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By Laura Davison
Jan. 12 — A new regime for auditing partnerships will greatly change how the IRS will examine the entities, so partners are beginning to revisit their agreements to sort out how the entity plans to handle an audit.
The new regime, unveiled in October and set to take effect in 2018, makes it easier for the Internal Revenue Service to audit partnerships by collecting tax adjustments at the entity level, rather than from individual partners. The rules apply to partnerships with 100 or more members. Small partnerships can opt out, as long as no partner is a passthrough entity.
“Our assumption is not that everybody is out there cheating in the partnership area,” IRS Commissioner John Koskinen told Bloomberg BNA. “Our problem is, and they know and we know, that we haven't been auditing them.”
Partnerships should pull out the operating agreements this tax season to see what parts might need to be revised to reflect the new audit rules, said Michael Greenwald, a partner at Friedman LLP. Any final changes should wait until there are final regulations, he said.
“One big concern is that this could lead to opening up other provisions,” Greenwald said. “Minority partners might try to gain more control. The biggest concern is that the partners may not be as agreeable at this point as they might have been early on” in the life of the partnership.
How to revise the agreements depends on the number of partners and the relationship they have. As more of these agreements are written, Steven Schneider, a director at Goulston & Storrs PC, expects the industry will begin to coalesce around standard language.
Partners should also address in the agreement if they are going to elect to opt out of the rules and pass the adjustments through to the partners, said Michael Grace, counsel at Whiteford, Taylor and Preston LLP.
“In lots of places this could be a source of contention or friction,” he said. Partnerships have 45 days after the date of the notice of final partnership adjustment to make the adjustment, which isn't much time, especially if there is disagreement among the partners, Grace said.
The rules also “bind” the partners to a decision made by one tax representative for the group, Grace said. Under previous rules used to govern partnership audits, enacted under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the IRS gave the settlement agreement to an appointed tax matters partner, who then shared it with all the partners. The new representative role will be able to act on the partnership's behalf, so partners should explicitly state how the representative must communicate with all the partners, Grace said.
Grace also said indemnification clauses are likely to appear in many agreements so that if partners sell their stake before an examination is opened for a year they were involved in the business, they still agree to be responsible for an adjustment.
Practitioners are waiting to see how the Treasury Department and the IRS will treat certain types of partners in regulations interpreting the rules. For example, grantor trusts were treated as passthrough entities under the now-defunct TEFRA rules, but some expect they won't be under the new regime. If grantor trusts aren't considered passthroughs for audit purposes, many small partnerships could elect out of the rules.
The treatment of tiered partnerships, such as publicly traded partnerships and private equity funds, under the regime is also a high priority for guidance.
“It's not 100 percent clear that the upper tier partnership has the ability to pass the adjustment through or if they have to pay it at the partnership level,” Michael Hauswirth, a tax director at PricewaterhouseCoopers LLP, told Bloomberg BNA. “I'd like to see confirmation that the upper tier partnership has the same decision as the partnership under audit.”
What may be material to a lower tier partnership may not be to a partnership that owns an interest in that entity, Brian Meighan, a partner at PwC, said.
“As a result the upper tier may desire to elect to pay the liability rather than flow through immaterial amounts to its partners,” Meighan said. “Allowing this flexibility should be beneficial to both taxpayers and the IRS.”
Some of the main questions could be outlined first in a notice and then followed by specifics in proposed regulations, Schneider said. He said a notice could come as soon as mid-2016, with rules following about a year later. The IRS will likely run into some “chicken and egg” issues, because it will be hard to decipher how the regulations will work before the new procedures are used, Schneider said.
In the statutory language there are “enough specifics to draft agreements,” Grace said. “I think it is important to not act like a deer in the headlights. We can use our professional judgment.”
The procedures in the new regime shift the administrative burden from the IRS to the taxpayer, who is now responsible for paying the imputed adjustment. Partnerships have been audited at very low rates, sometimes at less than 1 percent, because the IRS would have needed to track down each partner and collect his or her individual share of the adjustment.
“Our goal is to make the partnerships, especially the large and complex ones, simpler and easier for us and the taxpayer, so that we can get more covered with the existing resources,” Koskinen said. “I think we can set the program up so that even with the same resources for audits, we can audit significantly more partnerships.”
Koskinen said he doesn't expect to see a huge shift in examiners or funding to the partnership audit arena. Some practitioners are skeptical that the IRS will be able to increase audit rates without a significant resource shift.
“If they are serious about expanding the number of partnerships examined, they need more examiners and better training,” Greenwald said. Even one code section of Subchapter K, such as Section 704 about partnership allocation, can take practitioners years to learn, and the IRS hasn't had the time or the financial resources to provide that level of detailed training to its auditors, he said.
“The big picture here is that Treasury has a lot to do here before this can be effective and work,” Hauswirth said. “There is a lot more to come. It's also, in many ways, a sea change. Now there is the possibility of significant taxes imposed on partnerships at the entity level and that changes the way practitioners think about the provisions around audits and adjustments in agreements.”
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