New partnership audit rules raise questions

As we begin a new year, let us reflect on what is important. People, and our relationships to those people are most important. Things really do not matter.

I do not mean to be sappy. But perhaps the most important lesson I learned from my parents is that people are more important than things. It helped that we did not have many things.

What interesting things we had, my Dad often built, or through mechanical ability kept alive. My grandmother used her experience working in a rug mill to make clothes.

Many years later, in my tax practice, I learned that sometimes things can be useful to people. Corporations and LLCs can provide liability protection as one thingtype benefit.

Clients who want to defer taxes by use of like-kind exchanges almost always require a “qualified intermediary” to facilitate the exchange. I advise clients to never hire a person as an intermediary.

Intermediaries have four tasks to do for the client, and these tasks can take as long as 180 days. The intermediary must do all four of these tasks or tax benefits are lost.

People cannot guarantee they will survive the 180 days. But things can. So people who want to be intermediaries can form corporations or LLCs to be the facilitator, with a plan for the thing to complete the task if the person cannot.

So sometimes things can help. But usually we get rid of them when they served their purpose. Once it has completed all exchanges, an LLC-intermediary can disband.

Corporations and LLCs are liquidated when their purpose has been served. But the tax law may extend the purpose in surprising ways.

Beginning in 2018 partnerships are subject to what tax people call “centralized audits.” This means that the IRS will audit the partnership and will assess taxes against the entity rather than its owners.

Partnerships do not pay taxes. Their income passes through to the partners who pay the tax. The idea of IRS collecting tax from the partnership is a radical change in approach. It happens only upon audit.

These new rules require the partnership to designate some party as the “partnership representative,” or PR. This designation is made on the annual partnership return and IRS will contact the designee when an audit arises.

Partnerships may be asked to indemnify the PR for dealings with the IRS. The partnership may be forced to ask partners to contribute capital to pay an assessment.

So let’s say a partnership sells its properties and disbands in 2020. It files a tax return marked final and distributes all remaining capital. The thing has served its purpose and the people can move on from the thing.

In 2023 the IRS audits the 2020 filing. It will contact the PR designated on the 2020 return. Remember this is a partnership audit. A wellknown partnership tax attorney recently asked some simple questions about such events.

How does this partnership pay for the representation in the audit? What does liquidation mean for the defunct partnership’s indemnification of the PR? How does this partnership enforce capital contributions to pay the tax assessment?

If the partnership has agreed not to sue the PR for their representation, what does that agreement now mean? If an outside advisor, such as a CPA or attorney is hired to help, who does that outside person represent?

Partnership agreements often contemplate a supervision process for the PR. How will this now occur? If the PR is dead, or unwilling to serve, how does the partnership designate a successor?

How does the partnership file an administrative adjustment request (AAR) with IRS if it no longer exists?

Some readers will think that principles of transferee liability, which apply to things such as corporations and estates, will handle the problems. But the issue of liability does not address the procedural/governance aspects of the partnership-PR-IRS interactions where one of those parties no longer exist.

Qualifying partnerships may elect out of these centralized audit provisions. This is done annually and many partnerships do not qualify to elect out. Others may be better served to not elect out.

Maybe partnerships should not disband until all tax statute of limitations have passed. Maybe things do matter.