New Partnership Audit and Collection Law
From The Desk Of Herb Fineburg
On September 8, 2016 I was a guest speaker at a tax conference sponsored by the Greater Philadelphia Chamber of Commerce for the region’s businesses. We spoke about the new IRS audit rules for partnerships. The changes are massive and will have a very material impact on every business or investment vehicle that is taxed as a “partnership”. That is every entity that files a Form 1065 – U.S. Return of Partnership Income, which includes most limited liability companies.
In general terms, under current law, the partners pay all income tax obligations for the partnership’s income ("K-1 Income"). This also includes any adjustment to income that is later picked up or assessed during a partnership tax audit.
Under the new rules, the partnership is liable for the tax payments resulting from partnership audits, not the partners. The problem under the new rules is that the partnership is liable for the tax in the year in which the audit adjustment is made, not for the year being adjusted.
For example, if the IRS audits the 2018 partnership return (called the “Review Year”) and issues an adjustment in 2021 (called the “Adjustment Year”), the tax assessed becomes a liability in the adjustment year. If the partners have changed since the Review Year, this becomes a serious problem because the old 2018 partners have withdrawn from the partnership without paying all of the tax due. Therefore, in essence, the partners in 2021 are paying the tax due by the former partners who may have walked away with the 2018 income. This problem arises each time a partner exits a partnership (through, for example, redemption or sale) or a partner joins a partnership.
Therefore, a partnership and it partners will need to make sure that former partners indemnify the partnership and the partners for any tax that should have been paid by the former partner. A similar problem and need for indemnity may exist if a current partner’s interest is diluted in order to protect the new partners entering after the Review Year.
It is important that all limited liability companies operating limited partnership, general partnership and agreements (taxed as partnerships) should be reviewed and amended to deal with among other things indemnification by exiting partners, the new rules for audit options (such as elections out of the rules) and the appointment of a Partnership Representative as required under the new rules. The Partnership Representative will act alone on behalf of the partnership during an audit and shall have full authority to bind the partnership and all of its partners with IRS and for all elections under the partnership audit rules. And if you fail to appoint a Partnership Representative, the IRS has the authority to appoint one for the partnership.
We would be glad to answer any questions you have regarding the preparation of an amendment to your existing agreements.
ABOUT HERBERT A. FINEBURG
Herbert A. Fineburg, a firm shareholder and co-managing principal of the firm’s Philadelphia office, concentrates his practice in the areas of Business Law and Transactions, Mergers and Acquisitions, Estate planning, Estates and Trusts, and Tax Consulting. He is recognized as one of Philadelphia’s most respected business lawyers whose substantial knowledge of tax law provides clients with strategic and cost-saving benefits in connection with commercial transactions, taxation and wills, trusts and estates matters. Known for his ability to resolve complicated matters effectively, Mr. Fineburg has assisted businesses and individuals with the organization of their finances, business and real estate affairs, and the structure of their assets (i.e., in LLCs, partnerships, corporations, trusts or joint ownership). He has substantial expertise in the preparation of buy-sell agreements for co-owners who are family members or are unrelated business partners. In addition, to working on bank financings, business contracts and employment matters for his business clients, Mr. Fineburg also provides advice on business acquisitions and sales, and the resolution of shareholder and partner disputes and buy-outs.
ABOUT OFFIT KURMAN
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