Dave Cain: Welcome to unsuitable on Rea Radio, the award-winning financial services and business advisory podcast that challenges your old school business practices and the traditional business suit culture. Our guests are industry professionals and the experts who will challenge you to think beyond the suit and tie, while offering you meaningful modern solutions to help enhance your company’s growth. I’m your host, Dave Cain.
Dave: The IRS has replaced the existing rules for auditing partnerships with a set of new streamlined rules. Chris Axene, a principal at Rea and Associates with a passion about pass-through entities is here to explain what these new rules are and how they will impact partners, members, and partnerships going forward. Welcome back to unsuitable, Chris.
Chris Axene: Thanks, Dave, for having me back. Appreciate it. This is an important topic, so glad to be here.
Dave: We just got together last week. We tried to cover this, didn’t have enough room, so we booked you again.
Chris: I’m all in.
Dave: Your booking agents do a nice job getting you on these shows.
Chris: Do I get a commission?
Dave: Yes, you do. Yeah, watch your mailbox for the check. We’re going to talk about here in a minute about operating agreements in partnerships and things like that, that a new rule that’s maybe a flying under the radar a little bit. Before we do that, I think we want to identify that any time you talk about an operating agreement, that’s a legal document. Today, we’re not going to get into legal issues and the legal side of this, so we want to encourage listeners as they listen today that you need to talk to counsel when we starting talking about operating agreements. What we want to cover today is more the tax implications and some of the things to be on the lookout for.
Chris: That’s right, and a good point, Dave. As accountants, we can help advise certainly on the tax law and ramifications of that and how that might impact the operating agreement, but as you pointed out, that’s the legal document that the attorneys need to be involved with. We’ve worked hand in hand with legal counsel for clients as we’ve helped them implement these new rules and figured out what all they need to do as we go forward.
Dave: Before we dig into these new rules, let’s hit some of the highlights of the importance…
Chris: Well, there’s so many.
Dave: Of an operating agreement. Just give me two or three.
Chris: The operating agreement is the legal playbook for how the partners will conduct their business and they’ve chosen to do it in a partnership format versus, for example, maybe as an S corp. Among other things, it talks about who can be an owner and a partner in the partnership and how you become one, how you exit. There’s restrictions a lot of times on your ownership and that to prevent you from transferring to somebody that, if we were partners, that I might not want to be a partner with. Maybe call that like a right of first refusal, or outright restriction on transferability. Legal terms, to be certain, but that’s… if you don’t have an operating agreement on the tax side of things, we don’t know how to prepare a tax return.
Dave: I think you’ve undersold the importance of this document, and we can only share stories with our audience that you and I’ve both been involved where that document was not followed and created havoc throughout the partnership.
Chris: That’s right, and oftentimes, too, the partners, this won’t come as a surprise, they will sign the document, and they don’t know what’s in it. They have… they’re thinking one thing, and then they may get their K-1s from when we prepare the tax returns and they may say something different. They’re scratching… they’re going, This isn’t what I expected. Well, did you read your agreement?
Dave: The hundred-page agreement, and they can be hundreds of pages of stuff.
Chris: Right. That’s right.
Dave: If you think out loud, in a partnership that has a lot of things going on, a lot of times you’ll have some capital guys, the money guys, that are passive, and then you have the action guys, the activity guys, the idea people.
Chris: That’s the majority of what we see in our client base is you have the idea people and you have the money people, and coming together to form a venture to execute and make some money for everybody.
Dave: Again, I want to maybe throw a little caution in the wind. The internet is great, but it’s a dangerous place to find documents. You can go on the internet, find out how to fix your brakes. You can fix your slice …
Chris: Really? I haven’t found that one yet.
Dave: You haven’t that found that? Keep on looking. Of course, you got that draw, so you’re pretty good, but I did… prior to going on there, I did find a template for free for doing your operating agreement.
Chris: Yeah, I’ve seen some of that and I’ve actually had an instance where we had to help a client out and they had done that. They had gone to the internet to find a boilerplate document that they more or less inserted their company name and EIN and signed it. The problem with that is it’s… many things in life, it’s as good as you paid for it and it actually had, in this particular one, it had some provisions that were contrary to each other and was just a disaster. It really wasn’t effective for anything.
Chris: The good news for us and our client in this regard was that helped us get out of a tax jam in terms of the type of entity that they thought they were versus what they wanted to be and what they had filed with the IRS and what the IRS thought they were. That it turns out in the end was a good thing that we could fall back on that to get them out of a tax jam, but you need to… I know we run into this. Clients, they get antsy you talk about, Well, go see your attorney and have a discussion, or, Let’s have a meeting with the CPA and the attorney in the room, and they see the meter running, but there’s a reason why you have the professionals in the room because they’re looking out for your best interests. When you don’t do that, you’re going to regret that later on.
Dave: Sure, and you and I could devote a couple of podcasts to just telling stories about how the operating agreement was not followed.
Chris: Right. Well, there’s… it’s legion the stories that are out there, and a cautionary tale of what not to do. That’s why as we’re working with our younger staff, we drill into them the concept of, Do we have a copy of the operating agreement? If we don’t, we need to get it.
Dave: Sure, sure. Let’s dig into this significant changes to partnership audit procedures and the operating agreement. Let’s start… what’s going on?
Chris: Sure. Yeah, so the background on this is… as you astutely pointed out in the intro, this is kind of a little bit flown under the radar with The Tax Reform Act that happened a year ago. This actually was a part of final regulations issued by the IRS that first became effective for tax year 2018, so the year that we just filed coming out of busy season. With the tax law change, that also impacted 2018. It kind of got lost in the shuffle. The background on this is the IRS has a history of very low audit rates on partnerships. In part, that’s because they don’t have the manpower to look at them and there are… It’s become a common way for businesses to do business in the choice of entity because there’s lots of flexibility with LLC stocks taxed as partnerships.
Chris: The historical context there is they’ve had a low audit rate because you run into situations where under the old rules if you had a partnership of fewer than a hundred partners, and the IRS came in and audited that partnership and they came with an adjustment, they would then have to roll that adjustment through 90-plus partners’ tax returns. It is very hard. You might not be surprised to learn that the IRS’s computer systems are… they have lots of them. They don’t talk to each other very well, and so it was very hard for them to track and understand if they made a hundred-dollar adjustment at the partnership level that that hundred dollars was going to make its way through all of the partners that are in that particular partnership return and at the right, if you will, the right level of tax being paid on it. They just couldn’t track it.
Dave: Yeah, right. Right. I have to admit, when this first came out I thought, Well, gee, they’re after the publicly-traded partnerships, and I believe they are, but as this thing unfolded, we thought, Oh boy. This is all partnerships, all LLCs basically.
Chris: Well, that’s right, and under the old rules, the old regime there were really three different sets of rules. If you were over a hundred partners, you were going to fall into a different set of rules that largely are what’s in place now, and so as a part of this tax reform, or partnership audit update, what the IRS did was is they were trying to make it easier for them to audit and by, without unspoken if you will unstated, is a revenue raiser because they’re going to collect money directly from the partnership so they’re going to get it quicker and they’re going to know that they’re getting all of it versus running it through partners’ tax returns.
Dave: Right. It seems to me, again, that they were going after the big business, and a byproduct of this is my two-member LLC got caught in this and I’ve got to comply with the same rules basically out of the gate as the publicly-traded partnership. Now, I have some outs, and we want to talk about the outs, but again, I think this is a case where they went after the big business and then all of a sudden, oh my goodness, all these partnerships got to do something.
Chris: That’s right, and in large part that’s because they changed the powers if you will of the tax matters partner. Under the old rules, every partnership had to designate a tax matters partner. It had to be a partner in the partnership, and from the IRS’s perspective, what that individual was was the point of contact under the old rules. When they were going to initiate an audit, they would send the audit notice to the tax matters partner. You disclose that in your partnership tax return each year. That’s really all the authority the tax matters partner had in the eyes of the IRS.
Dave: In the old days.
Chris: In the old days.
Dave: I bet that’s going to change. I bet you’re going to tell us how that’s changed.
Chris: Well, it changed.
Dave: I’m trying to stay ahead of you here.
Chris: It changed.
Dave: You’re way ahead of me. I usually work in a marketing side department, so this is way above my head.
Chris: The rule changed and they… I don’t know why, but they came up with a new designation that we call the designated partnership representative, and they the designated partnership representative far more powers and authority from the IRS’s perspective than did the tax matters partners under the old rules. You need to designate who your partnership representative is because if you don’t and you didn’t elect out of these audit rules, the IRS can nominate one for you. Nobody knows yet what that looks like because where… they aren’t going to… The first year that these rules applied to was 2018. The IRS doesn’t audit in real time, so it’s likely not… is going to be 2020 before we start seeing the practical implications of what these rules really mean.
Dave: If I’m designated the partnership representative, that means I’m the kind as far as the IRS is concerned. I can make the decisions that binds all of the partner group.
Chris: That’s correct with regard to tax matters before the IRS, and as a partner in that partnership, that causes… that makes me nervous. When we talk about the operating agreement and making changes to it, one, first and foremost, is we need to change the language from tax matters partner to the designated partnership representative. That needs to be updated. It may or may not be the same person, individual. What’s new now with the… I’m going to call it the DPR, is the DPR can be an entity. It doesn’t have to be a partner. There may be reasons for that. We’ve had some clients ask us, Hey, Rea & Associates, could you be our designated partnership representative?
Chris: In that agreement, as you pointed out, from the IRS’s perspective, you can extend the statute of limitations. You can compromise on an issue. You can create tax liability for the other partners, and that power needs to be checked on the… on our side of the table.
Dave: Right. Hey, Siri, take a note. Call counsel. We need to get the partnership representative made, the election made as soon as possible.
Chris: That’s right.
Dave: You talked about these opt-out agreements. I guess as I think about that, okay, I’m a small guy, a small partnership. I don’t have to… apparently I have choices. I don’t have to follow these same rules. How do I do that? Can I make an election? What do I do
Chris: Sure. What’s interesting is, is when you back up and look at what the IRS’s premise was for enacting these regulations and changing them if you will, the audit rules, is they were trying to make it easier for them to audit, but at the same time, they provided some elections where you can elect out of these rules and basically back into the old rules for small partnerships. What that means is …
Dave: I like it.
Chris: What that means is, is that the IRS comes in and audits the partnership. They come up with an adjustment. That adjustment then has to roll through the partners’ tax returns. So much for simplification because most of the discussions we’ve had with our clients is if you’re able to elect out, you’re going to elect out. There’s tax-related but reasons on why you would do that. The election out is something that… there’s a couple of different ones. The basic one, if you will, is made… is on a year-by-year basis.
Dave: Year by year?
Chris: With a tax… Yeah. Actually, in the tax return there’s a question about, Are you electing out? That’s done on a year-by-year basis. Unfortunately, there are some prohibitions on the ability to elect out. If you have …
Dave: I knew that was coming. Come on, it couldn’t… this is too good to be true.
Chris: If you don’t have the right partner types and as partners in your partnership, then you can’t elect out, cannot elect out… you have… using this election that’s in the annual return. I don’t know where they came from on this, what their thinking was, but again, maybe going back to, Hey, is it too good to be true? Yeah, you have an election out, but if you hold your interest as in a single-member LLC, you can’t elect out, cannot. If you’ve done estate planning and you may have transferred your interest to a grantor trust, cannot elect out. If you have another partnership, so what we would call an upper-tier partnership… That’s a partner in your partnership… Can’t elect out.
Dave: Right, right. I can think of a couple of examples like maybe a partnership that’s an accounting firm, law office, medical practice, a larger one where partners have a tendency to come and go. You’re admitting new partners and some are retiring. This election to opt out is pretty important for that group.
Chris: It is. When you have a partnership where the owners turn over, you would want to elect out, and again, this goes back to the concept that the IRS doesn’t audit in real time. You and I may be in a partnership here in 2018, but I may retire in 2019 and the IRS audits this year and 2020, so this concept of the year they’re auditing is a later year when the partners may not be the same partners who existed in the year under audit. What happens then? Well, if you didn’t elect out, those partners are going to be on the hook for the tax on any adjustments.
Dave: Right. Now, you’d mentioned again this election is… you have to make it annually-
Chris: Correct.
Dave: Because you’ve got to look at your ownership annually and see if you qualify.
Chris: Right, and each year stands on its own.
Dave: Sure, so there’s the partnership. Should you… what’s your recommendation? Should we put that the preference is in the what we want to do in the operating agreement? Is that something we can add to the operating agreement every year?
Chris: Well, it is something that can be added to the operating agreement, and we might argue it should be as to… in terms of discussing what the powers of the DPR are, what powers they have in terms of elections to make, this being one of them. Do they make that election each year? Or expressedly… explicitly to state that we want to elect out.
Dave: Yes. That’s the intent.
Chris: Yeah, and now going hand in glove in that, though, is then, okay, we may have… me, you, and Brad may be in a partnership today and that’s fine. We’re all eligible to elect out and we’re going to elect out, but next year we might admit Becca, who for appropriate non-tax reasons, has her ownership in a different form that would make us now ineligible to elect out. Should we have language in our agreement that limits your ability to have an owner that would prevent you from electing out? Again, that’s where… we’re way in the weeds on this and that’s a lot of focused on tax only things, but those are conversations we’re having with clients.
Dave: Again, I think you and I have looked at a couple of pieces of tax software and the danger there if you’re using off-the-shelf software for business, you have to make that election because if you don’t, I think that software is going to assume you want to follow the new audit procedures. You could make a mistake pretty easily there without knowing that you’re under these new procedures.
Chris: That’s right.
Dave: Again, I think we have to… it’s a must, we have to review and amend the partnership operating agreement for a couple of things that we just talked about, the partner representative and maybe put the election ideas within the document. If you’re going to go in for those two things, it’s probably a good item to sit down with your CPA as well as counsel and look at maybe the other things in there that are outdated. Some of these operating agreements are probably 10, 15 years old.
Chris: Well, that’s true, and part of the reason for that is they get put on a shelf and you forget about them, but the other part of that is sometimes it can be difficult to amend an operating agreement. It can be difficult because you got lots of partners and you got to have votes. You have to be… you have to keep that in mind when you’re looking at this issue.
Dave: It’s a great way to do business, partnership LLC, but as you and I pointed out, it’s also probably the most complex entity structure.
Chris: It absolutely is. It’s fraught with landmines for the ignorant and uninformed, and that’s why you need a professional.
Dave: Even if you’re a two-man engineering firm or a publicly-traded partnership, these documents are critical, but both sides.
Dave: Before we wrap up, I want to exit the conversation about the operating agreement and ask you about some of the new language and discussion that’s up about the self-employment tax that is coming down on the limited liability companies that maybe we haven’t seen in the past.
Chris: Yeah, so we’ve had some… what I’ll call some clarity in the guidance that’s available on the whole issue of partnership and a partnership and being subject to self-employment tax on all of the pass-through income allocated to them, not just guaranteed payments that they may get, their wage equivalent. That really transpired through the results of some court cases, tax court that have fallen out in the last 18, 24 months now. We’ve had conversations and we’ll continue with our clients about how to deal with that, and one of the options could be, again, going back to choice of entity is maybe electing S. It’s not a be-all end- all and it doesn’t fit every fact pattern, but that certainly is one way to address the issue.
Dave: A lot of business planning ahead in 2019 and early 2020, and a good place to start is this document.
Dave: Our guest today has been Chris Axene, Senior Tax Partner with Rea & Associates. Chris is located in Rea’s Dublin, Ohio, office, but you’ll see him around the state at all the other Rea offices from time to time. Thanks again for joining us, Chris.
Chris: Thanks for having me, Dave, and I’ll see you on the golf course.
Dave: Well, I’m going to be working this summer, so have at it. I’ve got to do some other work this summer. I don’t have time to play like you tax guys.
Dave: Clearly, this is a complex topic with lots of serious implications. Listeners, if you’d like to learn more about the new IRS partnership audit rules, you can shoot us an email at contactus@reacpa.com, or for those of you watching on today’s episode of YouTube, you can leave your question in the comments section below. In the meantime, please take a moment to give this episode a big thumbs up, share it with your professional network, and if you haven’t already, go ahead and subscribe to unsuitable on Rea Radio anywhere you choose to listen to your favorite podcasts.
Dave: Until next time, I’m Dave Cain encouraging you to loosen up your tie and think outside the box.
Disclaimer: The views expressed on unsuitable on Rea Radio are our own and do not necessarily reflect the views of Rea & Associates. The podcast is for informational and educational purposes only, and is not intended to replace the professional advice you would receive elsewhere. Consult with a trusted advisor about your unique situation so they can expertly guide you to the best solution for your specific circumstance.