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The Current: New Audit Rules Could Have Broad Impact

Published by Forrest D. Milder on Friday, January 1, 2016

Journal cover January 2016   Download PDF

With relatively little fanfare, the Bipartisan Budget Act of 2015, which became law in November 2015, made massive changes to the rules that apply to federal income tax audits of partnerships. The new rules apply to tax returns for 2018 and later tax years, although taxpayers can elect earlier application if they wish. Recognizing that most tax equity investments in renewable energy make use of the partnership form of business, and that parties involved with transactions closing now will want their agreement to at least recognize the coming change in tax rules, it’s an ideal opportunity to consider an overview of the new provisions. Note that the new rules also apply to LLCs taxed as partnerships; in this discussion, references to “partnerships” also include such LLCs.

Why an Overview

A detailed summary of the new tax rules isn’t practical or even possible because the rules provide many open-ended provisions that are waiting for Internal Revenue Service (IRS) regulations or other guidance to provide actual procedures, forms, deadlines and so on. That’s not to say that all partnership or LLC agreements shouldn’t have at least some basic revisions, but it does mean that revisions made today may be revised again once the IRS publishes guidance and taxpayers and their advisors have the opportunity to reflect on what matters and which steps should be taken.

History

Before 1982, audits of partners were done on an individual basis, at great cost for multiple proceedings, and with the probability of inconsistent results. With the adoption of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), many partnership audits, particularly those involving partnerships that have partners which are themselves partnerships, became subject to the “TEFRA rules,” providing for one audit of the partnership, with one partner, the “tax matters partner” (TMP), representing the partnership before the IRS. Other partners were often eligible to be “notice partners” and get copies of all correspondence from the IRS, and possibly “opt out” of the proceedings. Results became more consistent, but exceptions and complexities and the ability of partners to “opt out” still left the IRS feeling underpowered in its audit function. When it comes to truly large partnerships, with $100 million or more in assets, the Government Accounting Office (GAO) reported that fewer than 1 percent of partnerships were audited in 2012.

Introduction to the New Rules

The new rules advance the IRS audit function considerably, making the audit of larger partnerships more nearly resemble corporate audits. Partnerships with 10 or more partners or which have partnerships (or LLCs) as partners (regardless of size), are subject to the new rules, and these partnerships cannot elect out. Partnerships will now be represented by a “partnership representative” (PR) who has broad powers to deal with the IRS on behalf of the partnership, and the additional tax liability (if any) will be owed by the partnership, unless an election is made to make the partners liable (more on this below). It’s hard to know just how aggressively the IRS will use its new tools, but the same GAO report described above concluded that approximately 27 percent of C corporations with $100 million or more in assets were audited in 2012, and it has been projected that the new rules will raise between $9 billion and $14 billion.

Will Renewable Energy Partnerships be Subject to These Rules

With partnerships of partners unable to elect out, any deal structure that has one of the following will be subject to the new rules:

  • a GP/managing member that is an LLC with two or more members,
  • a limited partnership or LLC that, in turn, has a fund with two or more partners/members as its limited partner/investor member, or
  • a two-tier lease transaction that has the master tenant as a member or partner, where the master tenant has two or more members or partners.

Conceivably, some deals will involve only corporations or an individual developer and a corporate investor. But given the interest in flips, and developers frequently choosing the LLC form of business, it seems likely that most tax equity ventures in renewables will be subject to the new audit rules.

Partnership Representatives

The PR needn’t be a partner and (as noted above) it will have great powers to represent and bind the partnership before the IRS. There are no rules yet for how this person may be selected. Because the PR has so much power, and the actual partners do not, selection of the partnership representative, and assuring that it keeps the partners informed of the partnership’s interactions with the IRS, are of even greater importance than under the TMP regimen. So far, many new partnership agreements simply designate the person who is now the TMP to automatically become the PR for 2018 and later tax years, but ultimately, this may change. Depending on who is ultimately liable for the tax bill, and the possible development of professional PRs, there may be a switch to people other than the general partner/managing member serving as the PR. Nonetheless, provided the agreement reserves rights to change the designation, it likely makes sense to designate someone to serve as the PR, if only to make sure that the IRS doesn’t make an unfavorable selection for the partnership when its rules come out.

Who Is Liable for the Tax

An especially large change in the audit rules is that the partnership/LLC (and not its individual partners or members) is now presumed to be liable for the tax liability at the highest tax rates applicable to ordinary income and capital gains, as applicable. Alternatively, the partnership can elect to have the partners for the year being audited be liable for the tax, using their own, actual rates. This election has a very short 45-day window. As of now, there are no rules addressing the possibility that the partnership is insolvent. Of course, by making the election, the partners for the audited year could get the tax break while the partnership (which might now have different partners) would wind up with the liability.

Obviously, this has all kinds of implications, particularly ethical concerns as to how one chooses one group of partners over the other. For example, imposing the potential tax liability on the partnership (which might have post-flip partner ratios, if the audit lasts that long) might be an effective way to provide a kind of indemnity to the investors in appropriate situations. At the same time, lenders have become concerned that the tax liability, which used to be a partner responsibility, might now become a partnership liability, thereby impairing the value of the assets that they are relying on when making a loan to the venture.

Special rules may enable a partnership to demonstrate reduced liability. In particular, if liability is being allocated to tax-exempts, there is a 270-day window to show that the allocation would not result in liability. Similarly, partners may be able to file their own returns to take advantage of lower tax rates, and thereby reduce the tax due. Given the short windows (45 and 270 days), and the absence of guidance at this point, we don’t know how these rules would actually work.

Interestingly, the rules do not take into account that a tax detriment to one partner may be a tax benefit to another partner (as where a credit is allocated away from one and to another). Under the rules, the increased tax (if applicable) is a liability and it quite possible that no one else will get the benefit of the reallocated tax break. Amended returns may be a possibility here, subject to some limitations in the new provisions.

Addressing the New Rules in Current Agreements

Although the rules don’t apply until year 2018 tax returns (unless the partnership elects otherwise, which would seem to be unwise, given the complete lack of guidance), partnerships are closing deals now that should probably have language in them to address these rules. Some are adding “the partners will negotiate in good faith” language, but this has enormous gaps–for example, suppose that the IRS rules designate someone as the PR with no requirement that it give notice to, or otherwise deal with, the investors. Some agreements are already requiring the partnership to elect to allocate the resulting adjustments to the persons who were partners for the tax year to which the audit applies. This most nearly resembles prior law, and also has the potential to take advantage of lower tax brackets, if applicable. As noted above, if the liability is computed at the partnership level, then the highest ordinary and capital gains rates must generally be used.

Awaiting IRS Guidance and Technical Corrections

Of course, many of the new rules await guidance from the IRS on how to make the applicable elections, whether the PR can agree to be bound by directions from the partners of the partnership it represents and many similar issues. And with a bit more time to think about the ins and outs of the rules, taxpayers and their advisors will give more thought to understanding them and developing appropriate strategies. Moreover, there are several defects in the statute that may require amendment. For example, there seems to be a flaw in the statute of limitations language that could enable the statute to never end. We’ll keep an eye on the new provisions and address the rules again as further guidance is provided.

Forrest David Milder is a partner with Nixon Peabody LLP. He has more than 30 years’ experience in tax-advantaged investments including the tax credits that apply to affordable housing, energy, new markets and historic rehabilitation, as well as the tax treatment of partnerships and LLCs, tax-exempt organizations, and structured financial products. He can be reached (617) 345-1055 or [email protected].

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