Fund managers may not be aware of their new role during an IRS audit of companies with partnered members.
The new centralized partnership audit regime (CPAR) introduced by the Bipartisan Budget Act (BBA) started with the 2018 tax year.
Under the old rules, there was no mechanism for the IRS to collect tax at the partnership level when issuing an IRS audit adjustment. Instead, the IRS had to seek payment of underpaid tax directly from partnership members. The old rules left the IRS with the inability to effectively collect tax from partnerships that have dozens, or even hundreds, of minority members.
The CPAR resolves the issue by allowing the IRS to collect tax directly from a partnership and shifts the responsibility for the collection of tax to the partnership.
Under Sec. 6221(b), certain partnerships are eligible to elect out of the BBA annually. If electing out, the IRS would generally make any adjustment relating to the partnership’s return in an audit of a partner, not an examination of the partnership. The partnership would not owe any taxes, interest or penalties.
A partnership can elect out of the CPAR if the partnership meets specific eligibility requirements. A partnership is eligible within a tax year if it has 100 or fewer eligible partners. Eligible partners are individuals, C corporations, S corporations, foreign entities that would be C corporations if they were domestic entities, and estates of deceased partners.
A partnership is not eligible if it is required to issue a Schedule K-1 to any of the following partners:
- Other partnerships
- Disregarded entities
- An estate of an individual other than a deceased partner
- Any person who holds an interest in the partnership on behalf of another person
- Foreign entities that would not be treated as a C corporation were it a domestic entity
With these restrictions, fund managers will often find that their fund does not meet the eligibility requirements to elect out of the CPAR based on the composition of the fund’s investors.
Role of the Partnership Representative
Section 6223 of the code provides that unless the partnership has made a valid election out of the CPAR, each partnership must designate a partner or other person with a substantial presence in the U.S. as the partnership representative who shall have the sole authority to act on behalf of the partnership.
If an entity is designated as a partnership representative, the partnership must also appoint an individual to act on the entity’s behalf (a designated individual). To be a designated individual, the appointed person must also have a substantial presence in the U.S.
The partnership representative (or designated individual) can be the fund manager or any other individual, such as a CFO or controller. With the CPAR allowing the IRS to make tax assessments and collections of tax, interest and penalties at the partnership level, there are a few issues for fund managers and partnership representatives to consider:
- Should the private placement memorandum (PPM) or LLC operating agreement be updated?
- Can the fund withhold the tax from current year distributions, and what effect would that have on the fund’s yield?
- Will a prior-year tax liability be shouldered unevenly by the current investors whose composition has changed through the admittance of new investors, or can the tax be specially allocated?
- How to plan for the collection of taxes from investors who have already redeemed their investment from the fund
LLC Operating Agreement Revisions
Fund managers should review their PPM and LLC operating agreements with their legal counsel and tax advisors. Suggested changes include, but are not limited to, the following:
- Replacement of a “tax matters partner” with a “partnership representative”
- A statement that under section 6223, the partnership and its members are bound by actions of the partnership representative in dealings with the IRS
- The elections or opt-outs that the partnership representative may make
- That the designation for a partnership tax year remains in effect until the designation terminates
- The partnership being held responsible for remittance of additional tax rather than individual partners being taxed
- Current partners may be held responsible for the tax liabilities of prior partners
- A disclosure that the taxes, interest and penalties would be calculated based on the highest tax rates
The 2018 IRS Data Book published in May 2019 accounts for the number of IRS examinations in 2018 of the 2017 tax year. Out of the 195 million tax returns filed in 2018 for the 2017 tax year, only 8,945 partnerships were selected for audit. Compare that with the 892,187 of individual tax returns audited, and it is clear to see that the IRS saw little benefit in pursuing audits of nontaxable partnerships. The question arises of whether we will see the IRS increase the number of partnership examinations for 2018 and future tax years.