The New Partnership Audit Rules Presented by Abdon

The New Partnership Audit Rules Presented by: Abdon Rangel Managing Director – Houston

Learning Objectives • After completing this session, you should be able to: – Understand the new partnership audit rules – Use words such as “Partnership Representative, ” “Designated Individual, ” Push-out election, ” and “Pullin election” – Understand who can be a Partnership Representative and the importance of their role – Determine if a partnership can elect out of the rules

Overview • Summary • Prior Law • New Law in Detail • States’ reaction to new system • Drafting Inserts to address New Law

New Statutory Framework • Takes effect for taxable years beginning on or after Jan. 1, 2018 • Need to review your documents

Old Law • TEFRA (Tax Equity and Fiscal Responsibility Act) • ELP (Electing Large Partnership) • Tax Common Law: Pre-TEFRA Law

TEFRA Rules Summary • Partnership-Level Proceedings; – Partnership items addressed in unified partnership-level administrative and judicial proceedings. • TMP (Tax Matters Partner); – IRS interacts with TMP (who must be a general partner). • Notice, Participation & Settlement; – IRC gives partners rights to be notified of audit, participate, and dissent from settlement. • Adjustments Flow Through to Partners; – Partnership-level adjustments passed through to reviewed-year partners; everyone’s reviewed-year return gets to Correct Return Position. • Collection from Partners; – IRS computes amount everyone owes and then must collect from reviewedyear partners. • Statute of Limitations; and – IRS has 3 years from partnership’s filing date, which can potentially be extended by TMP (even as to partner-level “affected items”).

TEFRA Problems that Triggered Need for Change • Identification & Monitoring of Partners; – Very difficult task • Partner Participation; – Cumbersome intervention of numerous partners in proceedings, and widespread rights to initiate proceedings. – Procedural protections for partners complicate audits and invite litigation • Obstacles to Settlement; – IRS generally needs agreement of every partner to settle. • Partner Refund Claims for Corollary Adjustments; – Deficiencies in one year frequently give rise to refund claims in later years. • Multiplicity of Small Partner Adjustments; and – Costs of collecting small amounts from (or delivering refunds to) many partners can be prohibitive even if the amount is significant in the aggregate.

Problem: TEFRA Impact • Result: IRS audits few large partnerships, most result in no change to the partnership’s return, and the aggregate changes are small.

Electing Large Partnership (ELP) • ELP would pay the tax, but this was a voluntary system and there were very few volunteers. – Less than 1% of large partnerships elected to be ELPs.

Bipartisan Budget Act (BBA) Basics • Enacted November 2015 (minor technical corrections in December 2015) – Replaces TEFRA and ELP. • Applies to partnership returns filed for 2018 and later years. – Partnerships with less than 100 partners, all individuals or corporations, may elect out.

More BBA Basics • Audit is conducted at partnership level – Individual partners have no statutory right to receive notice, participate, or disagree with result. – Single representative, who need not be a partner, interfaces with IRS. • When audit concludes, IRS computes an “imputed underpayment” that the partnership owes to IRS. – Roughly equals understatement of income multiplied by the highest tax rate in effect for “reviewed year”. – Collection from partnership avoids need to track through tiers of partnerships to ultimate top-tier partners.

BBA is effective for • Taxable years beginning after Dec. 31, 2018 • Can elect in but why?

2018 Technical Corrections Act-Narrow scope • The Technical Corrections clarify that the partnership audit rules do not apply to taxes or require withholding under the self-employment tax or net investment income tax provisions, the nonresident alien and foreign corporation withholding provisions, or the FATCA (Foreign Account Tax Compliance Act) withholding provisions.

Section 6221(a) • Pre-2018 Technical Corrections: – Any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year (and any partner’s distributive share thereof) shall be determined, and any tax attributable thereto shall be assessed and collected, at the partnership level.

2018 Technical Corrections Act • Amend the scope of the provisions by changing the phrase, “income, gain, loss, deduction, or credit” and instead refer to “partnership related items, ” which is defined as – any item with respect to the partnership that is relevant in determining the income tax liability of any person, without regard to whether the item or amount appears on the partnership’s return and including an imputed underpayment and an item or amount relating to any transaction with, basis in, or liability of, the partnership

Section 6221(a) • Post 2018 Technical Corrections Act: – Any adjustment to a partnership-related item shall be determined, and any tax attributable thereto shall be assessed and collected, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to any such item shall be determined, at the partnership level

Section 6221(b) • Election out—will discuss later

Section 6222 • A partner’s return is to be consistent with the partnership’s return • Partner’s Return must be consistent with Partnership Return – If IRS then finds an error, the IRS can treat it as mathematical error so limited relief to the taxpayer unless disclose inconsistent treatment

Section 6223: Partnership Representative • Rules for designation of a partnership representative. • Under this provision, a partnership representative must be a partner (or other person) with a substantial presence in the United States. • If a designation is not in effect, the IRS may select any person as a partnership representative

Partnership Representative • Partnership must designate a “Partnership Representative” (PR); – “Tax Matters Partner” under TEFRA is gone. – Procedures to designate PR not announced • PR is not required to be a partner in the partnership; and • PR must be a “person” with “substantial U. S. presence”

August Final Regulations • On Aug. 6, the IRS issued final regulations governing the designation and authority of the partnership representative. • The final regulations are effective Aug. 9, 2018. • They added a great deal of clarification

Entity as the Partnership Representative • If Entity is chosen, then must chose a “Designated Individual” to act on the Entity’s Behalf – Designated individual must have substantial presence in the US – Who appoints this individual? § Partnership and not the entity – Must individual be employee of Entity? § No, but only find this in Preamble and not in the regulations itself

Form 1065 Designation Each Form 1065 requires indicating the: Partnership Representative and Designated Individual Can you change designation every year? YES, you designate for each year and are not bound to use the same person the next year

Can you designate a Disregarded Entity (DRE)? • Yes, DRE can be a Partnership representative provided that: – DRE must have substantial presence in the U. S. & – DRE must appoint a Designated Individual to act on its behalf

Can you designate the Partnership? • Yes, the partnership itself can be the Partnership Representative provided that – The partnership has substantial presence in the U. S. – Partnership must appoint a Designated Individual who has a Substantial Presence in the U. S.

Substantial Presence Clarified • Must make themselves available to meet with IRS in the U. S. at a reasonable time and place • Must have U. S. Street Address and Phone Number with U. S. Area Code – Dropped language that they can be reached at this phone number during normal business hours • Must have U. S. TIN • No safe harbor adopted

Deleted Capacity to Act requirement • Proposed regulations said if file for bankruptcy, certain other events happen or die, you lack the capacity to act and cease to be a Partnership Representative • Final regulations deleted this to give more flexibility

Changing a Partnership Representative or Designated Individual • Partnership can only change with the IRS after: 1) IRS mails a NAP (Notice of Administrative Proceeding); 2) In conjunction with Partnership filing a valid AAR (Administrative Adjustment Request); and 3) New--Partnership receives notification that the partnership return has been selected for examination. Otherwise, IRS does not want to be bothered.

Resignation of Partnership Rep or Designated Individual • Final regs. eliminated the ability of a resigning person to designate their successor. • Final regs. eliminated the ability of a resigning partnership rep cannot resign at the time of fling an AAR

Revocation of Partnership Rep or Designated Individual • Proposed regs. only allowed the GP or Managing Member to revoke – Final regs. now allow any partner to revoke. • Proposed regs. required revoking person to be a partner at end of year – Final regs. only require person to be a partner at any time during year – Final regs. allow revocation for any reason

Effective Date of Resignation/Revocation • Final regs make this now effective upon receipt by the IRS or if the designation was made by the IRS, upon acknowledgement by the IRS that the revocation was valid. – Since revocation is effective upon IRS receipt, not mailing, partnerships with a very urgent need to change their partnership representative should consider hand-delivery of their revocation to IRS personnel.

IRS Determination • An IRS designation that the Partnership Rep. is not effective will be sent to the Partnership and the most recent Partnership Rep

IRS Designation of Part. Rep. • Will not designate IRS employee, agent or contractor unless person is a partner • Otherwise, no restriction on who they may designate

Authority of Partnership Rep. • It is conclusive. • Partnership can enter into any contractual arrangement, but that does not affect IRS

Can someone join the Partnership Rep? • Yes, IRS does allow entering into a POA (Power of Attorney). – A partnership representative may engage another person (such as a CPA) to act on its behalf during the examination using the existing POA procedures.

Section 6225 • Addresses partnership adjustments & calculation of any resulting imputed underpayment • Section 6225(a) generally provides that amount of imputed underpayment resulting from adjustment must be paid by partnership.

Notice 2016 -23 • Request for Comments Regarding Implementation of the New Partnership Audit Regime Enacted as Part of the Bipartisan Budget Act of 2015

Section 6226 • Exception to the general rule under section 6225(a)(1) that the partnership must pay the imputed underpayment.

4 Methods to Reduce Amount Partnership Owes the IRS (1) § 6225(c)(2) (A) Amended Returns: One or more partners may elect to file an amended return (CRP) for reviewed year. – Reduces Imputed Underpayment the partnership owes. (2) § 6225(c)(3)/(c)(4) Reduction: Partnership may try to prove to IRS Exam that “highest rate of tax” is not appropriate rate based upon characteristics of partners. – Reduces Imputed Underpayment the partnership owes.

4 Methods to Reduce Amount (cont. ) (3) § 6226 Push-Out: partnership sends § 6226 notice to all reviewed-year partners telling them they must compute CRP and pay IRS directly. – Partnership entirely off the hook. --CRP = Correct Return Position: what reviewed-year partners would have owed, and their future-filed returns would show, if reviewed-year Form 1065 (and subsequent returns) had been consistent with audit results.

4 Methods to Reduce Amount (cont. ) (4) “Pull-in” Procedure adopted by 2018 Technical Corrections Act, § 6225(c)(2)(B): Allows partners to submit a recalculation of reviewed year tax liability (and intervening, affected years) This could get to the "right answer" without filing amended returns

“Pull-In” Procedure • Payment is due by the same deadline for filing amended returns - within period ending 270 days after the notice of proposed partnership adjustment was mailed • Partner must provide necessary information to IRS to substantiate tax was correctly paid but that amended returns where not filed • Effects on partners tax return limited to tax attributes such as basis

“Pull-In” Procedure (cont) • Does not require the participation of all direct and indirect partners • Partnership representative or the partnership’s accounting firm may collect all information and payments from partners who choose to use the pull-in procedure

Election Out for Small Partnerships • Partnerships with 100 partners or less can opt out of the entity-level partnership determination. – Partners must be individuals, C corporations, S Corporations or estates of deceased partners (no upper-tier partnerships). – S Corp. shareholders counted for purposes of 100 partner test.

Election out (cont. ) • If election is made, IRS must make determinations at the partner level (just like pre-TEFRA). • Drafting Points: – Should agreement mandate or preclude this election or revocation of election? – Should agreement restrict transfers so this election remains available? – Should agreement require the partnership to provide the partners the information they may reasonably request to respond to the audit of partnership items?

Partnership Level Determination and Assessment: Definitions • “Reviewed Year” -- Partnership tax year or return under audit • “Adjustment Year” -- Year in which the adjustment for the “reviewed year” – Becomes final under a court decision; – Year in which an adjustments is made pursuant to a request for administrative adjustment (partnership files a request for administrative adjustment); or – Year in which final partnership adjustment is mailed.

Definitions (cont. ) • “Imputed Underpayment Amount” -- Net non-favorable adjustments to the partnership tax year multiplied by the highest applicable tax rates under sections 1 and 11. • “Partnership Representative” -- Party selected to represent the partnership before the IRS and to make tax decisions on behalf of the partnership.

Partnership Level Determination • All partners are bound by a final resolution in the partnership proceeding. – Partners have no right to participate in proceeding or receive notice of proceedings from IRS although partner has right to file notice of inconsistent position. • Tax assessment is made for the Adjustment Year; not the reviewed year

Partnership Level Determination (cont. ) • Penalties determined at the partnership level; no partner level defenses to penalties. • Only partnership-level statute of limitations is relevant – partner statute of limitations no longer taken into account

What are the states doing?

Four States have acted (so far) • California recently joined a small group of states that have passed legislation conforming to federal partnership audit rules. – Arizona, Georgia and Hawaii have adopted legislation

California • California added a new section to the California Revenue and Taxation Code that requires a partnership to file a report with California when the entity is issued an adjustment under I. R. C. § 6225 because an item required to be shown on its federal partnership return is changed or corrected by the I. R. S. Each change or correction must be reported to the Franchise Tax Board (“FTB”) within six months of the final determination.

California (cont. ) • The new rules also include an option for partnerships to request a different election from their federal election, so long as the amount of tax is properly calculated and the partnership establishes to the satisfaction of the FTB that such election does not impede the state’s ability to collect taxes.

Other States • Arizona and Georgia require partnerships to report federal changes within 90 days. • Hawaii conforms to I. R. C. § 6221, 6222, 6223, 6225, and 6226, but has also specified that any election under I. R. C. § 6221(b) to not have audits assessed at the entity level for federal tax purposes is also effective for Hawaii state tax purposes.

Multistate Tax Commission (MTC) • The MTC is currently in the process of developing a model statute for states to incorporate conform to federal partnership audit rules, but it remains to be seen whether states will continue to adopt similar provision to the new federal partnership audit structure.

Drafting Your LLC/LP Agreements

Payment of Tax (cont. ) • (c) In the event that the Section 702(a)(8) income of the Company is decreased (or its Section 702(a)(8) loss is increased) as a result of the operation of Code § 6225 of the Code, such decrease (or increase in loss) shall be proportionately specially allocated to the Member or Members whose income was decreased (or loss increased) in the Reviewed Year.

Partnership Rep: Total Control (cont. ) • The Partnership shall reimburse the General Partner for all costs and expenses incurred by it in performing its duties as the partnership representative (including legal and accounting fees and expenses). • Nothing herein shall be construed to restrict the Partnership from engaging an accounting firm or a law firm to assist the General Partner in discharging its duties hereunder.

PA-Subject to Control by Board • With respect to taxable years beginning after Dec. 31, 2017, the Class A Member is hereby designated as the “Partnership Representative” of the Company pursuant to Code 6223. • The PA shall represent the Company in any disputes, controversies or proceedings with the Internal Revenue Service or with any state or local taxing authority. • The PA shall act at the direction of the Board of Managers with respect to any actions that it is permitted to take when acting in its capacity as the Partnership Representative, including (1) electing out of Subchapter C of Subtitle F, Chapter 63 under section 6221(b) of the Code, and (2) making the election under Section 6226 of the Code to have the Members take tax adjustments into account on their own tax returns.

PA-Subject to Control by Board (cont. ) • In the event that the Board is deadlocked with respect to an action of the PA, the PPA is authorized to act in its discretion, but where the interests of the Members diverge, the PA shall act in such a manner that it believes will minimize the overall tax liability of all Members. • If the PA, with the consent of the Board of Managers, decides to have the Members file amended tax returns pursuant to Section 6225(c)(2), all Members shall timely file and include payment of any tax due with such amended returns.

Choices as to What to do

Payment of Tax • SECTION X. 1. Payment and Refund of Tax. • (a) The Company shall timely pay any taxes due under Code § 6225. • Any amount paid by the Company under this Section X. 1 that is attributable to any Interest in the Company shall be treated as distributed to the holder of such interest at the time that the payment is made by the Company. • Any deemed distribution under this Section X. 1(a) shall be credited against distributions otherwise payable on such Interest. • For the avoidance of doubt, in the event that an Interest to which this Section X. 1 applies is held by a different Member during the Reviewed Year than in the Adjustment Year (as such terms are defined in the Code), the Member holding the Interest in the Adjustment Year shall be treated as receiving the distributions called for herein.

Payment of Tax (cont. ) • (b) In the event that the Company receives any refund of taxes paid pursuant to Section X. 1(a), such refund shall, to the extent feasible, be apportioned and distributed among the Members in such a manner as to offset the prior operation of Section X. 1(a).

Election Out -- Optional • SECTION --. Election out of the Partnership Audit Rules. • The Company shall take whatever steps necessary to make the election under Code § 6221(b) of the Code and any guidance issued thereunder so as not to be subject to Company level tax audit proceedings. • In the event that the Company is ineligible to make such election for any reason, [INSERT NAME] is hereby protectively designated as the “partnership representative” of the Company for any year in which the election under § 6221(b) is invalid. • In this capacity, [INSERT NAME] shall represent the Partnership in any disputes, controversies or proceedings with the IRS or with any state or local taxing authority and is hereby authorized to take any and all actions that it is permitted to take when acting in that capacity, including making the election under Code § 6226 to have the Partners take tax adjustments into account on their own tax returns.

Election Out (cont. ) • SECTION --. Audit Information Rights. • The Company shall, within thirty (30) days of receipt of a written request, make available to any Member (including a former Member), at such Member’s expense, any information such Member reasonably requests in connection with any federal, state, or local audit in connection with such Member's interest in the Company. • Each Member (including former Members) shall inform the Company of any adjustments to Company items that result from any audit of such Member within sixty (60) days of the close of such audit.

Partnership Rep: Total Control • With respect to taxable years beginning after Dec. 31, 2017, the General Partner is hereby designated as the “partnership representative” of the Partnership for any tax period under Code § 6223. • In this capacity, the General Partner shall represent the Partnership in any disputes, controversies or proceedings with the IRS or with any state or local taxing authority and is hereby authorized to take any and all actions that it is permitted to take when acting in that capacity, including making the election under Section 6226 of the Code to have the Partners take tax adjustments into account on their own tax returns.

Investor Representation – Possible but may not be business feasible • That such Member's tax status does not render the Company ineligible to make the 6221(b) Election. • Each Member further represents and warrants that it will not, for any period that it is a Member, elect a tax status inconsistent with such election, for example by electing to be taxed as a partnership under Regulations Section 301. 77013.

Transfer Restrictions • No Member shall transfer any part of its interest in the Company if such transfer would result in the Company becoming ineligible to elect out of Company level audit procedures under Code § 6221(b) (the “ 6221(b) Election”). • A Member who wishes to transfer its interest (1) to more than one person (or who wishes to transfer less than all of its interest to any person who is not a Member), or (2) who wishes to transfer its interest to an S corporation, must request the permission of the Company before such transfer becomes effective. • The Company shall grant permission unless the proposed transfer would render the Company ineligible for the 6221(b) Election. Any purported transfer in violation of this Section XXX is invalid and of no effect.

QUESTIONS? 69

Contact Information Abdon Rangel Managing Director, Houston abdon. rangel@andersentax. com +1. 832. 463. 4069