Reconciling GAAP Basis and Tax Basis in Partnership Income Tax Returns and K-1 Schedules FOR LIVE PROGRAM ONLY WEDNESDAY, JULY 25, 2018, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at 1-800-926-7926 ext.1 (or 404-881-1141 ext. 1). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x1 (or 404-881-1141 x1) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.
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Reconciling GAAP Basis and Tax Basis in Partnership Income Tax Returns and K-1 Schedules WEDNESDAY, JULY 25, 2018 Jeffrey N. Bilsky, Partner, National Tax Office BDO USA, Atlanta jbilsky@bdo.com Thomas A. Orr, CPA, Senior Manager BDO USA, Washington, D.C. torr@bdo.com
Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
GAAP, Tax, & 704(b) Capital Account Maintenance Jeff Bilsky, Partner, National Tax Office Tommy Orr, Senior Manager, National Tax Office
Agenda GAAP, Tax, & 704(b) Capital Account Reporting Required Reconciliations for Tax & 704(b) Basis Capital Account Reporting Detailed Reconciliation Example Financial Statement Implications for Partnerships (ASC 740, FAS 5) Including New Partnership Audit Rules 6
GAAP, Tax, & 704(b) Capital Account Reporting
GAAP, Tax, & 704(b) Capital Accounts GAAP vs. Tax vs. 704(b) Partnerships often maintain multiple capital accounts, including: - Section 704(b) Basis Capital Accounts: Reflect the partner s economic interests in the partnership. - Tax Basis Capital Accounts: Reflects the partner s interest in the partnership based on federal income tax principles. - GAAP Basis Capital Accounts: Determined in accordance with various financial accounting principles. Limited impact on Tax Basis and Section 704(b) Basis capital accounts. 8
GAAP, Tax, & 704(b) Capital Accounts GAAP vs. Tax vs. 704(b) GAAP Basis Capital (+ / -) GAAP to Tax Differences Tax Basis Capital (+ / -) Sec. 704(c) Adjustments Sec. 704(b) Basis Capital 9
GAAP, Tax, & 704(b) Capital Accounts Tax vs. 704(b) Section 704(b) Capital Increases: FMV of property contributions, including money Partner share of Section 704(b) income Positive Section 704(b) revaluations (book-ups) Decreases: FMV of property distributions, including money Partner share of Section 704(b) losses Negative Section 704(b) revaluations (book-downs) Tax Basis Capital Tax basis of property contributions, including money Partner share of taxable income No change due to Section 704(b) revaluations (book-ups) Tax basis of property distributions, including money Partner share of tax losses No change due to Section 704(b) revaluations (book-downs) 10
GAAP, Tax, & 704(b) Capital Accounts Effect of Liabilities on Section 704(b) Capital Assumption of partner liability by partnership treated as cash distribution. Includes contribution of property subject to liability Assumption of partnership liability by partner treated as cash contribution. Includes distribution of property subject to liability Changes to allocable share of partnership liabilities is not an assumption and has no effect on capital 11
GAAP, Tax, & 704(b) Capital Accounts Effect of Liabilities on Section 704(b) Capital Example: A Value Basis Building $100 $50 Mortgage ($ 60) ($60) $120 of AB s liabilities are allocable to A after the contribution. AB What is A s Capital Account? What is A s Basis in AB? 12
GAAP, Tax, & 704(b) Capital Accounts Effect of Liabilities on Section 704(b) Capital Value Basis Building $100 $50 Mortgage ($ 60) ($60) A $120 of AB s liabilities are allocable to A after the contribution. AB Capital = $100 Building Value - $60 Mortgage assumed by AB = $40 Basis = $50 Building Basis - $60 Mortgage + $120 Liability Allocation = $110 13
GAAP, Tax, & 704(b) Capital Accounts Effect of Liabilities on Section 704(b) Capital No increase for contribution of a partners own note until the note is sold or as principal payments are made. No decrease for distribution of the partnership s own note until the note is sold or as principal payments are made. If note is readily tradable on an established securities market the forgoing rules are inapplicable. 14
GAAP, Tax, & 704(b) Capital Accounts Revaluations Partnership may periodically revalue Section 704(b) capital accounts Regulations provide for Mandatory and Optional revaluations Revaluations must reflect fair market value of partnership property at the date of revaluation Allocation of book-up or book-down adjustment must reflect the way the unrealized gain or loss would be allocated if recognized Revaluations have no impact on tax basis of assets therefore create additional Section 704(c) layers Revaluations generally have no GAAP impact, but transactions that trigger purchase accounting rules may have a similar impact (i.e. partnership merger) 15
GAAP, Tax, & 704(b) Capital Accounts Revaluations Mandatory Revaluations Partnership is required to revalue distributed assets immediately before the partnership distributes property to any partner Partnership is required to revalue capital accounts immediately after an exercise of a noncompensatory option Optional Revaluations Partnership may choose to revalue capital accounts upon certain events: - Contributions of money or property for a partnership interest - Liquidation or distribution as consideration for a partnership interest - Grant of a partnership interest as consideration for services rendered - Issuance by the partnership of a noncompensatory option, or - Generally accepted industry accounting practices (hedge funds) 16
GAAP, Tax, & 704(b) Capital Accounts Determination of Section 704(b) Income GAAP Income is the typical starting point Determine Taxable Income by adjusting for M-1 items Determine Section 704(b) Income (economic income) by adjusting for differences between tax basis and Section 704(b) basis Section 704(b) basis may not equal tax basis as a result of property contributed with values different than tax basis and Section 704(b) revaluations Differences between Section 704(b) and Tax basis are addressed through 704(c) allocations 17
GAAP, Tax, & 704(b) Capital Accounts Impact of Section 704(c) Section 704(c): Income items with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. - GAAP, Tax, & 704(b) Capital reconcile variances between Tax Basis and Section 704(b) Basis - Built-in gain or loss on the sale of contributed property must be allocated back to the contributing partner - Tax depreciation/amortization on contributed property is allocated first to the non-contributing partner in an amount equal to the partner s Section 704(b) depreciation 18
GAAP, Tax, & 704(b) Capital Accounts Impact of Section 704(c) Section 704(c) rules apply to: - Contributions of property where the Section 704(b) value (FMV) is not equal to the tax basis ( Forward Section 704(c) Layers ) - Book up or down adjustments caused by Section 704(b) revaluations ( Reverse Section 704(c) Layers ) - Possible to have multiple Forward and Reverse Section 704(c) Layers 19
GAAP, Tax, & 704(b) Capital Section 704(c) Depreciation Allocation Methods Traditional Method Allocations are limited to the tax items associated with the contributed property. Ceiling rule limitations are not fixed, and the built-in gain shifts to noncontributing partners. Traditional Method with Curative Allocations Start with the traditional method Reallocate other partnership items to overcome ceiling rule Other items must generally have the same effect as depreciation. Remedial Method Provide correct amount to non-contributing partners. If figure that exceeds total tax items, contributing partner picks up offsetting income. 20
Tax Allocations & Economic Effect 22
Tax Allocations & Economic Effect General Rules Section 704(a): Except as otherwise provided in the Code, a partner s share of partnership income items is determined by the partnership agreement. Section 704(b): A partner s share of income items is determined in accordance with the partner s interest in the partnership ( PIP ) if the allocations per the partnership agreement do not have Economic Effect. Regulations provide that the allocations must also be Substantial. Section 704(c): Income items with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. 23
Tax Allocations & Economic Effect Safe-Harbor Allocations Economic Effect An allocation must be consistent with the underlying economic arrangement of the partners. Partners that are allocated income or loss must ultimately bear the economic benefit or burden associated with the allocations Regulatory Safe-Harbors - General Test for Economic Effect - Alternate Test for Economic Effect - Economic Effect Equivalence Allocations that do not meet a regulatory safe-harbor are allocated based on the partner s interest in the partnership ( PIP ) 24
Tax Allocations & Economic Effect Safe-Harbor Allocations General Test for Economic Effect 1. Partnership maintains Section 704(b) Capital Accounts; 2. Liquidating distributions made in accordance with positive Section 704(b) Capital Accounts; and 3. Partners have obligation to restore any negative capital account balance (a Deficit Restoration Obligation or DRO ) Alternate Test for Economic Effect 1. Partnership maintains Section 704(b) Capital Accounts; 2. Liquidating distributions made in accordance with positive Section 704(b) Capital Accounts; and 3. In lieu of a DRO, the partnership agreement contains a Qualified Income Offset ( QIO ) provision Economic Effect Equivalence Partnership agreement does not satisfy the General or Alternate Test of economic effect. However, allocations are deemed to have economic effect if, as of the end of each partnership taxable year, a liquidation of the partnership at the end of such year or at the end of any future year would produce the same economic results to the partners as would occur if the General Test of economic effect had been satisfied. 25
Tax Allocations & Economic Effect Safe-Harbor Allocations Substantiality The economic effect of an allocation is substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. - Overall Tax Effect Rule: One partner benefits at the expense of another - Shifting Tax Consequences: The net increases/decreases in the partners' respective capital accounts won t differ substantially from the baseline allocations and the aggregate tax liability of the partners will be reduced - Transitory Allocations: There is a possibility that original allocations will be largely offset by offsetting allocations, providing there is a strong likelihood that the net increases/decreases in the partners' capital accounts won t differ substantially from the baseline allocations and the total tax liability of the partners will be reduced in present value terms 26
Tax Allocations & Economic Effect Targeted or PIP Allocations In General Liquidating distributions are not based solely on the partner s Section 704(b) Capital Accounts General and Alternate Test of Economic Effect cannot apply Targeted Allocations may have Economic Effect Equivalence or may be in accordance with PIP Profits & loss allocations (including gross income) are generally made in the amounts necessary to ensure ending Section 704(b) Capital Accounts reflect the partner s liquidating distribution rights 27
Tax Allocations & Economic Effect Targeted Allocations Safe-Harbor Allocations Capital Account Beginning $50 Income/(Loss) $100 Ending Capital Calculated Targeted Allocations Capital Account Beginning $50 Income/(Loss) Distribution Rights Calculated $150 28
GAAP, Tax, & 704(b) Capital Accounts GAAP Capital In Summary Client financial data generally comes as GAAP financial statements, so you will already have total GAAP capital to begin The GAAP amounts by partner are generally presented on the schedule K-1s as the partner s ending section 704(b) capital ratio times total ending GAAP capital Difference between GAAP and 704(b) capital will result based on the schedule M-1/M-3 differences as well as any 704(c) amounts Additional differences may result from liabilities that exist for GAAP purposes but not for tax or 704(b) purposes The same event may give rise to GAAP/704(b) differences (i.e. a purchase accounting transaction for GAAP purposes treated as a carryover basis transaction for tax purposes, partnership consolidated for GAAP purposes but stand alone for tax purposes, etc.) 29
Detailed Reconciliation Example 30
GAAP, Tax, & 704(b) Capital Exercise Exercise 1, Part 1 Individuals A, B and C form equal partnership ABC. A contributes depreciable equipment worth $18,000 with a basis of $9,000 subject to a $8,000 liability. B contributes land with a basis of $7,200 and value of $10,000. C contributes $10,000 cash. In the first year of operations, ABC earns GAAP net income of $10,000. In the first year tax and book depreciation are $3,000 and $5,000, respectively. The traditional method is chosen to apply section 704(c). Determine the section 704(b) and tax basis capital accounts. 31
GAAP, Tax, & 704(b) Capital Exercise 704(b) Book A B C Contribution Income Depreciation Tax Basis A B C Contribution Income Depreciation 32
GAAP, Tax, & 704(b) Capital Exercise A contributes depreciable equipment worth $18,000 with a basis of $9,000 subject to a $8,000 liability. 704(b) Book A B C Contribution 10,000. Income Depreciation Tax Basis A B C Contribution 1,000. Income Depreciation 33
GAAP, Tax, & 704(b) Capital Exercise B contributes land with a basis of $7,200 and value of $10,000. 704(b) Book A B C Contribution 10,000. 10,000. Income Depreciation Tax Basis A B C Contribution 1,000. 7,200. Income Depreciation 34
GAAP, Tax, & 704(b) Capital Exercise C contributes $10,000 cash. 704(b) Book A B C Contribution 10,000. 10,000. 10,000. Income Depreciation Tax Basis A B C Contribution 1,000. 7,200. 10,000. Income Depreciation 35
GAAP, Tax, & 704(b) Capital Exercise GAAP to Tax Income Conversion: GAAP Net Income 10,000 GAAP Depreciation 5,000 Taxable Income Before Depreciation 15,000 Tax Depreciation -3,000 Taxable Income 12,000 Tax to 704(b) Income Conversion: Taxable Income Before Depreciation 15,000 704(b) Depreciation (Tax depr. on $18,000 of basis) -6,000 704(b) Net Income 9,000 36
GAAP, Tax, & 704(b) Capital Exercise In the first year of operations, ABC earns taxable income of $15,000 before tax depreciation on the equipment of $3,000. 704(b) Book A B C Contribution 10,000. 10,000. 10,000. Income 5,000. 5,000. 5,000. Depreciation Tax Basis A B C Contribution 1,000. 7,200. 10,000. Income 5,000. 5,000. 5,000. Depreciation 37
GAAP, Tax, & 704(b) Capital Exercise 704(b) Depreciation is proportionate to tax depreciation: Equipment Tax Depr./ Tax Basis = $3,000 / $9,000 = 1/3rd Equipment 704(b) Depr. = 1/3 x $18,000 = $6,000 704(b) Book A B C Contribution 10,000. 10,000. 10,000. Income 5,000. 5,000. 5,000. Depreciation (2,000) (2,000) (2,000) 13,000. 13,000. 13,000. Tax Basis A B C Contribution 1,000. 7,200. 10,000. Income 5,000. 5,000. 5,000. Depreciation 38
GAAP, Tax, & 704(b) Capital Exercise Under the traditional method, tax depreciation is allocated first to the non-contributing partners to match 704(b) depreciation, but only to the extent of tax depreciation 704(b) Book A B C Contribution 10,000. 10,000. 10,000. Income 5,000. 5,000. 5,000. Depreciation (2,000) (2,000) (2,000) 13,000. 13,000. 13,000. Tax Basis A B C Contribution 1,000. 7,200. 10,000. Income 5,000. 5,000. 5,000. Depreciation (0) (1,500) (1,500) 6,000. 10,700. 13,500. 39
GAAP, Tax, & 704(b) Capital Exercise Under the remedial method, tax depreciation is allocated first to the non-contributing partners to match 704(b) depreciation whether or not there is enough tax depreciation 704(b) Book A B C Contribution 10,000. 10,000. 10,000. Income 5,000. 5,000. 5,000. Depreciation (2,000) (2,000) (2,000) 13,000. 13,000. 13,000. Tax Basis A B C Contribution 1,000. 7,200. 10,000. Income 5,000. 5,000. 5,000. Depreciation* 1,000. (2,000) (2,000) * Remedial Method 7,000. 10,200. 13,000. 40
GAAP, Tax, & 704(b) Capital Exercise Under the curative method, tax depreciation is allocated first to the noncontributing partners using the tradition method, and other items are reallocated to make up for any shortfall 704(b) Book A B C Contribution 10,000. 10,000. 10,000. Income 5,000. 5,000. 5,000. Depreciation (2,000) (2,000) (2,000) 13,000. 13,000. 13,000. Tax Basis A B C Contribution 1,000. 7,200. 10,000. Income 6,000. 4,500. 4,500. Depreciation* 0. (1,500) (1,500) * Curative Method 7,000. 10,200. 13,000. 41
GAAP, Tax, & 704(b) Capital Exercise Assuming the GAAP contributions were equal to fair market value, the same as 704(b) capital, the GAAP capital should be as follows GAAP Books A B C Contribution 10,000. 10,000. 10,000. Income 5,000. 5,000. 5,000. Depreciation (1,667) (1,667) (1,666) 13,333. 13,333. 13,334. In this example income and depreciation are broken out for consistent presentation, the full net income would be allocated in proportion to ownership in this case 42
GAAP, Tax, & 704(b) Capital Exercise Exercise 1, Part 2 On the first day of year 2, the value of land has increased to $16,000 and the company has created goodwill value of $30,000. Partner D is admitted as an equal partner in exchange for a $25,000 cash contribution. What are the 704(b) capital accounts immediately after D s admission If the partnership agreement calls for revaluations? If the partnership agreement does not call for revaluations? 43
GAAP, Tax, & 704(b) Capital Exercise With Revaluation A B C D Beginning 13,000. 13,000. 13,000. 0. Revaluation Gain Contribution Without Reval. A B C D Beginning 13,000. 13,000. 13,000. 0. Revaluation Gain Contribution 44
GAAP, Tax, & 704(b) Capital Exercise The value of land has increased by $6,000 to $16,000 and the company has created goodwill value of $30,000 ($36,000 unrealized gain) With Revaluation A B C D Beginning 13,000. 13,000. 13,000. 0. Revaluation Gain 12,000. 12,000. 12,000. 0. Contribution Without Reval. A B C D Beginning 13,000. 13,000. 13,000. 0. Revaluation Gain Contribution 0. 0. 0. 0. 45
GAAP, Tax, & 704(b) Capital Exercise Partner D is admitted as an equal partner in exchange for a $25,000 cash contribution. With Revaluation A B C D Beginning 13,000. 13,000. 13,000. 0. Revaluation Gain 12,000. 12,000. 12,000. 0. Contribution 25,000. 25,000. 25,000. 25,000. 25,000. Without Reval. A B C D Beginning 13,000. 13,000. 13,000. 0. Revaluation Gain 0. 0. 0. 0. Contribution 25,000. 13,000. 13,000. 13,000. 25,000. 46
GAAP, Tax, & 704(b) Capital Exercise The partnership sells all its property shortly after D s admission for $100,000 and distributes the proceeds in accordance with the Capital Accounts (ignore pre-sale activity) With Revaluation A B C D Beginning 25,000. 25,000. 25,000. 25,000. 704(b) Gain on Sale Final Distribution Without Reval. A B C D Beginning 13,000. 13,000. 13,000. 25,000. 704(b) Gain on Sale Final Distribution 47
GAAP, Tax, & 704(b) Capital Exercise The partnership sells all its property shortly after D s admission for $100,000 and distributes the proceeds in accordance with the Capital Accounts (ignore pre-sale activity) With Revaluation A B C D Beginning 25,000. 25,000. 25,000. 25,000. 704(b) Gain on Sale 0. 0. 0. 0. Final Distribution Without Reval. A B C D Beginning 13,000. 13,000. 13,000. 25,000. 704(b) Gain on Sale Final Distribution 9,000. 9,000. 9,000. 9,000. 48
GAAP, Tax, & 704(b) Capital Exercise The partnership sells all its property shortly after D s admission for $100,000 and distributes the proceeds in accordance with the Capital Accounts (ignore pre-sale activity) With Revaluation A B C D Beginning 25,000. 25,000. 25,000. 25,000. 704(b) Gain on Sale 0. 0. 0. 0. Final Distribution 25,000. 25,000. 25,000. 25,000. Without Reval. A B C D Beginning 13,000. 13,000. 13,000. 25,000. 704(b) Gain on Sale 9,000. 9,000. 9,000. 9,000. Final Distribution 22,000. 22,000. 22,000. 34,000. 49
Partnership Audit Rules 51
Partnership Audit Rules Overview Bipartisan Budget Act of 2015 (the BBA ) significantly changes the way in which partnerships are audited: Applicable to tax years beginning after 12/31/2017 Default rules apply to ALL partnerships Small partnerships may be eligible to elect out Audits are conducted at partnership level Unfavorable audit adjustments result in an imputed underpayment obligation payable by the partnership Favorable audit adjustments allocated out to the partners in the year the audit is completed Push-out election eliminates partnership s obligation to satisfy the imputed underpayment obligation 52
Partnership Audit Rules Overview Small Partnerships (those with 100 or fewer eligible partners) may elect out of the new rules In order to elect out, partnerships must make an annual affirmative election and disclose required partner information Eligible Partners: - Individuals - C-corporations - Foreign entities that would be treated as a C-corporation if domestic - S-corporations (each shareholder is counted for purposes of determining the 100 partner limit) - An estate of a deceased partner Ineligible Partners: - Partnership entities, i.e., upper-tier partnerships - Trusts - Disregarded entities such as singlemember LLCs and grantor trusts - Estate of an individual other than a deceased partner - Nominee partner
Partnership Audit Rules Overview (Net Positive Adjustments * Highest Tax Rate) Adjusted Credits Step 1: Partnership first groups its adjustments into (i) Reallocation Grouping; (ii) Credit Grouping, or (iii) Residual Grouping Step 2: Partnership adjustments within each grouping/sub-grouping are then netted. Netted amounts resulting in a non-positive adjustment are disregarded for purposes of calculating the imputed underpayment. Step 3: The total netted partnership adjustment calculated in Step 2 is multiplied by the highest effective federal tax rate under section 1 or section 11. Step 4: The product resulting from Step 3 is then reduced, but not below $0 by the net adjustments to partnership credits. 54
Partnership Audit Rules Overview Audit Adjustments Residual Grouping Credit Ordinary Capital Grouping Sub-Group Sub-Group Increase Ordinary Income 200.00 - - Decrease Depreciation Expense 30.00 - - Increase Long-Term Capital Gain - 75.00 - Decrease Long-Term Capital Loss - 50.00 - Decrease Tax Credit - - 2.00 Total Audit Adjustments 230.00 125.00 2.00 Assumed Highest Tax Rate 40% 40% Initial Imputed Underpayment 92.00 50.00 2.00 Imputed Underpayment Obligation Imputed Underpayment (Ordinary Sub-Group) 92.00 Imputed Underpayment (Capital Sub-Group) 50.00 Imputed Underpayment - Residual Grouping 142.00 Add: Credit Grouping 2.00 Net Imputed Underpayment 144.00 55
Partnership Audit Rules Overview Audit Adjustments Residual Grouping Credit Ordinary Capital Grouping Sub-Group Sub-Group Increase Ordinary Income 125.00 - - Decrease Long-Term Capital Gain - (125.00) - Decrease Tax Credit - - - Total Audit Adjustments 125.00 (125.00) - Assumed Highest Tax Rate 40% 0% Initial Imputed Underpayment 50.00 - - Imputed Underpayment Obligation Imputed Underpayment (Ordinary Sub-Group) 50.00 Imputed Underpayment (Capital Sub-Group) - Imputed Underpayment - Residual Grouping 50.00 Add: Credit Grouping - Net Imputed Underpayment 50.00 56
Partnership Audit Rules Overview Reallocation Grouping Audit Adjustments Partner A Sub-Group Partner B Sub-Group Reallocate Ordinary Income 30.00 (30.00) Reallocate Depreciation Expense (70.00) 70.00 Total Audit Adjustments (40.00) 40.00 Assumed Highest Tax Rate 0% 40% Initial Imputed Underpayment - 16.00 Imputed Underpayment Obligation Imputed Underpayment (Partner A Sub-Group) - Imputed Underpayment (Partner B Sub-Group) 16.00 Imputed Underpayment - Residual Grouping 16.00 57
Partnership Audit Rules Overview In lieu of the default payment rules the partnership can elect to push-out the imputed obligation to its partners. Reviewed year partners are liable for tax, penalties and interest on their respective shares of partnership adjustments Reviewed year partners are bound by the election and must take the adjustments into account and report and pay additional tax, penalties and interest A partnership making the push-out election must furnish statements to the reviewed year partners with respect to the partner s share of the adjustments and file those statements with the IRS The rate of interest imposed on the underpayment is increased by two percentage points creating a surcharge to use the push-out method Under proposed regulations, make push-out election through multiple tiers 58
Partnership Audit Rules Overview Reallocation Grouping Audit Adjustments Partner A Sub-Group Partner B Sub-Group Reallocate Ordinary Income 30.00 (30.00) Reallocate Depreciation Expense (70.00) 70.00 Total Audit Adjustments (40.00) 40.00 Assumed Highest Tax Rate 0% 40% Initial Imputed Underpayment - 16.00 Imputed Underpayment Obligation Imputed Underpayment (Partner A Sub-Group) - Imputed Underpayment (Partner B Sub-Group) 16.00 Imputed Underpayment - Residual Grouping 16.00 59
Partnership Audit Rules Overview Partnerships are required to have a person function in the role of partnership representative ( PR ). The PR has sole authority to act on behalf of the partnership All partners are bound by the actions of the PR and they have no right to contradict its decisions. This broad authority cannot be limited by state law, the partnership agreement or any other document or agreement The PR does not have to be a partner but can be any person, including an entity, as long as it has a substantial presence in the United States and the capacity to act The proposed regulations require a partnership to designate the PR on the partnership s return filed for each taxable year If a partnership fails to designate a PR the proposed regulations allow the IRS to select a PR 60
Partnership Audit Rules Considerations Entity Structure Specific considerations vary based on entity characteristics GP Manager Limited Partners Common considerations Partnership agreement amendments Legacy Partners Equity Investor Corporate Partner Risk assessment of existing positions for partners/partnerships Transactional considerations (i.e., enhanced due-diligence) Operating Partnership Financial statement impact 61
Partnership Audit Rules Considerations Legacy Partners GP Manager Entity Structure Equity Investor Operating Partnership Limited Partners Corporate Partner CONSIDERATIONS Not eligible to elect out because Equity Investor is an ineligible partner Should not have ASC 740 exposure but consider FAS 5 liabilities Consider due diligence exposure if potential candidate for capital transaction Increased reporting requirements for investors to assess tax risk (and reserves) Amend partnership agreement Imputed underpayment obligation risk assessment Analyze capital accounts and allocations Develop information needed by partners for ASC 740 or due diligence purposes 62
Partnership Audit Rules Considerations Legacy Partners GP Manager Entity Structure Equity Investor Operating Partnership Limited Partners Corporate Partner CONSIDERATIONS Not eligible to elect out because GP Manager is an ineligible partner Consider ASC 740 implications if issuing audited financial statements Consider due diligence exposure if potential candidate for capital transaction Assess LP indemnification potential (and fund indemnification for LPs) Consider co-investor rights and obligations Amend partnership agreement Imputed underpayment obligation risk assessment Analyze capital accounts and allocations Financial statement impact analysis 63
Partnership Audit Rules Considerations Legacy Partners GP Manager Entity Structure Equity Investor Operating Partnership Limited Partners Corporate Partner CONSIDERATIONS Evaluate possible ASC 740 exposure resulting from imputed underpayment obligations at the partnership level Exposure exists regardless of whether Operating Partnership decides to pay the imputed underpayment obligation directly or make the push-out election Financial statement impact analysis Understand potential exposure from investment in Operating Partnership 64