Where the buck stops

One lawyer describes it as “a huge change.” Two years ago Congress upended how the Internal Revenue Service treats partnerships when it overturned statutes in place since 1982. Before the Bipartisan Budget Act of 2015 the tax body audited partnerships, but had to collect revenue from the individual partners, a costly and time-consuming process. Instead, the BBA allows the IRS to collect monies directly from the partnerships, and in January, the Treasury proposed regulations as to how it will enforce the new law.

In a sense, the BBA shifted the administrative burden for collecting revenue from the IRS to GPs. In the event of an audit, any adjustments to the partnership’s income will be billed directly to the partnership. It will then be up to the GP to decide how best to gather the monies from its investors to pay that bill. There are some ways to lower those tax liabilities, or even “push them out” to the individual partners, but any such mechanism comes at a cost. The proposed regulations also create unexpected issues that could be hard to resolve. The BBA now requires the GP appoint a single person with a US presence and who can’t be removed from that position until an audit is underway, to serve as a liaison with the IRS. The new rules also free GPs from any requirement to report audits to LPs, leaving investors to negotiate their own powers with regards to audits and any response to them. And the way to opt out of this new regime altogether isn’t applicable to most private equity funds in the market.

Thankfully, these new rules only apply to audits of 2018 and beyond. And since the proposed regulations arrived just before the presidential inauguration, they were put on hold as part of the administration’s temporary freeze on new regulations. But the industry is already gearing up to address the proposed rules despite the reprieve.
“A lot of LPAs and side letters are currently being negotiated to address concerns about the BBA’s new rules,” says Dan Meehan of the law firm Kirkland & Ellis. No matter how the regulations change, the BBA still overturns major elements of the longstanding Tax Equity & Fiscal Responsibility Act, passed in 1982.

Under TEFRA, the IRS could audit a partnership, but was forced to collect any additional revenue from the individual partners. “That sometimes meant going through chains of partnerships to find the taxpayer, for relatively small pools of revenue,” says Kat Gregor of the law firm Ropes & Gray. “They were sometimes spending more to collect the tax than they were getting in payments because it was so dispersed.”

The BBA now allows the IRS to collect the revenue from the partnership itself. “It’s a huge change,” says Jeremy Naylor of the law firm Cooley. “Until now, the partnership was only a flow-through entity, but under new rules, the tax is imposed on the partnership itself.”

The proposed regulation also frequently favors the IRS over the taxpayer. Lawyers find the Treasury’s interpretation of the BBA has taken a broad view of the statute, to include as much of the larger partnership world under this regime as possible, with few exceptions.

“In reading the statute, we assumed the partnership tax liabilities would only include adjustments to income and loss, but the IRS will consider any resulting income tax, even if the adjustment is to another partnership item,” says Gregor. “For example, if the IRS changes the allocation of liabilities between partners, that could change how much suspended losses a partner is able to deduct from a prior year, and suddenly the IRS can run a calculation that will create imputed tax liability and charge it to the partnership.”

Release valves

There are a few mechanisms to lighten the liabilities now charged to the partnership. The first and perhaps most reliable one allows a partnership to transfer the tax status of the underlying partners in calculating that bill. “The code allows the GP to import the tax attributes of individual partners – say, a tax-exempt investor, a non-US investor or individuals who are subject to a lower capital gains rate,” says Rafael Kariyev of the law firm Debevoise & Plimpton. “However, all a partnership can take into account is the type of an investor, and not things like net operating losses that one partner may have.”

The second relief mechanism involves pushing out the liabilities to the individual partners, essentially forcing the IRS to go back to collecting revenue from the underlying partners. But there are limits. “Partnerships that elect to push out liabilities should be aware that if one of their underlying investors is a partnership, the IRS’s view is that underlying partnership can’t push it out to their underlying partners,” says Kariyev.

That liability, then, can only be pushed out from one partnership to another partnership once, and doing so has a cost. “The push-out election imposes a higher interest rate on the payment, which has to be weighed against any administrative burden the partnership will bear,” says Naylor. “Perhaps the liability is small when compared to the administrative burden, so using this relief mechanism may depend on a given circumstance.”

But such relief mechanisms are already being negotiated in limited partnership agreements and side letters for new funds, with a few LPs demanding that the GP always push out all liabilities to ensure they can take advantage of their tax-exempt, or otherwise favorable status.

“More often than not, however, investors are granting GPs certain authority to consider all factors – including the amount of the liability and the cost of a push-out or other alternative mechanism – in deciding how to proceed,” says Meehan.

Obviously, the thorniest issue is how the partnership will finally collect the funds to pay any liabilities that arise out of an audit. “The rules don’t say anything about how that liability gets shared and leaves it up to the partnership,” says Naylor.
So even if the audit was of the taxable year 2018, the partnership will be responsible for paying any adjustments whenever the audit is complete, which could be much later, long after some partners have left with their distribution in hand.

“Fund sponsors now need mechanisms in their partnership agreements or transfer agreements that establish a continuing liability, even after people leave or withdraw funds, so that the partnership can claw back any money in the event of a liability for a year when they were present,” says Naylor.

As expected, a tax-exempt or non-US investor wants to ensure they aren’t somehow charged for a liability they could otherwise avoid. “LPAs may now include language that requires commercially reasonable efforts to allocate the economic burden of such liabilities to the right partners,” says Meehan.

The limits of a loophole

The IRS did build ways for some partnerships to opt out of the new regime altogether, allowing any partnership with fewer than 100 partners to be exempt. But before firms get excited, the exemption won’t be granted to any partnership that has an underlying partnership as a partner, ruling out almost all private equity funds.

“Even in the case of the rare partnership consisting of a few individuals and S-Corps, its eligibility can be voided if any of the underlying partners change their tax status,” says Gregor. Given the strict nature of this opt out, lawyers expect most GPs to fall under the new regime, which may actually solve some current problems.

For example, now the partnership must appoint a single individual, called a partnership representative, to deal with the IRS directly, but the new rules afford real flexibility in selecting that person. “Under the old TEFRA rules, a ‘tax matters partner’ was required to liaison with the IRS, but there were some questions about a GP serving that role if they didn’t have economics in the fund,” says Kariyev. “Now just about anyone can serve as the partnership representative.”

This makes some LPs anxious. “Theoretically, this means someone without a fiduciary duty to the fund is negotiating on its behalf with the IRS,” says Meehan. “So, some LPAs are spelling out who can be that partnership representative.”

Under the proposed regulations, the only requirement for a representative is that they have a physical presence in the US, essentially an office and phone number, so they can meet with the IRS if necessary. But this trips up funds based offshore. “We have a China funds practice and these fund sponsors don’t have offices in the US,” says Naylor.
“However, given the flexibility granted to who can serve as a partnership representative, some accounting firms or fund administrators might soon offer that service to clients.”

While the regulations offer flexibility in appointing a representative, they make it difficult to change representatives over the life of a fund. Once the audit begins, the partnership can revoke the appointment, but that still takes 30 days to take effect.
The problem with this arrives in the likely event that the individual who serves as the representative leaves or is fired from the firm before the IRS launches an audit: when the IRS sends them the paperwork, “there are no statutory requirements for that person to notify the firm about that audit,” says Gregor.

Foolproofing the reps

Lawyers offer two ways to address these concerns. One, regulations permit an entity to be appointed as the representative, provided there is an individual within that entity named to be the rep. “By naming an entity as the rep, any audit documents will arrive at the entity’s address even if the specific representative has left,” says Gregor.
Next, there should be contractual obligations negotiated with the representative so that they are required to update the firm and follow any sponsor’s directive, even after they step down or leave.

But one of the biggest changes wrought by the passing of the BBA concerns a GP’s obligations to LPs once an audit starts.

“Under TEFRA rules, partners have significant rights to step into a proceeding and take a position that’s different from the tax matters partner, which was the current version of the partnership representative,” says Gregor. “Now Treasury says they won’t mandate any rights for partners, so they’ll have to negotiate for their own rights to notice or participation in a partnership proceeding.”
However, GPs might not be too keen to alert every LP in the event of an audit. “One compromise is that GPs resolve to inform the LP advisory board of such events,” says Meehan. Lawyers are finding LPs negotiating for greater control during these audits, having once relied on TEFRA’s default regulations to protect these rights.
And these conversations are taking place over proposed, not yet final, regulations.
“The future is still unknown,” says Gregor. “The regulations haven’t been reissued or released in the Federal Register.” Most lawyers expect greater clarity by the end of the year, just before the first day of 2018, when these rules come into effect.
“Even before final regulations arrive, it’s important to note that the IRS is likely gearing up to audit partnerships,” says Kariyev. “That’s what these changes are designed to do.” ?

Under the radar

The new provisions surprised the industry when they were included in the Bipartisan Budget Act of 2015.
They were initially proposed in Congress during the summer of that year, and one lawyer explained that since it seemed to come out of left field, industry groups didn’t expect it to go far. But that December, the new audit regime was tapped as a “revenue raiser”.
As a result, the legislation passed without the usual debate and industry feedback. Since then, it’s been up to the Treasury to figure out how best to implement it. Though regulations proposed in January are currently on hold, few expect them to be scrapped as the BBA is already signed into law.