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It’s more important than ever that taxpayers know when they have formed a partnership because failing to disclose this status to the IRS will result in greater tax liabilities after 2018, an agency official and tax attorney said.
“Be very careful and keep your eyes open for partnerships that on their face don’t look like partnerships,” said Clifford M. Warren, special counsel to the associate chief counsel (Passthroughs and Special Industries) at the Internal Revenue Service. Licensing agreements, technology cooperative agreements, and purchase or sale agreements can often result in a taxable partnership, he said June 6 at a Practising Law Institute event.
Correctly identifying partnerships will be critical when the partnership audit regime enacted by Congress in the 2015 Bipartisan Budget Act takes effect Jan. 1, 2018, Warren said. The statute streamlines the auditing process by allowing the IRS to collect tax adjustments at the entity level, rather than from individual partners.
Up to this point, when failing to disclose a partnership “maybe you wouldn’t make some entity-level elections you should have made; maybe you were failing to file some forms that you should have filed,” said Eric B. Sloan, a partner with Gibson, Dunn & Crutcher LLP in New York, who specializes in the use of partnerships and limited liability companies in domestic and cross-border mergers and acquisitions, financing transactions, and restructurings.
That all changes in 2018. Taxpayers who don’t properly disclose their partnerships could face “substantive” tax liabilities, Sloan said. “It’s a brand new thing, completely changes the game, and makes this issue more important than it’s been since 1997.”
“We all think we know when we have a partnership,” Sloan said. An agreement will say “limited liability company” at the top and somewhere in the body of the agreement there’s a note that says the entity is a partnership for tax purposes, he said.
But “it is very easy to slip into partnership status,” he said. For example, a joint marketing and sales agreement under which the parties share all costs and net profits is “almost certainly” a partnership for tax purposes, he said.
Even if a corporate lawyer puts “no partnership” in the agreement, “it might well be a partnership,” he said.
Both speakers also advised taxpayers not to lean too much on the “check-the-box” rules—also known as the “default” rules—that help taxpayers determine if their entities are corporations or partnerships for tax purposes.
“You should always file” Form 8832, Entity Classification Election, Warren said. “Don’t rely on the default rule.”
Warren said to make sure the form is filed where someone can find it 10 years from now: “Not having a form is sort of awkward from a housekeeping standpoint.”
Sloan said this advice is especially important for foreign entities because they have a more complicated set of default rules than domestic entities.
For domestic companies, if a taxpayer forms an unincorporated entity, the entity will be classified as a passthrough, he said. “If it has one owner, it defaults to disregarded status, so it’s simply not regarded as an entity separate from its owner for most purposes. If it has two or more owners, it defaults to partnership tax status,” he said.
“If you have a non-U.S. entity, the default rule is: If it has limited liability—if all of its owners have limited liability in their capacity as owners—the entity defaults to corporate status,” Sloan said. But in cases where one or more of the owners has unlimited liability, if the entity “has one owner, it defaults to disregarded status; two or more owners, it defaults to partnership status,” he said.
“If you are forming a non-U.S. entity, don’t think about what the default rule is,” Sloan said.
Government officials discussed other recent developments in the partnership realm at a June 5 conference hosted by the New York University School of Professional Studies.
Thomas C. West, tax legislative counsel and acting assistant secretary for tax policy at the Treasury Department, said Treasury and the IRS may revisit temporary regulations (T.D. 9788) issued in October under tax code Section 752. The rules address obligations where a creditor guarantees only the “bottom” part of a loan.
The government has sought to end bottom-dollar guarantees, where a partner agrees to pay a partnership debt only if the bank collects less than the guaranteed amount from the entity. While the guarantees have been used for many years, people have rarely paid on them, IRS officials have said.
Everyone can acknowledge that there is some abusive, “non-economic, non-commercial activity” going on with respect to the existing regulations under that statute, West said. But “there are some legitimate questions” about the temporary guidance, he said.
The existing rules under Section 752 were meant to be taxpayer-friendly, Glenn Dance, special counsel in the IRS’s Office of Chief Counsel (Passthroughs and Special Industries), said at the June 5 event. “Unfortunately, I think in some technical respects they fell a little short and people kind of filled in the gaps.”
Treasury and the IRS are still accepting comments on the temporary regulations, West said. The rules are also under review as part of President Donald Trump’s April executive order directing Treasury to scrutinize “significant” tax regulations issued since Jan. 1, 2016, for possible changes or repeal, he said.
The Section 752 rules may be ones the government has to go back and address, West said.
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