Pass-through tax entities beware! Under the Bipartisan Budget Act (“Act”),¹ beginning in tax year 2018, by default, partnerships (and entities choosing to be taxed as a partnership for federal income tax purposes)² will now be responsible for the income tax underpayments, interest and penalties of its partners. If you own an interest in a pass-through tax entity, now is the time to speak with your counsel to determine how the company’s partnership agreement can be updated to navigate, and possibly bypass, the new auditing laws.
I. Partnership Level Auditing and Assessment.
Traditionally, a partnership is not taxed at the entity level. Instead, accounting decisions are made at the partnership level and the netted income is allocated to the partners, who individually report and pay tax on their respective share. Should the IRS later audit the partnership and determine an erroneous deduction or other accounting error was made at the partnership level, all adjustments made to the partnership’s income for the audited year would be reallocated to the partners, who would then be responsible for amending their individual tax returns and paying any additional tax, interest and penalties.
Under the Act, the same partnership level accounting decisions and income allocation will occur. However, if the IRS audits a partnership and decides an adjustment to the partnership’s income is appropriate, the partnership, not the partner, will be assessed the underpayment.
The idea is efficiency. The IRS does not want to find an error at the entity level and then have to chase thirty partners for payment. Instead, the Act empowers the IRS to audit and assess the partnership directly, leaving the task of collecting (or not collecting) from the partners to the partnership.
While efficiency is achieved for the IRS, the Act creates some unsettling scenarios for partners. One, ownership changes happen. If a partner sells his or her interest after the tax year under review but before the year of assessment, the current partners can become responsible for what would have been the individual tax obligation of a person who is no longer a partner of the entity. Another reality is that partners can be subject to varying financial circumstances. $50,000 of partnership income allocated equally to two partners might result in drastically different tax liabilities, because each partner might have other sources of loss and income for the year. Under the Act, the partnership is not given the opportunity of circumstance. Instead, the adjusted income allocated to the partnership is taxed at the highest possible individual tax rate for the tax year being reviewed.
Luckily, the Act provides two elections that partnerships can make to avoid the scenario of placing a tax burden on an entity which, by its very nature, is not directly subject to tax.
a. § 6221 Opt-Out Election.
Under § 6221 of the Act, a partnership may opt out of the partnership level assessment rules on Form 1065 in every year for which it is eligible.³ A § 6221 election is a proactive decision by the partnership that should the tax year for which the election is made later come under review by the IRS, any adjusted tax, interest and penalties assessed will be the obligation of the partners, not the partnership. Essentially, a § 6221 election retains the status quo prior to the Act.
To be eligible to make a § 6221 election, the partnership must:
- have 100 or less partners for the tax year; and
- be comprised only of partners which are any of the following: an individual, C Corporation, S Corporation, an estate of a deceased partner, or a foreign entity that would be treated as a C Corporation were it domestic.
An eligible partnership making a § 6221 election must then notify its partners of the election and disclose each partner’s name and tax payer identification number to the IRS.
b. § 6226 Push Election.
Alternatively, if a partnership is not eligible for a § 6221 election, or if it fails to make the election for a tax year which is later audited, the partnership may elect to push all liability assessed on the partnership to the partners.
A § 6226 “push” election must be made within 45 days of the partnership receiving notice of a final partnership adjustment. When the election is made, the partnership details how the final partnership adjustment is to be allocated among the partners and tells the IRS to look to the partners for collection. The partners then have the obligation to make and pay the adjustments as prescribed in § 6225 of the Act.
c. Partnership Agreement Amendments
Navigating these new partnership auditing waters requires a review of and possible revisions to the tax provisions in your partnership agreement.
To avoid uncertainty, default procedures and courses of action can be placed in the agreement. For example, provisions can be added which prohibit the partnership from having ineligible partners under § 6221 and requires the partnership to make the § 6221 election for every year in which it is eligible. Making this decision retains the status quo prior to the Act and lessens the possibility of a partner presenting self-interested tax decisions as the best course of action for the partnership when a § 6226 election is called for a vote. Indemnity provisions can also be added to afford additional protection by requiring partners to repay the partnership for any assessments made against the partnership due to the under reporting of taxable income.
II. Partnership Representative.
Similar to the familiar “tax matters partner/member,” § 6223 of the Act creates the new position of Partnership Representative (“PR”).
The PR has the sole authority to bind the partnership regarding partnership level auditing and assessment decisions. The PR is not required to be a partner, and to the extent the partnership has not elected a PR, the IRS may choose a PR for the partnership.
As if the IRS choosing your company’s PR is not scary enough, by default, a PR has no duty to inform or consult the partnership about the tax matters the IRS has brought to the PR’s attention. Without the appropriate provisions in a partnership agreement establishing affirmative duties and limitations, the partnership and its partners are effectively at the mercy of the PR.
Therefore, a partnership should consider the following provisions regarding the PR: (i) the procedure by which the PR is appointed/removed, (ii) whether the entity should require the PR to be a partner, (iii) the PR’s duty to inform the partnership, and (iv) any limitations on the PR’s ability to bind the partnership, e.g. only after a vote of the partners.
III. Final Thoughts.
Each business is unique, and the elections discussed in this article may or may not be appropriate for your business’s circumstances. Regardless, such a significant change in the norms to the partnership taxing structure warrants a discussion with your counsel about the effectiveness of your current partnership agreement or operating agreement to navigate these changes.
*This article is for general informational purposes only and is not intended as or a substitute for legal advice.
¹ 26 USCS § 6221, et seq.
² This article speaks in terms of partnerships, partners and partnership agreements. This article is equally applicable to owners and the operational documents of all entities which are taxed or choose to be taxed as partnerships, such as: limited liability companies, limited partnerships, family partnerships, S Corporations, etc.
³ A § 6221 election is made on Line 25 of Schedule B. If the § 6221 election is not made, the partnership is directed to designate a “Partnership Representative,” discussed in Section II of this article.