Summary of BBA Provisions

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1 I. Introduction MASTERING CORPORATIONS, LLCS, & PARTNERSHIPS NEW TAX AUDIT PROCEDURES FOR PARTNERSHIPS AND LLCS TAXED AS PARTNERSHIPS Norman S. Newmark, JD, LLM (Taxation) AEGIS Professional Services Law Practice Group Clayton, Missouri September 6, AEGIS Professional Services. All rights reserved. Use by Rossdale CLE is with permission. It is common for many business owners to choose the partnership form of taxation so as to pass through company profits and losses to the owners, allocated among the owners based upon percentage of ownership. i Partnership taxation avoids the double taxation of C corporations (i.e., business taxed upon profits first, then shareholders taxed upon distribution of dividends) and the complications of qualifying for and maintaining S corporation status. In the end, the goal of partnership taxation is to pay one level of tax at the partner level and hence allow tax free distributions of profits to the equity holders. Many LLCs opt to be taxed as partnerships for that reason. ii Of course, the IRS does not merely accept partnership returns as filed, and from time to time will audit partnership returns to ensure that the proper amounts of taxes are reported and paid. Prior to 1982, the IRS would essentially audit individual partners on their respective shares of partnership income, loss, deduction, credits, etc., and collect additional tax revenue through normal individual audit and collection procedures. This proved to be problematic where a given partnership had numerous partners, or where audits produced inconsistent results, so as part of the Tax Equity and Fiscal Responsibility Act of 1982 iii Congress added Sections 6221 through 6255 of the Internal Revenue Code iv to provide unified rules for making adjustments at the partnership level in most circumstances. In effect, the goal was to make certain each partner s share of partnership income was uniformly treated in one proceeding. The TEFRA audit rules provided for an IRS determination of partnership level income, loss, deduction, credit, etc. and then proper allocation thereof among the partners for the partnership tax year. Under TEFRA audit rules, each partnership appointed a Tax Matters Partner ( TMP ) essentially to receive various IRS notices, work with the IRS in resolving any audit (or file or intervene in a suit), and provide various notices to partners in given circumstances. However, the TMP could bind only certain partners in any settlement. v Hence in many circumstances a given partner could decide not to be bound by any TMP settlement with the IRS, and instead file suit in US Tax Court or other jurisdiction. vi In any event, at the end of any TEFRA proceeding, the IRS would need to assess and collect taxes from the partners, i.e. at the partner level. In short, the TEFRA system essentially mirrored the individual nature of each partner s responsibility to pay taxes on his or her share of partnership income.

2 Having said, the Treasury felt restricted by TEFRA audit rules in its ability to audit and collect taxes on partnership income, particularly given the increased complexity, size and number of partnerships. For example, in recent years the IRS audit rate for large partnerships was substantially less than the rate for large corporations, due in part to difficulties in determining which partners were ultimately responsible for paying the tax bill in tiered partnerships with several flow-through partners. vii In response to a request from Congress, in 2014 the Government Accountability Office issued a report indicating that the IRS rate for partnership audits was comparatively low and that the IRS ability to audit and collect taxes from partnership income would not improve under existing TEFRA rules, and recommended legislation to address the matter. viii As a result of the GAO report and other activities, Congress passed, and President Obama signed into law, the Bipartisan Budget Act of 2015, as amended by the Protecting Americans from Tax Hikes Act of 2015, or BBA for short. ix Among other items, the BBA replaces TEFRA audit rules for tax years beginning after 12/31/2017. x The BBA essentially provides for a centralized partnership audit regime applicable to most partnerships, allowing the IRS to audit and collect taxes from the partnership in many cases, based upon an imputed underpayment amount, taxed the highest applicable tax rate for the year audited (called, reviewed year ). Thus after 12/31/2017, partners will still report and pay taxes on their shares of partnership income in due course, but any tax deficiency found by the IRS will be generally assessed against, and collected from, the partnership entity, akin to collection from a C corporation which does not pay its taxes in full. xi And instead of a TMP which could not bind other partners in many circumstances under TEFRA rules, the BBA provides for a partnership representative ( Partnership Representative ) who has virtually unlimited authority to handle any IRS audit or other proceeding, and resolve or litigate the matter notwithstanding the contrary positions of other partners. xii In essence, the BBA rules turn partnerships into C corporations, at least for purposes of audits and collections. xiii And in turn that poses a substantial non-tax threat of conflicts between or among the partnership, partners, former partners, and the Partnership Representative as to who will bear the taxes and who will deal with the IRS, as examined in Part III. II. Summary of BBA Provisions The provisions of new (BBA) subchapter C of chapter 63 of subtitle F of the Internal Revenue Code ( IRC ), replacing TEFRA rules, can be summarized as follows: Section 6221, IRC, which provides for entity level taxation after audit, etc. under the BBA, except when an eligible partnership elects out of the BBA rules (fewer than 100 partners who must be individuals, C corporations, etc.); Section 6222, IRC, which requires each partner s return to be consistent with the partnership returns, with some exceptions; 2

3 Section 6223, IRC, provides that the partnership and partners will be bound by the actions of the partnership representative for purposes of the BBA rules; Section 6225, IRC, provides that the entity must pay any imputed underpayment of tax (or if there is no imputed underpayment, for the allocation of overpayments among the partners), and provides rules for the determination of imputed underpayments at the highest tax rate, including procedures to modify imputed underpayments in cases of amended returns of partners, etc. The 6225 rules may be difficult to implement and determine tax, in practice; Section 6226, IRC, allows the partnership representative to push-out the liability for any imputed underpayment to the partners of the reviewed year, akin to a TEFRA result; Section 6227, IRC, allows the partnership to file for an administrative adjustment request with the IRS; Section 6231, IRC, provides for various notices to be made to the Partnership Representative, e.g. notice of administrative proceeding and notice of any final partnership adjustment; Section 6232, IRC, provides for IRS assessment procedures including assessments based upon mathematical errors; Section 6233, IRC, provides for entity level penalties and interest; Section 6234, IRC, provides for judicial review procedures; and Section 6241, IRC provides for definitional rules under the BBA, and special rules in the event of bankruptcy, etc. III. Practical Analysis of BBA Procedures As a tax matter, the BBA rules for determining the amount of tax owed and the liability therefor may prove challenging, and will probably require several years of regulatory activity, IRS rulings and case law to clarify. xiv Having said, while the BBA may make life easier for the IRS audit and collection efforts (at least in the long run), the bigger and more immediate practical problem is the BBA s tremendous potential to create non-tax conflicts or even lawsuits among various constituencies of the partnership. That is, given the unlimited authority of the Partnership Representative to settle, and shift the ultimate burden for, unpaid taxes, someone is bound to be an unhappy taxpayer. For example, suppose individuals A, B, C and D form a partnership ABCD on January 1, 2018 with calendar tax year reporting, each owing an equal 1/4 share of the profits and business. For whatever reason, $100,000 of ordinary income is not reported on the 2018 partnership return, meaning A, B, C and D do not report $25,000 of ordinary income, respectively, on their personal 1040 IRS returns. Suppose A is appointed as the Partnership Representative. 3

4 In 2020, there is a falling out among the partners and A is asked to leave, and he sells his interest in equal shares to B, C and D, say, at fire sale prices. Later that same year, the IRS audits the partnership and finds the missing $100,000 of ordinary income. Under TEFRA rules, A, B, C and D would bear the taxes, penalties and interest from failing to report their respective shares of the missing income, that is, based upon $25,000 of income for each. Under BBA rules, however, ABCD, as an entity, is generally required to pay taxes on the entire $100,000 income, taxable on the 2020 return at the highest applicable rate for the reviewed tax year, or Hence while indirectly B, C and D will bear their respective shares of income as under TEFRA, effectively A has escaped taxation and B, C and D are paying his share of the tax bill, at the highest tax rate, not a happy result from their perspective. If A had not sold his interest to B, C and D, but rather to third party E, E would also not be happy about paying taxes of his predecessor in interest, albeit indirectly. Moreover, A is still the Partnership Representative under BBA rules, even though he is no longer a partner, until such time as his designation is revoked or he resigns, or cannot serve due to death or incapacity, etc. as provided by Treasury regulations. xv Hence A may decide to fix his former partners by settling with the IRS without consultation or approval, at the maximum tax, penalty and interest payable. He is not required to push out the liability (in part to himself) under Section 6226, IRC, so he will not bear any portion of the tax bill, and he might be in a vengeful mood. The remaining partners must take immediate action, under such circumstances, to revoke A s designation and prevent a calamity, from a liability perspective. There are other numerous other examples of potential mischief resulting from the BBA rules. Suffice it to say that partnership or LLC operating agreements should be updated to eliminate or ameliorate such possibilities. IV. Conclusion The BBA rules represent a sea change in partnership taxation, not only as to audits and collections, but as to a very real and practical possibility of litigation among partnership constituencies outside of the taxation arena. Hence it is recommended that practitioners review existing and new partnership, operating or other agreements in conjunction with BBA rules, and determine the best means of avoiding conflicts for each partnership client and its constituencies. Alternatively, where appropriate, the practitioner may want to review the possibility of S corporation (or even C corporation) status, to avoid such conflicts in the first place. Good luck! i See subchapter K, chapter 1, subtitle A of the Internal Revenue Code of 1986, as amended. 4

5 ii For purposes of this outline, references to partners and partnerships shall include similar terms for LLCs and other entities which are treated as partners and partnerships for federal tax purposes, e.g. limited liability company and members. iiiiii PL , as amended by PL and PL , commonly known as TEFRA for short. iv Subchapter C and subchapter D of chapter 63 of subtitle F of the Internal Revenue Code, commonly known as TEFRA audit rules for short, as in effect for tax years starting at and prior to 12/31/2017. Note that the TEFRA rules will stay around for the next few years, until the time has expired under applicable statutes of limitation on IRS assessments. v See, e.g., Section 6224(c)(3), Internal Revenue Code, as in effect for tax years at and prior to beginning 12/31/2017. vi Section 6226(b), Internal Revenue Code, as in effect for tax years beginning at and prior to 12/31/2017. vii See NPRM , filed with the Federal Register on June 14, 2017, TD 9. viii See US Government Accountability Office, GAO , Large Partnerships: with Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency, 13 (2014). ix PL , as amended by PL , commonly known as the BBA for short. x Unless otherwise elected by any partnership to apply for tax years beginning after November 2, 2015, and before January 1, See Section 1101(g)(4) of PL and Treas. Reg T. xi There are exceptions to this rule, such as when a partnership elects out of the BBA rules under Section 6221(b), Internal Revenue Code, or when a partnership elects to push out the tax liability to the reviewed year partners, Section 6226, Internal Revenue Code, as such sections are in effect after 12/31/2017. xii This is also akin to a C corporation, which has officers to handle such matters on behalf of the corporation and indirectly for its shareholders, i.e. as affects the values of their shares. xiii Another procedure under the BBA allows the partnership to seek an adjustment of various partnership items, to avoid or reduce taxes, penalties, additions to tax and interest which may result from an IRS initiated audit, or to seek a reduced tax by showing overstated income, etc. This is not covered in this outline due to time constraints. However, that procedure essentially follows BBA procedures for payment of tax at the partnership (entity) level. See Section 6227, IRC, effective for tax years after 12/31/

6 xiv See, e.g., NPRM , filed with the Federal Register on June 14, 2017, TD 9, in which the Treasury Department has issued proposed regulations but nonetheless makes requests for comments in several unregulated areas. xv See Prop. Reg