Earlier this year, Congress enacted new IRS audit procedures applicable to partnerships. The new rules, which apply to partnership returns filed after 2018, are expected to have a significant impact on tax exempt partners.
As part of the desire to diversify portfolios, tax exempt organizations have increased their exposure to alternative investments. Many of these investments are pass-through investments either partnerships or limited liability companies taxed as partnerships. Because they are taxed as partnerships, that is what is relevant for purposes of this new law and this discussion. Partnership investments are unique because income, expenses, and other separately-stated tax items are collected by the partnership level and reported to the partners. The partners then report the separately stated items on their tax returns.
For tax exempt organizations, most of the income earned through these investments is passive income (interest, dividends, capital gain, etc.). It is thus statutorily exempt from federal and state income tax.
If the exempt organization is a private foundation, it may be subject to the one or two percent excise tax on net investment income.
This co-investment between taxable and tax-exempt partners in investment partnerships has worked well for many years, since public charities won the landmark case allowing them to co-invest with for-profit investors.1 Each partner received their distributive share and reported based upon their tax circumstances.
What Can Tax Exempt Partners Expect?
As stated above, the new IRS audit rules are expected to have significant impact on this happy co-investment existence. To avoid unfavorable consequences, partnership operating agreements must be carefully reviewed today and may require revisions to mitigate the impact of the new rules.
Provisions which may have a negative impact on tax exempt partners include:
- The IRS may assess and collect additional taxes, interest, and penalties directly from the partnership, rather than through auditing each partner. The tax could be collected at the highest individual tax rate even though there are tax exempt partners invested in the partnership, which would have no tax on the adjusted income.
- Current partners could be liable for the taxes of prior investment partners. If those partners were for-profit investors and the purchase price of the investment incorporated no contingent liability or payback provision to the tax-exempt investor, there is potential for private benefit from the tax-exempt organization paying the tax liability of a prior for-profit investor.
- Additionally, private foundations may co-invest with disqualified persons. Because the adjustment in tax will happen at the partnership level, there is the potential for self-dealing if the private foundation is assessed taxes owed by disqualified persons.
Important questions to ask:
- How many partners are in the partnership? If there are 100 or fewer partners, the partnership may make an annual election to opt-out of the new audit provisions. The election must be made on a timely filed Form 1065.
- Does your partnership agreement identify a partnership representative (formerly known as a tax matters partner)? If not, the document likely needs to be updated to rename this person and give them authority to:
- Represent the partnership before the IRS;
- Make the opt-out provision (if applicable and desirable as described above)
- Carry out any other decisions or responsibilities that require specific identification
- Who is the partnership representative? Do they know there are tax exempt organizations? Do they know the issues which may arise with a mixed pool of taxable and tax-exempt partners? The partnership representative has the authority to bind the partnership and the partners during an IRS examination. It is important they are informed as to the diversity of their investor constituency.
Partnerships continue to be a valid alternative investment in an exempt organization’s well-balanced portfolio. However, it is more important than ever to carefully review the partnership agreements. This allows organizations to ascertain if:
- They’re current with the latest tax laws,
- Their partnership representative is identified and familiar with tax exempt organizations, and
- The representative is prepared to make good decisions regarding the partnership interests they are charged with representing.
What Precautions Should Tax Exempt Partners Take?
- Ensure the partnership agreement is up-to-date with current tax laws (uses the term “partnership representative”);
- Be sure you have filed a Form W-9 expressing you are a tax-exempt partner;
- If you are a tax-exempt partner, co-invested with disqualified persons, making sure your partnership representative is aware of this fact to avoid any inadvertent acts of self-dealing;
- Inform the partnership representative that you do not wish them to pay any taxes on your behalf. The exempt organization is not liable for at the partnership level.
Please call us or contact us if you would like to discuss the changes in the partnership audit rules or to review your planning opportunities.
1 In Plumstead Theatre Society, Inc. v. Commissioner, 74 T.C. 1324 (1980), aff’d, 675 F.2d 244 (9th Cir. 1982)
© Clark Nuber PS, 2017. All Rights Reserved