Social enterprises and impact investors will need to strongly consider their special tax and economic needs as audit planning takes center stage for all partnerships, most LLCs, and their respective partners and members when the thirty-five year old partnership audit regime meets its end on January 1, 2018.
On Tuesday, June 13, 2017, the IRS issued proposed regulations implementing the new centralized partnership audit regime, which completely overhauls the longstanding partnership audit, assessment, and collection procedures. Still reading? Good. There are some changes coming as a result of these new regulations that will likely affect you.
- It’s simpler. The new regime simplifies things for the IRS. Under the current system, if an audit results in liability, the IRS seeks payment from the responsible partners. Under the new system, the IRS will seek payment from the partnership itself. Without risk-shifting mechanics, current partners may bear the costs of past partner action. This change will affect all partnerships, and will have additional effects on tax-exempt entities.
- It’s got a new cast of characters. The current “Tax Matters Member” is replaced with a “Partnership Representative,” who need not be a partner or member of the LLC and who has sole and exclusive authority to bind the partnership and the partners—much more power than the Tax Matters Member has under the current regime. Note that, despite its name, a Partnership Representative has no duty to represent the interests of the partnership or its partners—an oddity that will cause a lot of head-scratching and (to the extent possible) require additional risk-shifting.
- Now, with even more audits. With the increase in efficiency and effectiveness of the audit process, the number of audits may increase, and with it, the risk profile of pass-through entities. Moreover, additional and different regulations, along with new or larger penalties, will make errors and omissions much more costly and increase the importance of clarity and understanding of the new proposed regulations.
For a full summary breakdown of the changes under the proposed regulations, please see MoFo’s Client Alert.
While the proposed regulations affect a wide range of taxpayers, social enterprises and impact investors have unique considerations under this new system.
Back to the Drafting Board
All partnership agreements and most LLC agreements will need to be amended before January 1, 2018. Absolutely no partnership or LLC agreement in place at this time deals sufficiently with the proposed regulations and any tax provisions in the current agreements were negotiated (to the extent any negotiation was done) under the current audit regime. At a minimum, these agreements will need to be amended to designate a Partnership Representative. The substantial power of the Partnership Representative (and the lack of a requirement that the “Partnership Representative” must represent the interests of the partnership or its partners) means that great care will be needed in selection.
Participants in the impact space will want to work with their legal counsel and accountants to select a trusted Partnership Representative and draft new partnership tax provisions that create indemnities and other protections in order to provide remedies for partners as they face a loss of control over audits and a resulting increase in risk. No longer can partnerships and LLCs rely on tax provisions from a standard form; the practical and economic impacts of the proposed regulations require entity-specific planning. For more drafting considerations, please see our Client Alert.
More Audits, Fewer Pass-Through Entities?
The new audit regime and the proposed regulations have been put in place to help the IRS more effectively conduct audits on entities like LLCs and partnerships. This translates into more audits for more taxpayers. How much more audit activity should we expect? That’s a question that won’t have a clear answer for a couple of years.
We can, however, reasonably expect that audit risk will increase. Most social enterprises and many impact investors have never undergone an audit or faced a substantial audit risk. Especially in the last five years, the risk of audit for pass-through entities (like partnerships and LLCs taxed as partnerships) has been considered small—which meant that the benefits of pass-through taxation have outweighed the limited concern over audit issues. With the new regime and the expected increase in audit activity, pass-through entities may be less attractive to certain potential investors, particularly tax-exempt investors. How much less attractive? The answer will depend on what the new audit regime looks like in practice—both the level of audit activity and the amounts of adjustments that the increased activity yields. All parties will need to consider and build partnership audit risk into their compliance, administration, and economic modeling in a way that was not previously required.
Most hybrid structures will experience a change in their audit risk profile, because most hybrids include at least one pass-through entity in their structure, particularly with the rise in popularity of fund structures in the impact space. We anticipate that the benefits will still outweigh the risks and that the new regime will not substantially chill the use of pass-through entities.
Beware of Accidental Partnerships
Under the new audit regime, taxpayers who fail to disclose that they have formed a partnership will face substantial new penalties. A penalty may come as surprise to taxpayers who didn’t know they had formed a partnership in the first place. Partnerships are most often created by forming a new entity and making the affirmative decision to have the entity treated as a partnership for tax purposes. Those cases are straightforward and the taxpayers creating the entity know and expect pass-through tax treatment. However, taxpayers can also inadvertently create a partnership for tax purposes without any intention or even knowledge that they have done so.
Licensing agreements, marketing agreements, technology cooperative agreements, and purchase and sale agreements can result in a taxable partnership if they are not carefully drafted. Even if an agreement explicitly states that no partnership is intended to be formed, it may very well slip inadvertently into partnership status if not carefully structured and administered. For example, a joint sales and marketing agreement where the parties share the net profits and costs is likely to be classified as a taxable partnership. All of a sudden, these contracting parties become tax-paying partners in a partnership they never intended to create.
These “accidental partnerships”—arrangements between parties that never intended to be partners—may just as inadvertently fail to disclose such a partnership to the IRS. While this risk of failure to disclose has always existed, under the current regime, the penalties were minor. Starting in 2018, this failure will carry a large bill.
Special Worries for Special Partners: Tax-Exempt Partners and the Proposed Regulations
Tax-exempt entities that are partners find themselves in a unique position due to their exemption from most types of pass-through income and loss.
A tax-exempt partner is exempt from tax on partnership income related to its charitable purpose. On the other hand, it’s not automatically exempt from audit liabilities of the partnership. Under the current regime, tax-exempt organizations need only concern themselves with time periods when they were a partner. They can impose measurement and reporting mechanisms to monitor appropriate activities while partners, but—to date—haven’t had to negotiate or complete diligence activities from prior periods. This is important, since tax-exempt organizations need to be quite careful about how they deploy their resources, especially when entering into partnerships where activities may extend beyond their charitable purpose. Under the default rule of the new regime, diligence of prior periods—outside the time when the tax-exempt partner was involved—will be necessary. This will substantially increase risk, cost, time, and process for tax-exempt organizations, which may have a chilling effect on deal activity.
Tax-exempt entities that are partners will generally want to take steps to limit the adverse impact of the new regime compared with the current one. The new partnership regime creates a larger gap in treatment of for-profit partners and tax-exempt partners, which has knock-on effects for the priorities of each. Tax-exempt partners should explore the possibility of a “push-out” election for all material adjusted partnership items, which would prevent a tax and economic mismatch.
The special treatment of tax-exempt partners may also reduce the overall liability of their audited partnerships or LLCs. In this case, tax-exempt partners can and should form contracts to ensure that they capture this benefit. These and other specific concerns of tax-exempt partners should be addressed in the partnership or LLC agreement and fall into the “Don’t try this at home” category. More on this important subject coming soon.
Starting January 1, 2018, the new partnership audit regime and the accompanying proposed regulations are expected to be a huge shock to the system for all sorts of enterprises, and will affect social enterprises and impact investors in complex and ongoing ways. The bottom line is: Don’t wait! Act now! Social enterprises and impact investors will want to start considering the risks and planning alternatives associated with these new rules and making the necessary adjustments in a wide variety of their agreements, as we all work to adjust. (Yep. That was a tax audit joke. Don’t judge us.)