a former partner is a corporation, trust, limited liability company, or other entity, it may no longer be in existence. 

However, even when the former partner is easy to find, the partnership agreement, itself, could provide obstacles that prevent the partnership from collecting taxes, interest and penalties from former partners.  Unless the partnership agreement or other written documents signed by a partner obligates a former partner to reimburse the partnership for these amounts, the partnership and ultimately, the current partners could end up shouldering the burden of taxes for years in which they were not even members of the partnership.

The post-TEFRA rules also replace what previously was known as a “tax matters partner” with a “partnership representative.” Since a partnership representative has different (and generally broader) authority than a tax matters partner, partnerships need to appoint a partnership representative.  Typically, this is done in the partnership agreement.

The post-TEFRA rules will take effect to every existing new and existing partnership on January 1, 2018 UNLESS the partnership elects every year to opt out and instead, to operate under the TEFRA rules.  Conventional wisdom is that every partnership that is eligible to opt out of the post-TEFRA rules should do so. 

Unfortunately, however, the post-TEFRA rules do not allow all partnerships to opt out.  In order to opt out, a partnership must have fewer than 100 schedules K-1, and generally must be individuals or estates or be taxed as a C corporation, S corporation. This means that partnerships which have other partnerships (or limited liability companies taxed as partnerships) or trusts (including grantor trusts) as partners usually must operate under the post-TEFRA rules. If the partnership discloses all indirect owners (e.g., beneficiaries of the trust and partners of the partnership member), then it still may be able to opt out of the post-TEFRA rules.

Every partnership (and limited liability company taxed as a partnership) should do the following to address concerns raised by the post-TEFRA Rules:

  1. Consult with its attorney and amend its partnership (or LLC) agreement to appoint a partnership representative.
  2. If necessary, amend the partnership (or LLC) agreement so that partners agree to reimburse the partnership for additional taxes, interest, and penalties determined after an audit, even if they are no longer a partner when the audit occurs.
  3. Amend the partnership (or LLC) agreement to direct the general partner (or LLC manager) to opt-out of the post-TEFRA rules if the partnership qualifies to do so.
  4. If the partnership qualifies, request that its tax preparer elect to opt out of the post-TEFRA rules.  This must be done every year.
  5. If the partnership has fewer than 100 Schedules K-1 but cannot opt out of the post-TEFRA rules because one or more of its partners is a trust or partnership (or LLC taxed as a partnership), then consider requesting those partners to provide information about their partners/beneficiaries to see if the partnership can opt-out of the post-TEFRA rules by providing that information to the IRS.

With awareness and diligent preparation, many partnerships should be able to opt out of the post-TEFRA rules and continue to operate as they have in the past the TEFRA rules, but they still should amend their agreements in case they find themselves subject to the post-TEFRA rules in the future.  For those partnerships that cannot opt out of the post-TEFRA rules, amendments to their partnership agreements can help prevent tomorrow’s partners from paying for today’s partners’ “wrong notes.”

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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