While much of the recent news has focused on the proposed tax reform currently making its way through Congress, there are new mandatory laws affecting all partnerships starting in January 2018.
What is changing?
As you are aware, a partnership is a “flow-through” entity. In other words, the income from a partnership flows through to the individual partners, and they pay tax on the income. Therefore, there is no tax assessed at the partner level. Under current (soon-to-be-old) law, in an examination, the IRS is required to keep each partner’s liability for partnership operations separate. This most often resulted in many, if not all, of the individual partner’s returns being examined as well.
In these new laws, Congress intended to make a streamlined, efficient system to examine partnerships and collect accessed deficiencies from them. As a result, the IRS may now collect tax at the partnership level as a result of an audit. The IRS will no longer need to keep track of individual partner’s tax liability.
While this sounds like an administrative home run, unfortunately, there are a few hidden issues with the new law.
First and foremost, the tax assessed to the partnership will be assessed at the highest income tax rate applicable. With the pending House bill, that would retain the 39.6% rate for individual taxpayers with over $1M in taxable income. The current Senate version has a top rate of 38.5% for individual taxpayers with over $1M in taxable income. Obviously, most owners of partnerships do not fall into these tax brackets. Therefore, settling deficiencies in examination at the partnership level will most likely be very costly.
Second, under the new law, any new partners to partnerships could pay tax on additional income assessed for when they were not a partner. Since the tax deficiency is assessed at the partnership level as it exists at the time of assessment, current partners only will be burdened by that tax.
New Partnership Representative Must Be Designated
In addition to the above, the new law mandates all partnerships must designate a “partnership representative.” This representative has very broad, and very powerful, responsibilities. A partnership representative does not need to be a partner in the partnership. While an entity can be assigned as a representative, an individual must still be appointed to act on that entity’s behalf. This representative will have the power to bind the partnership and the individual partners. Also, neither the IRS nor the partnership representative are required to notify the partners of partnership matters, including an examination. The representative will have ultimate authority with the IRS. If the partnership does not elect a partnership representative, the IRS will have the authority to designate one.
Potential to Elect Out
Certain eligible partnerships can decide annually if they wish to elect out of the new laws. If the partnership elects out of the new treatment, essentially, each partner will be responsible for his or her share of any deficiency assessed. If a partnership does not expressly elect out of the treatment on a timely filed tax return, it is required to conform to the new laws.
The elect out decision, if available, will obviously be made based on individual facts and circumstances. However, as a rule, partnerships with a smaller number of partners will want to strongly consider electing out. For example, a partnership with only four partners may want to elect out and most likely pay less tax on any deficiency assessed. Those four partners may be willing to tolerate the administrative burden. However, a partnership with 50 partners may find it easier and less costly to pay the tax at the partnership level as opposed to each partner undergoing an audit.
What You Need to Do Immediately
All partnerships need to evaluate and amend their partnership agreement. Questions to be addressed in the agreement include:
- Who appoints or removes the partnership representative?
- What procedures should be implemented to limit the partnership representative’s authority within the partnership (i.e., establish a voting committee)?
- When should the partnership representative give written notice to all of the partners in the case of certain events (audit notices, elections, )?
- To what extent should the partnership representative exercise due diligence with respect to elections available?
- Who is responsible for determining whether to elect out annually?
- Should partners be precluded from transferring their interests in the partnership to ineligible partners?
- If the partnership unintentionally fails one of the electing out criteria, what is the outcome?
- Must partners who left the partnership reimburse the partnership for amounts owed for audit years in which they were partners?
- Should new partners have to pay taxes related to a tax year they were not partners?
- How to true-up partners when inequities exist among the partners as a result of paying the tax on the partnership level vs. the individual level.
- How to fund the payment (i.e., partner capital contributions, cash reserve, financing, )
- Should the Partnership Representative make a “push out” election if available?
As you can see, there are quite a few fiduciary responsibilities and duties of the partnership representative. Without guidance in the partnership agreement, the representative is at risk for a number of potential “self-interest” accusations and lawsuits. Such representatives should carefully consider an indemnification agreement if they decide to serve as a representative.
We encourage you to have a conversation with us as soon as possible to start addressing some of these issues in your partnership agreement. As always, we will help guide you through the implementation of these new regulations and work to put you in the best position possible in the event of an exam. Contact us online or call 215-723-4881.