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.

Taking Your Real Estate Investments “On Tour”

Consider that you are a professional violinist who lives in Maryland. To build your career as a solo violinist you are planning your first tour to Pennsylvania and Ohio, and you need to attract local audiences in those states.  How would you connect with potential concertgoers?  Newspaper ads, Internet advertising, and mass mailings all could be effective in attracting individuals in Ohio and Pennsylvania who would be interested in hearing you perform.

It would be a lot more difficult if there were rules that required that your advertisements for the Ohio concerts only reached individuals in Ohio and the advertisements for the Pennsylvania concerts only reached individuals in Pennsylvania. If the rules were changed again so that only musicians who resided in Ohio could seek Ohio concertgoers, that would derail any opportunity for your Maryland orchestra to go on tour.

That is the exact dilemma real estate securities sponsors faced if they attempted to issue securities under the exemption in federal securities Rule 147 – at least until the Securities and Exchange Commission adopted Rule 147A, which became effective on April 20, 2017.

Under the previous rules, the intrastate exemption in Rule 147 was available to a securities sponsor only if the securities were issued by an entity formed in the state in which the real estate was located and that securities were only offered and sold to investors resident in the same state. Since advertisements might be considered offers to sell securities, from a practical matter, that prevented sponsors from using advertisements, such as the Internet or newspaper ads, which might reach individuals outside of that state.

Now, in recognition of changes in business practices and technology since Rule 147’s adoption in 1974, the SEC has adopted Rule 147A[1], which eliminates the requirement that the securities offeror be organized in the state in which the real estate is located. Rule 147A also eliminates restrictions on the offer of securities, as long as securities are only sold to individuals residing in the state.

Rule 147A offerings will not be exempt from state securities laws, so issuers will need to find a state securities exemption or qualify their securities in the state in which they are sold. Nevertheless, just as the Maryland violinist can perform for audiences in other states, a national real estate securities sponsor now can “go on tour” and develop custom real estate programs consisting of real estate in a single state for sale to residents of that state – and like the violinist, the real estate sponsor can use modern advertising to reach qualified prospective investors without running afoul of federal securities laws.

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[1]  Legal Geek Fact:  Much of the SEC’s authority is derived from the Commerce Clause of the US Constitution, which gives Congress the power to regulate interstate commerce.  Rule 147 was a safe harbor implementing Securities Act Section 3(a)(11), and is known as the “intrastate exemption.” Although the Supreme Court has significantly expanded the scope of the Commerce Clause of the US Constitution since its adoption, arguably, Section 3(a)(11) was not an exemption at all, but rather a tacit acknowledgement that an offering by a state’s resident entity that is offered and sold only to that state’s residents and is used entirely in that state might well not involve interstate commerce and therefore, be outside of the SEC’s jurisdiction.  Rule 147A, on the other hand, was NOT adopted under Section 3(a)(11), but rather, was adopted under the SEC’s general exceptive authority in Section 28 of the Securities Act, thereby eliminating any statutory requirement that the offering be made entirely in a single state. Section 3(a)(11) and an amended Rule 147 remain in effect, so securities offered pursuant to the intrastate exemption remain a possibility if the issuer can comply with the more strict standards imposed by that section.

© 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 attorneys.