January 11, 2016
Interviewed by: Privcap
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Why PE Partnerships Need to be Rewritten

Reforms of U.S. partnership audit laws will transform the audit landscape for private equity and real estate LPs and GPsand require that every partnership agreement be rewritten. Don Susswein, principal in the Washington National Tax office of RSM US LLP, talks about the practical implications of the easing of partnership audit rules, why the Internal Revenue Service has been dared to step up its audit game, and how current investors could be making tax liability decisions for former investors.

Reforms of U.S. partnership audit laws will transform the audit landscape for private equity and real estate LPs and GPsand require that every partnership agreement be rewritten. Don Susswein, principal in the Washington National Tax office of RSM US LLP, talks about the practical implications of the easing of partnership audit rules, why the Internal Revenue Service has been dared to step up its audit game, and how current investors could be making tax liability decisions for former investors.

Why PE Partnerships Need to Be Rewritten
With Don Susswein of RSM

Q1: Partnership audit laws have been reformed. What’s happened?

Don Susswein, RSM US LLP: Partnerships and LLCs are what we call “pass-through” entities. They have gone through incredible transformation over the last 30 years. Back in the early 1980s, they were a backwater. The only people who were set up as partnerships were either professional service corporations, lawyers, or accountants (because they had to be) or tax shelters.

A very cumbersome set of audit rules existed primarily to attack tax shelters. However, tax shelters were virtually eliminated in 1986. So, for the last 20 or 30 years, we were left with this vast, very complicated infrastructure of rules that made it very difficult for the IRS to audit partnerships or LLCs if they had more than a few partners or members.

That issue came to a head this year. Part of the problem was that partnerships have not only proliferated, but they have become multi-tiered entities, so it was almost impossible for the IRS to audit these entities. Some people said that, if you are a partner in the third or fourth tier of an entity, you were essentially audit-proof. Those are words that the Congress doesn’t like to hear. Then, everybody knew they had to do something and this was the year, finally, for a variety of reasons that they finally decided to do something.

Q2: What does it mean in practice for private equity and real estate firms?

Susswein: First of all, the cost and burden to the IRS of initiating an audit of a partnership has dropped precipitously. It used to be an incredible hassle and, of course, the new law doesn’t take effect until audits of the 2018 tax year. However, for audits before the new law takes effect, the burden for the IRS to initiate an audit was immense. They had to provide all different kinds of notice to the managing partner, the tax manage partner and a whole range of investors, because investors at different levels could take different positions.

Now, beginning in audits of 2018 tax years, that is no longer the case. The partnership must speak with one voice. It must be represented by one party who has the ability to bind the partnership to cut deals with the IRS that bind the partnership and every one of its partners.

Q3: Why do LPs and GPs need to pay close attention to these reforms?

Susswein: I don’t think it’s an overstatement to say that every partnership agreement and every LLC agreement in the U.S. has to be rewritten.
Now, that may sound like an exaggeration. When I say “rewritten,” people may be thinking, “We have to change the reference to 704 B1 to 704 B2” or something obscure like that. There are a few changes like that that will have to be made.

However, there’s a whole new set of business issues that are presented for partners and partnerships because not only do you have a single representative of the partnership, but that representative may have different interests than you do as an investor. And…let’s say you leave the partnership after a couple of years, the interest of current investors and of former investors, and it may be the former investors who are the ones who are going to be hit with a tax bill, if the partnership is audited today—after all, you’re audited in the retrospect. So, if there’s an audit in 2020, they’re looking at whether the 2018 tax return was done. You may no longer be a partner at that point, by the time it’s audited, and yet, somebody is there, making decisions, cutting deals with the IRS as to what your ultimate tax liability is going to be.

Q4: Will this make the IRS more aggressive and will it change GP behavior?

Susswein: With a partnership, before this law and even with this law, but certainly before this law, it was an immensely complicated matter to have a tax controversy and—particularly in the private equity, real estate and investment management field with very large partnerships that were mainly focused on making money, not on tax gimmicks—the management simply did not want to have any kind of a problem.

Now that the IRS is going to be much more aggressively auditing, first of all, that may change. Some partnerships may say, “If I’m going to be scrutinized to begin with, maybe I can take some positions that I might not have taken before.”

But, whether there is or is not a tax-compliance problem (and I suspect there really is not as big a tax-compliance problem as many people believe), the IRS has been dared to move forward. Now, the burden is on them. They’re going to have to generate some kind of a program to significantly increase their audits. They may not find anything, but they’re going to have to do something.

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