Original Publish Date: August 8, 2017
The number one priority for hospitals should be to take care of their patients – not to worry about taxes. Unfortunately, on June 13, 2017, the IRS re-issued controversial audit regulations that could put a huge strain on hospitals that participate as members in LLCs or partnerships, whether it is a joint venture or as a member in a for-profit entity. These new audit rules are not simply a retooling of the way the IRS handles partnership audits. They are a revenue raiser designed to raise almost $10 billion in tax revenues over the next 10 years – a clear sign that more partnership and LLC audits are on the way. The greater likelihood of audits makes it even more important that physicians and health care practices review their operating agreements and partnership agreements to ensure that they have language addressing the relevant issues, and that each member understands the impact of this new audit structure.
KEY CHANGES TO PREPARE FOR:
OPTING OUT OF THE NEW RULES
The Rules are novel, among other reasons, because they would make audit adjustments to partnerships at the entity level rather than at the partner level. There are several ways for the partnership or LLC to opt out of the partnership level adjustments.
The “True Opt Out” Election
Some small partnerships and LLC may be eligible to completely opt-out of the new IRS audit rules. Partnerships and LLCs with 100 or fewer partners, all of which are individuals, corporations, or estates of deceased partners, can make the election to opt-out of the Audit Rules. The proposed regulations make it clear that a partnership determines how many partners it has by counting the number of K-1s required to be issued. For example, if a partnership has issued two K-1s to the same individual (which technically is not in accordance with the instructions) because they serve as both a general and a limited partner, this only counts as one partner for purposes of the 100-partner limitation because the two K-1s are not technically “required.” On the other hand, a husband and wife (who were treated as a single partner under the TEFRA audit rules) will be counted as two partners for purposes of this limitation.
One area of concern had been whether certain trusts, such as grantor trusts, and “disregarded entities” would be a permitted partner for a partnership wanting to opt-out of the new rules. Both of these types of entities are, for almost all purposes, disregarded for federal income tax purposes. The thought was that, for instance, a single member LLC disregarded for tax purposes would be a permitted partner for the opt-out rules, provided that the owner of the disregarded LLC was a permitted partner (such as an individual). The proposed regulations specifically decline to permit this. In most cases, if opting out of the Audit Rules was important enough, the partnership interest could be transferred back to the permitted owner in most cases without incurring a tax. Of course, doing so would unwind the benefit of setting up the trust/disregarded entity structure in the first place.
Finally, for those partnerships considering whether opting out will reduce the chance of an audit, the summary of the regulations makes it clear that the IRS intends to audit partnerships regardless of whether or not they have opted out. Partnerships that opt-out will only have one or, in the case of partnerships with an S corporation partner, two levels of owners to assess, and the IRS will have the taxpayer identification numbers of all these partners. This will make it relatively easy, compared to the current rules, for the IRS to audit even those partnerships that elect to opt-out of the Audit Rules. It seems clear, therefore, that while opting out can be beneficial to a partnership under certain circumstances, reducing the risk of an audit will not be one of those benefits.
The “Push Out Election”
Although there is only one true “opt out” provision where a partnership can completely elect out of the new audit rules, there are several ways that partnerships can modify the assessment liability on the partnership itself. This election is sometimes referred to as a “push-out” election since the tax liability resulting from the audit is pushed out to the partners. There is at least one cost to using this election – interest on any underpayment will be assessed at a rate that is 2 percent higher than if the partnership had paid the tax.
The partnership must make this election within 45 days of receiving notice of the final audit adjustment. If the election is made, the partners will, after receiving the information return, report the income and pay the additional taxes through a simplified amended return process using either the calculation rules set forth in the regulations or a “safe harbor” amount. The regulations allow a partner to calculate the additional tax as though the adjustment had been made in the year under audit (taking into account the partner's actual tax rate and other tax attributes), whereas the safe harbor payment is simply calculated using the highest individual tax rate. Importantly, the adjusted income information is issued to those who were partners in the year under audit, even if they are not partners in the year that the audit is performed and the assessment is made against the partnership. This ensures that new partners will not be responsible for taxes of partners who have left the partnership after the year under audit, but prior to the audit itself.
CALCULATING THE TAX DUE
An important element of the new rules is the tax rate imposed on the additional income that results from any audit adjustment. The tax resulting from the audit adjustment is referred to as the “imputed underpayment,” and is calculated by multiplying the net increase in income resulting from the audit by the highest income tax rate in the Internal Revenue Code, which is currently the individual tax rate (39.6 percent). This rate and the resulting tax liability can be modified if the partnership shows that a lower amount is appropriate based on the tax rates applicable to the actual partners. Modifications to the imputed underpayment can be made in instances where:
These procedures may prevent a partnership from paying a flat rate of 39.6 percent on the entire assessment. But, unless one or more partners files an amended return, tax on a partner’s share of the assessment is still imposed on the highest rate applicable to that type of partner and not the actual tax rate of that particular partner. So if a partnership shows that some of the assessment is allocable to a corporation partner (which is generally taxed at lower rates than an individual partner), the tax imposed will be the highest corporate tax rate, not the actual tax rate of the specific C corporation partner for that particular tax year.
The Role of the Partnership Representative (Formerly the Tax Matters Partner)
The second major change included in the new audit rules is the implementation of rules requiring a partnership representative. Under the current rules, partners usually give little thought as to who will serve as the tax matters partner (TMP). The TMP is only relevant in certain types of partnership audit proceedings, and individual partners generally have the right to participate in these proceedings.
Under the new audit rules, the role of the TMP is replaced by a “partnership representative” who has complete authority to act on behalf of the partnership (and therefore effectively the partners) when dealing with the IRS. This authority includes the ability to bind the partnership and the partners with respect to audits and other proceedings, including settlement authority and decisions on procedural issues such as extending the statute of limitations and whether to proceed to litigation. Significantly, there is no legal obligation under the IRS rules for the partnership representative to keep partners updated on the status of the audit or even to notify the partners of the audit. Finally, unlike a TMP, the partnership representative does not even need to be a partner of the partnership. If a partnership does not designate a partnership representative the IRS “may select any person as the partnership representative.” These changes in the role of the former TMP are significant and raise issues that every partnership agreement and operating agreement should address.
Issues to address NOW
In light of the drastic changes to the partnership audit rules as described above, there are a number of changes that partnerships and LLCs should consider making to their partnership or operating agreements – and it’s important to begin considering these issues now.
WILL YOU MAKE ONE OF THE AVAILABLE ELECTIONS?
One of the first issues to be considered by any partnership is whether the partnership should make one of the available elections under new audit rules, either by choosing to opt out of the new rules entirely (for eligible partnerships) or by choosing one of the alternative methods of reporting the assessment at the partner level. While the initial reaction might be that opting out is always desirable, the new audit rules may actually provide an administrative benefit for some partnerships. Although it is more difficult for the IRS to audit the returns of the individual partners rather than the partnership itself, an audit of the individual partners also means each partner will have to spend a significant amount of time complying with information requests and other audit-related matters. With the “push-out” election, assuming the partners have not changed during the years at issue, it may be easier for the partners, as well as the IRS, to simply have the IRS audit and assess the partnership instead of having the partnership satisfy the reporting obligation of that election by issuing information returns to each partner, then requiring each partner to make an amended filing. Allowing the IRS to audit the partnership would also avoid the additional two percent interest charge on underpayments required with the pushout election.
Despite the potential administrative benefits of not opting out, many partnerships will likely choose to do so either in part or in whole. This is especially true if it is likely that ownership of a partnership will change over time, since the new audit rules in effect impose the tax liability resulting from an audit on those who are partners at the time of the audit - not those who were partners in the year under audit.
WHO MAKES THE DECISION?
The decision to completely opt out must be made annually on the partnership’s tax return. On the other hand, the election to “push out” the tax liability to the partners must be made 45 days after the IRS assessment. At a minimum, a partnership agreement should specify who has the authority to make these decisions and when. If the decision is made to make the annual “true opt-out” election, the partnership agreement should provide for this, with the ability to revisit the decision if a specified percentage of the partners decide to do so. The same procedure could be implemented for the push-out election, with the partnership agreement providing that this election will be made after an IRS assessment – unless a specified percentage (presumably more than a majority) of partners decides to not make the election for a particular audit. It is critical that these provisions be added now because once the audit has happened, the partners may have differing interests depending on their ownership status during the year under audit.
Leaving this decision up to the partnership representative would usually not be desirable since he or she may have an interest in the audit procedure used. For instance, if the partnership representative had been a partner in the year under audit, but new partners have been admitted, not making a “true opt out” or “push out” election would shift some of the burden of any assessment to the new partners since the tax would be paid out of current partnership assets and not out of the partnership representative’s pocket. The partnership agreement should therefore set forth the procedures for how the partners make this decision and should not leave the decision in the hands of the partnership representative. The agreement should also be clear that if the decision to opt out can be made without the consent of all the partners that written notice of the decision be given to all of the partners.
MAKE A PLAN FOR YOUR PARTNERSHIP REPRESENTATIVE
Because of the significant authority granted to the partnership representative, every partnership and operating agreement should address the partnership representative’s status, authority and the limitations imposed on the exercise of this authority. It is important to remember that “opting out” of the new audit rules or making any of the elections described above impacts how the partnership is audited and how any additional tax is assessed; it does not mean the partnership is opting out of the rules applicable to the partnership representative.
Since it is possible that a partnership representative would have a conflict of interest in acting on behalf of the partnership, give consideration to imposing some level of fiduciary duty on the partnership representative or at least provide for the possible replacement of the partnership representative if it appears that there is a conflict of interest.
PREPARE FOR ADJUSTMENTS TO DISTRIBUTIVE SHARES.
One of the more alarming provisions of the new rules relates to audit adjustments to distributive shares. This happens when the result of the audit is not that the partnership has more overall income, but that the IRS determines that one partner should have been allocated more income (or fewer deductions) than was actually allocated to that particular partner. Under the current rules, this type of audit adjustment would essentially represent a “wash” between the partners as a whole, since an increase in income allocated to one partner implicitly results in a decrease in the income allocated to the other partners.
THINK AHEAD TO PURCHASE AND SALE ISSUES
Another area calling for potential agreement revisions relates to the fact that the adjustment made and tax assessed against the partnership will take place the year the adjustment is made. This means that the tax burden relating to an audit could be imposed on partners who were not the partners that received the benefit of the erroneous income calculation the year that was audited.
Accordingly, partners buying into a partnership will need to be especially careful with the new audit rules. If the partnership has not opted out of the rules, a new partner buying in could essentially be responsible for taxes that relate to a year prior to the purchase – effectively paying a tax liability that was the responsibility of the former partner(s). Because the "push out" election is made only after the assessment, a new partner has no assurance that the partners in the year under review will agree to elect to bear the tax burden of the audit. This issue can be dealt with by contract, either in the partnership agreement or in the purchase agreement for the acquired interest.
While the new audit rules are applicable to tax years beginning after 2017, some partnerships can elect to have these rules effective as of Jan. 1, 2016, meaning the partnership in which a buyer is purchasing an interest may have adopted or be planning to adopt these rules for the current tax year. Although unlikely, this is an important issue for any buyer of a partnership interest even before the effective date of the new audit rules.
DECIDE ON RECONCILIATION OF REVISED TAX CALCULATIONS
Once an assessment is made against the partnership, the calculation of the tax due is one of the more complicated parts of the new audit rules. A partnership will have the ability to reduce the tax due by showing that certain partners (tax-exempt organizations, for example) are subject to a lower rate than that used by the IRS in calculating the partnership’s liability. If the partnership does have the assessment reduced because a partner is subject to a lower tax rate, there are many unanswered questions on how the revised assessment affects the burden on the partners for the remainder of the tax liability.
Mr. Cooper provides legal representation to a broad range of hospitals, other healthcare facilities and physician groups across the United States. He has been listed in The Best Lawyers in America for health law for twenty-three consecutive years and selected for inclusion in Ohio Super Lawyers (2005-2015).
Visit the McDonald Hopkins LLC web site at www.mcdonaldhopkins.com.