Client Alert. Tax News and Developments

Transcription

1 Tax News and Developments North America Client Alert November 17, 2015 Newly-Enacted Legislation Makes a Sweeping and Radical Overhaul to the Partnership Audit Rules and Will Likely Require a Revision of Most Partnership Agreements The Bipartisan Budget Act of 2015 On November 2, 2015, President Obama signed into law the Congressional debt ceiling deal in the Bipartisan Budget Act of 2015 (the Budget Act ). The Budget Act includes sweeping and radical changes to the partnership audit rules that have as their primary goal to make it easier for the Internal Revenue Service (the IRS ) to audit partnerships and collect tax from those audits. Over the past few years, there has been a general perception on the Hill that the current partnership audit rules do not work in an age of tiered partnerships and for partnerships with thousands of partners. There also has been growing concern in Congress about the low audit rate for partnerships. For several years, the tax writing committees in Congress, the Department of the Treasury ( Treasury ), the IRS, and the private sector have had ongoing conversations about how to fix the partnership audit rules. Legislation with similar provisions was introduced earlier this year and in the last Congress. However, although the general approach had been the topic of recent discussions, the contemplated legislative language was not extensively vetted. This may have contributed to some of the unanswered questions and issues identified below, because the language wasn t quite ready for prime time. Nevertheless, because Congress passed legislation with less-than-ideal language, we have considered the implications of this sweeping overhaul in the partnership audit rules. The following client alert begins with a summary of the new streamlined partnership audit rules, followed by an elaboration on the implications of these new rules, and our initial thoughts on what kinds of revisions will need to be made to partnership agreements. We also highlight some new considerations for purchasers of partnership interests and offering documents for investment funds. Lastly, it bears repeating that the goal of all of these changes is to make it easier for the IRS to audit partnerships and collect tax, and we expect partnership audits to significantly increase in frequency. Baker & McKenzie Global Services LLC 300 East Randolph Drive Suite 5000 Chicago, Illinois 60601, USA Tel: Fax: Repeal of the Current Partnership Audit Rules For partnership taxable years beginning on or after January 1, 2018, the Budget Act repeals the current system for auditing partnerships which is comprised of three different regimes: (i) the rules of Code Sections 6221 to 6234, which were

2 enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 ( TEFRA ), (ii) the Electing Large Partnership Rules of Code Sections 771 to 777 and 6240 to 6255, and (iii) the small partnership audit rules. The New Streamlined Partnership Audit Rules The Budget Act replaces the old three regime system with one new streamlined set of rules for auditing partnerships in new Code Sections 6221 through There are a number of central and salient features of these new rules which are set forth below. New Partnership Entity-Level Tax. The new partnership audit rules represent a radical change from the rules enacted under TEFRA. Under TEFRA, the IRS generally conducts unified audits of partnership items at the partnership level, and may assess each partner of a partnership for the audited year for such partner s share of adjusted partnership items, once the IRS finalizes the adjustments at the partnership level. Accordingly, the IRS would impose liability for audit adjustments on the partners that were partners in the audited partnership year. Under the new partnership audit rules, the default position is that a partnership (and not the partners) is required to pay any federal tax deficiency arising from an audit (the imputed underpayment ), unless an alternative to the default position is elected as described in the section below titled, Election for Audit Adjustments to be Paid at Partner Level. Partnership audit adjustments will no longer be assessed and collected at the partner level, but will instead be assessed to, and the tax collected directly from, the partnership. Partners in the year in which the assessment is finalized (the adjustment year ) will bear the cost of the partnership adjustment from a prior year (the reviewed year ). This is the case even if a partner was not a partner in the partnership during the reviewed year. Partners will not be held jointly and severally liable for the tax liability of the partnership, but payments of a partnership under the new rules will be nondeductible. When the IRS issues a Notice of Proposed Partnership Adjustment at the close of a partnership audit, the notice will net the partnership adjustments and will calculate the imputed underpayment for the adjustment year at the highest marginal federal tax rate (without regard to the character of any income or gain) in effect for the reviewed year. The tax calculation will not take into consideration any partner-level tax attributes. Furthermore, to the extent that any adjustment reallocates partnership items from one partner to another partner, such adjustment will not take into account any decrease in any item of income or gain, and any increase in any item of deduction, loss or credit. Accordingly, if an income reallocation were made from one partner to another partner resulting in a partnership tax due to an increase in income to one partner, such assessment will not take into consideration any reduction in income to the other partner. A partnership and the partnership representative (discussed below) have the ability to demonstrate that modifications to the imputed underpayment, and a lower rate of tax, are appropriate. Specifically, a partnership and the partnership representative may provide to the IRS, within 270 days from the date of mailing of a Notice of Proposed Partnership Adjustment by the IRS, and before the issuance of a Notice of Final Partnership Administrative Adjustment by the IRS, partnerspecific information reflecting certain tax attributes of the partners (e.g., taxexempt partners, individual partners subject to favorable rates on capital gains 2 Tax News and Developments Client Alert November 17, 2015

3 and qualified dividends, foreign partners and C-corporation partners (which are currently subject to tax at a rate that is lower than the maximum individual ordinary income rate)). Additionally, modifications and reductions to the imputed payment may be made to the extent that a partner files an amended tax return for the reviewed year which takes into account the partnership adjustments and includes the tax payment due. The Budget Act directs the IRS to establish rules to implement the modification procedures. Election for Audit Adjustments to be Paid at Partner Level. Under the new partnership audit rules, and as an alternative to the default position discussed above, a partnership may elect to have adjustments from a partnership-level audit reflected on adjusted Schedules K-1 (which are provided to both the partners as well as the IRS) and paid at the partner level by those partners that were partners in a reviewed year (the Passthrough Adjustment Election ). The Passthrough Adjustment Election must be made no later than 45 days after the date of the issuance of the Notice of Final Partnership Administrative Adjustment, and once made, the Passthrough Adjustment Election is revocable only with the consent of the IRS. The partners would be required to take the adjustments into account on their own tax returns in the adjustment year. (The legislation does not address who pays the tax if the partner in the reviewed year does not exist or is deceased at the time of the adjustment year). Penalties would be determined at the partnership level, but interest would be determined at the partner level at the large corporate underpayment rate, which is currently 5%. This rate is 200 basis points higher than the rate that would otherwise apply. Small Partnership Exception. Certain partnerships may opt out of the new partnership audit rules altogether, but they must elect to do so every year. Eligible partnerships are those that issue fewer than 100 Schedules K-1 a year and only have individuals, C corporations (including comparable foreign entities), S corporations, or an estate of a deceased partner as partners. Each S corporation shareholder is counted for purposes of the 100-Schedule K-1 limit. Partnerships that have another partnership as a partner (i.e., tiered partnership structures) cannot opt out. Replacement of Tax Matters Partner with Partnership Representative Concept. The new rules do not give partners any statutory right to notice of, or participation in, the audit proceedings. The new rules eliminate the designation of a tax matters partner or TMP. Instead, a partnership will designate a partnership representative who does not need to be a partner (but must have a substantial presence in the US) and will have broad authority to resolve any partnership audit. The partnership representative s actions and decisions will bind the partnership and all partners. Determination of Statute of Limitations at Partnership Level. Under the new rules, the statute of limitations is generally three years from the latter of (i) the due date of a partnership tax return (without regard to extensions), or (ii) the filing of the partnership tax return. This is different from the current rules under TEFRA, where the statute of limitations is based on the last to expire of the partnership s or a partner s statute of limitations. 3 Tax News and Developments Client Alert November 17, 2015

4 Observations and Implications of the New Streamlined Partnership Audit Rules Many Details Unknown. The new partnership audit rules are a drastic change from current law, and will impact virtually every partnership transaction and partnership agreement, including but not limited to funds and M&A deals. The new partnership audit rules contain broad frameworks but leave many details up to the IRS to clarify and issue procedures and guidelines. It is not clear when these procedures and guidelines will be available, and their exact substance is also unknown. The new partnership audit rules are effective beginning in 2018, but there is some time frame between now and then to establish a cogent operating set of procedures and guidelines given the sweeping breadth of the legislative changes. Concerned taxpayers and tax practitioners should voice their comments, concerns and suggestions to the IRS and the Treasury as soon as possible. From what we have heard, the Treasury and the IRS are looking to taxpayers and practitioners to assist them in the monumental undertaking of implementing this legislation in a short time span via procedures and guidelines that comport with the legislation and are manageable to administer on the part of both the government and taxpayers. If any of our clients and/or readers are interested in engaging with the Treasury or the Hill on this topic, please let us know as soon as possible. Payment of Tax at Partner Level. As discussed above, modifications and reductions to an imputed underpayment may be made to the extent that a partner files an amended tax return for the reviewed year which takes into account the partnership adjustments and includes payment of tax due. If a partnership makes a Passthrough Adjustment Election, the partners that are partners in the reviewed year would be required to take the adjustments into account on their own tax returns in the adjustment year. In both of these situations, the partnership presumably is not liable for tax at the entity level, as any taxes owed would be paid at the partner level. The new partnership audit rules do not provide clarity, however, as to how the IRS will enforce the collection of tax. In fact, in the absence of any guidelines or procedures enforcing the collection of tax at the partner level, the above situations are no different from the landscape under current law, where each partner is assessed its allocable share of partnership adjustments and is responsible for the ensuing tax liability. Query if the tax liability would default to the partnership if a partner fails to file a tax return and pay the tax. In light of the above, partnerships and general partners/managers should consider including provisions in their partnership agreements and transaction documents to the effect that if a partnership makes a Passthrough Adjustment Election, each partner will be required to indemnify the partnership, the general partner, the manager and their affiliates for all taxes, penalties and interest that may be imposed on such persons if the partner fails to file a tax return to report such partner s share of the adjustments and pay the taxes owed as a result of such adjustments. Revisions to Partnership Agreements. Partnerships, general partners, managers and their partners should re-examine existing partnership agreements to determine what revisions will need to be made in light of the new partnership audit rules. Revisions that should be considered include the following: 4 Tax News and Developments Client Alert November 17, 2015

5 Baker & McKenzie North America Tax Chicago Dallas Partnerships need to determine whether they can, and wish to, opt out of the new partnership audit rules, and if so, they should provide for same in their partnership agreements. As discussed above, the opt-out is not available to tiered partnership structures, and therefore most, if not all, investment funds will not be able to take advantage of this opt-out. If a partnership cannot, or will not, opt out of the new partnership audit rules: Houston Miami New York Palo Alto San Francisco Toronto Washington, DC o o Partnerships and their general partners/manager should make the following revisions: a designation of a partnership representative; a mechanism to collect any and all information from partners so as to enable a partnership to demonstrate to the IRS that modifications of imputed underpayments are appropriate; a mechanism to collect any and all information from partners so as to enable a partnership to make a Passthrough Adjustment Election; and language requiring a partner to indemnify a partnership, its general partner/manager and their affiliates in the event that the partnership makes a Passthrough Adjustment Election and the partnership, its general partner/manager or their affiliates become subject to taxes, penalties and interest as a result of such partner s failure to file the requisite tax return and pay the taxes owed. Partners should consider negotiating for the following: notice rights with respect to audits and proceedings, and control rights over the actions of the partnership representative; requirement for a partnership to maintain robust records with respect to any Passthrough Adjustment Election as well as any submissions to the IRS supporting a reduction of any imputed underpayment; and requirement for the partnership to make the Passthrough Adjustment Election, or otherwise implement and memorialize a clawback mechanism so that the cost of tax adjustments may be clawed back from those partners that were the partners in the reviewed year, including any former partners. New Advice New Considerations for Purchasers of Partnership Interests. The new partnership audit rules will impact the drafting and negotiation of purchase agreements involving the acquisition of partnership interests. Purchasers of partnership interests should consider seeking indemnities from sellers for any losses and taxes incurred by purchasers as a result of pre-closing taxes, penalties and 5 Tax News and Developments Client Alert November 17, 2015

6 For additional information please contact the authors of this Client Alert or any member of Baker & McKenzie s North American Tax Practice Group. Richard M. Lipton Richard.Lipton@bakermckenzie.com Patricia McDonald Samuel P. Grilli Samuel.Grilli@bakermckenzie.com Diana Myers Diana.Myers@bakermckenzie.com interest imposed on the partnership as a result of the partnership s noncompliance with any aspect of the new partnership audit rules that would have avoided a partnership-level tax (for example the failure to make a small partnership election, or the failure to make a Passthrough Adjustment Election). Prospective purchasers should also seek robust representations from sellers and consider holding back a portion of the purchase price in escrow as additional protection. New Considerations for Fund Documents. Disclosures on the new partnership audit rules should be added to offering documents for all investment funds. Existing funds should consider preparing an amendment to their offering documents, or otherwise issue a notice to all partners, that sets forth the new rules and the potential risks. Existing funds should also amend their partnership agreements. Partnership Audits to Increase in Frequency The new partnership audit rules were intended to make it easier for the IRS to audit partnerships and collect tax. Until now, as a result of the complicated set of current audit rules, partnerships were by and large generally avoiding IRS audits relative to their corporate brethren. Only about 1% of tax returns filed by partnerships with $100 million or more in assets are audited, compared to a 27% audit rate on similarly-sized C corporations, according to a Government Accountability Office report released in July As a result of the new partnership audit rules, that is all likely to change dramatically, and we expect partnership audits to significantly increase. Questions and Further Action If you have any questions about the new partnership audit rules in the recently enacted Budget Act of 2015, or any of the above, or if you need assistance with any partnership agreements or purchase agreements in light of this new law, please feel free to contact any of the attorneys listed at the bottom of this client alert. We will continue to monitor issues and developments relating to the new partnership audit rules, and will provide further updates. Tax News and Developments is a periodic publication of Baker & McKenzie s North American Tax Practice Group. This Alert has been prepared for clients and professional associates of Baker & McKenzie. It is intended to provide only a summary of selected recent legal developments. For this reason, the information contained herein should not be relied upon as legal advice or formal opinion or regarded as a substitute for detailed advice in individual cases. The services of a competent professional adviser should be obtained in each instance so that the applicability of the relevant jurisdictions or other legal developments to the particular facts can be verified. To receive Tax News and Developments directly, please contact taxnews@bakermckenzie.com. Your Trusted Tax Counsel 6 Tax News and Developments Client Alert November 17, 2015