Got partnerships? New rules demand new updates
Virtually everybody knows the “Got milk?” ad campaign, recently refreshed by the cast members of “Hamilton.’’
My question to you is — “Got partnerships?”
This question is timely, because the IRS rules on partnerships have changed and are mind-numbingly complex. You don’t want to get caught without up-to-date partnership or LLC Member Operating agreements (“partnership agreements”) if the IRS calls. Your agreements should now reflect the new audit rules from the Bipartisan Budget Act of 2015 (“BBA”).
Here are three high-level issues to consider.
- The budget act throws out the old TEFRA partnership audit rules. Now the IRS will conduct an audit of the partnership and assess tax to the partnership — not the individual partners anymore — at the highest partner tax rate. So if the partner is an individual, that tax rate is 39.6 percent at the moment. The rate could be 35 percent for a corporate partner. Under the new rules, the partnership must pay that tax instead of the partners. Worse yet, the partners lose their ability to contest the adjustment.
- A second big issue is the fact that the partners who now bear the burden of the audit adjustment in the year the audit is finalized (“adjustment year”) may differ from the partners who owned the partnership and paid tax on the income in the year under audit (“reviewed year”). Partnership agreements must now address how the partners’ capital accounts, basis in the partnership interest, and potentially basis in debt will be calculated.Additionally, partnership agreements should address how former partners will indemnify future partners with respect to both positive and negative tax adjustments. Restorations of basis in the partnership interest can also be affected. Those calculations will probably also be affected by new proposed regulations that address the allocation of partnership liabilities that were issued on October 4, 2016.
- The composition of the partners may be important because small partnerships, those who issue fewer than 100 Form 1065 Schedules K-1, have the opportunity to opt out of the new audit treatment. Care must be exercised in counting K-1s. For instance, if a Subchapter S corporation is a partner, you must count the S corporation, plus all of its shareholders, in that K-1 count.
The caveat is all of the partners must be “eligible” partners for every day of the tax year in which the partnership wants to opt out. Other partnerships and most trusts are ineligible partners for the opt-out provision. Therefore, some partnerships may wish to restructure their ownership in order to be eligible to elect to opt-out each year.
Additional rules on “push-outs” and partnership representatives
A provision also exists to help you avoid the highest tax rate assessment. The new statutes create an election to “push out” the audit adjustments to the review-year partners instead of the adjustment-year partners. That “push out” will avoid the highest rate tax treatment, but will incur a higher interest rate calculation in determining the amount of interest on adjustments. Again, the partnership agreements should reflect selected governance for that election.
A new partnership “god” responsibility is also created under BBA, called the partnership representative (“PR”). The PR now has the authority to bind all partners with respect to the elections and conduct of the audit. The PR replaces what used to be a “Tax Matters Partner.”
Partnership agreements must be updated to reflect this new role and establish governance and internal controls over the conduct of the PR. Conflicts of interest may arise over the choice of PR, and the partnership agreement should reflect how those conflicts would be resolved.
Additionally, under Accounting Standards Codification 740, partnerships may be required to accrue taxes for financial reporting purposes. Doing tax provisions on partnerships hasn’t been an issue because taxes were always paid by the individual partners in the past. Under the new audit rules, the partnerships must pay the tax.
In light of these many changes, it is wise to contact your CPA or attorney now to update those partnership agreements.
Edward R. Jenkins is an instructor of accounting at Pennsylvania State University and a consultant with Boyer & Ritter LLC Certified Public Accountants and Consultants.