New IRS Rules Could Give Headaches to Partnerships

Proposed IRS rules place more responsibility, and more potential for unhappy surprises, on the partnerships themselves.
Heléna M. KlumppSeptember 6, 2017

New rules poised to take effect next year will significantly alter the way the IRS audits partnerships and other “pass-through” entities. The rules could have widespread effects, since many large companies are formed as partnerships and other types of pass-throughs, and even more invest in them via third parties. In fact the vast majority of U.S. businesses are already pass-through entities.

In fact, the explosive growth in the number of such entities in recent years precipitated the new regime, as the IRS begged for an approach to help them run such audits more efficiently. The proposed rules, known as the centralized partnership audit regime, represent Congress’s attempt to make these audit exams easier for IRS auditors.

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Heléna Klumpp

The core principle of the regime is the focus of activity at the partnership level. Partnerships will be audited at the partnership level, adjustments will be calculated at the partnership level, and – importantly – any underpayments of tax will be assessed at the partnership level.

The result is a structure that places more responsibility, and more potential for unhappy surprises, on the partnerships themselves. New rules interpreting the statutory provisions – first proposed under the Obama administration, then withdrawn and re-proposed (with minimal changes) under President Trump’s watch – while not yet final, have added to the complexity.

For partnerships not ready for their onset, the IRS’s purportedly helpful regulations could quickly become a headache. To prepare, smart partners are preparing to go back to the drawing board and revise their governing documents to address various aspects of the new rules. Here are three of the many reasons to rethink those documents.

1. The opt-out election. Some partnerships will be able to opt out of the rules by making an election on a timely filed tax return. The consequence is that issues related to the partnership can then only be raised within the context of individual partner audits.

To be eligible for this election, a partnership must have 100 or fewer partners, and all partners must be “eligible partners” – individuals, C corporations, and a few other specified categories. Partners should together decide on an approach and memorialize it in their partnership agreement.

One possibility is to specify that the partnership will (or won’t) make the election every year. Another is to establish a mechanism, such as a vote, by which the partners could make the decision each year. If the partners feel strongly about opting out of the new rules, they may wish to use the partnership agreement to restrict transfers that would negate the partnership’s ability to do so.

2. Silent Partners. Some complaints about the old partnership audit rules were attributable to the role of the tax matters partner (TMP). The new rules eliminate the TMP, replacing it with the “partnership representative” as the new link between the IRS and the partnership.

In a critical distinction from the TMP regime, actions of the partnership representative bind not only the partnership, but all the partners as well. And to further ensure that the lines of responsibility are clear, the new rules provide essentially no notice or participation rights to anyone other than the partnership representative.

Absent some attention in the partnership agreement, the rules could easily create a situation in which partners will be held to an audit result in which they had no say. Every partnership is required to designate a partnership representative annually on its tax return. As such, partners should use their partnership agreement either to designate an evergreen partnership representative or to outline an approach to choosing one each year.

Partners should consider using the partnership agreement to impose some notice and consent rights on the partnership representative — that give partners a say in the tax-related decision-making and put guardrails around actions the representative may take. A partnership representative will likely want some protections as well — limitations, for example, and indemnifications covering situations in which she or he may have to act when unable to reach one or more partners.

3. Push-out Election. The new centralized audit rules differ from the former audit rules in another important way. If, at the conclusion of the audit process, the IRS determines that an underpayment exists, the liability is calculated, imposed, and paid at the partnership level.

That is a substantial departure from longstanding partnership theory and practice, which dictate that partnerships themselves don’t owe or pay tax. The rules offer an alternative: The partnership can elect to “push out” the audit adjustments so that the partners themselves are required to pay their shares of the partnership-related underpayment directly to the IRS.

While this may have some appeal, a push-out election is not without potential downsides. For example, partners will pay interest at a higher rate than the partnership would under normal procedures. A partnership agreement can restrict the partnership representative’s authority to choose this approach.

One possible starting point is to insert a requirement that the partnership representative notify the partners when it receives the IRS’s final partnership adjustment, which triggers the opening of the 45-day election window. Partners may wish to use their agreement to prevent the election entirely, or they could establish a voting mechanism to make the decision when the issue arises.

Heléna M. Klumpp is a partner in the Washington office of Ivins, Phillips & Barker.