Tax Effects of Partnership Audit Rules

Because the partnership audit rules (the PARs) assess and collect deficiencies at the partnership (not the partner) level, the PARs can affect the ability of  private equity funds, real estate investment partnerships, and other entities classified as partnerships for federal tax purposes to generate projected returns. For sake of ease I have used the term “private equity fund” throughout but the matters described herein would apply to any entity classified as a partnership for federal tax purposes. The PARs were adopted as part of the Bipartisan Budget Act of 2015 (the BBA) and provide a centralized partnership audit regime effective for audits of private equity funds classified as partnerships for tax years beginning on or after January 1, 2018. Prior to the adoption of the PARs, the IRS assessed and collected tax underpayments and penalties from the partners for the year subject to audit (the reviewed year). Under the PARs, the IRS imposes any tax underpayments and penalties for the reviewed year on the private equity fund itself in the year the adjustment is determined (the adjustment year), thereby potentially (1) leaving the private equity fund with less cash than would otherwise be available to distribute to its partners in accordance with projected returns, and (2) adversely affecting partners who did not receive the benefit of an underpayment in the reviewed year because they were either not partners in the reviewed year or owned a smaller interest during such period. Because the PARs require the IRS to deal only with the private equity fund and not its partners, the PARs represent a much simpler means of assessment and collection for the government and, accordingly, it is thought that partnership audits under the PARs will increase compared to prior years.

Accordingly, because the imposition of the PARs could affect the private equity fund’s ability to generate projected returns, a careful review of private equity fund agreements which became effective prior to the PARs but which are now subject to these new rules should be undertaken in order to identify representations in offering materials and subscription documents which may not have anticipated factors affecting returns such as those presented by the PARs and to identify situations in which an amendment to the private equity fund agreement may be necessary (which may require consent from the private equity fund partners).

There are a number of important provisions which must be included in existing fund operating agreements. While a complete listing of these provisions is beyond the scope of this article, some of the provisions are briefly discussed here.

1. The Partnership Representative Provision.
The private fund agreement must include for applicable tax years, the designation of a “partnership representative”. A private equity fund agreement which became effective prior to the PARs will also need to continue to provide for a “tax matters partner”. Much ado has been made about the need to appoint the partnership representative, but the partnership representative is not the equivalent of a “tax matters partner”. Under the PARs, the partnership representative has authority to act on behalf of the private equity fund and bind all partners with respect to federal tax matters. Unlike a tax matters partner, the partnership representative need not be a partner of the private equity fund but must be a person having a “substantial presence” in the U.S. If the partnership representative is not a natural person, the partnership representative must appoint a “designated individual” who is a natural person who will be authorized to act on behalf of the private equity fund with the IRS.

2. Capital Commitment and Additional Capital Contribution Provisions.
With respect to both private equity fund agreements which became effective prior to the PARs, as well as “new” private equity fund agreements, provisions relating to the capital commitments of the partners and obligations of the partners to make additional capital contributions to private equity funds should be carefully reviewed to determine whether capital contributed by a partner in satisfaction of a capital commitment may be used by the private equity fund to “cover” tax underpayments and penalties. Similarly, it should be determined whether the private equity fund make a call for additional capital contributions for the purpose, alone or in concert with other purposes, to fund the payment of tax underpayments and penalties. Additionally, the private equity fund agreement should also be reviewed to see whether it provides for the allocation among current (and former) partners for the satisfaction of tax underpayment and penalty amounts.

3. The “Opt-Out” Provision.
The PARs provide that a private equity fund with 100 or fewer partners may “opt-out” of the new rules, if all the private equity fund’s partners are “qualifying partners” which include individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic, S corporations, and estates of deceased partners. However, regardless of whether a private equity fund has 100 or fewer partners, if a private equity fund includes one or more partners which are classified as partnerships for federal tax purposes, the private equity fund is not permitted to “opt-out” of the PARs. Accordingly, a domestic private equity fund which is formed as a limited partnership classified as a partnership for federal tax purposes and which has, as a general partner, a limited liability company classified as a partnership would not be eligible to “opt-out”. Therefore, the presence of an “opt-out” provision in a private equity fund agreement may have limited (if any) value.

4. The “Push-Out” Election Provision.
The PARs also provide that instead of tax underpayments and penalties being assessed and collected at the partnership level, a private equity fund agreement may include a provision which permits the partnership to elect to “push-out” such assessment to the private equity fund’s partners and by doing so such partners would report such amounts on their respective partner-level tax returns. Because the “push out” election provides a means for avoiding the potential impact tax underpayments and penalties might have on the private equity fund’s ability to generate projected returns, it should be a very attractive tool for private equity fund managers. A private equity fund which desires to utilize a “push-out” election must not only include an appropriate provision in the private equity fund agreement but also must make an annual “push-out” election within 45 days after a notice of final adjustment is issued to the private equity fund, and must issue statements to the partners which specify their respective shares of such adjustment.

Whether you are a private equity fund manager or an investor in a private equity fund, if we can assist you in reviewing your private equity fund agreement and offering and subscription materials, please contact Frank L. Leffingwell an tax attorney in the firm’s Tax Planning & Controversy and Real Estate sections.