I have been a tax practitioner for over 36 years. I have been a CPA for over 35 years. And for much of my career, partnership tax has been my principal focus.
I have taught partnership tax courses for several international CPA firms. I have taught partnership tax for state CPA societies, associations of CPA firms, and at many annual tax conferences.
In recent years I have come to appreciate an old saying, not attributed to a particular person, that “I don’t have a solution but I certainly admire the problem.”
I might have more solutions than problems with most partnership tax issues, but there is a looming issue that partnership tax practitioners fear at a level of the “Y2K” problem that once struck fear into the hearts of citizens of the world.
There are more than 4 million partnership tax returns filed each year. Many of these are fairly simple arrangements with few partners. Some are quite complex and involve many partners.
Because partnerships do not pay taxes, the partnership tax return is an information return. It informs each partner of their share of income and deduction so they can report that on their tax return.
An information return should not be overly complicated. Much of partnership taxation is not complicated. But the increasing use of LLC business entities, which are taxed as partnerships, has led to increasing complexity in partnership tax law.
The growth of LLCs alone would not create a need for complexity, but the growth has included use of LLCs by the most sophisticated taxpayers in the country. Large multinationals are using LLCs in ways not envisioned even 10 years ago.
So, IRS has had a problem auditing partnership information returns. This problem is an important one because as business tax reporting has shifted from use of regular corporations, which are down 25 percent in tax filings over the past 10 years, to partnerships, IRS will need to devote more resources to partnership tax audits.
For partnership tax filings after the 2017 tax year, new “centralized” audit procedures have been mandated by Congress. Partnerships may now be assessed tax, penalties, and interest by the IRS.
The former information filing only will be replaced by the possible payment of taxes by the partnership itself. Partnership agreements will need to consider how a tax payment could be collected from the partners.
The law mandates that a partnership have a “partnership representative” to deal with the IRS. This representative has the authority to bind the partnership, and thereby its partners, to tax assessments.
Partnerships, big and small, will need to consider who will serve as this representative. The representative need not be a partner. So the partners could find an outside tax expert to serve in this role.
The representative will not serve, unless they are ignorant, without specific indemnifications against partner actions against the representative. These legal protections will need to be drafted. No one is certain what the protections should say.
Partnership agreements will need to address how the representative will be selected, how the representative may be changed, and how the partnership will collect tax from the partners. No one knows how the agreement should be worded.
Certain “small” partnerships may elect out of the new rules. Electing out means the partnership’s audit procedures return to pre-1982 law. This is because the new rules replace changes made in 1982. Few remember what the pre-1982 rules were.
Small partnerships can have only corporations, individuals and estates of deceased partners as owners. Trusts and other partnerships cannot be partners if the partnership wants to elect out of the new centralized audits.
Partnership agreements might need to restrict ownership to permitted partners. Current agreements have no such provisions and will need modification.
States are considering conforming, or nonconforming, changes to their partnership audits. No one knows what these rules may be.
Because partnerships might need to pay tax, buying an interest in a partnership now means you may be buying a potential tax liability for years before you became a partner. You should check into this before you buy. No one has ever done this before.
Partnership Y2018 is coming. I have no solution, but I admire the problem.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.