If You Play A Wrong Note, The Entire Orchestra Now May Pay The Price — Be Aware Of New Partnership Tax Audit Rules That Take Effect On January 1

In 1985, the “participatory journalist” George Plimpton worked as a temporary percussionist, playing sleigh bells, triangle, bass drum, and most notably, gong, with the New York Philharmonic. During a performance, he once struck the gong so hard and created such an overwhelming sound that Leonard Bernstein, who was conducting at the time, burst into applause.  Although one of the world’s most famous orchestras was playing, it was Plimpton, not the orchestra that received the credit or blame for the huge gong sound.

Likewise, most of the time, if one musician in an orchestra misses a note, it doesn’t impact the orchestra as a whole. Certainly, if a musician misses a note in one performance, it should not impact a future performance of the orchestra or musicians who join the orchestra in the future. Until now, the same as been true of partnerships, limited liability companies, and other entities taxed as partnerships under federal tax law.

Partnerships are considered “pass-through” entities under federal tax law. Partnerships have to file a tax return on Form 1065, but partnerships do not have to pay federal income taxes.  Instead, the partnership issues a Form K-1 to each partner allocating partnership income and expenses to that partner.  The partner puts the information from the Form K-1 onto the partner’s tax return and pays any taxes attributable to the partnership income.

In this way, partnership taxation is not unlike musician responsibilities an orchestra. The orchestra manager or conductor provides each orchestra member with his/her part.  However, it is up to the individual orchestra members to play the part.

Just as an orchestra may sometimes have critics passing judgment on its performance, sometimes the Internal Revenue Service (IRS) may audit a partnership tax return. Under the current rules (referred to as the TEFRA rules), when the IRS adjusted partnership income in an audit, it was up to the IRS to collect any tax deficiency, interest, and penalties from the taxpayer.  Since the partners, not the partnership, are the taxpayers, the IRS, then, collected any amounts due after an audit from each individual partner.  This is akin to a critic commenting adversely on the orchestra’s performance but then attributing the “blame” for the performance on the individual musicians who failed to perform their parts.

Just as it may be difficult to name every musician who failed to perform his/her part as well as expected, it is a hassle for the IRS to collect amounts for several different partners. Therefore, the Bipartisan Budget Act of 2015 replaced the TEFRA rules effective January 1, 2018 the IRS adopt new rules (I will call the new rules the post-TEFRA rules).  The post-TEFRA rules allow the IRS to collect any amounts due after a partnership tax audit from the partnership, itself, but allow the partnership to pass those amounts on to individual partners.  The post-TEFRA rules also provide that any additional taxes determined upon audit are to be computed at the maximum rate, even though the rate paid by the partners, who are the taxpayers, may be lower.  If the post-TEFRA rules were applied to music critics, they would allow music critics to blame the orchestra for a poor performance and leave it to the orchestra to allocate blame to individual musicians.

At first glance, this sounds reasonable. However, unlike a music critic’s article, which typically will be published the day after a performance, a partnership tax audit typically will occur years after the tax year in question.  Just as orchestra personnel may change from year-to-year, the partners in a partnership also may change over time.  So, under the post-TEFRA rules, a partnership is left in the unenviable position of paying taxes for a previous tax year and either allocating those taxes to partners who weren’t even part of the partnership in the tax year in question or tracking down former partners to get reimbursed for the taxes, interest, and penalties the partnership must pay.

As the IRS undoubtedly experienced in trying to collect these taxes, interest, and penalties, this is easier said than done. The partnership may not be able to find its former partners.  If a former partner is an individual, he/she may have moved, changed names, or even died.  If a former partner is a corporation, trust, limited liability company, or other entity, it may no longer be in existence.

However, even when the former partner is easy to find, the partnership agreement, itself, could provide obstacles that prevent the partnership from collecting taxes, interest and penalties from former partners. Unless the partnership agreement or other written documents signed by a partner obligates a former partner to reimburse the partnership for these amounts, the partnership and ultimately, the current partners could end up shouldering the burden of taxes for years in which they were not even members of the partnership.

The post-TEFRA rules also replace what previously was known as a “tax matters partner” with a “partnership representative.” Since a partnership representative has different (and generally broader) authority than a tax matters partner, partnerships need to appoint a partnership representative. Typically, this is done in the partnership agreement.

The post-TEFRA rules will take effect to every existing new and existing partnership on January 1, 2018 UNLESS the partnership elects every year to opt out and instead, to operate under the TEFRA rules. Conventional wisdom is that every partnership that is eligible to opt out of the post-TEFRA rules should do so.

Unfortunately, however, the post-TEFRA rules do not allow all partnerships to opt out. In order to opt out, a partnership must have fewer than 100 schedules K-1, and generally must be individuals or estates or be taxed as a C corporation, S corporation. This means that partnerships which have other partnerships (or limited liability companies taxed as partnerships) or trusts (including grantor trusts) as partners usually must operate under the post-TEFRA rules. If the partnership discloses all indirect owners (e.g., beneficiaries of the trust and partners of the partnership member), then it still may be able to opt out of the post-TEFRA rules.

With the post-TEFRA rules taking effect in January, every partnership (and limited liability company taxed as a partnership) should do the following to prepare for the post-TEFRA Rules:

  1. Consult with its attorney and amend its partnership (or LLC) agreement to appoint a partnership representative.
  2. If necessary, amend the partnership (or LLC) agreement so that partners agree to reimburse the partnership for additional taxes, interest, and penalties determined after an audit, even if they are no longer a partner when the audit occurs.
  3. Amend the partnership (or LLC) agreement to direct the general partner (or LLC manager) to opt-out of the post-TEFRA rules if the partnership qualifies to do so.
  4. If the partnership qualifies, request that its tax preparer elect to opt out of the post-TEFRA rules. This must be done every year.
  5. If the partnership has fewer than 100 Schedules K-1 but cannot opt out of the post-TEFRA rules because one or more of its partners is a trust or partnership (or LLC taxed as a partnership), then consider requesting those partners to provide information about their partners/beneficiaries to see if the partnership can opt-out of the post-TEFRA rules by providing that information to the IRS.

With awareness and diligent preparation, many partnerships should be able to opt out of the post-TEFRA rules and continue to operate as they have in the past the TEFRA rules, but they still should amend their agreements in case they find themselves subject to the post-TEFRA rules in the future. For those partnerships that cannot opt out of the post-TEFRA rules, amendments to their partnership agreements can help prevent tomorrow’s partners from paying for today’s partners’ “wrong notes.”

For more information, please contact Elizabeth A. Whitman at (301) 664-7710 or eawhitman@mirskylawgroup.com.

© Elizabeth A. Whitman

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC or any of its attorneys.

Making “Best Efforts” to Play in Tune or to Comply with Real Estate Contract Covenants

It is difficult to play a violin in tune.  For one thing, unlike with a guitar, there are no frets or markings on a violin fingerboard to tell the violinist where to put his/her fingers.  The fingers must move up and down the fingerboard and from one string to another, always hitting the perfect spot.  Even a millimeter difference in finger placement can be the difference between an in-tune and out-of-tune note.

It is particularly difficult for a violinist to play in tune if the violin is out of tune. Yet, violin strings are prone to going out of tune. The type of string,[1] weather, bumps to the instrument, and even playing the violin normally can cause the strings to go out of tune.

If it were not difficult enough, what being “in tune” means can change with the type of music being played.   Violins are not “tempered”[2] instruments; a D-flat and C-sharp are the same note on a piano but not so on the violin. The skilled violinist must be able to adjust his/her ear between tempered tuning when playing with a tempered instrument, such as a piano, and untempered tuning when playing with a string quartet, for instance.

As a result, even though it is of critical importance that a violinist play in tune, what sometimes, that doesn’t happen under the best of circumstances.   Likewise, in a real estate transaction, most parties work hard to accomplish the transaction goals, but sometimes that doesn’t happen either.

Also, like the violinist, who must play with different intonation in different environments, sometimes participants to real estate transactions are asked to modify their efforts to reach a goal through contract terms.  Various real estate contracts terms may require things such as “reasonable efforts,” “commercially reasonable efforts,” or “best efforts,” which may be as amorphous to the real estate party as tempered and untempered tuning seem to the uninitiated musician.

Terms such as “reasonable efforts,” “commercially reasonable efforts,” and “best efforts” are used in a contract to show the level of effort a party is obligated to use to pursue a covenant or promise that party has made.  For example, let’s use the covenant “I will play the violin in tune.”  If that isn’t qualified, then I have an absolute obligation to play the violin in tune no matter what happens. If I do not succeed in playing the violin in tune, I can be considered to have breached my covenant. That type of covenant frequently isn’t attractive to a party making the covenant, so the party will ask for the covenant to specify a specific level of effort required.

If the covenant is changed to say, “I will make best efforts to play the violin in tune,” then I might be required to keep my violin in good shape, practice many hours a day, take any lessons necessary from the best available teacher, and purchase any equipment necessary, regardless of the time commitment or cost or adverse consequences to my job, family, or health.  However, as long as I make that high level of effort, if I still do not succeed in playing the violin in tune, I will not have breached my covenant to “make best efforts to play the violin in tune.”

However, maybe I don’t want to have to give my all to playing the violin in tune.  In that case, I might ask that the covenant read “I will make reasonable efforts to play the violin in tune,” which doesn’t require as much effort be expended as best efforts.  “Reasonable efforts” still would require that I keep my violin in good shape, practice every day, and possibly, take lessons and purchase some equipment, but it would not require that I give up my job and family life and go bankrupt in order to play the violin in tune.

“Commercially reasonable efforts” is a newer term.  If I say, “I will use commercially reasonable efforts to play the violin in tune,” then most attorneys would say that adds an element of economic reasonableness and business practices given the circumstances into the mix.  Therefore, if, for instance, the typical violinist practiced two hours a day and had one lesson per week and used only an iPhone app as a tuner, rather than a fancy standalone one, I should be considered to be complying with my covenant to use “commercially reasonable efforts” if I do what the typical violinist would do.

So, just as a D-flat and a C-sharp aren’t the same note on a violin, “best efforts,” “reasonable efforts,” “commercially reasonable efforts,” and silence as to efforts don’t mean the same thing in contract covenants.  Just as violinists must adjust their tuning to the circumstances, contracting parties should the level of effort required to comply with covenants be adjusted in contracts to the circumstances involved.

______________________

[1]   Originally, violin strings were made of sheep gut, and violins also were tuned to a lower (flatter) A than they currently are. As tuning changed and increased tension were placed on the strings and technical demands on violinists increased, violinists started wrapping the gut strings in metal.  Eventually, the smallest string, the e string, (which has to be quite thin to produce the required pitch and therefore, tended to break when it was made of sheep gut), transitioned to an all-metal e-string.  Although there were experiments with all metal and metal core strings, metal-wrapped gut strings remained the gold standard until the 1990’s when synthetic core strings were accepted as producing a sound comparable to gut strings with more reliability. As an early adopter of technological advancements, I am proud to say that I started using synthetic core strings in the early 1980’s.

[2]  Violin tuning is based upon acoustical physics, such that the length of the string is changed so that it produces certain wave lengths when played. In untempered tuning, a C in the key of C major might not be the same as a C in the key of D-flat major. This untempered tuning, proved to be a challenge for keyboard players, because they had to retune their entire instruments in order to play in different keys. Therefore, in the 18th century, tempered tuning, where the sizes of intervals between notes is modified slightly so that it sounds close to in tune in every key was adopted for keyboard instruments.  The method, famously taken advantage of by Johann Sebastian Bach’s Well-Tempered Clavier, now is commonly used by violinists when playing with keyboard instruments.  However, an advanced violinist still will use untempered tuning when playing unaccompanied pieces or when playing chamber music with other string players.

For more information, please contact Elizabeth A. Whitman at (301) 664-7710 or eawhitman@mirskylawgroup.com.

© 2017 by Elizabeth A. Whitman

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC or any of its attorneys.