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Cutting Edge Tax Issues for Partnerships
PRESENTED BY:
› KIM PALMER, CPA, MT, PARTNER
› JON WILLIAMSON, CPA, SENIOR MANAGER
July 9, 2019
Welcome & Introductions
Jon Williamson, CPA, MTKim Palmer, CPA, MT
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CPE Credit Guidelines
› To receive CPE you must:- Be logged in for at least 50 minutes- Answer at least 3 of the 4 polling questions
A copy of today’s slides will be available following this presentation
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Questions During the Webinar
› If you have questions during the webinar:- Use the “Questions” feature to “Enter a
question for staff” then click “Send”- We will address during the program if
there is time or will follow up after the program
IRS Audit Rules for Partnerships
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New Partnership Audit Rules – General Information
› Effective for tax years beginning after December 31, 2017› Replaces the partnership audit rules under both:
- Tax Equity and Fiscal Responsibility Act (TEFRA)- Electing Large Partnership rules (ELP)
› Affects all types of partnerships, as well as limited liability companies (LLCs) taxed as partnerships
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New Partnership Audit Rules – Key Differences
› Shift from adjustments to partner tax returns to adjustments directly to partnership returns- May result in tax and penalties due from partnership rather than partners- Limited amount of partnerships are eligible to “opt-out” of new audit rules
- Must have less than 100 partners- All partners must be individuals, C Corporations, S Corporations or estates
- Each shareholder of an S Corporation counts towards the 100 partner limit
- Required to file an annual opt-out election- In addition to the opt-out election, upon adjustment, partnerships may make a
“push-out” election upon an IRS adjustment under audit- Allows a partnership to shift the tax and penalty burden to its partners in
the reviewed year
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New Partnership Audit Rules – Key Differences
› “Tax Matters Partner” replaced with “Partnership Representative”- New role which is granted authority to make certain partnership decisions
under audit, including:- Sole authority to act on behalf of the partnership and to bind the
partnerships and all partners with respect to IRS audits- Making an opt-out election- Making a push-out election
- Does not have to be a partner in the partnership, but must:- Have a substantial presence in the U.S. and be able to make themselves
available to meet in person with the IRS- Have a U.S. address, tax ID number and phone number- Designate an individual that will act on its behalf if an entity is designated
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Polling Question # 1
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Designating a Partnership Representative – IRS Guidance
› A Partnership Representative must be disclosed on the partnership’s tax return annually- Should the partnership not designate a Partnership Representative, the IRS has
the authority to designate one on behalf of the partnership› A partnership can only have one Partnership Representative› Partnerships may designate a different Partnership Representative each
year.› The Partnership Representative may resign or have the power revoked by
the partnership for a given year- This may only occur after the IRS issues a notice of selection for examination or
a notice of administrative proceeding- The IRS must be notified in writing of any resignation or revocation
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Designating a Partnership Representative – Partnership Considerations
› Understand the differences in responsibilities between the Tax Matters Partner and the Partnership Representative
› Strongly consider documenting the process of designating a Partnership Representative in the partnership’s operating agreement- Restrictions or guidelines for the Partnership Representative should also be
considered and documented in the operating agreement, if used› Rather than a specific individual, a partnership may consider appointing a
specific position- This may allow the partnership to change its Partnership Representative
without requiring an amendment to the operating agreement- CFO, Controller or President of the partnership or an affiliate is a common
choice
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Impact of New Partnership Audit Rules – Partnership Considerations
› Generally, the impact of having an adjustment applied at the partnership level will result in a higher tax liability- The IRS will not consider any netting when the adjustment results in a
shift of income between partners- The partnership will be taxed at the highest applicable rate
› Remaining partners may bear burden for ex-partners- Can be offset by making push-out election or having other
reimbursement measures added to operating agreement › Theoretical increase in partnership audit rates
- New rules were created due to the administrative burden of auditing a partnership under previous audit regime
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Impact of New Partnership Audit Rules – Partnership Considerations
› Consider optional operating agreement amendments/side letter details which provide further guidance or support of Partnership Representative- Indemnity agreement
- Provide Partnership Representative with indemnity of liability from partners or partnership, provided they act within certain restraints
- Permitted acts and actions- Guidelines of how a Partnership Representative is required to respond and
act to specific duties- IRS audit rules provide Partnership Representative with the power to bind
the partnership, regardless if they act within permissions of the operating agreement
- Acting outside of permissions, however, could allow the partners or partnership recourse against the Partnership Representative
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Impact of New Partnership Audit Rules – Partnership Considerations
› Investment type partnerships may consider the new audit rules favorable for purposes of investor relations
› Evolving state taxation impact and adoption› Partnerships may consider limiting the types of partners admitted to
preserve the opt-out election- No trusts, partnerships, disregarded entities, etc.- S Corporations number of shareholders limited to remain under the 100
partner count
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Polling Question # 2
Targeted Capital Accounts
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Overview
› What is a targeted capital account?- Method to allocate taxable income/loss among the partners on their
annual K-1s› Becoming the new standard in operating agreements› Historical operating agreements:
- Income/loss allocations based on the safe harbor provided under IRC Regulation 1.704-1(b)(2)
- A “cash follows tax” approach – calculation for the allocation of taxable income/loss and distributions were then made based on the balance of the partners’ capital accounts
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Historical Language
› Safe harbor for economic effect if:1. Capital accounts of the partners are maintained under 704(b),2. Upon liquidation of the partnership, liquidating distributions are to be
made in accordance with positive capital account balances, and3. If such partner has a deficit balance in their capital account following
the liquidation of his/her interest in the partnership, he/she is unconditionally obligated to restore the amount of such deficit balance or the agreement provides for a “qualified income offset”
› Does it meet requirements of IRC Section 704?
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Targeted Capital Account Language
› “Tax follows cash” approach› Distributions based on the liquidation provisions (waterfall) of the
operating agreement› Taxable income/loss allocated so that after the income/loss
allocation has been made, the balance in each partner’s capital account shall, to the extent possible, be equal to an amount that would be distributed to the partner based on a hypothetical liquidation of the partnership and distributions are made based on the waterfall calculation- Capital account definition
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Sample Language
› Net income/loss shall be allocated annually by the partnership in a manner such that, after allocations have been made, the balance of each partner’s capital account shall, to the extent possible, be equal to an amount what would be distributed to such partner if: (i)(A) the partnership were to sell its assets for their Gross Value, (B) all partnership liabilities were satisfied, (C) the Partnership were to distribute the proceeds of sale pursuant to section XX and (D) the partnership were to dissolve pursuant to section XX, minus (ii) the sum of (X) such partner’s share of Partnership Minimum Gain or Partner Nonrecourse Debt Minimum Gain, and (Y) the amount, if any, that such partner is obligated (or deemed obligated) to contribute, in its capacity as a partner, to the partnership, computed immediately prior to the hypothetical sale of assets.
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Sample Language (cont.)
› After taking into account all allocations described in section XX, net income and net loss for any fiscal period shall be allocated among the unitholders in such manner that, as of the end of such fiscal period and to the greatest extent possible, the Capital Account of each Unitholder shall be equal to the sum of (i) the Unitholder’s share of Company Minimum Gain and Unitholder Minimum Gain and (ii) the respective net amount, positive or negative, that would be distributed to such Unitholder from the company or for which such Unitholder would be liable to the Company under this Agreement, determined as if, on the last day of such fiscal period, the Company were to (x) liquidate the assets of the Company and (y) distribute the proceeds in liquidation in accordance with Section XX.X.
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Polling Question # 3
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Capital Account as defined in Operating Agreement
› IRC Section 704(b) – referred to as “book” capital accounts› This is NOT GAAP or books and records but a tax concept› Tax and book capital accounts may not be equal› Fair market value concept› Intention of targeted capital account allocations is that each
partner’s book capital account is reflective of the amount that partner would receive upon liquidation
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704(b) “Book” Capital Account and Fair Market Value Differences
› Income/loss is not typically reflective of appreciation/depreciation of the partnership’s value
› Differences between “book” and tax capital accounts:- Contributions of appreciated/depreciated assets by a partner- A book-up or book-down has occurred due to:
- New partner was admitted to partnership- Property (other than money) is contributed to or distributed by the
partnership- A grant of an interest (profits or capital interest)
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704(b) “Book” Capital Account and Fair Market Value Differences
› Regulations require book up or book down of capital accounts in certain situations, optional in others
› Operating agreement should state whether a book up or book down will be made in certain situations
› Appreciation/depreciation in the assets do NOT result in book up or book down for 704(b) – real estate fund accounting differences
› Book up and book down is NOT the same as 754 election- What is the difference?
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Allocation of Taxable Income/Loss
› Because of differences noted on previous slide, the allocations of both book and taxable income need to be reviewed on an annual basis, and a standard formula will not work under the targeted capital allocations approach
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Polling Question # 4
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Targeted Allocation - Example Year 1
› AB LLC waterfall distribution: - (1) 8% preferred return to A- (2) return of capital to A ($100)- (3) return of capital to B ($10)- (4) 80/20 split – 80% to A and 20% to B
› Year 1 taxable loss of ($10) – how to allocate in targeted capital approach? No distributions were made- Targeted Capital Account Calculation:
- Total tax capital year 1 = $100 ($110 capital contributed, less loss of $10)- Upon hypothetical liquidation, cash would be distributed (1) $8 to A; (2)
$92 to A; (3) $0 to B- Therefore B receives all of loss in year 1
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Targeted Allocation – Example Year 1
A BCapital – Beginning of Year $100 $10
End of Year Hypothetical Liquidation Value = $100
Step 1 – A Preferred Return $8 $-0-Step 2 – Return of A Capital $92 $-0-Step 3 – Return of B Capital $-0- $-0-Step 4 – 80/20 Split $-0- $-0-Total Liquidation Proceeds $100 $-0-Capital – Before Allocation $100 $10Difference & Allocation $-0- ($10)
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Targeted Allocation – Example Year 2
› AB LLC waterfall distribution: - (1) 8% preferred return to A- (2) return of capital to A ($100)- (3) return of capital to B ($10)- (4) 80/20 split – 80% to A and 20% to B
› Year 2 – 1 of 2 properties sold, gain of $25, cash distribution of $75 ((1) $8 to A, (2) $67 to A)› After distribution, A has year 2 unpaid preferred return of $8; A has unreturned capital
account of $33; and B has unreturned capital account of $10- Targeted Capital Account Calculation:
- Beginning of year capital $100, less distributions of $75, plus gain of $25 = $50 ending capital- Upon hypothetical liquidation, $50 would be distributed (1) $8 to A; (2) $33 to A; (3) $9 to B- Gain of $25 – allocate $16 to A (beg of year capital $100, less cash distributed of $75 = $25,
compared to targeted capital of $41 calculated in above step) targeted capital noted in above and $9 to B (beg of year capital $0 compared to end of year target capital of $9 calculated above)
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Targeted Allocation – Example Year 2A B
Capital – Beginning of Year $100 $-0-Distributions – Property Sale ($75) $-0-Capital – Before Allocation $25 $-0-
End of Year Hypothetical Liquidation Value = $50
Step 1 – A Preferred Return $8 $-0-Step 2 – Return of A Capital $33 $-0-Step 3 – Return of B Capital $-0- $9Step 4 – 80/20 Split $-0- $-0-Total Liquidation Proceeds $41 $9
Capital – Before Allocation $25 $0Difference & Allocation $16 $9
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Targeted Allocation – Example
› Issues with this example:- Year 1 – Investors may have been promised cash first plus an allocation
of taxable losses or expect an allocation of taxable losses- Year 2 – Partner B allocated gain with no cash distribution
- Due to recapture of prior year loss allocation, but memories are short
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Factors/Issues to Consider
› Waterfall distribution calc (preferred returns to preferred members, how is capital returned and in what order, profits partner and distributions)
› Is taxable income/loss reflective of an economic appreciation/depreciation
› Waterfall distribution investment by investment› Taxable income/loss and cash are usually not the same - timing› 704(b) income but taxable loss› Historic allocations of income/loss and any true-ups› Special allocations under IRC Section 704(c)› Admission of new partners in later years
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Summary
› Modeling and projection based on factors listed› An annual calculation factoring in all items – will not necessarily be
pro rata› When amending agreements, consider changing to this language› CPAs should review operating agreements before finalization
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Questions for our Presenters?
Kim Palmer, CPA, [email protected]
Jon Williamson, CPA216.774.1103 [email protected]
A copy of today’s slides will be available following this presentation
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Upcoming Events
SAVE THE DATE:
Cleveland CPE Conference Wednesday, November 20, 2019
Learn more at www.cohencpa.com/events
Thank you.
July 9, 2019
Information presented is not meant to constitute legal, accounting or other professional advice. Any action based on information in this presentation should be taken only after a detailed
review of the specific facts and circumstances. Information is current as of the date presented.
© 2019 Cohen & Company. All rights reserved. Reproduction or disclosure in whole or in part shall be made only upon the express written consent of Cohen & Company.
