Private Equity & Hedge Fund Corner

Transcription

1 Private Equity & Hedge Fund Corner New Partnership Audit Rules Pose Issues for Investment Funds and Their Investors By Donald B. Susswein * and Thomas C. Lenz Introduction and Overview DONALD B. SUSSWEIN is a Principal in the Washington National Tax Office of RSM US LLP. He is also the leader of the firm s tax practice in partnerships. He can be reached at don.susswein@rsmus.com. THOMAS C. LENZ is a Tax Partner in the Financial Services Group of RSM US LLP, located in Chicago, Illinois. He can be reached at tom.lenz@rsmus.com. By now, most practitioners are aware of the fundamental changes to the partnership audit process enacted by the Bipartisan Budget Act of 2015 (BBA). The new law repeals the controversial TEFRA partnership rshi rules and replaces them with new rules governing partnership rship audits and adjustments. 1 The new rules also replace the existing rules for electing large partnerships. 2 The new rules will apply pl for tax years beginning nin after 2017 although partnerships may elect to apply them to tax years beginning after November 2, The new rules will apply to all partnerships (including multiple-member LLCs), 3 unless the entity qualifies for and affirmatively elects an exemption. Such an election must be made annually with the tax return for the year to which the election applies. Thus, for calendar-year partnerships, the first elections out must be made with returns filed in 2019 for the 2018 tax year. Despite the delayed effective date, some partnerships may need to take action now to assure new or existing partners that their interests will be protected by the partnership and its management once the new rules take effect. Otherwise, some partners may be unwilling to invest or remain invested. At the same time, some managers may want to maximize their flexibility and minimize their potential liabilities with respect to the new rules. Moreover, some investment funds that invest in LLCs or other partnerships will need to consider the implications of the new rules from two perspectives as entities that may be audited and as investors in other partnerships that may be audited. This column identifies a number of areas where investors and managers may need to focus their attention sooner rather than later. It also identifies a number of potential technical corrections or regulatory clarifications that should be kept in mind as existing agreements and arrangements are revised or new ones are entered into. JANUARY FEBRUARY CCH INCORPORATED AND ITS AFFILIATES. ALL RIGHTS RESERVED. 23

2 PRIVATE EQUITY & HEDGE FUND CORNER Summary of Legislative Changes from TEFRA Rules To summarize the important changes from current law: The BBA rules will apply to all partnerships and entities taxed as partnerships unless the entity elects out. In order to elect out for a given tax year, the partnership must have 100 or fewer partners, all of which are either individuals, estates of deceased partners, C corporations (or any foreign entity that would be treated as a C corporation if it were domestic) or S corporations (treating S corporation shareholders as partners for purposes of the limitation to 100 or fewer partners). In general, the new rules will allow the IRS to initiate and resolve the audit, and any related judicial proceedings, dealing only with a single partnership representative. Nevertheless, all direct and indirect partners will be bound by the results of the partnership audit or any related judicial proceeding. As a result, the IRS will no longer be required to provide notices to anyone other than the duly appointed partnership representative. Unlike the Tax Matters Partner of the TEFRA rules, the partnership representative does not need to be a partner. Most importantly, a new rule will theoretically impose an entity-level el tax at the top individual rate 4 on any understatements ent of partnership income along ng with a comparable amount to recoup any overstated ed tax credits. In practice, ce however, the entity-level tax can be avoided d if the audited partnership elects to provide its partners, for the year under audit, with adjusted K-1s reporting their allocable share of any partnership-level audit adjustments. Partners receiving such statements will be required to pay an additional tax with their regular return for the year in which the adjusted K-1 is issued. Although the additional tax is reported and paid with the current year s return, it is equal to the additional taxes, if any, that would have been due if the corrected partnership information had been included on the original K-1 with appropriate adjustments for any possible effects on intervening tax years. In the event the partnership does not elect to issue adjusted K-1s, the entity-level tax can be reduced in two ways. First, it will not apply to the amount of any adjustment that is properly allocated to a partner that files an amended return reporting and paying any additional taxes due. Second, for all other amounts, the applicable tax rate may be reduced for the portion of any adjustment properly allocated to a partner that is demonstrated to be subject to a top tax rate lower than the top individual tax rate. Examples would include tax-exempt partners, corporate partners and individuals whose adjustments consist of amounts that would be taxed as qualified dividends or long-term capital gains. By way of background, the novel procedure for the issuance of adjusted K-1s was first developed and proposed by a working group of The Real Estate Roundtable s Tax Policy Advisory Committee in September 2015, 5 and was subsequently published as part of a comprehensive partnership audit reform proposal in Tax Notes on October 5, The working group concluded that the simple entity-level tax contained in the leading legislative proposals under consideration was unworkable unless it could be avoided using an alternative procedure of this nature. The main problem was the fact that the entity-level tax would be borne by the current partners, even though it related back to a tax benefit enjoyed by former partners, unless some cash had been withheld for this purpose. In addition, for similar reasons, a partnership might not have the ability to require its former partners to file amended returns reporting and paying additional partner-level taxes that would relieve the partnership and its current partners from entity-level liability. The disruptions to existing business practices that would have been required without the adjusted K-1 process would have been quite serious. Anticipating the difficul- ties of the entity-level made the adjusted d K-1 process the default with hane election to pay yan entity-level ev tax, instead of the l tax, the working group proposal would have other way around. In practice, issuance of adjusted K-1s may well become the norm. The working group proposal also included the recommendation, adopted in the final legislation, that any entity-level tax ultimately payable could be reduced to the extent it was shown that the relevant partners were subject to a top tax rate lower than the individual rate. Technical Corrections and Minor Substantive Changes That May Be Anticipated Tiered Partnership Structures The statute evidently anticipates that any partnership that was itself a partner in an audited partnership, and that receives an adjusted K-1 from the audited partnership or any other lower-tier partnership, will be required to provide its own partners with adjusted K-1s reflecting 24 JOURNAL OF PASSTHROUGH ENTITIES JANUARY FEBRUARY 2016

3 their allocable share of the adjustment reported by the lower-tier partnership unless the recipient partnership decides to pay an entity-level tax on the understatement reflected on the adjusted K-1 it receives. This process will continue at each tier if there are multiple tiers of partnerships. In this manner, what has been described as an indecipherable spider web of legal and business relationships will spin itself. This process is anticipated to replicate what occurs in a typical filing season with respect to original K-1s. A technical correction may be necessary to ensure that this process works automatically, without requiring the active intervention of the IRS. In the absence of a technical correction, it appears that New Code Sec does not impose any tax on a partnership receiving an adjusted K-1, inasmuch as a partnership does not have any tax imposed by chapter 1 for the taxable year that could be increased by the amounts reported on the adjusted K-1. Thus, the IRS will need to go through the formality of issuing to that upper-tier partnership a notice of final partnership adjustment containing the information reported on the adjusted K-1 issued by the audited partnership or any other intervening partnerships in the chain. A simple and straightforward technical correction might provide that the receipt by any partnership of an adjusted K-1, pursuant to a lower-tier partnership s election under New Code Sec. 6226, should be treated as if the recipient partnership had been issued an otherwise timely notice of final partnership adjustment containing the specific c adjustments reported on the adjusted K-1 issued su by the lowertier partnership. That will then automatically aticall trigger, ger for the recipient i partnership, the obligation either to pay an entity-level tax as provided by New Code Sec or to elect to issue adjusted K-1s to its own partners, as provided by New Code Sec The issuance of adjusted K-1s at any tier will thus trigger an obligation of any partnership in the next tier either to pay an entity-level tax on the reported understatement or to issue its own adjusted K-1s. Partial Use of Adjusted K-1s The partnership apparently must use either New Code Sec or New Code Sec for the full amount of any partnership adjustment. In some cases, it may be desirable to allow the partnership to pay an entity-level tax with respect to certain portion of an adjustment and to issue adjusted K-1s with respect to other portions. A technical correction may be useful to clarify that this would be permissible, or at a minimum to allow the IRS to permit such a hybrid response through regulations or on a case-by-case basis. Preserving Taxpayer Rights When IRS Adjustments Are Contested Th e provisions of New Code Sec and New Code Sec do not appear to properly take into account the possibility that a partnership will contest a notice of final partnership adjustment by filing a timely court petition under New Code Sec If such a petition is filed and the court proceeding is later terminated with an agreement or final decision that the partnership has failed to properly report its income, a technical correction should provide that the final decision or agreement will be treated as if it were the issuance of a notice of final partnership adjustment. That will then trigger all of the rights and responsibilities the partnership would have under New Code Sec or New Code Sec in the case of an audit resolved without litigation. The new rules will apply to all partnerships (including multiplemember LLCs), unless the entity qualifies for and affirmatively elects an exemption. Obtaining Judicial ia Review ew of Overreported rted Income It appears that provisions corresponding to Old Code Sec permitting partnerships or partners to sue for refunds if the IRS does not act on an administrative adjustment request were inadvertently excluded from the final legislation. Overpayments and Interest For partnerships that utilize the adjusted K-1 process, corrective legislation or implementing regulations should clarify that partners deemed to have overpaid their taxes, for the reviewed year or any other years affected by the reviewed year, will receive an appropriate credit, offset or adjustment for the overpayment, together with an amount in the nature of interest on their overpayments. This is important, among other reasons, to eliminate any incentive the IRS might otherwise have to propose adjustments (or reallocations) principally to take advantage of the disparity between the treatment of underpayments and overpayments. Similar concerns may exist for partnerships that JANUARY FEBRUARY CCH INCORPORATED AND ITS AFFILIATES. ALL RIGHTS RESERVED. 25

4 PRIVATE EQUITY & HEDGE FUND CORNER pay partnership-level taxes with interest on underpayments as provided by New Code Sec. 6225, but may not get any corresponding interest on account of overpayments. Deficiency Interest Rate and Tax Rates Under Adjusted K-1 Process The deficiency interest rate for partners using the adjusted K-1 procedure is statutorily set at two percentage points above the normal rate (the average market yield on Treasury securities with three years or less to maturity, plus three percent). As a policy matter, there does not appear to be any reason to impose a higher deficiency interest rate for partners using the adjusted K-1 procedure. If the notion of a higher rate was adopted as a way of encouraging the rapid transmission of adjusted K-1s through tiered structures, consideration should be given to other approaches. For example, Congress could restore the normal deficiency interest rate under the adjusted K-1 process, except to the extent it takes more than a specified period of time such as one year between the end of the audit and the date on which the understatement of tax is paid by the ultimate taxpayer. There may also be an issue as to whether the taxes imposed under the adjusted K-1 procedure are properly computed. As currently written, a partner receiving an adjusted K-1 is not required to pay any additional amount of taxes imposed by Chapter 2 of Subtitle A, such as self-employment taxes or the tax on net investment income. That could be intentional, inasmuch as the sponsors of the original legislation, as well as the drafters of the final language, evidently intended that such amounts would not be collected in the event the partnership resolved the audit with an entity-level tax. The entity-level tax is imposed at the highest income tax rate under Code Sec. 1 or 11. In contrast, under the original legislation as well as the final language, the taxes imposed by Chapter 2, such as self-employment and net investment income taxes, would be adjusted if an amended return were filed by a partner reflecting the partnership adjustment, as a way of avoiding or reducing the entity-level tax. It may be argued that the adjusted K-1 process is analogous to the amended return option, albeit filed as a schedule attached to the taxpayer s current year return. If that analogy is persuasive, a comprehensive legislative change might provide that all of the tax and interest computations under New Code Sec. 6226, in both directions, would be substantively identical to those that would have applied if the taxpayer had filed amended returns for all affected years. That would also restore the normal deficiency interest rate. In addition, as appears to be intended by the current statute, it could be clarified that the applicability of penalties imposed based on the partnership s conduct in connection with the filing of a return (such as the penalty for negligence or disregard of rules and regulations) would be determined at the partnership level, but the amount of any such penalty would be determined based on partner-level information (such as whether there was any actual understatement of tax, whether it was a substantial understatement or whether any defenses might be applicable based on disclosures made or opinions received at the partner level). Again, the substantive results should be the same as if amended returns had been filed for all years affected by the information reported on the adjusted K-1. Procedurally, however, the law would continue to require that the substantive adjustments be reported on a form or schedule included with the taxpayer s current year return and paid or credited as adjustments to the taxpayer s liability il for that year. As a policy matter, there does not appear pea ar to be any reason to impose a higher her deficiency cy interest rate for partners using the adjusted K-1 Locating Former r Partners procedure. re Post-enactment legislative history, regulations or corrective legislation should clarify that if an adjusted K-1 is sent by the partnership on a timely basis to the partner s last address known to the partnership, with a copy to the IRS, no entity-level tax under New Code Sec should be applicable. If the address is not correct, the IRS can generate a letter to the taxpayer to the last-known address the IRS has on file based on the partner s taxpayer identification number. Here too, if there are errors in complying with the adjusted K-1 process, the entity-level tax should apply only to any portions of the adjustment as to which an adjusted K-1 was not properly issued. State and Local Tax Issues Except where substantially all of the partners have similar state and local tax obligations, the payment of an entitylevel tax does not seem well suited to dealing with state or local tax liabilities arising out of a federal adjustment. Thus, it would not appear to be productive for state or 26 JOURNAL OF PASSTHROUGH ENTITIES JANUARY FEBRUARY 2016

5 local governments to impose an entity-level tax, even if one is paid at the federal level. If the adjusted K-1 process is not elected, the partnership would appear to have sufficient information to provide its direct partners with the information that an adjusted K-1 would have included. States and localities may seek to collect additional taxes at the partner level based on that information. However, that may not be workable for multitier entities. For these reasons, states and localities may be expected to consider legislation that would encourage the use of the adjusted K-1 procedure. That is another reason why it may become the default rather than the option. For situations when the adjusted K-1 process is elected, states and localities may decide to amend or clarify their statutes or regulations to provide that the payment of an additional current federal income tax, relating back to the correction of an original K-1 for a prior year, triggers a corresponding obligation to pay any additional state or local taxes that would have been due if the original K-1 had been correctly filed. It is to be hoped that those amounts can also be calculated and paid with a current state or local return. Issues for Investment Fund Managers and Partners Although the statute is only effective for audits of partnership tax years beginning ng after 2017, it is not too soon on to start analyzing, negotiating ing and drafting any necessary changes to partnership agreements, side agreements ements or arrangements or disclosures. In particular, the statute requires the partnership to appoint a partnership representative for all dealings with the IRS. From the manager s perspective, a partnership representative, or a partnership manager responsible for appointing and directing the activities of a partnership representative, would want the maximum degree of authority and flexibility that could reasonably be obtained without incurring potential liability for any actions or decisions that might be questioned by direct or indirect partners. In contrast, new or existing partners might wish to constrain the actions or authority of a partnership representative. Thus, the issues that partnerships may need to address will be business issues as well as technical tax issues. They generally fall into four categories. Obtaining and Maintaining Exemption Where Appropriate Although the new rules may not be that onerous, any partnership that is eligible to opt out of the BBA rules altogether or that might become eligible if changes were made to its structure should certainly consider that option. 7 If a partnership is eligible to elect out, the entity s governing agreement should indicate the circumstances in which such an election will be mandatory, permissible or forbidden, as well as the person responsible for making any decisions in that regard. Of course, as a practical matter, the opt-out election will not be available to most investment funds since most of them will have at least one partnership as a partner. For the same reason, portfolio companies that are partnerships for tax purposes will be unable to opt-out. Accordingly, even if a fund were eligible for exemption itself, it may be indirectly subject to the new rules and may have to consider their implications with respect to audit adjustments made with respect to a lowertier entity that is not exempt. In addition, entities that are currently eligible for exemption may wish to consider restrictions on actions that would jeopardize that status. That would include admitting (whether by issuance of the transfer of existing interests) an excessive number of partners; admitting nominees, grantor trusts or disregarded entities as nominal partners that prevent the partnership from identifying the number and status of the beneficial owners; or admitting as partners any persons other than individuals, C corporations or their non-u.s. equivalents, or S corporations and, in the latter case, maintaining knowledge or control over the number of their shareholders. ho For example, if a partnership has two partners, an individual iv and an S corporation, it appears ars that the S corporation could not have more than 98 (or possibly 99) partners. Electing Out of the Entity-Level Tax or Allocating Its Cost For partnerships that are subject to the new rules for tax years beginning after 2017 or earlier if they make an appropriate election it may be desirable to impose a general mandate that the partnership representative elect to apply the adjusted K-1 rules of New Code Sec in the event the partnership receives a notice of final partnership adjustment (or an adjusted K-1 from a lower-tier partnership treated as if it were a notice of final partnership adjustment). This will completely avoid any of the problems associated with the payment of an entity-level tax. In some cases, however, the payment of an entity-level tax may be preferable to all concerned. The difficulty will be developing guidelines or procedures for identifying those cases and dealing with the economic and business issues caused by the payment of any material amount at the entity level. JANUARY FEBRUARY CCH INCORPORATED AND ITS AFFILIATES. ALL RIGHTS RESERVED. 27

6 PRIVATE EQUITY & HEDGE FUND CORNER In cases when the current and historical holdings of the partners are the same, one safeguard would be to provide that when the adjusted K-1 process is not elected, the partnership must provide meaningful communications to its partners regarding the status of any partnershiplevel proceedings (or lower-tier proceedings of which it is aware) and must ensure that any partner has the right to effectively opt-out of its share of the entity-level tax by filing an amended return reporting and paying any additional tax that results from a partnership adjustment. The cost of any remaining entity-level tax would then presumably be allocated to the partners that did not file such amended returns. Although the new rules may not be that onerous, any partnership that is eligible to opt out of the BBA rules altogether should certainly consider that option. In order to make an informed decision regarding the filing of an amended return, each partner will need to be notified of fhi his or her share of the proposed adjustment and the amount of tax xto be paid by the partnership thereon if he or she does not file an amended return. If an amended ed return at the partner level is properly perl filed and the partnership or its representative esen e communicates cates that fact to the IRS in a timely fashion (generally not more than 270 days after the issuance of a notice of proposed partnership adjustment), the portion of any adjustment properly allocable to the partner who files an amended return is excluded in the computation of any entity-level tax. As a result, if the entity-level tax is paid with respect to other amounts, the associated cost should be allocated entirely to those partners who do not file such amended returns. If a partnership adjustment involves a reallocation of income, this amended return option gives relief to the partnership only if such returns are filed by all partners affected by that adjustment. Accordingly, if partners benefitting from the reallocation file amended returns, but those facing detriments do not file or do not pay the required amount of added partner-level tax, the cost of the resulting entity-level tax should presumably be allocated to the latter partners. In situations where the holdings of current and former partners are not the same, guidelines could provide that certain types or amounts of proposed adjustments may be satisfied with an entity-level tax. For example, 90 percent of the current partners might be historical partners in the year under audit, while 10 percent were not, having purchased their partnership interests from the historical partners. In that event, it might be desirable for the tax law to allow and for the partnership agreement to allow the partnership to pay an entity-level tax with respect to the 90 percent of the adjustment relating to the current partners who were partners in year under audit (and to allocate the cost of that tax to those partners) and to issue adjusted K-1s with respect to the historical partners who sold their 10-percent interest sometime after the year under audit. As written, the statute does not appear to allow a partnership to elect New Code Sec only for certain portions of an adjustment. As suggested above, a technical correction to permit this may be appropriate. Representing the Partnership in Its Dealings with the IRS or the Courts As described above, the new rules will preclude partners from obtaining separate representation, or representing themselves, before the IRS or the courts in any proceeding to review the correctness of the partnership return. Instead, a single partnership representative who need not be a partner in the partnership will be responsible for representing the interests of all direct and indirect partners in a single administrative or judicial proceed- ing, the results s of which will be binding on all direct and indirect partners. Regulations will l provide more detail on the manner of selecting ecti and replacing the representative as far as the IRS is concerned. From the point of view of the partnership and its partners, either state law or the partnership agreement will otherwise determine how these issues are handled. Apart from the manner in which the representative is appointed, partnership agreements may need to expressly address the powers, responsibilities, potential liabilities of the person selected as the partnership representative and any appropriate indemnifications. At a minimum, the possibility that the partnership representative will take actions not favored by any current or former partner or even by a majority of partners may need to be disclosed. Indeed, even partners in partnerships that have validly elected out of the BBA rules should be advised of the consequences that may arise if their partnership acquires a partnership interest in another partnership that is audited under the new rules, unless such investments are proscribed. Although the new tax law may not require the partnership or the partnership representative to provide partners with notice of any tax inquiries, audits or adjustments at 28 JOURNAL OF PASSTHROUGH ENTITIES JANUARY FEBRUARY 2016

7 the partnership level, it may be worth considering whether the partnership agreement should require something along those lines. Aside from these generalities, this seems to be the most difficult and complex aspect of dealing with the new rules, and it would be impossible to list all of the possible conflicts that may arise, let alone address how they might be handled. Perhaps the most obvious concern is that a partner disproportionately affected by a possible proposed adjustment may have different concerns and strategic preferences than other partners. This is particularly the case in any issue related to allocations. In addition, any former partner may have interests in the favorable resolution of an audit that may conflict with the interests of current partners who may wish to minimize the costs of dealing with the controversy. 8 Reserves to address the cost of dealing with IRS audits may need to be considered. In some cases, when issues of this nature arise or can be anticipated, appropriate action may be considered on an ad hoc basis. Dealing with Terminated or Defunct Partnerships As explained above, the election to issue adjusted K-1s is the safety valve that makes the BBA rules workable. Practically, it should probably be viewed as the baseline or default assumption su of what partnerships can be expected to do, unless a partnership affirmatively decides to pay yan entitylevel el tax. To make the process work smoothly for multi-tier ier arrangements, angem some cooperation may be needed on the part of partnerships, ps, partners, practitioners and the IRS. The system should work well as long as no audited partnership is terminated or liquidated before it is audited, and no intervening partnership that was an upper-tier partnership to an audited partnership is terminated or liquidated before it receives any adjusted K-1 issued by a lower-tier partnership. Partnerships and partners should accordingly endeavor to ensure there are arrangements in place in the case of any terminated or liquidated partnerships to represent the partnership if it is audited and to issue adjusted K-1s to its historical partners in the event a terminated partnership receives an adjusted K-1 from a lower-tier partnership. If no one is left to perform this function, the IRS appears to have the authority to issue adjusted K-1s on behalf of a defunct partnership, so as to keep the information flowing through a tiered arrangement. New Code Sec provides that, If a partnership ceases to exist before a partnership adjustment under this subchapter takes effect, such adjustment shall be taken into account by the former partners of such partnership under regulations prescribed by the Secretary. In the case of an intervening partnership that is issued an adjusted K-1 after it ceases to exist, the regulations should authorize and require the IRS to issue adjusted K-1s to that entity s historical partners based on the allocations of income in the original return. In simple cases, that should be readily obtainable from the face of the original returns. Similar action may need to be authorized if the recipient of an adjusted K-1 is a partnership that has duly elected out of the new rules. In more complex cases, some assistance from the preparer of the original returns may be needed. Nevertheless, it would probably be more prudent for partnerships that are liquidating or terminating to make their own arrangements. In that regard, regulations could provide that a partnership may continue to exist solely for purposes of these procedural rules even if has no assets and no partners. Although the new partnership audit rules will affect all partnerships, investment funds will be on the front lines in dealing with their implications both as investment entities and as investors in other partnerships. Accordingly, partnerships rs should consider arrangements or restrictions designed d to ensure e that they are not on the receiving end of a potentially delayed or incorrect adjusted K-1 because a lower-tier partnership has ceased to exist but has not made arrangements to deal with these issues. In addition, funds should consider similar arrangements for cases where they cease to exist, so as to be considerate of the interests and concerns of their investors. Other Questions That May Arise How Will the Enactment of These New Rules Affect Audit Rates? Some may anticipate that the rate at which new audits are initiated will slow down until audits commence with respect to tax years beginning after 2017.The IRS may not wish to devote more resources to administering an inefficient process soon to be obsolete. Of course, that may not be the case for any egregious situations in tax years beginning before Once the new rules are effective, the anticipation of Congress was certainly that audit rates would increase. JANUARY FEBRUARY CCH INCORPORATED AND ITS AFFILIATES. ALL RIGHTS RESERVED. 29

8 PRIVATE EQUITY & HEDGE FUND CORNER However, the long-term effects may depend on how much noncompliance the IRS actually discovers in new audits that it does undertake. In addition, the IRS may conclude that many potential errors in the returns of large partnerships are self-correcting at either the partnership level or the partner level, under the provisions of subchapter K, within a reasonable period of time. How Will the Enactment of These New Rules Affect Tax Compliance? It is unclear, and probably impossible to know, precisely how the revenue associated with the legislation was expected to arise. Was it actual collections from additional audits, or was it improved voluntary compliance on original returns because of an increased risk of audit? Conversely, it is also possible that the greater ease with which partnerships may pay an entity-level tax to resolve an audit could lead some partnerships to take return positions as to which there is sound authority, but which they might have eschewed under the TEFRA rules solely for reasons of administrative convenience. What Are the Drop Dead Dates for Modifying Agreements or Making gel Elections? It tca can be argued that there is no need, under the tax law, to make any amendments to any existing partnership agreements, ents, inasmuch as the authority to take any needed ed actions (such hasa appointing poin a partnership representative rese and making any appropriate discretionary decisions) is inherent in state law. On the other hand, as a practical business matter, new or existing partners, partnerships and partnership managers may need to start addressing needed changes almost immediately. What Considerations Apply to the Option to Elect into Early Application of the New Rules? It appears that such a decision need not be made, at the earliest, until returns are filed in 2017 for the 2016 tax year. Even then, there may be substantial uncertainties as to how the law will operate. The IRS might be well advised to allow taxpayers that are selected for audit of their 2016 returns to elect into the new rules at the time an audit commences if they are so inclined. Conversely, some partnerships might wish to assure their partners that they will not elect early application of these rules or to notify them if they intend otherwise. If an Entity-Level Tax Is Paid, How Should It Be Treated Under Subchapter K and the Agreement? To the extent the entity-level tax corresponds to a tax benefit enjoyed by a current partner who was a partner in the year under audit, considerations of fairness suggest that an allocable portion of the tax should be treated as a cost specially allocated to that partner. The partner s capital account would thus be reduced accordingly, and his or her outside basis should also be reduced, in much the same way if it were a deemed distribution. Otherwise, it appears that the entity-level tax should be allocated under the general rules of the agreement for allocating unanticipated costs or expenses. It may be advisable for the partnership agreement to specify these results or others that may be deemed appropriate. In addition, some interesting issues may be raised if current partners bear the economic cost of taxes on income properly allocable to historical partners. Th e payment of an entity-level tax also raises issues regarding whether and how the corresponding items of income, deduction, gain, loss or credit should be reflected in the returns of historical partners to whom such items would have been allocated if an adjusted K-1 had been issued. Indeed, the need to make such calculations, and communicate them to partners, may make the entity-level tax no less burdensome for taxpayers or the IRS than the adjusted K-1 procedure e under New Code Sec These issues s should also be reviewed. ew Will There Be Any New Nontax Requirements to Maintain Reserves, or to Disclose or Report Contingent Liabilities Associated with Uncertain Tax Positions? If the adjusted K-1 process is universally elected, the partnership has no responsibility for ensuring that the recipient of an adjusted K-1 pays any partner-level taxes imposed by New Code Sec It is to be hoped that this would eliminate any need for any cash reserves or for any financial statement disclosures. It might be preferable for regulations or legislation to allow the partnership agreement to make a protective election under New Code Sec on its tax return and for legislation to provide that the penalties for failing to file adjusted K-1s in that event would be the same as the normal penalties for failing to issue original K-1s, instead of an entity-level tax. 30 JOURNAL OF PASSTHROUGH ENTITIES JANUARY FEBRUARY 2016

9 Should Any Changes Be Considered for Subscription Documents? It may be desirable for prospective partners to provide the partnership with a designated agent to whom adjusted K-1s may be sent in the event the partnership interest is disposed of and the partner s address is not otherwise obtainable. Other procedures may also be considered to deal with this issue. In addition, as under current practice, complete information as to the nature and extent of any tax exemption enjoyed by a prospective partner should be obtained. Final Thoughts Although the new partnership audit rules will affect all partnerships, investment funds will be on the front lines in dealing with their implications both as investment entities and as investors in other partnerships. Although there will likely be further clarification of the new rules through technical corrections and regulations over the next two years, it is not too early for investment funds and their partners to consider modifications to their agreements, disclosures and operating procedures. ENDNOTES * Donald B. Susswein is one of the principal drafters of the September 2015 recommendations of the Tax Policy Advisory Committee of the Real Estate Roundtable regarding proposed legislation related to the partnership audit process, many of which were incorporated in the final legislation, most particularly the adjusted K-1 process now contained in New Code Sec See Susswein and McCormick, Fixing the Partnership Audit Process, TAX NOTES, October 5, 2015; Susswein and McCormick, Understanding the New Partnership Audit Rules, TAX NOTES, November 30, Act Sec of the Bipartisan Budget Act of 2015 (P.L ) was enacted on November 2, Many yofthe same section numbers are used for the existing TEFRA provisions and the new rules that will replace e them. To avoid confusion, references to New Code Sec. are to provisions ions of fth the Internal lr Revenue Code of 1986 ( Code ) as amended by the Bipartisan Budget Act of 2015 (P.L ), effective for tax years beginning after Dec. 31, References to Old Code Sec. are to the TEFRA provisions that are repealed for tax years beginning after Dec. 31, References to Code Sec. are to provisions of the Internal Revenue Code of 1986, as amended, that are unaffected by the repeal and replacement of the TEFRA partnership rules. 2 In addition to changes to audit procedures, this new law completely removes all rules regarding the tax treatment of electing large partnerships, thus reverting those entities to a status similar to partnerships that had not made the election. 3 Unless otherwise indicated by the context, all references herein to partnerships and partners are intended to refer also to LLCs and other entities treated for tax purposes as partnerships and their members. 4 Technically, the tax is imposed at the higher of the top individual or top corporate income tax rate. Currently and for the foreseeable future, that would be the top individual rate. As explained more fully below, the top individual income tax rate does not include any amount with respect to self-employment or net investment income taxes. 5 Tax Policy Advisory Committee of The Real Estate Roundtable, Improving the Partnership Audit Process (Sept. 2015). 6 Donald B. Susswein and Ryan PMc P. McCormick, Fixing the Partnership Audit Process, 149 TAX NOTES 123, October 5, 2015, at Partnerships eligible to elect out may do so on an annual basis, when the partnership return is filed. To be eligible, all of the 100 or fewer partners must be individuals, C corporations, foreign entities that would be taxed as corporations if they were domestic entities, estates of deceased partners or S corporations (with each shareholder counted as a partner in applying the limitation to 100 or fewer partners ). A partnership electing out would presumably need to ensure that it has properly identified the actual partners that might be holding interests through any nominees, grantor trusts or other disregarded entities. Presumably grantor trusts and single-member LLCs would be disregarded for this purpose. While the S corporation rule apparently permits S corporations to have trusts as shareholders, with each such trust presumably counted once against the 100-partner limitation, partnerships whose partners include trusts (other than disregarded grantor trusts, presumably) are not eligible to elect out, except to the extent the Treasury issues regulations that treat trusts in a manner similar to the way S corporations are treated. Thus, some arrangements an may be restructured to include an S corporation on partner through which h a trust could invest in the partnership without t its losing the ability to elect out. Incidentally, the concept of a passthrough partner, indirect partner or notice partner does not exist in the new law. 8 Thus, the potential for conflict between current and former partners may also create the need to address these issues as part of the negotiation process related to the sale or redemption of partnership interests. This article is reprinted with the publisher s permission from the JOURNAL OF PASSTHROUGH ENTITIES, a bi-monthly journal published by Wolters Kluwer. Copying or distribution without the pub lish er s permission is pro hib it ed. To subscribe to the JOURNAL OF PASSTHROUGH ENTITIES or other Wolters Kluwer Journals please call or visit CCHGroup.com. All views ex pressed in the articles and col umns are those of the author and not necessarily those of Wolters Kluwer or any other person. CCH Incorporated. All Rights Reserved. JANUARY FEBRUARY CCH INCORPORATED AND ITS AFFILIATES. ALL RIGHTS RESERVED. 31