US Partnerships Get a Makeover
Partnership agreements will have to be revised in the wake of new partnership audit rules that the United States enacted in early November.
The new rules may also complicate future sales of interests in existing partnerships, loans where a partnership is the borrower, and the allocation of risk and tax contest provisions in tax equity deals.
The Internal Revenue Service is having a hard time auditing large partnerships. For example, master limited partnerships in the energy sector can have 10,000 or more partners. Since 1982, how a partnership is audited depends on its size. For most partnerships, any audit is at the partnership level. The IRS then goes after the partners for payment of any back taxes. However, small partnerships with up to 10 partners, each of whom is an individual or a C corporation, must choose to have this approach apply to them. Otherwise, the IRS audits the partnership and the individual partners separately. Large partnerships with 100 or more partners can choose to have any tax assessments flow through to the partners in the year the IRS assesses back taxes rather than the tax year under audit. Thus, current-year partners end up with the tax burden if the partnership chooses to handle the tax adjustment that way.
Congress replaced this approach with a new approach in early November as part of a budget deal to increase the federal borrowing limit. The new rules will apply starting with tax returns filed for 2018, but they may start affecting transactions involving partnerships that expect to be in business past 2017 immediately.
Under the new approach, the IRS would audit partnerships at the partnership level. If there is an adjustment, then the partnership would pay the tax and reduce cash distributions to partners in the year the tax is paid. Thus, current partners would bear the burden rather than the partners during the tax year under audit.
Effects on Transactions
This means anyone buying an interest in an existing partnership will have to factor in the risk that he may be hit with additional taxes that should have been paid in the past by the person selling him the partnership interest.
It also means that lenders to partnerships will have to factor in the possibility that the partnership will have to make a tax payment. Most lenders calculate debt-service coverage ratios by assuming that income taxes are paid by the partners directly and are not an expense at the partnership level.
It will also affect tax equity transactions in the renewable energy market. The tax equity investor in such transactions takes the risk that the structure works to transfer tax benefits. However, if the IRS adjusts the partnership allocations, for example, so that the tax equity investor is allocated a smaller percentage of the investment tax credit, then it would have the effect of shifting risk back to the partnership. The partnership agreement would have to be amended to require the tax equity investor to indemnify the partnership for the tax.
The IRS will assume that any tax assessed at the partnership level should be at the highest marginal income tax rates even though partners would not have had to pay taxes at that rate. The highest tax rate is the corporate tax rate — currently 35% — or the individual tax rate — currently 39.6% — whichever is higher. The partnership can provide evidence to the IRS that the taxes would have been lower if they were based on partner-level information for the tax year under audit. Examples are the status of the partners — for example, the partners may all be corporations rather than individuals or some may be tax-exempt entities — or the type of income involved — for example, the income may be capital gains or dividends on which the partners qualify for a reduced rate of tax. Congress assumed that there would be back and forth with the IRS agent about the appropriate tax rate to use while the partnership is under audit.
A peculiar feature of the new rules is that if the IRS finds fault with how the partnership allocated income, deductions or tax credits among the partners, then it will not net the shift in amounts. For example, suppose a partnership allocated $1 million in deductions to partner A that the IRS feels should have been allocated to partner B. It will assess the partnership for taxes at 39.6% of $1 million.
The partnership can reduce the taxes it has to pay by sending amended K-1 forms to each person who was a partner in the tax year under audit. This would leave the extra taxes with them, but require them to file amended tax returns for the year under audit. This would spare the partnership from having to pay the assessed taxes only to the extent each partner pays its share of the assessment within 270 days after the partnership received the notice of proposed adjustment from the IRS. The IRS likes this approach because the partnership, not the IRS, would have to do the work of dividing up the assessment and chasing partners.
A partnership with 100 or fewer partners can opt out, in which case the partnership and partners would be audited separately. Clifford Warren, a special counsel to the IRS associate chief counsel for partnerships, described this as going back to “prehistoric days” where “each partner can litigate separately and take its own position” at an American Bar Association tax section meeting in Philadelphia in early November. However, it would mean that any audit adjustments affect persons who were partners in the tax year when the additional taxes should have been paid. Partners would still be under a general obligation to report partnership results consistently with how the partnership is treating them or to alert the IRS to the inconsistency. A partnership choosing this approach would make an election under section 6221(b) of the US tax code.
Any such election would have to be made on each tax return the partnership files for 2018 and future years. If that is what the partners want, then the partnership agreement should require the managing partner to make such an election.
Opting out is not an option unless all the partners are individuals, S corporations or C corporations. The IRS will look through any S corporation and treat all of its shareholders as if they were partners directly for determining whether there are too many partners to make the election.
It is unclear whether the election will be available where one of the partners is itself a partnership. On its face, the statute does not allow an opt-out election, but it gives the IRS the authority to apply a look-through approach of treating all the partners in the upper-tier partnership as if they were partners in the main partnership directly. The IRS will have to think about the challenges of auditing partnerships that opt out in this situation when deciding whether to allow opt-out elections. Tax staff on Capitol Hill say it has authority to allow the elections.
As an alternative to making opt-out elections on each tax return, the partnership can wait until it receives notice from the IRS of a final partnership audit adjustment and then send K-1s to persons who were partners in the tax year under audit. Those partners will be allowed to include the additional taxes on their current-year tax returns rather than have to go to the trouble of filing amended returns. However, the partners will have to pay higher interest on the late payment. The partnership is relieved from having to pay any taxes at the partnership level. The partnership must notify the IRS within 45 days after receiving the final partnership audit adjustment from the IRS that intends to use this approach. In so doing, it makes an election under section 6226 of the US tax code.
Lenders may insist in future loan agreements that any partnership to which they lend make opt-out elections under section 6221(b) or commit to use the procedure in section 6226 for shifting taxes back to the audit-year partners. They also may need to make sure, through borrower covenants and transfer restrictions, that all the partners remain individuals, S corporations or C corporations so that the partnership remains eligible to make an opt-out election.
An opt-out election could cause contests in tax equity deals to be conducted at the partner rather than the partnership level. (Contests where the section 6226 procedure is chosen would remain at the partnership level.) The typical contest clause in a partnership flip tax equity transaction allows the sponsor to control any contest for losses for which the sponsor will have to indemnify the tax equity investor, but requires it to keep the tax equity investor informed. Some rethinking may be required of these contest provisions in opt-out situations. Most tax equity documents require the partners to try to push the contest back to the partnership level.
Another change is in who can be the “tax matters partner,” or the partner designated to deal with the IRS on behalf of the partnership. Under current law, the tax matters partner must be a member-manager, if the partnership is a limited liability company. Starting with the 2018 tax year, the partnership can designate either a partner or a person who is not a partner with sole authority to act for the partnership in IRS audits and court proceedings.
A partnership may elect to have the new provisions apply immediately to tax years starting after it was enacted on November 2, 2015. Any partnership making such an election could not then opt out before the 2018 tax year.