Congress has passed a controversial law permitting IRS, upon concluding an audit, to collect US tax from partnerships, in order to raise an estimated US$9.3 billion over ten years (Bipartisan Budget Act of 2 November 2015). This changes the historic requirement that IRS must collect tax from the partners rather than the partnership, via tiers of intermediate entities if necessary, and was enacted to improve the low rate of IRS annual inquiries into large partnerships (currently 0.8% versus 27.1% for corporates).
It applies to any entity treated as a partnership for US tax purposes, which has either at least one US owner, or some US assets or activity but no US owners. Because of the easy elective regime for US partnership status, all electing corporates and trusts formed under non-US law are subject to the new law. The law does not apply to entities that are fiscally transparent for reasons other than US partnership status (e.g., REITs, mutual funds, and trusts).
The new law comes into effect after 31 December .2017, but there is no grandfather exemption for existing partnerships. Also, existing partnerships can elect for the regime to apply before that time. Accordingly, the following should commence protecting their interests now:
- Any existing partnerships which expect to continue beyond 31 December 2017, their current partners, and anyone acquiring partnership interests henceforth; and
- Any partnerships to be formed henceforth, and any partners acquiring interests in them, directly or from another partner.
If no action is taken, a partnership and its partners are subject to the following disadvantages starting 1 January 2018:
- Assessed US tax falls on the partnership (and so burdens the current year partners) even if the partners in the prior, audited year have departed (or have changed their relative interests).
- The tax is computed at the highest US marginal rates on income, with no automatic reduction for capital gain rates or the tax attributes of partners (e.g. individuals with brought forward losses, pensions, charities).
- The IRS will deal only with a single “partnership representative” who has wide powers to negotiate and compromise, need not be a partner, and can be appointed by the IRS if the partnership fails to do so.
- Partners are not automatically entitled to be notified of the start of an IRS audit.
There is an exception for small partnerships, and a means whereby the liability can be shifted to the audit year partners if the partnership representative promptly elects.
Items that should be negotiated in the partnership agreement or an ancillary document include:
- The identity of the partnership representative and indemnification rights.
- Agreements on desired elections and how the representative should resolve conflicts of interest between partners or affiliated entities.
- Covenants from partners to cooperate, in case they leave the partnership before the IRS commences an audit.
- Representations/warranties to be given by a partnership or a selling partner to an incoming partner.
Typical transactions which may be affected by this new law include:
- Joint ventures between corporates
- Private equity acquisitions of targets if holding partnerships are formed
- Private investment fund formation
- Carried interest vehicle formation
- “Separate accounts” in partnership form
- “Secondary” or “funds-of-funds” purchasing interests in primary funds; due diligence on entity-level tax liabilities
- Scuritisations involving partnerships
- Securitisations of entities intending to avoid partnership status but which could be considered such upon IRS audit (e.g., thinly capitalised Delaware trusts issuing notes)
- All real estate funds involving US assets or partners
- Investment by pension schemes or charitable endowments in US investment funds
Partnership status is the norm for US business ventures, whether private or widely held (other than those which need to access the capital markets), so this new law is widely applicable. Participants are encouraged to protect their interests now.