CHANGE IN U.S. PARTNERSHIP TAX RULES WILL REQUIRE CHANGES TO PARTNERSHIP AGREEMENTS

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1 BRIEFING CHANGE IN U.S. PARTNERSHIP TAX RULES WILL REQUIRE CHANGES TO PARTNERSHIP AGREEMENTS NOVEMBER 2015 PROVISIONS IN THE BIPARTISAN BUDGET ACT OF 2015 CHANGE THE RULE FOR TAX AUDITS AND CONTESTS OF PARTNERSHIPS IN THE U.S. THOSE DRAFTING NEW OR RELYING UPON EXISTING PARTNERSHIP AGREEMENTS WOULD BE WELL-ADVISED TO CONSULT A U.S. TAX PROFESSIONAL REGARDING THE CHANGE IN LAW. Provisions included in the Bipartisan Budget Act of 2015 (the Act ) signed November 2, 2015 change the rules for tax audits and contests of partnerships 1 in the U.S. THESE CHANGES WILL IMPACT CURRENT TAX PLANNING FOR PARTNERSHIPS AND LLCS These changes will impact current tax planning for partnerships and LLCs that file U.S. tax returns including non-u.s. partnerships and may also require changes to their governing documents. Those who are drafting a partnership agreement with U.S. tax provisions, or who are relying on a previously-drafted agreement, would be well-advised to consult a U.S. tax professional regarding the change in law. PRIOR LAW The United States does not tax entities that are classified as partnerships. Instead, an entity treated as a partnership for U.S. tax purposes files an information return on Form 1065 and sends Schedule K-1s allocating income, losses and other tax items This publication constitutes attorney advertising 1 A partnership for this purpose means any entity that is classified as a partnership for U.S. tax purposes. This can include limited liability companies ( LLCs ), and includes non-u.s. entities with more than one partner/owner/member that have elected to be classified as partnerships for U.S. tax purposes.

2 2 Watson Farley & Williams of the partnership as a whole to the individual partners. The partners themselves then report the income and other tax items and pay any resulting income tax. Until 1982, this meant that partnership income or loss was reviewed by the IRS as part of a review of the tax return of each partner. This proved very cumbersome and often yielded inconsistent results for example, some partners might be audited and others not. In 1982, the U.S. created a centralized partnership audit system known as TEFRA. 2 Under TEFRA, the basic rules are: The tax treatment of all partnership items must be determined at the partnership level. 3 The partnership or LLC designates a tax matters partner who must be a partner or member of the entity to represent it in TEFRA proceedings. The tax matters partner generally has the right to extend the statute of limitations, file for refunds and settle proposed adjustments, and is the person the IRS will normally deal with during the audit process. Other partners or members with a 1% or greater profits interest in the entity, or any interest if there are 100 or fewer partners or members ( notice partners ), have the right to receive notices of proceedings and adjustments directly from the IRS and to initiate a contest (if the tax matters partner does not do so) and to participate in any contest proceeding. The tax matters partner generally may not bind a notice partner to a settlement agreement. The TEFRA rules provide a minimum statute of limitations of three years that applies to the partnership return (i.e., the statute of limitations for partnership items in a taxable year cannot be less than three years after the filing of the partnership return or the due date for the return, whichever is later) but the true statute of limitations is either this period or the period determined by reference to the partner s tax return, whichever is the longer. THE NEW AUDIT RULES ALLOW THE IRS TO DEAL EXCLUSIVELY WITH A SINGLE REPRESENTATIVE OF THE PARTNERSHIP NEW PARTNERSHIP AUDIT RULES The new partnership audit rules apply to all entities treated as partnerships for U.S. tax purposes (mostly partnerships and LLCs) that are required to file U.S. partnership tax returns. A non-u.s. partnership generally is required to file U.S. tax returns if it is engaged in a U.S. trade or business, or earns U.S.-source income and has U.S. partners. At a very general level, the new audit rules allow the IRS to deal exclusively with a single representative of the partnership, impose the burden of paying the resulting tax on the partnership, and allow the partnership, in turn, to push the liability on to its partners or members. 2 The Tax Equity and Fiscal Responsibility Act of In certain circumstances, partnership items can be converted into non-partnership items, the effect of which is that a partner can deal with the IRS directly, rather than through the partnership.

3 U.S. PARTNERSHIP TAX: CHANGE IN PARTNERSHIP AUDIT RULES 3 Partnership Representative The new partnership audit rules replace the concept of a tax matters partner with the concept of a partnership representative. There are several important differences between a tax matters partner and the new partnership representative. A partnership representative does not need to be a partner. The only requirement is that the representative has a substantial presence in the United States. The Act eliminates the concept of a notice partner. As a result, the partnership representative has the exclusive right to take action with respect to a partnership audit, which may include litigating or settling IRS claims. This may create perverse incentives, some of which are discussed below. THE NEW PARTNERSHIP AUDIT RULES IMPOSE THE LIABILITY FOR ADJUSTMENTS TO TAX ON THE PARTNERSHIP OR LLC, RATHER THAN ITS PARTNERS OR MEMBERS. Partnership-Level Tax The new partnership audit rules impose the liability for adjustments to tax on the partnership or LLC, rather than its partners or members. The imputed underpayment is generally calculated by netting all audit adjustments, and multiplying the net underreported income by the highest marginal U.S. federal income tax rate (currently 39.6%), regardless of the actual tax rates applicable to the partners. The payment is made for the tax year of the adjustment, not the tax year under review. For example, if the IRS determines in 2021 that a partnership s 2018 tax return resulted in an underpayment, the partnership would owe tax on its 2021 tax return. The partnership also owes interest, and possibly penalties, on the deemed underpayment. This interest is not deductible (in contrast to the usual rule for interest). There is no netting of benefits and costs to partners. For example, if a partnership allocates $100 of income 50/50 between Partners A and B, and the IRS determines on audit that the full $100 should have been allocated to Partner A, the partnership owes tax on the additional $50 allocated to Partner A, with no offset for the $50 of income removed from Partner B s allocation. IF ONE OF THE PARTNERS OR MEMBERS IS ITSELF A PARTNERSHIP, THE ENTITY CANNOT ELECT OUT. If the partnership ceases to exist prior to the assessment, the historic partners are liable for the imputed underpayment (pursuant to regulations to be drafted). Otherwise (and in the absence of a push-up election as described below), there is no joint and several liability for an imputed underpayment. The liability is on the partnership alone. Electing Out There are two ways that a partnership may elect not to pay the tax: A partnership may elect out of these rules entirely by so noting on its partnership return if (i) it has 100 or fewer partners, and (ii) none of its partners are partnerships or trusts. This means that if one of the partners or members is itself

4 4 Watson Farley & Williams a partnership, the entity cannot elect out. If a partnership elects out, the IRS may still audit the partners, but will generally be unable to perform a unified audit of the entire partnership. The election to opt out is made for each taxable year, so a partnership may be eligible to make the election in one year but not another. If on audit of a partnership that has not elected out, the IRS assesses the partnership, the partnership may avoid paying the adjustment by instead issuing revised Schedule K-1s (or similar forms) to its partners, effectively passing the tax obligation up to the partners. We refer to this as a push-up election. Other Features of the New Audit Rules THE NEW RULES HAVE SOME VERY STRICT DEADLINES. Statute of Limitations The Act provides a statute of limitations for IRS audits of a partnership return, which expires three years after the return is filed (or the return due date, if later), with certain exceptions. This is in stark contrast to the statute of limitations under TEFRA, which is complex, but generally provides that the statute of limitations is at least three years, but may extend further. For example, under TEFRA, if a partnership files a timely return, but one of the partners never files a return for the relevant year, the IRS could assess the tax on partnership income long after three years from filing. Under the new partnership audit rules, the IRS cannot assess the tax on partnership income on the partner who has not filed a return once the partnership-level statute of limitations period has expired. Deadlines The new rules have some very strict deadlines. Most importantly, the push-up election must be made within 45 days of receipt of a final partnership adjustment from the IRS. WHEN THE NEW PARTNERSHIP AUDIT RULES START APPLYING AUTOMATICALLY IN A FEW YEARS, THE EXISTING TAX AUDIT ARRANGEMENTS IN THESE AGREEMENTS WILL NOT WORK. Effective Date The rules are scheduled to go into effect for partnership taxable years beginning in Because a partnership s 2018 return will be filed only in 2019, and it typically takes at least a calendar year to begin audit proceedings, the new rules likely will not be applied until 2020 at the earliest. However, a partnership may elect to have the new partnership audit rules apply as early as its 2016 tax return. WHAT NEEDS TO BE CONSIDERED NOW Most U.S. partnership and LLC agreements contain rules for dealing with the TEFRA audits: the agreement provides for a tax matters partner and divides responsibility and rights among the partners for how the tax matters partner can act and how any TEFRA audit and contest may be conducted. When the new partnership audit rules start applying automatically in a few years, the existing tax audit arrangements in these agreements designed for the TEFRA audit will not work. Partnerships and LLCs should be revising their governing agreement well before the effective date. The most important questions in drafting the agreement are:

5 U.S. PARTNERSHIP TAX: CHANGE IN PARTNERSHIP AUDIT RULES 5 1. whether to elect out (if possible) or require the push-up election if electing out is not possible; 2. how much power to give the partnership representative in making decisions on behalf of the partnership; and 3. how the agreement s default provisions work together if the parties cannot come to a resolution regarding tax decisions. TREATING THE IMPUTED UNDERPAYMENT AS A GENERAL PARTNERSHIP EXPENSE HAS THE VIRTUE OF SIMPLICITY, BUT IT ALSO MAY RESULT IN AN UNJUST ENRICHMENT TO A PARTNER (AND AN UNFAIR BURDEN TO THE OTHER PARTNERS) Some issues relating to these questions are noted below. These are illustrations of just some of the decisions that the partnership or LLC will need to make about how to deal with IRS audits under the new rules. Election to Transfer Tax Liability to the Partners One of the important decisions to be made is whether to elect out of the rules for partnerships that qualify. Partnerships that do not qualify (or choose not) to elect out need to decide whether to make the push-up election mandatory. This decision may be made by the partnership each time the IRS actually makes an adjustment but it may be better to decide how and whether that election will be made in the governing agreement. The major economic advantage to pushing the imputed underpayment up to the partners is that the partners will be able to calculate the imputed underpayment based on their actual tax rates and offset any increase with any other tax benefits that may be applicable rather than a tax at the highest marginal rate with no offsets. In addition, interest on imputed underpayments paid by the partners may be deductible as a business expense, whereas interest paid by the partnership is not deductible. Finally, pushing the imputed underpayment up to the partners means that the partnership does not need to consider how to allocate the imputed underpayment. In some instances, having the partnership pay the adjustment itself may be simpler, especially if there are many partners, all of whom would need to calculate the tax on the portion of the imputed underpayment attributable to them. If the partnership or LLC may pay the adjustment itself, the partnership or LLC agreement needs to specify the effect of that payment. The parties need to decide whether the payment of these taxes and interest (and any penalties) should be treated as just a general partnership expense like any other business operating expense, or should be allocated to the partners who would have borne the burden of the tax if it had been pushed up. Treating the imputed underpayment as a general partnership expense has the virtue of simplicity, but it also may result in an unjust enrichment to a partner (and an unfair burden to the other partners), particularly if the tax adjustment relates to how income is allocated among partners rather than to how much income the partnership earned. Identity of Partnership Representative Since the Act no longer contains the concept of a notice partner, the only parties that will receive notice from the IRS are the partnership representative and the partnership itself. There may be advantages, therefore, to having the partnership representative not be an individual but rather a company or institution that passes

6 6 Watson Farley & Williams along notices and continues to act despite illness, incapacity or death of a particular individual. THE CHOICE OF WHICH PARTNER OR OTHER PERSON WILL BE THE PARTNERSHIP REPRESENTATIVE IS AN IMPORTANT ONE THE PARTIES MAY WISH TO LIMIT THE AUTHORITY OF THE PARTNERSHIP REPRESENTATIVE TO TAKE ACTION WITHOUT THE OTHER PARTNERS CONSENT... UNLIKE IN THE TEFRA RULES, NO OTHER PARTNER CAN INDEPENDENTLY BRING THE MATTER INTO COURT. The choice of which partner or other person will be the partnership representative is an important one, and should be discussed by the parties. The parties may also need to consider the degree to which the partnership representative needs to be shielded from liability for actions it takes as a partnership representative. Partnership Representative Control of Contests The partnership representative has the sole authority to act for the partnership in an audit or litigation proceeding, including extending the statute of limitations, contesting or settling an audit proceeding, or litigating a claim in Tax Court. The parties may wish to limit the authority of the partnership representative to take action without the other partners consent. For example, the partnership or LLC agreement may provide that all partners (or a majority or supermajority) must consent to any action that may materially affect them. Unfortunately, the failure of the partnership representative to act can also adversely affect partners. For example, the only way to contest a partnership adjustment by the IRS is for the partner representative to commence a lawsuit unlike in the TEFRA rules, no other partner can independently bring the matter into court. Nor does any other partner have the right to be heard by the IRS or the Tax Court. For this reason, in order to provide the other partners with contest rights, the governing agreement has to provide a mechanism not just for preventing the partnership representative from acting adversely to the other parties, but also for actually determining the actions the partnership representative must take. The agreement could give sole discretion to the partnership representative. Alternatively, the agreement may provide that all decisions of the partnership representative (whether actions or omissions) shall be dictated by a board or other governing body, with specific provisions to address a deadlock. The agreement can also set certain default rules (such as whether the push-up election will be made). In some situations, where the impact of an audit may fall disproportionately on some of the partners, the agreement may permit the most affected partners to instruct the partnership representative in return for those partners holding the non-instructing partners harmless. CONCLUSION There are still many parts of the legislation that are unclear and regarding which the IRS has yet to issue rules and guidance. Further analysis and changes to agreements may be required once this guidance is released. Nevertheless, these new rules are significant changes with far-reaching implications for partnership documentation, and firms would be well-advised to begin their planning now.

7 U.S. PARTNERSHIP TAX: CHANGE IN PARTNERSHIP AUDIT RULES 7 FOR MORE INFORMATION Should you like to discuss any of the matters raised in this Briefing, please speak with one of the authors below or your regular contact at Watson Farley & Williams. DANIEL PILARSKI Partner New York dpilarski@wfw.com STEPHEN MILLMAN Partner New York smillman@wfw.com Publication code number: v1 Watson Farley & Williams 2015 All references to Watson Farley & Williams, WFW and the firm in this document mean Watson Farley & Williams LLP and/or its Affiliated Entities. Any reference to a partner means a member of Watson Farley & Williams LLP, or a member or partner in an Affiliated Entity, or an employee or consultant with equivalent standing and qualification. The transactions and matters referred to in this document represent the experience of our lawyers. This publication is produced by Watson Farley & Williams. It provides a summary of the legal issues, but is not intended to give specific legal advice. The situation described may not apply to your circumstances. If you require advice or have questions or comments on its subject, please speak to your usual contact at Watson Farley & Williams. This publication constitutes attorney advertising. wfw.com