The January 1, 2018 effective date of the new federal partnership audit rules quietly came and went, with many of our partnership and LLC clients and their advisers hoping that the rules were just a bad dream or would at least be postponed a year. According to comments from Treasury Department officials earlier this month during the annual American Bar Association Tax Section meeting in Washington, these rules aren’t going away, and “all” existing partnership and LLC agreements should be amended. Also, language adopting the new rules should be included in any new agreements. They also warned us not to expect more substantive guidance any time soon, so there is no good reason to delay. We encourage all entities taxed as partnerships (as well as multi-member LLCs) to address the issues posed by these new rules as soon as possible—certainly before year-end. For those who are unfamiliar with the new rules, here are some FAQ’s.
1. Why should we be concerned about the new rules? Our company has been around for years.
The Bipartisan Budget Act of 2015 created a radically new and comprehensive partnership audit regime (“CPAR”), and the Consolidated Appropriations Act of 2018 provided some helpful technical corrections – for both existing and new partnerships. The “old” rules were repealed effective for tax years beginning after December 31, 2017. For 2018 and beyond, there is no such thing as a “tax matters partner,” nor the historical principle that partnerships aren’t taxpayers for income tax purposes. The partnership audit will now be performed by the IRS (and perhaps by the states) at the partnership level, and by default, the partnership will be directly liable for any income tax deficiency, interest, and penalties. There are options to shift the liability for the assessment to those who were partners in the reviewed (audited) years.
Traditional partnerships and multi-member LLCs are clearly covered by the new rules, but here’s the first surprise: so are joint ventures and other business arrangements that the IRS will try hard to classify as partnerships. Treasury officials have stated publicly that they want these new rules to apply to as many business arrangements as possible.
2. What do you mean my partnership (or JV) is covered by the new rules? We only have two partners!
Many owners are surprised to learn that their partnership or JV is covered by the new rules. That could result from having too many partners, or even one ineligible partner, or if they fail to make the annual opt-out election on a timely-filed Form 1065.
The new rules provide relief from the risk of entity-level tax assessments only for partnerships that: (a) have 100 or fewer “eligible” partners; (b) are owned (solely) by some combination of individuals, estates of deceased partners, C corporations, and S corporations; and (c) timely file their Form 1065 and check a new box on the return to opt-out, each year. There are special headcount rules for partners that are S corporations. So far, Treasury regulations and officials tell us that, if even one member of the partnership is an LLC or a trust – even a disregarded single-member LLC or a grantor trust – the opt-out election isn’t available. Thus, any tiered partnership structure won’t be permitted to opt-out.
3. Who controls the audit? Will partners have a say-so?
Under the new rules, each partnership must designate a “partnership representative” (“PR”) for each tax year, and that individual or entity can make the opt-out election if it’s available and, if not, will control the audit and any settlement or appeal. By statute, the PR is the only person empowered to work with the IRS; and Treasury officials reminded us of that fact during their speeches in D.C. last week. We call the PR the new “tax czar.”
However, the partnership agreement may require the PR to provide notice of and updates on audit proceedings, to obtain partner votes on various issues and elections, and otherwise restrict the actions of the PR. Obviously, it’s extremely important to appoint a qualified PR (and a “designated individual” if the PR is an entity). Failing to do so will allow the IRS to appoint one.
4. So the law isn’t going away and there’s no grandfather rule. What do we do now?
You and your tax advisers should quickly examine your company’s ownership structure. If, for example, one of your partners is ineligible (e.g., an LLC or family trust), consider transferring its partnership interest to an eligible partner or buy it back. This must have been done by December 31, 2017 for 2018 purposes, since eligibility is determined as of January 1 of each year and on every day thereafter. Thus, if changing ownership is required to allow the partnership to opt-out, that option now isn’t available for 2018 – only for 2019 and beyond.
Each partnership agreement should be amended to address your particular facts, but here is one common theme: every partnership (big or small) should have a PR, who must be officially appointed and in place before the 2018 tax return is due since he or she (or it) must be listed on the return. So consider now who would be the best, long-term PR.
There are a number of issues, federal and state, that should be addressed in any new or amended partnership agreement, and this column only scratches the surface. Bradley’s July 2017 Federal Tax Alert, available on our website, provides an abbreviated list of items that should be considered for inclusion in any new or amended agreement. These amendments should be made well before December 31. And, as mentioned, any new partnership agreement should address these issues.
If you have questions about these new rules and how they might impact your business, please contact your lawyer.