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1 Presenting a live 90-minute webinar with interactive Q&A New IRS Partnership Audit Rules: Impact on Private Equity and Hedge Funds Partnership Level Tax, Push-Out Elections, Partnership Representative Provisions and More WEDNESDAY, JANUARY 24, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Kristen E. Hazel, Partner, McDermott Will & Emery, Chicago Kevin Spencer, Partner, McDermott Will & Emery, Washington, D.C. Madeline Chiampou Tully, Partner, McDermott Will & Emery, New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 1. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 New IRS Partnership Audit Rules: Impact on Private Equity and Hedge Funds Madeline Chiampou Tully, Partner, McDermott Will & Emery Kristen Hazel, Partner, McDermott Will & Emery Kevin Spencer, Partner, McDermott Will & Emery January 24, Boston Brussels Chicago Dallas Strategic alliance with MWE China Law Offices (Shanghai) Düsseldorf Frankfurt Houston London Los Angeles Miami Milan Munich New York Orange County Paris Seoul Silicon Valley Washington, D.C McDermott Will & Emery. The following legal entities are collectively referred to as "McDermott Will & Emery," "McDermott" or "the Firm": McDermott Will & Emery LLP, McDermott Will & Emery AARPI, McDermott Will & Emery Belgium LLP, McDermott Will & Emery Rechtsanwälte Steuerberater LLP, McDermott Will & Emery Studio Legale Associato and McDermott Will & Emery UK LLP. These entities coordinate their activities through service agreements. This communication may be considered attorney advertising. Previous results are not a guarantee of future outcome.

6 Topics Background on the repeal and replacement of the audit rules governing partnerships (TEFRA) The default rule tax is assessed and collected at the partnership level Modifications of the imputed underpayment, including the pull-in election The push-out election Opt-out election Partnership Representative designation and authorities International considerations Changes to partnership agreements Some tax reform items to consider 6

7 Introduction Bipartisan Budget Act of 2015 (BBA) enacted on November 2, Repeals TEFRA and replaces with a new unified partnership level audit. Significant changes to the rules governing U.S. federal income tax audits of partnerships (New Audit Rules). Took effect for taxable years beginning on or after January 1,

8 Applicable BBA Regulations June 13, 2017 proposed regs providing procedure, the determination of the amount of taxes, interest, and penalties owed, and other consequences to adjustments to p ship return. November 30, 2017 proposed regs providing guidance on application of certain international rules under BBA. December 19, 2017 proposed regs address 6226 pushout election in tiered p ship structures, and certain issues involving tax assessment, collection, penalties, and interest. January 3, 2018 final regs relating to electing out of BBA per 6221(b). 8

9 Life Before TEFRA In 1982, Congress passed the Tax Equity and Fiscal Responsibility Act (TEFRA). Before the passage of TEFRA, the IRS could not audit partnerships at the entity level. Instead, any audit adjustment had to be made to an individual partner s return pursuant to an audit of the individual partner. Led to inconsistent results--one partner s settlement or judicial proceeding was not binding on another. Statute of limitations applied to the partner, not the partnership. There was no duty for partners to report items consistently with the partnership. 9

10 Audits Under TEFRA Unified Partnership Level Proceeding: Shifted audit of partnership items from the partner to the partnership by mandating that the tax treatment of any partnership item, as well as the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item must be made at the partnership level. Audit of partnerships were unified proceedings. Generally, the IRS was required to issue formal notice directly to all known partners at the start of an audit. 10

11 Audits Under TEFRA (cont.) Consistency Requirement- Generally, TEFRA required each partner s treatment of partnership items be consistent with the treatment of those items at the partnership level. Treatment was consistent for all partners - Consistency requirement applied both to the filing of a partner s return and if the partnership return is adjusted as the result of an audit. Tax Matters Partner - Tax matters partner (TMP) was the partner in charge of coordinating the audit and judicial proceedings for the partnership; had to be a partner. Individual partners also had the right to participate in an audit or judicial proceeding and to negotiate a settlement directly with the IRS. No penalties for TMP who did not perform duties, i.e., notice to fellow partners. 11

12 Audits Under TEFRA (cont.) Final Partnership Administrative Adjustment: Audit ended when the IRS mailed to the TMP (and to each partner who did not settle) a notice of Final Partnership Administrative Adjustment (FPAA). Partners could challenge the IRS s findings from the audit in court even if the TMP chose not to do so. Statute of Limitations: The IRS had one year after the issuance of the FPAA to audit and collect tax in respect of partnership items from the individual partners. 12

13 TEFRA The Failed Experiment Too much complexity Issues arose as to the applicable statute of limitations, which items were partnership items requiring consistent treatment, etc. Made administration and enforcement of the tax difficult and inconsistent. Linking partnership returns (Forms 1065), Schedule K-1s, and partners returns (Forms 1040) is laborious. No capability to automate the process. Partnership audit adjustments must be manually determined based upon the ownership share reported on the relevant Schedule K

14 TEFRA The Failed Experiment (cont.) No remedy if the TMP failed to notify other partners of audits or determinations. An increase in large tiered partnerships exacerbated the difficulties the IRS faced in auditing and making adjustments to tax liability for partnerships. Pass-through audit adjustments for numerous partners may not be worth it. 14

15 TEFRA The Failed Experiment (cont.) From , the number of large partnerships more than tripled but only 0.8% of such partnerships were audited. The GAO defined large partnerships as those with 100 or more direct and indirect partners and $100 million or more in assets. The audit rate for corporations with $100 million or more in assets was 27.1% in the same period. Audit Rate for Large Partnerships and Large Corporations, Fiscal Years 2007 to 2013 Fiscal Year Large Partnerships Audit Rate 0.5% N/A Large Corporations Audit Rate Source: GAO analysis of IRS data from IRS data book and Audit Information Management System, Compliance Data Warehouse, I GAO

16 What Led to the New Partnership Audit Rules Congress s Motivation Simplify and facilitate IRS audits and adjustments with respect to partnerships and LLCs taxed as partnerships, particularly tiered partnerships. Consistent partnership reporting and auditing. Potential increases in revenue with more streamlined, and thus potentially more frequent, audits of partnerships. 16

17 What Led to the New Partnership Audit Rules (cont.) How Do the New Rules Address and Fix the Problems with TEFRA Streamline audit and adjustment procedures for partnerships by allowing collection at the partnership level. Places onus on the partnership to apportion tax liability among the partners, after an adjustment, by taxing at the partnership level. Forces the partnership to gather amended K-1s and facilitate the pushout of the taxes and penalties to individual partners. 17

18 What Remains the Same Still a unified proceeding for the audit of partnership items. Still a duty of consistency: A partner shall, on the partner s return, treat each item of income, gain, loss, deduction, or credit attributable to a partnership in a manner which is consistent with the treatment of such income, gain, loss, deduction, or credit on the partnership return. Partner can avoid consistency requirement by filing a statement identifying the inconsistency. 18

19 Key Changes New default regime provides for tax adjustments at the partnership level and the collection of taxes, penalties, and interest from the partnership (i.e., entity level tax!). Partners do not have right to be notified of or participate in the audit, the administrative appeal, or a judicial review of a final partnership adjustment. Partnership Representative replaces Tax Matters Partner. 19

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21 Opt-Out Election Certain partnerships may elect to opt out of new partnership audit regime. If election is made, pre-tefra rules apply, meaning no unified proceeding IRS must initiate audit of individual partner returns and collect assessed tax directly from the partner. 21

22 Electing out of BBA 6221(b) -- Election out for certain partnerships with 100 or fewer partners Audit at partner level, not p ship Requirements: 100 or fewer partners during year (req d to furnish 100 or fewer statements per 6031(b)) Count number of K-1s If partner is S corp, number of S corp shareholder count towards 100 or fewer Must have all eligible partners to elect out: Eligible partner = individual, C corp, eligible foreign entity, S corp, or an estate of a decedent. Eligible foreign entity = entity treated as a C corporation if it were domestic S corp is eligible even if some of its shareholders would not otherwise be eligible Who s not eligible? DREs, p ship, trusts, foreign non-corporate entities not eligible, etc. Eligible partner rule likely means most private equity and hedge funds cannot elect out of BBA. 22

23 How do you elect out? Annual election on p ship return Must provide name, TIN (for all partners, including non-u.s. partners), and classification (i.e., C corp), and each shareholder of a partner that is an S corp P ship must notify each partner of the election within 30 days (any method). 23

24 Operative Provision for Partnership-Level Assessment 6221(a) Any adjustment to items of income, gain, loss, deduction or credit of a partnership for a partnership taxable year (and any partner s distributive share thereof) shall be determined, any tax attributable thereto shall be assessed and collected, and the applicability of any penalty, addition to tax or additional amount which relates to an adjustment to any such item or share shall be determined, at the partnership level pursuant to this subchapter. 24

25 Imputed Underpayments Partnership must pay tax on partnership level adjustments, called the imputed underpayment. The imputed underpayment is the net adjustment of items of income, gain, loss, or deduction multiplied by the highest tax rate in effect for the reviewed year under 1 or 11. Highest rate is currently the 37% rate applicable to individuals. Adjustment that reallocates distributive share of item from one partner to another is taken into account by disregarding any decrease in income or gain and any increase in deduction, loss, or credit

26 Imputed Underpayments (cont.) Adjustments to credits are added to or subtracted from the amount determined above. Imputed underpayment is assessed in the year in which the audit is finalized (the adjustment year ), not the year under review (the reviewed year ). Since the imputed underpayment is payable in year assessed, the tax assessment is borne by the adjustmentyear partners (even if they did not own an interest in the reviewed year or owned a different interest). 26

27 Example IRS audits partnership and increases ordinary income by $2,000, disallows deductions by $500, increases LTCG by $1,000 and decreases long-term capital loss by $500. The ordinary items are grouped together, resulting in an adjustment of $2,500. The same is done for the capital gain items, resulting in an adjustment of $1,500. The two adjustments are then combined to a total adjustment of $4,000. The adjustment is multiplied by 37% (the highest rate of tax) to arrive at an imputed underpayment of $1,

28 Modifications to the Imputed Underpayment Partnership has 270 days after the notice of proposed partnership adjustment to seek the following modifications to reduce the imputed underpayment: Adjustment allocable to a reviewed-year partner that is a tax-exempt organizations. Allocation allocable to a reviewed-year partner that is a C corporation. Reviewed-year partners include individuals and adjustments are increases in capital gain or qualified dividend income

29 Modifications to the Imputed Underpayment (cont.) Under a pull-in procedure, the imputed underpayment may be reduced to the extent the reviewed-year partners file amended returns taking into account their share of the partnership s adjustments and pay the resulting tax for both the reviewed year and any subsequent year with respect to which any tax attribute is affected by reason of the partner taking the adjustment into account in the reviewed year. If all reviewed-year partners file amended returns, the imputed underpayment could be zero. If only some partners file amended returns, the partnership pays the tax on the share of the adjustment allocable to the partners that do not. If adjustment is a reallocation of items from one partner to another, all partners affected by the adjustment must file amended returns. 29

30 Push-Out Election in 6226 Partnership can elect out of entity-level tax within 45 days of receiving the final audit adjustment notice. Avoid p ship having to make payment To do so, partnership furnishes each reviewed-year partner with a statement (similar to a K-1) of such partner's share of any adjustment. Reviewed-year partners are subject to tax in year in which statement showing partner s share of any adjustment is received. 30

31 Push-Out Election (cont.) Tax liability determined as follows: Calculate increase in tax liability for the reviewed year and all intervening years as if the partner s share of adjustments were taken into account for the reviewed year, including those adjustments that would have been disregarded in determining imputed underpayment. Include effect of hypothetical increase on tax attributes. Years in which partner would have owed less taxes are not taken into account. Total of additional taxes due with tax return for the year in which the statement is received. 31

32 Push-Out Election (cont.) Interest rate on imputed underpayments is determined at the partner level and is 2% higher than the rate for imputed underpayments which are not pushed-out. An entity level liability is imposed if a partnership does not pay or push-out. Partners are bound by the adjustments shown on the statements; no administrative or judicial recourse. 32

33 Push-Out Election for Tiered P Ships: Application to typical hedge fund structure U.S. Taxable Investors Principals General Partner (Delaware LLC) Foreign & Tax-Exempt Investors Shareholders Limited partners Investment Manager Incentive allocation Domestic Feeder (Delaware LP) Management fees Master Fund (Delaware LP or Cayman LP) Foreign Feeder (corp. for U.S. tax purposes) Foreign feeder will either invest directly in the Master Fund or through a tax partnership vehicle created to provide the GP a carried interest on foreign feeder s investment returns. Trading, investments and leverage 33

34 Push-Out Election for Tiered P Ships Proposed regs give guidance At each tier, pass-thru partner may choose to pay tax or push it out to its partners, shareholders, beneficiaries; failure to make choice will obligate such partner to pay Rules for making statements to next tier and computing the adjustment Due date to make payment is the extended due date for the return for the adjustment year of lower-tiered p ship that made election Rules for filing administrative adjustment request (permitting taxpayers to receive refunds of any tax overpayment) 34

35 Push Out Election Penalties Proposed regs give guidance Rules to calculate penalties, additions to tax, and other amount by partners when push out election made. Compute/test penalties by applying specific rules/thresholds based upon facts and circumstances of that partner as if correction amount were an underpayment or understatement for the first affected year. Partner can assert a personal defense against penalties (i.e., reasonable cause) by first paying tax and penalty due and then filing a claim for refund based upon the specific defense. 35

36 Push-Out Election Factors to Consider in Making Election Size of the adjustment. Cash flow available to pay the adjustment. Ability to recoup cost of adjustment paid by partnership from future cash flow. Time and expense of preparing adjusted K-1 s for reviewedyear partners. Extent of turnover among partners between current year and reviewed year. Cost of additional 2% interest. 36

37 Push-Out Election Factors to Consider in Making Election New partners will want push-out election to be agreed to in the partnership agreement Partnership agreement should also contain indemnity provisions for partners to insure each partner is only liable for own taxes (discussed later) The push-out election may be difficult in practice as each partnership must push-out the adjustments to its partners and must have detailed information about each partner 37

38 Partnership Representative The partnership must designate a partnership representative, who has the sole authority to act on behalf of the partnership in an audit. A partnership and all partners are bound by actions taken by the partnership and any final decision with respect to the partnership. The partnership representative does not have to be a partner, but must be a person with a substantial presence in the United States. If the partnership fails to designate a partnership representative, the IRS can select "any person" to be the partnership representative. Under proposed regulations, if the partnership representative is an entity, the partnership must also designate an individual to act on the entity s behalf. 38

39 International Partnerships Proposed regulations were released November 30, 2017 addressing how certain international rules operate in the context of the centralized partnership audit regime. Withholding of tax on foreign persons Withholding of tax to enforce reporting on certain foreign accounts Treatment of creditable foreign tax expenditures of a partnership 39

40 International Partnerships Withholding of tax on foreign persons Current rules require withholding on certain U.S. source income FDAP Current rules also require withholding with respect to non-u.s. partner s share of effectively connected income New rules impose a partnership level tax Coordination rules provided so that the tax is collected only once with respect to the same adjustment. Similar coordination rules for withholding with respect to foreign accounts. 40

41 International Partnerships Foreign Tax Credits Treasury and IRS agree that the long-standing foreign tax credit rules should be preserved while implementing the broader purpose of the centralized partnership audit regime. Treatment of creditable foreign tax expense Application of the foreign tax credit limitation Treatment of credits under sections 902 and

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43 Changes to LLC/Partnership Agreements Perhaps no changes needed if you control the entity, but may want to at least name Partnership Representative. Provisions to consider if entity not controlled by you Board appoints partnership representative Partnership representative acts at the direction of the Board Board authorized or directed to opt out if possible Board authorized or directed to push out if possible Partners required to provide information needed to opt out or push out If entity pays tax, tax is charged to reviewed-year partners 43

44 Partnership Representative Drafting Points Standards for selecting, terminating, and replacing the Partnership Representative. Current practice has been to include a Partnership Representative provision in the TMP section. Scope of Partnership Representative provision depends on who you represent (i.e., total authority vs. partner consent at some level). 44

45 Partnership Representative Drafting Points (Cont.) Key issues include: notice to partners; duty to inform; extending the statute of limitations; settling an audit; filing a petition for readjustment; other material concessions. Decisions to pay tax or make push-out election? Must partners approve? Which partners? What threshold? De minimis payments? Other considerations? Indemnification of Partnership Representative? Obligation of Partnership Representative to seek modifications to lower partnership rate of tax. 45

46 Partnership Representative Drafting Points (Cont.) Authority in partnership agreement to request partner-specific information, and obligation to provide information. May include confidential information (e.g., tax returns). Obligation of partners to file amended returns in order to reduce or eliminate the imputed underpayment. Ability to pay tax from partnership accounts, or to call capital or loans to pay the tax (and penalties for failure to contribute). Allocation of the tax burden among the partners. Indemnification and clawback from prior partners. 46

47 Buying/Selling Interest in Existing Partnership Buyer may want Partnership obligated to make push-out election for prior years so that Buyer does not end up bearing share of imputed underpayment paid by Partnership. Partnership will want former partner to remain obligated to pay tax on any adjustment pushed out to the reviewed-year partners and to reimburse partnership for imputed underpayment that relates to former partner. 47

48 Additional Considerations Statute of Limitations The Partnership Representative has the sole responsibility of extending statute of limitations. The statute of limitations expires within three years from the later of: The date the partnership return for the reviewed year was filed, The due date for such partnership return, and The date the partnership filed an Administrative Adjustment Request for the year 48

49 Additional Considerations Statute of Limitations (Cont.) If the amount of unreported income exceeds 25 percent of the gross income of the partnership for the reviewed year, the IRS has six years (rather than three years) to make the adjustment. If the partnership does not file a return or files a fraudulent return then there is no statute of limitations. 49

50 Tax Reform Has Significant Impact on Private Equity Investors Under the new tax law, individuals can deduct up to 20% of the qualified business income they receive from a pass-thru (with limitations) for tax years after 12/31/17 and before 1/1/26. Qualified business income is the net amount of domestic income generated from taxpayer s business. Excludes certain investment income, amounts distributed to partner acting outside role as a partner, guaranteed payments for services rendered to the partnership, or payments in the nature of compensation. If the amount of qualified business income is negative, loss can be carried forward. 20% deduction is limited where individuals taxable income exceeds threshold amount ($157,000 single/$315,000 joint). 50

51 Qualified Business Deduction If exceed threshold, amount of deduction is limited to lesser of: (a) 20% of the qualified business income; or (b) the greater of (i) 50% of the W-2 wages paid to employees by the business, or (ii) the sum of 25% of the W-2 wages paid plus 2.5% of the unadjusted basis immediately after the acquisition of all qualified property. If income exceeds the threshold, there is another limitation for an individual earns income specified service business. A specified service business includes businesses that perform financial services, investing, investment management, and any business where the principal asset is the reputation of the employees. No deduction is permitted where income from a specified service business exceeds the threshold. Individual investors in PE funds that invest in portfolio companies organized as pass-thrus are eligible for 20% deduction (subject to limitations) on qualified business income from those investments, but the income from management activities will not be. 51

52 Limitations on Interest Deductibility Business interest deductions limited to sum of business interest income plus 30% of the adjusted taxable business income. For years before 1/1/22, determine adjusted income without regard for deprecation, amoritization, or section 199 deduction. If meet gross receipts test (i.e., average annual receipts for 3 year does not exceed $25m), exempt from limitation. Limitation applied at p ship each p er s adjusted taxable income increased by distributive share of p ship s excess taxable income Equal to 30% of p ship s adjusted taxable income minus difference of business interest over business income divided by 30% of p ship s adjusted taxable income 52

53 Limitations on Interest Deductibility (cont.) Special rules for partners to calculate interest deduction limitation Can carryforward unused business interest expenses of partnership Limitations on deductibility of interest will likely increase cost of capital and may cause PE to rethink use of debt to finance acquisitions. Also may limit use of blocker entities 53

54 Carried Interest Pre-tax reform, profits paid to PE fund manager held for more the 1 year = capital Long term capital treatment after three year holding period; 83 election does not change result To get capital treatment, must be an applicable partnership interest (i.e., profits interest), incudes substantial services involving raising capital and investing in securities, commodities, etc. New law will affect PE investments for less than 3 years. 54

55 Grecian Magnesite Vitiated In Grecian Magnesite, Tax Court held sale of non-firpta p ship interest will not be taxable to foreign holder, even if p ship engages in U.S trade/business. Now gain/loss is effectively connected with U.S. trade/business Applies retroactively to sale on or after 11/27/17. Foreign investors will likely to continue to use blocker entities to avoid ECI characterization when making PE investments. 55

56 Madeline Chiampou Tully Madeline Chiampou Tully represents clients on federal income tax matters relating to taxable and tax-free mergers, acquisitions and divestitures, corporate restructurings and finance transactions. Within these areas, her tax practice focuses on energy tax issues, including advising on renewable energy transactions such as solar and wind projects. Madeline's areas of practice include: Emory University, School of Law, JD, 2005 College of the Holy Cross, BA, magna cum laude, 2002 Renewable energy projects, including tax equity structures, refinancings, acquisitions and dispositions, restructurings and workouts. Madeline has extensive experience with respect to the production tax credit as it applies to wind, geothermal, biomass, hydro, waste, fuel cell and refined coal. She has worked extensively with the investment tax credit for renewable projects, including utility-scale solar facilities and residential solar portfolio projects. Recently, Madeline has worked with the many energy-related programs and legislation included in the American Recovery and Reinvestment Act of 2009 Mergers and acquisitions, including working with buyers and sellers of electric generation and gas facilities, as well as of businesses outside of the energy sector. Madeline provides advice on corporate, partnership and consolidated tax issues generally and those specifically related to electric generation businesses, including agreements for treatment of power purchases, tolling, fuel and renewable energy credits New Markets Tax Credit projects, including assisting with transactions related to the use of the New Markets Tax Credit and the Section 1603 grant in lieu of the investment tax credit with respect to several renewable projects 56

57 Kristen Hazel Kristen E. Hazel has extensive experience representing clients in US and international aspects of federal tax matters, including international acquisitions and divestitures, international joint ventures, and capital plan design and implementation, including tax planning with respect to intellectual property. Her work includes both inbound and outbound transactions Loyola University of Chicago School of Law, JD, 1988 Wayne State University, BA, 1985 Kristen is the co-chair of the Firm's Captive Insurance Affinity Group. She regularly counsels clients with respect to the tax aspects of organizing, operating and defending captive insurance companies. She is chair of the Firm's New Business Committee and is a member of the Firm's Professional Responsibility Committee. Kristen frequently speaks on international tax topics for various professional organizations. She is an adjunct professor at the University of Illinois Law School, the John Marshall Law School and the Chicago-Kent College of Law. Kristen is a co-founder of Tax in the City: A Woman's Tax Roundtable, which consists of women tax professionals with an interest in discussing substantive tax issues in a collegial and confidential setting, and which meets regularly in Chicago and New York. 57

58 Kevin Spencer Georgetown University Law Center, LLM, with distinction, 2002 University of Miami School of Law, JD, cum laude, 1996 Kevin represents clients in complicated tax matters, and advocates for them against the Internal Revenue Service (IRS) and federal government at the administrative level (e.g., Examination and Appeals Divisions), and litigates cases in court. He has substantial knowledge of the rules and procedures that govern the IRS and the federal courts, and privilege and confidentiality matters. After earning his Masters of Law in tax, Kevin had the privilege to clerk for the Honorable Robert P. Ruwe on the US Tax Court. Kevin is a prolific writer and lecturer on a variety of tax topics, and is an active member of the Firm s Pro Bono and Community Service Committee. He is an editor of the Firm's Tax Controversy 360 blog, and was an adjunct law faculty member at Georgetown University Law Center. Mary Washington College, BS, cum laude,