Most US businesses are primarily sole proprietorships and partnerships.  But, the prime reason why sole proprietorships are so common is the “moonlighting” that is part of many an American’s life.  Once that classification is removed from the totals, the situation is dramatically different.  Partnerships (and LLC- limited liability corporations, which are usually taxed as partnerships)- both privately held and syndicated (widely held entities, with access to capital markets [i.e.,Wall Street])- are the primary business structure for US businesses.

And, given that many partnerships involve limited and general partners, where the interests of the general partners are paramount, it is not surprising that conflicts arise as to how various preference items are considered.  As such, many limited partners incur tax liabilities that are the direct results of the decisions of the general partners to save their interests’ tax dollars.   So, it is not surprising that a new regulation has been passed.

This new law (part of the Bipartisan Budget Act, 2 November 2015) now affords the IRS some new powers.  After an audit, the IRS is allowed to collect taxes owned directly from the partnership itself- and not searching for the various and sundry pass-through owners- or their individual assets.  In particular, the law reflects the fact that larger partnerships have been “shedding” their tax responsibilities for years.  Congress expects some $ 9 billion to be collected by this new IRS power over the next ten years.   That ain’t chicken feed.

The law covers any partnership that is subject to US taxes.  That means the change affects any entity as long as there is at least one owner of the partnership that is a US citizen, it has assets within the confines of the US, or effects activity in the US (even if there are no US owners).  However, trusts, mutual funds, and REITS are specifically excluded by this new law, which comes into effect after 31 December 2017.   Note that this deadline has NOTHING to do with the tax year involved; if an audit for 2015 were effected and concluded on 1 January 2018 and there is a US nexus to the partnership- the law applies.  Oh, and that applies even if every US based partner has resigned from the partnership since the audit began, but prior to the IRS audit’s conclusion.  (Now you see why this law was written- and why it will be effective.)

It gets better. Taxes will be computed using the HIGHEST marginal income rates.  There will be no automatic reduction for any capital gains or the partners’ individual tax attributes.  (The partner’s tax attributes means that even if a partner has a tax loss carryforwards, charitable deductions, or pensions, that fact will not affect the tax imposed or collected by the IRS.)

Only the “partnership representative” will be the entity involved in the discussions with the IRS.   That entity need not be a partner.  (For example, we are often the partner representative for our clients.)   Oh, and the failure of the partnership to appoint a representative only means that the IRS has the right to appoint one of its own choosing- so that won’t stymie the effects of the law.

This new law will not affect small partnerships.  (That is the situation for most of you- but some of those publically traded partnerships in which you have purchased an interest as a partner are NOT exempt.)  For small partnerships, the liability still remains with the individual partners- as long as the partnership representative so elects.

So, what does this really mean?   All partnership documentation should now stipulate a partnership representative and describe any potential indemnification rights.  Partnerships should consider stipulating how the representative may resolve any conflicts that may result between affiliated entities and the partners.  Another big addition to partnership agreements should be a covenant stipulating that partners will cooperate with an audit, even if these partners elect to resign from the partnership before the IRS decides to audit the entity.   Finally, there should be terms describing the representations and warranties proffered by the partnership or selling partner to any new incoming partners.

Caveat emptor!

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