Mark Lubin's article "Tax Treatment of Partnership and Their Partners—Are Rough Times Ahead?,” in The Legal Intelligencer
Reprinted with permission from the January 16, 2024, edition of The Legal Intelligencer © 2023 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or email@example.com.
Tax Treatment of Partnership and Their Partners – Are Rough Times Ahead?
Partnerships (which, for the purpose of this article, include limited liability companies treated as partnerships for tax purposes) have long been considered a flexible way of structuring investment arrangements and closely held businesses. Partnerships are not subject to entity-level corporate taxation and, unlike S corporations, they have flexibility to use special allocations and preferential distribution arrangements and to have various types of owners. However, partnership audit changes present increased exposure to partnerships and their partners, and future legislation may curtail much of the flexibility associated with partnerships. Now is a good time for partnerships and their partners to take steps to mitigate the potential consequences of the audit changes, and to anticipate potential legislative developments.
The partnership tax rules were intended to promote flexibility. However, that flexibility often results in complexity, which can sometimes allow partners to obtain benefits that were not contemplated by the tax law. The government has historically respected most partnership transactions reflecting that flexibility because adverse partner interests limit opportunities for obtaining unintended benefits. But by the mid-2010s, the IRS had become increasingly frustrated with difficulty in auditing partnerships and their partners. Congress responded by enacting a new audit regime as part of the Bipartisan Budget Act of 2015 (the BBA), and that regime generally became effective in 2018.
The BBA regime is taxpayer unfriendly, and it can result in partnership-level liability and far greater cost than what would have applied had a partnership’s tax returns been filed consistently with the IRS’s audit adjustments. There are, however, elections that can mitigate the regime’s harshness. One such election – an election out of the BBA regime for qualifying partnerships – must be made annually on the partnership’s tax return, IRS Form 1065. Other mitigating elections involve relatively short deadlines and can require substantial analysis and compliance.
After receiving funding under the 2022 Inflation Reduction Act, the IRS declared its intention to devote substantial resources to partnership audits. Already, the IRS has announced audits of 75 of the largest partnerships. A subsequent roll-out to other partnerships and their partners seems likely. The IRS is currently hiring new examiners to conduct those audits. While the IRS does not generally publicize how it selects taxpayers for audit, AI will almost certainly figure into that process.
An avalanche of audits doesn’t seem imminent, however. The IRS will need time to train competent examiners. Also, the “trickle down” from large partnerships to closely held business, investment and service partnerships will probably take a few years.
But it is important to note that audits apply to taxable years that have already ended, which means that an audit starting a few years from now could cover 2024 and subsequent years. Thus, now is a good time for partnerships to consider implementing stronger recordkeeping and documentation practices. Supporting “inside” basis (partnerships’ tax basis in their assets) and “outside” basis (partners’ basis in their partnership interests) may be crucial to avoiding future audit adjustments. Partnership agreements should be updated where necessary to reflect the BBA rules. Also, partnership agreements should be reviewed to ensure that allocation provisions, distribution provisions, and tax “boilerplate” language function as intended from economic and tax perspectives.
The ability of sophisticated planners to achieve tax advantages through partnerships has periodically attracted Congressional and administrative attention, and the U.S. Treasury has issued some regulations to deal with abusive arrangements. Although not covered by any such regulations, the IRS currently appears to be targeting an exclusion from self-employment income of certain partnership income allocated to limited partners, including its application to LLC members. The IRS seems to view the exclusion as inapplicable to income allocated to limited partners and LLC members relating to their performance of services, and the U.S. Tax Court is evidently receptive to that view. Partners and LLC members claiming this exclusion should consider their potential audit exposure (including at the partnership/LLC level under the BBA rules) and may wish to revisit their treatment of service income allocations, at least prospectively.
Tax legislation and regulations are often “after the fact” measures targeting benefits taxpayers had obtained before attracting government attention. Senate Finance Committee Chairman Ron Wyden seems to have concluded that a better approach would be to curtail partnership flexibility altogether. In 2021, Senator Wyden issued several restrictive proposals, including the removal of a long-standing regulatory “safe harbor” regarding tax allocations, requiring that partnerships make allocations among related partners based on proportionate capital balances and limiting partners’ ability to negotiate how to treat partnership property on certain “revaluation” events.
The Wyden proposals are controversial. Partnership tax practitioners have questioned whether finely tuned, longstanding tax regulations should be substituted with blunt restrictions. Wyden’s proposals have not been enacted -- and enactment doesn’t seem imminent -- but unadopted legislative proposals can quickly surface in legislation. Tax legislation and regulations can be effective on short notice (sometimes, even retroactively), so partnerships and their advisors should stay alert for developments.