How To Modify Your Partnership Agreement Under the New Partnership Audit Regime
Now is the time to dust off your partnership or operating agreement and amend it to reflect the new partnership audit rules. Effective January 1, 2018 (or earlier if elected), under the Bipartisan Budget Act of 2015, all partnerships (including LLPs and LLCs taxed as partnerships) are impacted by the new partnership audit rules. Below are key questions to consider as you update your partnership agreement.
Dealing with ownership changes
The Internal Revenue Service (IRS) may now collect tax at the partnership level as a result of a tax audit. Historically only the partners were subject to tax. The IRS collects the tax from the partnership in the year of the audit known as the “adjustment year.” The assessment of the tax, however, is from an IRS audit performed on a prior year known as the “reviewed year.” If there are ownership changes during these years, then the new partners in the adjustment year will essentially pay a tax on additional income derived from the reviewed year when they were not a partner. For example, law firm X had partners A, B, and C in 2018. In 2019, partner A leaves law firm X and partner D joins law firm X. In 2020, the IRS examines law firm X’s 2018 tax year and makes partnership adjustments, which increases law firm X’s taxable income resulting in additional tax owed by law firm X. The IRS assesses law firm X with additional tax in 2020. Unless law firm X’s partnership agreement is modified, partner D, not partner A, will be partially burdened by that tax. Questions to ask include:
- Must partners who left the partnership reimburse the partnership for amounts owed for audit years in which they were partners?
- Should new partners have to pay taxes related to a tax year they were not partners?
Acclimating to the partnership representative
Partnerships must designate a “partnership representative,” who has significantly more power than the “tax matters partner,” (the position it replaces from prior law). A partnership representative does not need to be a partner of the law firm. Not only can the partnership representative bind a partnership, but the partnership representative also binds the partners. The partnership representative is not required to notify partners of the partnership tax matters, such as partnership audits. The partnership representative determines whether or not to elect out of the new partnership audit rules, which are discussed later. In the event of an audit, the partnership representative has the authority to make decisions and certain elections with the IRS. Choose your partnership representative carefully. No provision in the partnership agreement will change the fact that the partnership representative has ultimate authority with the IRS. However, certain provisions in the partnership agreement may provide recourse to the partnership in the court system. Partnership representative considerations include:
- Who appoints or removes the partnership representative?
- What procedures should be implemented to limit the partnership representative’s authority within the partnership (i.e., establish voting committee)?
- When should the partnership representative give written notice to all of the partners in the case of certain events (audit notices, elections, etc.)?
- To what extent should the partnership representative exercise due diligence with respect to elections available?
Partnerships must decide annually whether or not to elect out of the new partnership audit regime, if eligible. In general, eligible partnerships are comprised of 100 or less partners who are at all times during the tax year eligible partners including individuals, certain foreign entities, S corporations and estates of deceased partners. If the partnership elects out, essentially each partner is separately audited on partnership items. There are specific procedures that must be followed to elect out. Most notably, the election must be made on a timely filed partnership tax return, including extensions. Keep in mind if no action is taken the partnership is required to conform to the new partnership audit regime.
The elect out decision tends to vary based on the number of partners in a partnership. For example, a partnership with four partners may want to elect out of the regime as the partners may pay less tax if individually assessed than if the partnership was assessed. When the partnership tax is assessed, the tax is based on the highest prevailing tax rate. If the tax is paid by each partner, the partner may take advantage of the graduated rate schedule and lower tax rates applicable to long term capital gains and qualified dividends on the individual level. Additionally, for a four-partner partnership, the individual partners may be willing to tolerate the administrative burden in order to save tax dollars. However, a partnership with 30 partners, may find it cumbersome to elect out of the new regime. It may be easier and less costly for the 30 partner partnership to pay the tax at the partnership level as opposed to each partner undergoing an audit. Electing out provisions may include:
- Who is responsible for determining whether or not to elect out annually?
- Should partners be precluded from transferring their interests in the partnership to ineligible partners?
Issues related to paying partnership tax
Payment of the partnership tax liability as a result of an audit may be of concern for those partnerships that conform to the new partnership audit regime. Considerations will vary depending on your business. Details to address include:
- How to true-up partners when inequities exist among the partners as a result of paying the tax on the partnership level vs. the individual level.
- How to fund the payment (i.e., partner capital contributions, maintain cash reserves, etc.).
No matter the size of partnership, your firm will be impacted by this new rule. Take the time at your next partner meeting to discuss these rules and amend your partnership agreement in a manner that best suits your business going forward. This helps protect both the partnership and its partners.