In the summer of 2015, the private equity industry was facing an unexpected challenge. Lawmakers were frustrated by an apparent inability of the Internal Revenue Service (IRS) to effectively audit large multiple-tier partnerships. Some even proposed to solve the government’s problem by taxing large partnerships as corporations. To help pay for an important highway funding measure, a proposal was floated to impose an entity-level tax on large partnerships found to have understated their income.
This change to the “pass-through” nature of these entities could have made for drastic changes to the private equity, investment management, and real estate industries – all of whom rely on large or multi-tiered partnerships or LLCs.
Donald Susswein, a principal at audit, tax and consulting firm RSM US, explains: “The private equity industry, as well as the investment management industry as a whole, dodged a bullet. There was a serious concern on Capitol Hill that investors in these entities were immune from IRS audits. The risk was that Congress would respond by imposing a tax on the partnership itself. But the administrative issues were very complex. Unless someone figured out how to make that possible, Congress might have simply thrown up their hands and decided to tax them as corporations.”
That would have been very problematic to the investment management industry. “Even if they had only imposed an entity-level tax on audit adjustments,” he adds, “that could have shut off new investments in these industries, at least temporarily.”
Fortunately, Susswein explains, the bill introduced in June was killed by effective lobbying from the private equity industry and others. But the issue was not dead and buried. That is because the IRS apparently had some legitimate problems that Congress would not ignore forever.
First, merely to start an audit was very cumbersome for the IRS. Complex rules required the issuance of notices to many of the audited partnership’s investors, who were theoretically allowed to represent themselves in any partnership-level proceedings. That was relatively easy and painless for Congress to fix, by requiring that the partnership speak with one voice – one representative who could bind all of the partners. The IRS would only have to notify and deal with a single human being. In most cases, that is what happens anyway with large partnerships.
A second problem was more serious, and had stumped the IRS and outside experts for years. In the case of a multiple-tier partnership, the IRS would typically be auditing a lower-tier partnership that had upper-tier partnerships as its direct and indirect partners. In many cases, the partnership being audited had no way of identifying all of the direct and indirect partners that were ultimately responsible for paying taxes on an understatement revealed by the audit at the lower level. And that meant the IRS also had no easy way of figuring out who to bill for the missing tax. The stakes were potentially quite high. Government economists estimated that billions of dollars of unpaid taxes could be collected if partnership audits could be simplified. Some estimated that new partnership audit rules could raise a billion dollars per year.
There was also a potential downside. If no one could figure out a solution – if tiered partnerships were effectively audit proof – it would be another argument for those who wanted to tax partnerships as corporations for all purposes. Susswein was one of several tax experts who, sensing the problem would not go away, worked to develop a mechanical solution that partnerships would find workable.
He and Ryan McCormick, senior vice president and counsel of the Real Estate Roundtable, were the principal drafters of comments on the original bill that advanced a novel pro-taxpayer idea. Instead of an entity level tax, any partnership that was audited could simply send a new, modified K-1 to its partners, including any partnerships that were partners, who would do the same thing for the next tier of investors, until the information was delivered to the ultimate taxpayers – the individual or corporation at the top of the chain.
Then, instead of the ultimate taxpayer filing an amended individual or corporate return, which few would find acceptable, the taxpayer would simply add another form to his next year’s individual or corporate return and pay any added taxes or interest due on account of the prior year underpayment. If it were a very small amount, like $100, an individual partner would probably just pay a flat $39.60. If the amounts were larger, the partners could pay the exact amount that would have been due in the year under review – which might be reduced by deductions or losses. Congress and its staff agreed that this would be an acceptable substitute for the entity-level tax, and included it as an option in final legislation that was enacted in November. That law will govern IRS income tax audits of partnerships after 2017.
Understanding the new rules
Three basic new rules were included in the Balanced Budget Act of 2015 (BBA).
The first rule allows the IRS to deal with a single person who is the designated representative of the partnership and all of its direct and indirect partners, for issues arising out of that partnership. Thus, all direct and indirect partners will be bound by the results of the audit and any subsequent proceedings, for matters arising out of the partnership’s audit, eliminating the need for the IRS to issue notices to anyone other than the appointed partnership representative.
Second, if the partnership has no objection, the new rules will allow the IRS to collect – from the partnership — the approximate amount of partner-level tax underpayments resulting from changes to the partnership’s return. In some cases that will actually be a desirable option for the partnership.
Third, if the partnership wants to elect out the entity-level tax, it can relieve itself of all liability simply by issuing new K-1s to its partners. If any of its partners are partnerships themselves, it is anticipated that they will do the same, on through the tiers.
This is essentially what happens every year at tax time – the private sector ensures that the information gets through to the ultimate taxpayer. The ultimate taxpayers will then be required to add a schedule to their next, regular tax return. The schedule would compute the taxes due as if the error had been made on the original return for the year under audit, but payment would only be required on the next regularly scheduled tax return. For example, if no added taxes would have been due in the original return, had it been prepared correctly, that will be reflected in the schedule and the partner’s tax burden will be zero. That might be the case if the taxpayer were tax-exempt or had enough losses or credits to eliminate the tax.
“In an ideal world, from the taxpayer’s perspective, there would never be any partnership tax audits,” Susswein explains. “But that is unrealistic with partnerships playing a much greater role in the economy than ever before.” This seems to be a compromise that is workable from the industry perspective, many believe, that also addresses the legitimate concerns of the IRS, but does not unduly encroach on the traditional “pass-through” nature of partnerships and LLCs.
The BBA rules apply to all partnerships and entities taxed as partnerships, for taxable years after 2017, which means that the first audits under the rules likely to start no earlier than late 2019 or 2020, on returns filed in 2019. So-called “small” partnerships with 100 of fewer total direct and indirect partners that are individuals or corporations – no partnerships in the tiers – may elect out and be audited strictly at the individual partner level.
What funds should watch for
Even with a delay until 2018, most partnerships and LLCs will need to review and possibly revise their agreements, sooner rather than later.
“The problem is not the technical tax issues, or even the collection issues like issuing a modified K-1, but the business issues associated with the audit itself,” Susswein explains. “With one representative for the partnership and all of its current and former partners, the parties will have to decide who will call the shots. Not everyone has the same interest in how a tax controversy is resolved.”
For example, current partners may be indifferent to adding to a former partner’s tax burden. And fund managers may wish to be indemnified for any liability arising out of their good faith dealings with the IRS. As a business matter, Susswein adds, “the sooner those business issues are addressed the better, so that no one develops unrealistic expectations.”