OP-ED: It’s Time to Review That Partnership/Operating Agreement
If your partnership was audited, would you want the IRS to select your representative? If you joined a partnership this year and that partnership was subject to a tax assessment related to a year when you were not a partner, would you think it is fair for you to pay a portion of that assessment? Of course not! Given that many real estate and construction companies are organized as partnerships (including limited partnerships and limited liability companies), failure to act over the next weeks and months could lead to those very outcomes. The time to act is now.
About two years ago, the Balanced Budget Act of 2015 was enacted into law. The rules in that Act (the “BBA Rules”) ushered in sweeping changes as to how partnerships and LLCs are audited. The BBA Rules are effective for all tax years starting on or after January 1, 2018, and will drastically affect future partnership audits.
The BBA Rules replace so-called Tax Equity and Fiscal Responsibility Act (TEFRA) audit procedures, which were established in the 1980s as a way of permitting a partnership audit to occur at the entity level, instead of the partner level. The government studied TEFRA audits, and determined the audit rates were less than one percent, while corporate audits exceeded twenty percent.
Citing “complexity” as a driver for change, Congress settled on the BBA Rules as the solution. Although the BBA Rules are equally complex, the following are three main takeaways that show why you need to act now, instead of later.
First, your “tax matters partner/member” provision is not effective going forward. Under the TEFRA regime, most operating and partnership agreements were spare on TEFRA details. Usually, those agreements included a single sentence, which identified the concept of the tax matters partner/member and may have identified the partner or member who would assume that role during an audit. Under the BBA Rules, that concept has been removed and replaced with the “partnership representative” (discussed next). At a minimum, you should be updating your tax matters partner/matter provision to contemplate the partnership representative concept in the BBA Rules.
Second, you should give thought to who will be the partnership representative and to what rights/obligations that partnership will be entitled or subject. The tax matters partner/member was required to be a partner or member of the entity. That is no longer the case. Your partnership representative can be almost anyone. This increased flexibility is a positive; however, downsides exist for the partnership, its partners, and the partnership representative. For example, the partnership representative is vested with broad authority in the BBA Rules to settle cases with the IRS. With that broad authority, however, comes equally broad fiduciary duties. With that in mind, when you are updating your agreement to include the partnership representative concept, you should give thought to defining the obligations of the partnership representative. Similarly, you should look to provide some sort of indemnification to the partnership representative for risks arising from the duties of that position.
Finally, and maybe most importantly, if you do nothing, your partnership may be subject to an assessment, instead of your partners. One “complexity” identified by Congress is the fact that under current law, a change at the partnership level usually results in flow-through changes to the partners of the partnership. In the case of an LLC, the members of which are also partnerships, this often led to serial audits of many entities in order to cause the results of the audit to reach the ultimate partners. Under the BBA Rules, the default is that an audit change will lead to an assessment at the partnership level.
What is wrong with that? Well, that assessment usually occurs years after the audited (or
“reviewed”) year. If the partners have changed in the intervening years, this could mean current partners would be required to pay the tax attributable to former partners. The BBA Rules provide ways to avoid this outcome, but you should be looking at this now—not at the time of the audit. Moreover, at least one of those options requires an election to be made with the entity’s tax return. This underscores why you cannot wait until the audit to take action. That time is now.
Column first appeared in the Daily Journal of Commerce on December 15, 2017.