When the Balanced Budget Act of 2015 was passed, the private equity industry knew that it would change the way the Internal Revenue Service audits partnerships, though they were uncertain how those changes would be implemented.
The proposed regulations were introduced on January 18, only to be halted under President Trump’s executive order freezing any new regulations. In June, however, they were reintroduced with minimal changes. The new regime is still expected to apply to fiscal year 2018, despite the industry having major questions.
Under the BBA, the IRS collects any adjustments that arrive from an audit at the partnership level, rather than collecting from the partners as they do now. But the service collects that tax on the year they complete the audit, which could levy charges on partners that were not present during the audited year. This makes general partners responsible for maintaining the tax attributes of limited partners, assigning deductions and liabilities to the appropriate investor. The IRS does allow GPs to use the attributes of underlying LPs to reduce the charge, but the process to do so is unclear.
The law allows a GP to push out the tax to the partners, but right now, that can only be done at one tier, preventing any underlying partnerships from pushing it out again to their partners. So GPs and LPs are busy reviewing fund documents to find the right balance of flexibility and protections for a regime that leaves a lot of room for interpretation.
Even with those questions, market participants expect regulations are imminent. “It seems inevitable at this point that the rules will take effect in 2018,” says Mike Hauswirth, a tax director at PwC. “A delay of the effective date probably would require an act of Congress, which seems unlikely, due in part to the potential revenue cost.”
Ready or not…
The release of regulations in June was followed by a comment period that ended on August 14, and a hearing on the proposed regulations is slated for September. But there are questions as to how much the proposed regulations will change in the coming months.
What will not change are the broad parameters of the new regime, which allows the IRS to collect any adjustments at the partnership level. “The current system forces the IRS to collect underpayments that arise from a partnership audit from each individual partner, which can be an administrative burden,” says Kevin Valek, a private equity funds leader with KPMG. But the new regime under the BBA shifts that burden to the partnership instead.
Now, the IRS collects the tax from the partnership once the audit is complete, which is called the “adjustment” year. However, that could be years from the “review” year which is the fiscal year under audit. But what if there are partner transfers between the review year and the adjustment year?
“It’s not crystal clear who would bear the burden of that, so the default rule is that whoever is the partner at the time would suffer the burden of that adjustment,” says Gerald Whelan, a tax partner with EY. “So, we’re working with our clients and their fund counsel to make sure LPAs and other fund documents do this in an equitable fashion.”
This implies the need for some mechanism to allow any such liability to be collected from a partner even after they leave the partnership. “Agreements will need a clawback or indemnification agreement from the partners, so the partnership can fairly spread the tax obligation,” says Adrienne Baker, a partner at Dechert.
While GPs may be focused on being able to get taxes from the appropriate partner, LPs are focused on maintaining their tax status under the new regime. “Many tax-exempt and foreign investors want to ensure that GPs work with the IRS to import their tax attributes to reduce liabilities, and that the benefit of reduced taxes goes directly to them,” says Rafael Kariyev, a partner at Debevoise & Plimpton.
Such promises can be met, but it gets complicated when LPs have different priorities. “In the case of certain investors such as a fund of funds, they may ask to be exempt from amending prior filings,” says Jay Milkes, a partner at Ropes & Gray. The work for such complex partnerships to amend filings may not be worth the eventual savings.
Most LPs will want the benefit of their tax status, but the current regulations are not clear on how exactly to do so. “The statute permits a partnership to reduce an imputed underpayment by taking into account certain tax attributes of its partners, including tax-exempt status, but there are questions regarding how to document and report those tax attributes to the IRS,” says Todd McArthur, a principal with PwC.
Pushing past the problem
This new regime does give GPs an option to sidestep all these issues, by granting them the right to push out the tax to the partners of the year under audit, as long as they do it within 45 days of getting the final adjustment. Those partners would then include any adjustments to their current year’s filing, though they would pay a higher interest rate of two percentage points. However, current regulations stipulate is that if the tax is pushed out to a partnership – say, a fund of funds – that underlying partnership cannot push out the tax again to its own partners.
“The IRS has been reluctant to approve pushing out beyond one tier,” says McArthur. “Yet, in the proposed regulations in June it seemed aware of the issue, and are open to a roadmap for how multi-tier push-outs would work.” Allowing unlimited push-outs may leave the IRS pursuing individual partners in the wake of underpayments, making the new regime irrelevant.
“Essentially, the IRS wants the partnership to notify it which partners owe tax at those other tiers to help relieve the burden of collections,” says Kariyev. Market participants stressed that while the IRS may be willing to consider a “roadmap,” it doesn’t mean one will be in place by 2018.
Yet, the regulations will be. “I wouldn’t hold out on any technical corrections this year,” says Baker. “It’s time for people to dust off their partnership agreements and think about what to do here.”
What makes that effort a priority is the new regulations indicate the IRS will be taking a much closer look at partnerships in the future. “There’s an understanding that there will be an increase in partnership audits,” says McArthur. “The reason the statute was enacted was because the IRS was having a hard time auditing partnerships and Congress wanted to give them a tool to do so.” n