Ready for the New Partnership Audit Rules

Tax, Regulatory, and Practical Considerations

For the 2018 tax year, Internal Revenue Code section 6223 (IRC 6223) requires entities to appoint a partnership representative as a sole authority to communicate on the firm's behalf in the event of an audit. For this webinar, our team of experts will cover the new Partnership Representative (PR) regulations from three perspectives—legal, tax, and client service. The panelists will also cover the regulations, practical considerations, and the risks of non-compliance.

This recorded webinar is a must for any tax professional or partnership seeking to understand the requirements of designating a Partnership Representative. View our recorded webinar to get the answers, tips, and deeper insight you require regarding this new regulation.

You'll learn:

  • What is the end goal of the IRS?
  • What are the legal and tax implications of PR?
  • What if a PR is NOT appointed?
  • What are the benefits of appointing an independent PR?
  • What issues have been resolved and what questions are still unanswered?
  • Who can serve as your PR and how can they be designated and replaced, if necessary?


Ready for the New Partnership Audit Rules—Tax, Regulatory, and Practical Considerations from CSC

Webinar Transcript:

Annie: Hello, everyone, and welcome to today's webinar "Ready for the New Partnership Audit Rules: Tax, Regulatory, and Practical Considerations." My name is Annie Triboletti, and I will be your moderator. Joining us today are Philip Gross, Robert Schachter, and Dave Straub.

Philip shares the tax department for Kleinberg Kaplan and advises clients on the taxation of hedge funds. He counsels clients on structuring funds, structuring investment managers and general partners, compensating managers and employees, investing in funds and seeding management entities.

Robert is a tax partner based in Withum's New York City Office. He has over 30 years of public accounting experience and is a licensed Certified Public Accountant in the states of New York and New Jersey. Robert's experience includes transactions involving a variety of financial products, derivatives, tax efficient trading, and investment strategies.

Dave is responsible for the growth of new business in all of the divisions' business segments at CSC, including corporate trust agents, independent director, SPE management, and default administration. His primary market focus includes mergers and acquisitions, structured finance, financial technology, real estate, and restructuring.

And with that, let's welcome Philip, Robert, and Dave.

Dave: Thanks, Annie. This is Dave with CSC. CSC has been a leader in providing business services focused on helping companies stay in compliance for 120 years.

We were approached in 2017 by a law firm asking us if we would serve as a Partnership Representative for their clients. As we developed our service agreement, we were also asked by the IRS to meet with them in Washington, D.C., to learn what we felt was important in helping companies meet the requirements of this new regulation.

As the first filing date approaches, we thought it would be good to offer this seminar. Today, we have two experts that will review the partnership audit rules, help us understand who can qualify as a Partnership Representative, review important considerations when appointing a Partnership Representative, share ideas of who should serve as the Partnership Representative, summarize the new Partnership Representative provisions, and just before time for questions, I will wrap up with additional considerations. Over to you, Robert and Philip.

Robert: Great. Thank you. This is Robert Schachter from Withum. Starting with the new partnership rules, we wanted to go through a history of where we got to be here today.

So the starting point really began in 1982 where they enacted the IRS and Treasury enacted the tax matters partner. That partner was responsible for handling 100% of a partnership's tax examination issues and was to be reported on a tax return.

In 2015, a new law came through in the Bipartisan Budget Act, which caught people by surprise. Many people weren't aware of it. And it basically said that there were new partnership rules that were to take effect for tax examinations by the IRS with years beginning January 1, 2018.

One of the rules that got implemented, which is the reason behind the webinar today, is they enacted instead of a tax matters partner, they put in a rule, a special designation, called a Partnership Representative. And the Partnership Representative is an all-empowering and -encompassing individual now during a tax examination and takes a lot of responsibility.

They enacted many rules which changed the way a partnership was going to be looked at and audited. Basically, a general rule is that the partnership gets audited by the IRS and in the year of audit, not the year that they are auditing . . . meaning let's go and say that they're auditing 2018, but in 2020, the audit is taking place, the general rule is that the changes go to the partnership that is in 2020 and doesn't get extended to the partners in that partnership. The partnership basically pays for the partners.

There are other situations that a Partnership Representative can make changes to that rule, but that we will talk about later.

And as time went on, after 2015, there were many issues that have evolved from the initial statutes that got enacted and proposed and final regulations were effectuated. And if someone would like more detail on that, Phil and I can go over that in questions later or after the webinar has concluded.

So the new partnership audit rules, as I noted, replaced the Tax Matters Partner. The Partnership Representative must be named on a tax return in 2018. The Partnership Representative will designate everything for the partnership as to what is going to happen during that audit.

The items that are required to be reported on the 2018 return, an entity can be named as representative for the partnership, but an individual must be named underneath that entity's name, if an entity is named. And then not only do you have to report that information, but you are required to report a TIN, a taxpayer identification number. The Partnership Representative must be a U.S. person, have situs to a U.S. source base, and must have a phone number and report their TIN.

What is a TIN? A TIN can be anything from a social security number, a taxpayer identification number given by the IRS if they don't have a social security number. It can be the PTIN, or Preparer's Taxpayer Identification number, as well as there are a couple other items that they have reported as what qualifies as a TIN.

Phil is going to talk to you about the next several slides.

Philip: This is a background to the new audit rules. The number of audits of partnerships prior to these rules was very small. I think it was, on a relative basis next to large corporations, which was like 27%, less than a percent, so it was very small.

And even on those audits, the IRS collected very little taxes. So the purpose of these new rules is really to enable the IRS to audit partnerships and collect taxes from partnerships. And we can expect, because of it, that there will be more partnership audits and more taxes collected in those audits.

And this is also due in part that the number of partnerships has proliferated as well. As Robert said, the old audit rules were enacted in 1982. And since that time, the number of LLCs taxed as partnerships in the U.S. and just partnerships generally has grown significantly. So, again, the overall idea of these rules is to increase the number of audits.

Under the rules, which again referred to sometimes as the BBA because of the Bipartisan Budget Act of 2015, again, the adjustments were generally done at the partnership level and then taxes, penalties, and interest are also computed partnership and paid at the partnership level. And we'll get into different abilities to shift that from the partnership itself, but they get pretty complex.

It applies to all partnerships that file U.S. tax returns. So whether you're a foreign entity that checks the box to be a partnership for U.S. tax purposes, or whether you're a U.S. LLC or U.S. partnership that's taxed as a partnership, the new rules apply to you.

There are a number of elections we'll get into. This isn't going to be when we get into all the details of the rules. I think we're going to try to emphasize what you need to know now and what you need to do now rather than at a level of difficulties or nuances in the rules. They are very complex.

So there is an ability to elect out for certain partnerships. A lot of partnerships will not meet those requirements. The partnership must have less than 100 partners, and you can have certain partners that are not eligible partners, such as partnership or trust or disregarded entity.

If you elect out of the partnership rules, you're actually back into pre-[inaudible 00:09:14] rules, which said that every partner is audited separately. I didn't write these rules. These rules have a lot of issues. I think they ended up coming out okay at the end of the day. But one of the things that I always thought wasn't a good rule was the 100 partners. I think it's way too many, but they should have had the lower number but more ability to elect out.

But anyway, that's my view, but it is 100 partners and many partnerships will not be able to elect out. In a typical case, let's say you have a limited partnership or a limited liability company and the general partner or the managing member is typically an entity itself, a partnership itself, and that knocks out the ability of the partnership under audit to elect out.

Robert: And also, Phil, S corporations you look through in the count of 100.

Philip: Correct. So an S corporation is eligible. There's a qualified S. Some might not be, but the S corporation itself is. Again, the idea is that the IRS only really wants to deal with one person, so that generally will limit it to dealing with your Partnership Representative, and a Partnership Representative will have various powers that we'll discuss later.

There is a power of attorney way to have other individual partners to participate. But right now I think . . . when you're looking at this, you have to consider this Partnership Representative.

Again, we're not going to get into the overall complexities. We'll get into some of the nuances and rules. As Robert said, they apply to audits of taxable years beginning on or after January 1, 2018. So your prior law still applies for audits in, let's say, 2017 year. So you can't just forget about all those rules and just learn the new rules.

Again, [inaudible 00:11:03] need the Partnership Representative of U.S partnerships and foreign partnerships that are required to file U.S. tax returns. A typical case may be where you have a . . . I deal a lot with various funds, hedge funds, private equity funds, and whatnot. A typical case may be where there's a foreign manager that sets up a U.S. partnership for U.S. investors. A Partnership Representative needs to meet certain rules, as Robert mentioned. And the Partnership Representative, if it's an entity, designates a designated individual to be that entity. And we'll get into the details of how you actually do that designation of both of them.

Again, you need certain U.S. presence requirements. For certain foreign partnerships in particular, it might not meet those requirements, and we'll get into who they want as Partnership Representative, or in certain circumstances may be domestic partnerships. Even domestic people might want an independent Partnership Representative.

The Partnership Representative, the idea was the IRS wants to just deal with the partnership representative and the partnership has all powers under the code. So we'll get into later how you might narrow that contractually with the Partnership Representative. At least based on the IRS, the Partnership Representative has all the power and the Partnership Representative does not have to provide notice or any other information basically to partners, again, unless we do it contractually but not vis-a-vis the IRS.

Under the law, the tax matters partner did not have such power. They would deal with the IRS, but it had to provide notices to all partners and each partner had a right to participate in an audit. So, again, the IRS just found that unwieldy.

The partnership is designated each year, so whoever you designate in 2018 doesn't necessarily have to be the 2019 person. You most likely are going to be consistent, but you don't have to be. And there are either ways to resign or revoke an election, or otherwise the partnership representative stays in effect. Usually you can't change it until you're under audit, and then there are different procedures for the person to resign as it, or for the partnership to revoke the partnership representative as the actual Partnership Representative.

Robert: So basically what you've got going here is all the rules have changed from the past. So let's look at, say, if a partnership is in a preexisting partnership, one of the things that the partnership should immediately do if they haven't designated is they need to look at their documents. It's very important because TMP, or Tax Matters Partner, does not exactly work into the new rules for Partnership Representative. And there may be some designations in your partnership agreement that may not assist the new person that is required to handle partnership matters.

So, appointment is valid until affirmative action is taken basically. What does that mean? That means that once the Partnership Representative is named, then that person has to be with the partnership as their representative until a tax examination occurs.

When the tax examination occurs, that is when a Partnership Representative gets notified by the IRS, and then the partnership has the option to actually revocate the Partnership Representative at that time or allow the Partnership Representative to handle the matters.

Revocation by the partnership must be done in writing. As I noted, it's only effective if an audit has commenced. And the IRS has the responsibility of notifying the partnership and the Partnership Representative of the acceptance of the revocation. If they don't accept the revocation, believe it or not, one of the rules that the IRS has provided in their rules is it's okay if they revocate this person, but let's just say they don't accept the person that's going to be the new representative, the IRS can actually represent a person instead.

That has not been cleared up in the regulations at this point as to why the IRS would come up with their own determination, but it looks like that . . . it was my opinion, and Phil concurred on this, that it was set up that if a Partnership Representative wasn't name, they could name somebody so that they'd have somebody in place, that it really wasn't the intention for them to go in and not let the partnership make a named Partnership Representative.

So what are the powers of the Partnership Representative? Believe it or not, everything. They have all rights and assume all responsibility and take on a significant fiduciary responsibility. The broad acts include settling a tax examination, extending the partnership statute of limitations. The one that's big and key here is bind all partners to a settlement agreement, decline to challenge/contest all or part of an adjustment, and make any and all decisions on paying tax including the push-out election, which is to push out the results, and that must be done within 45 days after the partnership audit has concluded.

Dealing with this area is very significant, and before anybody would decide to do something like that, they should have a consultation with counsel and the partners in the partnership before anybody would consider doing that. But the Partnership Representative has the right, believe it or not, to do that without consulting anybody.

The Partnership Representative, as noted in the next line, they're not required to consult or receive approval of actions from the partners. Normally, they would be in conjunction working with the general partner or the managing partner, depending upon if it was a limited partnership, general partnership, or a limited liability company.

The implied powers of the Partnership Representative are they can hire an attorney, accountant, or other professional to work on their behalf. They can direct how advisors will work and what the issues will be, hire all experts, bind the partnership, direct access to the books and records, and charge the partnership for their time. And that is something significantly different than in the past, because normally a Tax Matters Partner is a partner that's in the partnership and never got remunerated for handling matters.

It is my opinion that if somebody is going to charge for their time, it would be someone that is not associated with the partnership and is doing this as a professional service.

The partnership representative designation not in effect. As noted, if no Partnership Representative is chosen on the return or does not have U.S. substantial presence, you need to get one that does have a U.S. presence. The IRS will then, if you don't have somebody notified on the return, send notice to the partnership and the last known Partnership Representative, if there was one, if there isn't one, they will designate one. And there's a 90-day period after the IRS designates a Partnership Representative for the partnership to go out and get their own representative after that.

So who should serve as your Partnership Representative? In general, we're seeing right now a partner that is in the partnership or somebody who has close ties to the partnership. And that's basically for the U.S. partners.

For non-U.S. entities, we are finding that they are going to need somebody that's in the United States, that has a place to meet that is convenient for the IRS, not convenient for the Partnership Representatives, and they need a phone number that they can be contacted at, as well as making sure that they have access to the company's books and records if there was an examination.

So the question then becomes "Are potential conflicts fully vetted and addressed with a Partnership Representative?" It's very important that whoever you decide to utilize as your Partnership Representative doesn't have a conflict of interest. But at the same time, if you're the general partner and you pick yourself to be the Partnership Representative, there's always the potential for conflict. The question becomes there has got to be a trust factor based upon what has been designated here by the IRS.

At the same time, who accepts possible liability? The partnership is responsible for paying all of the IRS audit changes that end up being effectuated in a tax examination. The question becomes "Is there potential liability and fiduciary responsibility that is thrown upon the Partnership Representative?" And the answer is yes.

I am not an attorney. Just so that everybody knows, our firm as an accounting firm, Withum, will not be a Partnership Representative. We prefer to handle tax examinations and prepare tax returns from the tax side. We do not take any responsibility as far as trying to be a fiduciary for our clients.

So who should have the binding authority, and will binding authority upset any balance among the partners? Sometimes yes. Sometimes no. The binding authority is going to be with the Partnership Representative.

And to state this over and over again, the Partnership Representative is the all and powerful Oz, as they say, in "The Wizard of Oz," and they theoretically have all the power to handle everything once they are named as the Partnership Representative, until they are revoked as being the Partnership Representative.

Will the designated individual be around when the IRS sends a letter? That's an important item to note. Is it somebody that has a long-term presence with the partnership? Now, if you hire somebody that's outside of the partnership, revocation can occur and you can hire somebody else, but understand if somebody is hired today and they're not going to be there five years from today, that's what you really have to look at.

In most instances, five years from today doesn't matter. Statute of limitations is generally three years unless fraud is committed. And we would take the position that for this seminar or webinar that we are looking at entities that are going to be doing things by the letter of the law, so the statute of limitations would be three years.

Who is best positioned to coordinate the right resources to get the best outcome? That answer would be to go with somebody who's related to the general partner or the partnership or the managing member of the LLC.

Will the designated individual have the bandwidth to perform the role if they are generally the people associated with the general partner or the managing member? The answer should be yes, because that's what they're doing as their normal occupation.

You want somebody that has the time to be able to handle this. If somebody doesn't normally handle something like this in the past, I would not name them even if they were part of the general partnership just to take on this role.

Remember, also, that a Partnership Representative has the right to farm out the work to accountants, attorneys, etc., to handle all the work. They just have to be responsible for making certain decisions, and if they're not willing to make these decisions, they should put somebody in the role that is willing to make all the decisions for the partnership.

If handled within the partnership, will the Partnership Representative have access to the books and records? And this is very important. They've got to be given, when they sign up as the Partnership Representative, that they will have access to books and records, because if that partner may no longer be active with the partnership at a later date or they utilize an outside representative, they have to be given the rights to the books and records.

And what we're doing is we are actually sending out a letter to all of our partnerships where the partnership is naming the entity, and then if it is an entity, the individual who has access to the books and records is signed off by the client.

So, Phil, who should serve as your Partnership Representative going forward on the rest of these questions?

Philip: I think it will depend on the partnership itself. As you said, I think a lot of times it will be the general partner of the partnership or the managing member if there is one in the U.S. If not, like in a foreign partnership, then maybe someone like CSC, which we'll get into later.

And then who will be the designated individual will depend. I agree with you. When it first came out, I think a lot of people thought the accounting firms would take on the role of being the Partnership Representative, but that has not developed, nor have law firms have taken that role as well. So it really will be the people associated with the partnership itself or someone like CSC.

And then that person, when they handle an audit, you'll have to weigh different considerations in determining how to proceed. If you have an outside person or even a designated individual, you're generally going to want to have a contract with them limiting what their authority is.

I want to step back a little bit as far as when we get into what the partnership agreements need to address. I think we've gone a little bit more in detail on what the partnership audit rules are. And Robert said there's a review year, which is the year under audit, and then there's the adjustment year. It's just the year, basically, the audit is concluded. And the default rule is, again, the taxes are paid at the partnership level.

And there are various elections. One is you can elect out. If you can elect out of the partnership audit rules, you should. Again, this can be very limited circumstances where you can, but if you can, and we'll get into why, you should elect out. If you can't elect out, then there's either the "push-out" method, which Robert mentioned, that pushes out the changes up to the partners, and even if those were pass-through partners, generally up to those partners, to the ultimate partners. And those partners are then required to file amended returns and pay the taxes too.

The "push-out" method is . . . the way that changes work, it can be disastrous for the partners in the partnership because it can be where they just take positive changes and not negative changes. I'm sorry. If you determine to tax at the partnership level, the taxes can be much worse than if the numbers are passed through to the partners. They could just take the positive changes and not the negative changes and then the amount of tax can be very high.

If it's de minimis tax, you'd probably just pay it at the partnership level. If you're partners, maybe you don't change from the year reviewed versus the adjustment year. So for example, in a private equity fund where partners are basically static, you might have less concerns than a hedge fund where there are differences. The partners change. Can be pretty frequent changes or a lot of percentage changes in who the partners are and what their relative interests are.

So what type of partnership it is, what the tax asserted is will impact what the partnership decides to do. The partnership can try to reduce the taxes at the partnership level based on the characteristics of the partners. So if I'm in a partnership and it's not doing business in the U.S., and a big partner if it's a foreign corporation, it can actually reduce the amount asserted substantially. And if it was owned by a foreign corporation not doing business in the U.S., then it should reduce taxes asserted to zero.

So you're going to have to weigh a lot of different considerations in how to proceed, whether you elect out, how you try to minimize the tax, whether you try to push through the tax. If you push through, again, there's extra interest charged, so higher than normal interest charge on the amount due. So the numbers can add up, and obviously that's why I said initially if you can elect out, elect out.

Robert: One thing to note also with that, Phil, is we've been in touch with many states. And I've just met with the director of tax in New Jersey and New York, and both of them do not follow federal rules on this. They're trying to come up with a methodology and they figure that they're going to try to come up with something by 2019. So understand there are no rules currently at the state level, so if you have a business and you're doing business in a given state, this does not apply at the current time for any state in the United States.

Philip: And another thing to consider when you're looking at your partnership agreements or deciding how to proceed, it's going to be the case when a person invests in your partnership, they might want to see certain things in the operating room and how you end up offering them . . . and we'll get into that. Because they're basically buying into, let's say, a potential liability. And also, if someone is just in M&A, you know, people are buying your partnership interests.

There's also, as you know, a consideration in negotiating the purchase agreement and who bears liability for those facets too.

Your partnership agreement needs to . . . and also, we'll get into operating with the [PCMs 00:29:27] and [inaudible 00:29:28] briefly. You need to designate the Partnership Representative. You could also designate the designated individual in there. We've been typically designating the Partnership Representative and giving it the authority to designate the individual rather than doing both.

Under the partnership rule actually, the partnership itself could be the Partnership Representative, which sounds circular, but they allow that. It doesn't really mean much, but that is potential.

I've been very flexible in our documents. We try to preserve all flexibility to the partnership itself because a lot of these rules, even though they've been out now for four years or so, there have been a lot of regulations and guidance issues. There's still uncertainty until there are actually audits, in my view. Until you actually see how these rules develop, how they're applied, the facts and circumstances of your partnership, you really don't know certain things or [inaudible 00:30:24].

At first, I think in 2016 and '17, a lot of [inaudible 00:30:29] letters would try to pin down the partners, the partnership, and how it's going to react in all cases on your audits. And we pushed back substantially on that. Understandably, we basically didn't tie down our partnerships. We generally represent the partnerships not the investors, but even when we represent the investors, we understand that you can't really tie the partnership down so much on how they'll actually act in an audit because you don't know what the audit . . . what will be asserted.

So you need to address really the Partnership Representative, general language saying . . . I've seen people put in three or four pages in the agreements exactly how they try to proceed in each different situation, and I just think that's a huge mistake. We really had one or two paragraphs saying, "So-and-so will be the partnership rep. They can make all the elections, determinations, and decisions. All partners will provide information as requested by the Partnership Representative for an audit. They'll amend their returns if they need to. And they'll reimburse the partnership for taxes, interest, and penalties to the extent it relates to their partnership interest." So we will be very broad on that in the agreement.

And then the other thing is, are there any limits that we've put in? And we don't really put in limits, as I was saying earlier. We don't put in limits on the partnership rep, but you might. If you're an investor or you're in a partnership where there's three or four, not a large number of investors, and maybe you can't elect out because of who those partners are, you might put in that you need to provide contractual notice to people of when there's an audit or when there's material correspondence from or with the IRS. Can they extend the statute of limitations? What [inaudible 00:32:30] do they have to settle disputes? Do they need to get everyone? Do they need to get a majority of partners?

So you're going to try, particularly in small partnerships in my view, to limit what the Partnership Representative can do without partner approval. If you hire someone like CSC, you're going to put even more limits [inaudible 00:32:50] contracts on what they can and can't do without your approval. Again, I disagree with this, but you might put in whether someone . . . when they need to make the "push-out" election if they can. I think that's a mistake.

I think a lot of this you need flexibility of the Partnership Representative to try to get to the right result, which is the amount of tax that would have been determined if they reviewed year was adjusted and applied to the partners in a reviewed year. So if you can get to that outcome, you'll get to that. You might not be able to.

And responsibilities of the other partners. Again, we kind of put in language that they will provide information needed. They'll amend returns. If we want to qualify for the electing out, they won't transfer their partnership interest to partners that are not eligible. We haven't had that come up so much, but in a small partnership, you might.

For example, in the fund context, maybe the manager has just two or three principals that are individuals and they qualify to elect out. You might limit their ability to transfer interest in the partnership to somebody who doesn't qualify. Again, even those a lot of times will not qualify because they'll have trust or other potentially ineligible partners in the management entity.

Robert: That's a good topic to bring up. You know, there's a lot of trusts that are out there that are investors after the fact. Please note that grants or trusts are considered trusts for purposes that the IRS says that you cannot basically elect out. So if it was an individual and now it's not, the Partnership Representative becomes responsible for making sure that if they do something and represent it in front of the IRS, that all the partners are known.

It looks like you can probably spend a lot of time if a partner is not the designated partner. And we've had this before where a partner was not changed on the partnership tax return in name because the social security number is still the ID number for the grant or trust. But at a later date, if you go through the whole rigmarole of doing this and then you elect out, let's say, and the IRS finds out you're not allowed to elect out, it could create a severe issue on the Partnership Representative.

So the Partnership Representative has to know all the facts and circumstances of what's going on in a partnership. They just can't be in the role of saying that they're in name only.

Philip: Just a couple things coming up now . . . we've gotten a number of questions, "I've got to designate my Partnership Representative by March 15." And that's not the case, because I had some panicked people, "Who am I going to designate? How do I designate?" Again, you have to do it with your 2018 return, so if you're on extension, you have past March 15, until you file a return by September 15. So it's not a next week or next two-week type of issue generally, because many partnerships will go on extension this year.

And then another thing to consider is will the new rules affect positions that you take on your tax return or that accountants are willing to take on your tax return? And that remains to be seen, I think.

Will people get more aggressive on whether they're a trader fund or investor fund or other tax positions? Again, we'll see. I don't think so.

And I guess the last point is these rules . . . one of the major changes over the last 20 or 30 years or whatever out there, they got a lot of attention when they first came out in '15, because it was a dramatic change in the audit rules of partnerships. There was a huge number of articles. The regulations are hundreds of pages. They aren't as significant now, I think, generally just because people are more used to them, and they've had time to digest them, although you could spend a year just learning all the regs and we could speak for hours and hours on them.

I think there are so many other changes. I think we've heard less about the partnership audit rules than before because there are so many other new rules out there and new regulations that are hundreds of pages on other topics, such as indefinite interest expense on your 163(j), [inaudible 00:37:19], and whatnot.

So I think this is still a very important topic. We shouldn't forget about it. It's going to be important on your return, designating a PR.

The other thing, again, you have to do is just make sure your agreements have been changed, more so where you're a hedge fund where the partners change, less so where private equity, but even that I suggest that they should have changed their [PPMs 00:37:42] or operating agreements to address the partnership representation.

Again, we put in a paragraph or two in the operating agreements. We're putting in a paragraph or two in the offering memorandum. Again, it's a risk factor thing, highlighting that the partnership or you may be liable for taxes for prior years, and you agree to provide all such information. And we generally are putting in the [inaudible 00:38:04] agreement as well that, "I understand this and I agree to provide such information."

Robert: Now, what this has caused for us accountants is an accounting "Apocalyptic Moment." An example would be, in 2018, we have partners that are in a partnership. In 2020, these partners are no longer in the partnership and the partnership ownership percentages have changed. Phil makes a great point as to some of the partnerships have designated in their partnership agreements indemnity clauses, or some of the partnerships I've actually been looking at, they've actually got a hold-back where they're considering holding back funds.

This is never positive when you've got to start implementing rules on people's partnership agreements where cash . . . when people leave a partnership, they want to be able to leave the partnership. And unfortunately, general partners or managing members have the issue of being concerned about if an audit occurs, making sure that somebody has the payment that's going to be appropriated from it, because the partnership is responsible for paying it, not partners.

Philip: Great point. And it does bring up the 1048 part. Again, accountants have determined that this is not a 1048 tax because it's not technically on the partnership, I guess, is the view.

Dave: That's correct. It's a partner tax imposed on the partnership.

Philip: So it's not going to be under 1048. It's under another standard potentially, which makes it much less likely you're actually going to accrue these taxes on your GAAP accounting financial statements.

Robert: And as an accountant, the only thing that I will say is if anybody that's on this webinar has not addressed their partnership document . . . I'm not doing any slanting for an attorney to get a fee here, but it's very important that your document be updated because whoever the GP or managing member is going to be what I call "left on the hook."

If decisions need to be made in the future and partners are no longer there, the general partner exposes himself to the representative if they're not going to be that person that's representing, and there are going to be issues between partners saying, "I don't owe the money," and potentially a lawsuit could occur.

Philip: Absolutely. I think it's a great point. You want to make sure you're [inaudible 00:40:27] in the operating agreement and the PPM. You want to say, "Partners and former partners." So you want to bind it. You want to make sure that this stays in effect even after they're no longer partners, and even after the partnership is not there.

The rules actually also deal with liquid partnerships that no longer are in existence and how does the IRS go after those partners. So you want to make sure that's dealt with.

The other thing we deal with is also that this is really a partner [inaudible 00:40:52] so that we don't want to affect the incentive allocation or the carry, and we generally don't want to affect the management [piece 00:41:02], though less so on the management piece. We don't want to affect the incentive and we do want to have partners reimburse the partnership for the taxes due.

Robert: And what really gets a trifecta of the ladder scale, I would call it, is what happens is you have partners that have received remuneration for a guaranteed payment for putting in capital versus income? And if it's not addressed, it really causes some scary calculations to try to figure out who owes what.

So, you know, there's no what's called preferential treatment of a senior subordinated debt here, Phil. It's actually the calculations should be represented ahead of time. If you've got a very interesting waterfall calculation, there should be some connotation as to how your liability should be incurred to the individual partner, and I don't mean individual as a person, but to each partner, I should say, as to what their potential liability could be in these situations.

So considering the additional issues that we have, not only . . . we talked about now the partner issues, but now what could be the potential Partnership Representative issues with liability, Phil?

Philip: The Partnership Representative, especially if you're an outside person, you want to be held liable as long as you don't do anything wrong really, as long as you don't do it intentionally wrong.

The Partnership Representative is going to have to weight different determinations. If Robert is a former partner and I'm an existing partner, there's a conflict between us. So, you know, as I said, I always try to maintain as much flexibility with the ultimate desire to try to pin the tax, interest, and penalties on the partners that were partners in the reviewed year.

Robert: Is there anything explicit that you would definitely make sure that was in a partnership agreement?

Philip: Yeah. Dave will get into . . . an existing indemnification of Partnership Representatives will be an important requirement. If I'm going to be a Partnership Representative or that designated individual, I want to make sure I'm indemnified by the partnership.


Dave: Yeah, thank you. So as Rob said earlier, this position is like Oz, all-powerful. And we know from experience any time you accept a fiduciary role combined with large dollars, potentially large dollars at stake, there's a chance that the parties that feel hurt by a decision will sue. So because of this possibility, we believe the Partnership Representative should be protected by indemnifications in a contract, or in our case of service agreement, and that there should be adequate D&O insurance in place.

The partnership will also want to make sure the coverage has a tail that would cover any actions that the Partnership Representative has taken and that Partnership Representative is no longer in place.

And finally, as Rob has mentioned his conversation with a few states, we've not heard from any states that they've taken a position on the new federal regulation. However, if the IRS's hope comes true and the regulations make their life easier and allows them to collect more tax revenue from the partnerships, then it would be a good guess that the states will follow suit.

Why did we get into this business and why do we at CSC believe that we're a good choice when needed to choose a third-party service provider? Well, CSC has been operating since 1899. We've been around for 120 years and five years from now, 10 years from now, when a letter is received by us from the IRS, we'll still be here to receive that letter and act on it.

We set up a designated mailbox that all mail goes to. So even if the designated individual were to leave our company and we need to replace that person, we'll still receive and act on the mail. In fact, last year we received over a million pieces of mail, and our requirement is to process them within 24 hours.

We've been serving in similar roles either as a trust trustee or independent director. And so, we have experienced taking on what we call a passive role to start and then moving into an active role, and that change would take place when we receive a letter from the IRS.

And to the best of my knowledge, we're the only company that's been invited to Washington, D.C., a third-party service provider, to meet with the IRS to discuss the Partnership Representative role.