The Internal Revenue Service’s (IRS) new Partnership Tax Audit Rules take effect on January 1, 2018. As we continue through the New Year, New Jersey partnerships (including entities such as LLCs that have elected to be taxed as partnerships) should be considering required and optional amendments to their existing partnership agreement (or operating agreement) to reflect the new tax regime.
Changes under the Centralized Partnership Audit Regime (CPAR)
Under the new Centralized Partnership Audit Regime (CPAR), the current rules governing partnership audits, that were originally enacted by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), are repealed. In its place, the CPAR assesses and collects tax at the partnership level instead of at the level of individual partners. The applicability of any penalty or additional tax must also be determined at the partnership level.
The new tax audit rules apply to all partnerships, limited liability companies (LLCs) taxed as partnerships, and joint ventures. As more fully discussed in a, the IRS regulations also establish procedures for electing out of the centralized partnership audit regime, filing administrative adjustment requests, and determining amounts owed by the partnership or its partners attributable to adjustments that arise out of an IRS exam.
Partnership Agreement Amendments
The new IRS rules do not require businesses to amend their partnership and/or operating agreements. Nonetheless, it is more than just good business sense to do so. Below are several issues to consider:
- Designation of partnership representative: Rather than designating a “tax matters partner,” as provided under TEFRA, partnerships must now designate a “partnership representative.” While this designation need not officially be made until the filing of the partnership’s tax return for taxable years beginning on or after January 1, 2018, it is wise for businesses to proactively make this designation now and for the partners to fully discuss and understand all of the implications of this change. Given that the partnership representative has the sole authority to act on behalf of the partnership in any examination and the authority to bind the partnership for purposes of the CPAR, it is important to carefully devise a procedure for such designation and the exercise of such responsibility.
- Partner approval of certain decisions made by partnership representative: The partnership may contractually address the powers of the partnership representative via the partnership agreement. Notably, because the actions of the partnership representative may bind all partners and the partnership, it is recommended that the partnership agreement require prior approval of certain material decisions that might be made by the partnership representative.
- Contractual notice/participation rights: Under the CPAR, the partnership representative is the only individual (in addition to the partnership itself) with statutory rights during a tax examination, including notification rights and the right to participate in the proceeding. Accordingly, partnerships may want to better define these obligations through contract.
- Indemnification by current and former partners of partnership tax liability under default rule: In light of the new imputed underpayment rules, the partnership agreement may also address indemnification of the partnership and its partners by each current and former partner of the partnership for the portion of any imputed underpayment attributable to that partner, as well for any costs and fees associated with any audit or legal proceeding. It should be understood that the legal exposure of the partners has changed and there will be a need for recourse and indemnity under such changed rules on a look back basis.
The CPAR dramatically alters the federal tax treatment of all forms of New Jersey partnerships. We encourage businesses that are taxed as partnerships to begin the analysis of their newly formulated compliance burdens and contact experienced counsel with any questions.