On-Demand Webinar: Why IRS PE Audits Are About to Ramp Up
Our expert panel explains upcoming regulatory changes that will make it much easier for the IRS to audit private equity and real estate partnerships.
Our expert panel explains upcoming regulatory changes that will make it much easier for the IRS to audit private equity and real estate partnerships.
Privcap Webinar: Why IRS PE Audits Are About to Ramp Up
David Snow, Privcap:
Hello and welcome to a Privcap Webinar. My name is David Snow. I am CEO and Co-founder of Privcap. Today, we have a fascinating subject to share with you, and a very important one if you are a professional in the private equity industry or, really, in the private funds’ industry, or, even more broadly, have something to do with a private partnership. We’re going to learning about why IRS private equity audits are about to ramp up.
We have a couple of highly qualified experts to guide us through this topic. We have Don Susswein from RSM. We also have Fred Witt, a certified tax law specialist based in Phoenix, Arizona. I’m going to ask each of them to introduce themselves, starting with Don Susswein from RSM.
Don Susswein, RSM:
Thank you, David. I’m a tax lawyer, and I serve the principal in the tax headquarters, what we call our Washington National Tax Office for RSM, a firm some of you may know is the successor to McGladrey. Our practice tends to focus on pass-through, much more so than on large public traded corporations. I’m in charge of our firm’s partnership consulting group. As we’ll discuss a little later, I’ve been very involved in the development of these new rules regarding partnership audits.
Snow: Great. Fred, if you wouldn’t mind introducing yourself please.
Fred Witt, Fred Witt PLC:
Yes. I’m Fred Witt. I’m a board-certified tax specialist tax lawyer in Phoenix, Arizona. I have a national practice with three components. The first is I do actual IRS tax controversy work. I’ve been involved in over 26 tax cases leading to written opinions. Second, I have spent a lot of time drafting LLC operating agreements intending to comply with these new partnership tax audit rules. Third, I have a tax policy component in which I belong to the real estate round table. In that capacity, worked with Don Susswein and others on the development of these new rules.
Snow: Great. Here’s what we’re going to be going over in today’s webinar, if you can see our slides. First, we’re going to give you a tax and regulatory overview. Next, we’re going to be learning about what tax issues matter most to the IRS today. Finally, we’re going to leave you with some steps to consider when thinking about partnership audits. Let’s start with the first topic. Maybe Don can kick off. In general, are private equity firms, or, indeed, the private equity industry in the cross hairs of the IRS and even Congress. If so, why are they such an attractive target?
Susswein: Obviously, as we all know from reading the newspapers, there’s a huge divide politically and culturally in this country related to issues of fairness or perceived fairness in our economy, with a particular emphasis on what people pay or should pay in taxes now that tax reform is on the agenda. Unfortunately, perceptions and misperceptions, in many cases, seem to be fueling that divide more than accurate information. Whatever the cause, right or wrong, private equity firms, now sometimes in Washington, they’re referred to generically as hedge funds, which we all know is a bit of a misnomer, but I think what they mean in many cases is private equity firms and the private equity industry is really the poster child for that conflict.
Partnerships of all kinds really are also a target in Washington. I’ll tell you a little anecdote about that. Just about the time these new order rules were enacted, there was a fascinating study being done by a group of treasury department tax economists, a pretty sophisticated bunch. They actually set out to prove that because partnerships tended to be the vehicle of choice for wealthy people to invest large amounts of money and lower income folks tended to use other vehicles like mutual funds or they simply say they’ve invested less, this group of treasury economists tried to prove that it was the partnerships, the vehicle, that was causing the economic disparities among different income groups, not simply reflecting those.
They set out to prove and to argue that the cure for income inequality was to tax partnerships as corporations or failing that to seriously increase the amount of audits that were being done by the IRS. Now, they ultimately admitted that they failed to prove their cause and effect relationship. If you think about it, it was a little bit like blaming safety deposit boxes for inequality just because people that have something to put in them use them.
The point is this is a very highly sophisticated group of people, and it shows that the attitude towards industries like private equity, and partnerships, generally, investment partnerships, are not always rationale. There’s a lot of animus. There’s a lot of jealousy. From the IRS’ point of view, in particular, partnerships are exceedingly complicated and they really find them very difficult to understand, particularly when they’re in these large multi-tiered structures. They can’t understand what they call the spider web. That is an additional … It leads to a lot of suspicion as well on their part.
Congress tried to simplify the rules, and, basically sent the IRS a message, “You better go audit some partnerships.” That is coming. The new rules are going to take effect 4/20/18 for this coming year. The audits probably won’t begin until 2020, but the IRS is really gearing up to go after partnerships.
Snow: Fred, from your perspective, anything to add to the overview of the IRS taking a greater interest in partnerships.
Witt: I think if you look at the use of partnerships nationally in Arizona, about 90% of all new entities are LLCs taxed as partnerships. This is true across the country. In the last 10 years, there’s been sea change away from regular corporations and S corporations to the use of LLCs taxed as partnerships. The IRS and Congress, I think, perceives themselves to be a little bit behind the curve, and reacting to this dramatic shift in the marketplace.
Susswein: Let me add a little color on that.
David Snow: Sure.
Susswein: The interesting thing was this is a problem, the problem of how they order the partnership because, as many of people on the webcast know, the partnership files a tax return, and so is that information about its activities, but the tax is computed and paid at the partner level. If you’ve got three of four tiers of partnerships, it can be exceedingly complicated to figure out or to track how a deduction taken, or an item of income included, or a character issue at a partnership level filters down, in some cases, three, four, five, six, seven layers down.
They’ve been talking about a way to simplify this, almost literally for 30 years since the last time they’ve tried to simplify it. Ironically, this past simplification attempts have not led to simplification. They’ve only led to more problems. When they put forward the tax bills to fix this, they said, “This is going to raise $10 billion.” That’s why Congress fell in love with it because any time they have a chance to raise money, so they can spend it elsewhere, but they can’t be accused of raising taxes, they’re just collecting taxes that are due, that’s very attractive.
Right after the statute was enacted, Fred, and I, and others would talk to people at the IRS, and we would say, “What are the issues you’re looking at? Where do you think that $10 billion really come from? Where’s the noncompliance? What are the partnerships getting wrong?” We got nothing but blank stares. In part, it’s because there’s been so fewer partnership audits that they probably don’t even know where to start, but I’m wondering, Fred, if you have some ideas as to what are the substance of tax issues that if the IRS does start ordering partnerships more, they’re likely to be focusing on.
Witt: Don, interestingly, an LLC, and let’s just focus on LLCs taxed as a partnership just for the sake of discussion, an LLC is a hybrid entity. Most people think of it much like a corporation for state law purposes, but, yet, for tax purposes, it’s a partnership. As a partnership, the LLC will then file an IRS form 1065, which it must do annually.
Then, the first question is, who can sign the tax return? Oddly, I think everyone would think, “Gosh, isn’t that just assumed?” The answer for LLCs is no. For an LLC, the IRS tax return specifies that a member manager should sign the return. The term “member manager” is found nowhere else in the law. It’s a creation of the IRS. This has important and critical consequences because if the wrong person signs the return, it’s the IRS’ position that that return is invalid. If it’s invalid, then that means that the statute of limitations never begins. Immediately, you’re faced with a very practical challenge and problem starting with the most fundamental questions of, who can sign the return?
Susswein: Fred, as I understand it, many funds are set up as limited partnerships. The law isn’t entirely clear there, but it’s a little less unclear than with LLCs. I take that many of their portfolio companies could have this issue that you’re describing. Is that correct?
Witt: Yes, Don, that’s correct. Now, if you were structured as a limited partnership, the IRS form 1065 says that a general partner should sign the return. I would ask, in what document is the general partner authorized to sign the return? Again, this gets to the historic problem of the shift away from corporations and the world of corporations into the world of partnerships and limited liabilities, which then create this false sense of perspective and false sense of security that, “Oh, of course, we’re all authorized,” thinking that we’re in a corporate structure.
I think that the operating agreement for an LLC, the limited partnership agreement for a partnership, everyone needs to drill down. Every business owner, operator needs to drill down and check into their documents to make sure that these items and these matters are being addressed in the document. The reason, of course, for the concern is that these rules were changed for the first time in 30 years with one purpose in mind. The purpose is to increase the frequency and the intensity of auditing of partnerships.
Susswein: Fred, it’s interesting because I was on a conversation with an attorney representing another party. We were talking about it and on certain tax issue. The attorney on the other side said, “Surely, the IRS will recognize that this is just a footfall. They’re not going to hang a client out, hang a taxpayer out just for missing a technicality.” I laughed because that’s the lifeblood of the IRS, right? It doesn’t matter whether it made sense or not. If you violate a technical rule, that’s one of the great ways they can get you, isn’t it?
Witt: Don, that’s exactly right. It’s a great point. The IRS has proposed these technical rules, has made the change for the first time in 30 years with the idea of increasing audit activity. They are going to want to collect whatever additional taxes due. If they can do it based on a technicality, such as, “You know what, the wrong person signed the return, and the statute of limitations never began,” that, to the IRS, is benefit. It makes it easier if they can get you on a technicality rather than trying to dive into the very complex, as you say, Don, spider web of partnership tax.
Susswein: Now, Fred, I’ve also heard there a lot about, as we all have, about fee waivers, and carried interests, and profits interests in the private equity industry. Is that also an area that the IRS is going to be looking at?
Witt: Don, it is. There’s a host of these big issues that have been percolating around for a number of years. Carried interests, it’s gotten a lot of discussion because of the legislative attempts to change the terms to carried interest but continues to be on the shelf and continues to be a hot topic. Fee waivers, the IRS and policymakers have a hard time having a lot of sympathy for a taxpayer who gives up a million dollars ordinary fee income for a speculative interest, and what may or may not turn out to be a one million of capital gains. The equities are just not on your side when you’re trying to make that argument. Then, of course, Don, as you know, there’s a new proposed 15% rate for pass-throughs potentially. The question is, what does all this mean? Don?
Susswein: Yeah. Of course, we don’t have it yet. Who knows whether we’ll actually see tax reform. By the time this law, this new order law takes effect for tax years of 2018 and beyond, we may well find ourselves with three or four different tax rates applying to pass-throughs. We’ll have the special rate for self-employment income. We may have a special rate for pass-through income with some investments. We might have a different rate for pass-through income that’s from business rates, and a different rate for income that is considered to be compensation for personal services.
That is going to be a madhouse of tax litigation if rules like that are enacted; unless, they have extremely detailed very specific rules to police those differences. If they do have those specific rules, there may not be as much litigation, but it’s certainly going to be a lot of opportunities. In the tax area, we call them traps for the unwary. You forget the dot in I or cross T proverbially speaking. You could end up owing a much higher tax rate.
Witt: Don, that’s a great point. With respect to tax reform, you and I were just on a working group call with a real estate round table just two days ago. I was struck on by the fact that tax reform is turning out to be anything but simple. Just about every proposal that I have heard set forth, including the latest just a few days ago, all involved, both complexity and then additional complexity, just as you described.
Susswein: It will be really a strange world if we look back to the tax code of today and say, “Boy, we wish it was as simple as it is today,” but you may find yourself in that situation. There’s a whole menu of things that the IRS has go after once they begin to audit partnerships under these new rules in 2018.
Witt: Yeah. Don, again, just to summarize for the folks on the line here, we’re talking about two different issues. The first is the substantive issues that Don just mentioned, fee waivers, carried interest, what are the rates going to be going forward. That’s at the very top level. Then, separately, there are these new partnership procedure rules intended to make it easier for the IRS to audit private equity, and easier to get at the questioning of these big issues.
Susswein: Maybe, even though they’ve been in the news. Not everyone on the webcast is familiar with them. Basically, let me try to give you a little bit of a summary. Again, partnerships file a single tax return, and the positions on that tax return are generally applicable to all of its partners and all of the partners in those partners if the partners are partnerships. However, a partner, if he or she wants to, can take a position that’s inconsistent with the position of the partnership, although in some cases, that’s almost like an invitation to an audit.
That has been the law for many, many years. If the IRS wanted to audit the partnership, they would audit the partnership, but almost every partner in the partnership have the right, not only to take an inconsistent position on the return. Even if he took the same position, let’s say, the partnership took a deduction, and the partner took the deduction. The IRS came in and said, “You know what, we don’t think that deduction is allowable.” In theory, every single partner or many of the partners, there were some minimum threshold, but any significant partner could take a different position regarding the IRS.
Some could say, “I admit it’s wrong. I’m willing to give it up. No problem,” Others can say, “No. I’m going to take it up to the Supreme Court.” Others could say, “Maybe it was wrong. I’ll pay the tax, but I don’t want to have to pay the interest, or I don’t want to have to pay the penalty because I thought it was right.” The IRS had to deal with potentially hundreds or thousands, but it wouldn’t be thousands, but potentially hundred scores of different positions on the same tax issue.
It was very, very complicated for them to have to give notices to every single partner anytime anything happened. If they sent the notice out, it wasn’t enough just to send the notice out to the partnership. Notices had to be sent to all the partners. It was one of the reasons why they generally avoided auditing partnerships because in comparison to a corporation, you order a corporation, you deal with one party, the head of taxes, the VP of taxes, what have you at the corporation.
The big change that came about, it will be effective for 2018 and forward. It came about a year and a half ago was that henceforth in terms of the managing of the audit and the taking of positions, the partnership is now going to have to speak with one voice. The partnership is going to appoint somebody. They call them partnership rep. That person is going to have the authority to bind all of the partners in the partnership and all of their partnerships if it’s a multi-tiered organization, at least it’s to those issues.
This is a huge change. It’s a simplification for the IRS. It may be a simplification for the taxpayers as well, but it means that somebody running the show, as far as the audit, may not have the best interest, your best interest at heart as a partner. You might be a private equity fund, and you’re holding a 40% interest or a 50% interest in a portfolio company, and somebody else may be controlling what that portfolio company does if they’re audited even though the impact of the adjustment may be on you as the investor. This is huge, huge change in the law. This is a major change that partnerships, really, and LLCs have really barely begun to really consider the ramification.
Witt: Don, just to summarize again, the thrust of these rules is to, as best the IRS could treat the partnership like a corporation, and take all of the power, all of the decision making, and make the partnership a corporation for purposes of auditing and determining additional taxes due, which also means that the personal representative, the new representative of the partnership has a very powerful position, and the person selected or entity needs to be carefully identified and carefully considered.
The idea in the past that you didn’t really have to worry about these rules that partnerships audits were not really on the radar screen, that the IRS was not focused on any of the substantive issues of private equity, I think those days are gone.
Snow: I have a follow-up question for Fred and for Don. Either of you could answer. What do you predict will be the trend by the way of the kind of person within these private funds to be selected to be that representative? Do you think it will probably be the CFO or do you predict a broader range of individuals who might be put forth for that very important position?
Susswein: I’m not sure. Normally, I think it will be whoever is the managing partner or managing member in the case of an LLC. In some cases, they may just find somebody, appoint them. This actually key point because a number of our clients have come to us, and said, “Do you have draft language for our partnership agreement?” or “We’re starting a new partnership. Do you have, what we call in the legal profession, the boiler plate? We want to make the correct references to the right statutes.”
What we tried to explain, what we’re beginning to explain is it’s not really a boiler plate issue. It’s not really even a question of who you nominate or who you appoint. In fact, even if you don’t appoint somebody, God forbid, by the time you’re audited, or if you appointed somebody and they left, or they died, or whatever it may be, you get another chance to appoint a representative when the audit begins.
The real problem is not whose name is on the dotted line because you can change that. The real question is, who’s going to control that person? You might say it’s John Jones or Jane James, but he or she is going to have to take actions as directed by the managing partner.
Now, we get to the fun stuff. Maybe it’s not going to be the managing partner because we talked about carried interest, for example. There are circumstances in which a tax change that’s proposed on an audit may affect the general partner or the managing member, or may affect a manager in a way that’s different from the rank and file investor is treated, or the majority of the investors, might be corporations, let’s say. For a corporation, it may not make that much difference whether a particular item is capital or ordinary. In some cases, it will make a lot of difference; whereas, let’s say, 30% of the partners are individuals, that could have a huge impact.
You can’t necessarily even say, “All right. The partnership rep is going to be Jim. His decisions are going to be subject to review by a majority of the partners.” You can’t even do something simple like that because the majority may not have the same interest as the minority. The majority may be indifferent. The majority, say, may have capital gains, capital losses. Again, because we have to remember that although the partnership is going to be the one audited, the actual tax liability is determined ultimately by the impact of the tax on the individual partner.
This is just a potential morass of conflicts of interest, conflicts of interest between different partners, between formal partners, and current partners, and between managers and the partnership. It doesn’t mean they can’t be resolved, but it means that unfortunately, you can’t just go to a lawyer or a CPA, and say, “What’s the magic language I put in my agreement?”, but it isn’t really about magic language. What’s it about is sitting down and figuring out who’s going to make the decisions? Are certain decisions so simple that we can trust the manager to do it or are the decisions going to have to be put to a vote? If they’re put a vote, does everybody get the same type of vote?
Even though we say that it’s all in the hands of the partnership representative, that’s really from the standpoint of the IRS in the sense that they only have to talk to one person. That one person, in turn, has to be responsible under the terms of the partnership agreement to a whole range of people. That’s the really difficult part of adjusting. It’s not impossible. It just takes a certain amount of time to sit down and think through what could happen, what’s likely to happen, and if it does happen, how do we propose to resolve it.
Fred, I’m sure you’ve dealt with situations like this where there’s uncertainty or conflicts of interest in drafting partnership agreements.
Witt: Yes. Don, I have. Folks, I’ve spent the last two years in my practice drafting sample forms of the so-called boiler plate language that Don referenced. Don, I think that term now has to be also put into the trash can because, for the reason you just described, there isn’t really going to be any boiler plate that will fit.
Let me just give another example. You could be in a situation where you have professional managers, and the fund really just has 1099 income flowing through it. You may conclude that for your entity, “You know what, there’s not a lot of risks here, and the risk that we do have is small. We want to take advantage of these new rules. We want all the control to be at the entity level.” Let’s just say, if there’s a million-dollar adjustment, “You know what, we want the power first to make the payment at the entity level, and not even involve any of our partners or members.” For different reasons, the structure can be used for different purposes.
Snow: Don, your thought?
Susswein: That sounds like it will be pretty typical of a fund that has large numbers of investors that are changing from year to year. In fact, that’s the way REITs work a lot of time. When a REIT, a real estate investment trust, is audited, they pretty much just give the REIT the ability to just pay an extra dividend. It’s not even to the same people who are shareholders at the time the REIT had its problem. They just say as long as the money goes out to a group of people, we don’t care.
There are going to be other cases. I agree with you, Fred, that in some cases, you’re just going to want to keep it at the entity level. There are going to be other cases in which, let’s say, a portfolio company sells 70% of its shares to a private equity fund, and there’s some tax liability. Now, if it’s a 2017 tax liability, it’s not a problem. Once we get into 2018, and you have positions being taken for 2018 events and 2018 tax returns, even though the audit doesn’t happen maybe 2020, 2021, the issue arises. It can arise as early as January 2, 2018.
When that issue arises, one of the things you don’t want to have … There are two things. First of all, you don’t want to have the new investors being hit with having to pay liability that relates to an old investor’s understatement of his taxes. Yet, if you’re not careful in the way you implement these new partnership audit rules, that’s exactly what happens.
The IRS says, “We’re auditing the partnership in 2020, and we’re saying to that partnership, ‘Mr. Partnership, you understated your income in 2018, and the benefits all went to those people you bought the company from,’ but we don’t care. We don’t care who pays it. We’re going to get it. We’re going to get it from the current partnership.” The owners of the current partnership, because, typically, you’re not going to have a holdback. Typically, the sellers are just going to walk away with their money. You’re going to be left holding the bag.
Now, there’s a way to deal with that. There’s a way at the end of the audit to say, “No, we’re not going to pay the tax at the entity level. We’re going to send it back. We’re going to basically send the revised K1 back to the old investors and it’s their problem,” but you have to take affirmative take action to do that. It doesn’t happen automatically. That’s one sort of problem.
Then, if you do that, you’re left with the other problem, which is, okay, let’s say I’m the person who sold the portfolio company to a private equity fund or I’m a private equity fund who sold a company to another private equity, what have you. I may have a tax liability because maybe the partnership did something wrong, or maybe the flow was uncertain and it’s clarified, or a court decision comes down, and the IRS wins, and they decide to go after this case, then, they can go against the partnership. I’m no longer a partner anymore. They can go to the partnership. They can say, “You pay us some more money.” The partnership says, “No. I don’t want to. I’m going to shift that liability back to the person who sold it to me.”
That may sound equitable, and in some sense, it is. Then, you get to the question of how hard the manager fought because you’re basically giving the nuclear codes, so to speak, to the resolution of the audit to somebody else. You’re allowing somebody else to decide how much they’re going to fight for your tax liability. Typically, if the cost of handling the audit is coming out of them, and it’s your tax liability, they’re not going to be very eager to spend a lot of money, to fight with the IRS for your tax liability.
You don’t have a seat at the table anymore. As far as the IRS is concerned, you’re invisible. All these problems can be solved, but you have to solve it by either a contract or a part of the partnership agreement, you have to say, “Okay. I am selling the company or I’m going to sell part of the company. Now, you have to treat it the same types of issues that arise whenever changes in ownership and corporations that were used to, the same sorts of issues are now going to answer changes in ownership of partnerships.” This is an entirely new feature.
Snow: Let’s move on to some steps to consider now that we find ourselves in a new reality of the IRS taking a keen interest in partnerships. Don, I’m going to ask you to relay a bit of intelligence from your own professional history. I understand that early in your career, you were a tax counsel on the staff of the Senate Finance Committee when the old TEFRA partnership rules were written. Fast forward to the present, you are also very actively involved over the last two years as those new rules were enacted to replace them. What changed? How has Congress and the IRS reacted?
Susswein: The real world changed a great deal because back in ’82, before the ’82 Act, if you were a partnership, and, unfortunately, back then, most partnerships were either professional service corporations, doctors, lawyers, accountants, and they tended, at least, the big ones not to have that many big tax problems or they were tax shelters. Not only were the tax shelters very complicated, were they’re very aggressive, but you had relatively aggressive taxpayers investing in them.
Now, it’s a completely different situation. Now, for the most part, because of the passage of those rules, people invest in partnerships because they’re the most efficient way to make money, not lose money. It makes sense. They want to make money not lose money.
The TEFRA rules, which the rules that are still in effect through the end of 2017, they view a partnership investor as a person of interest, so to speak, or it’s this suspicious character. They’re really, really tough on them. The IRS, after the end of the audit, they actually send the bill, and they track the individual, and they wag their finger at them, and they say, “You better pay us.”
The whole idea of the new rules is very different because the rules say, “Hey, these are not the most aggressive taxpayers. They may be aggressive from an economic point of view, but these are good citizens who simply have found an efficient way to run their businesses, to run their investments. They happen to be in partnerships.” The theory of the new rules is as long as you get them a 1099 or a K1, it tells them what the change is, what they have to do on your next tax return, and pay up. Of course, many of them use professional tax repairs. The whole focus is different. The partnership investors today are the good citizens, and not the people looking to scam the tax shelter, or, at least, that’s the reality.
Unfortunately, the Congress, I think, has recognized this, but the IRS has not completely recognized it. I think the IRS is still, as we started out in the beginning, looking with a very jaundice eye. I think they’re just very, very suspicious without justification of people who invest in partnerships. Hopefully, that will change, but that is one of the unfortunate realities of the IRS perceptions that people will still have to deal with.
Witt: Don, just a comment here. While I agree with everything you say, what has happened is and the question is for those listening on the phone, does any of this even apply to me? Do I really need to care about this stuff? There have been a number of cases involving the TEFRA partnership tax audit rules in which in virtually everyone … This even includes a United States Supreme Court Case. Imagine, there is a US Supreme Court case on the TEFRA partnership audit rules, in each one of this, the taxpayer has argued, “Judge, Let me out of my tax liability because of this technicality.” In each instance, the judge has said, “No, taxpayer, we’re not going to let you escape.”
While you may wonder about these rules, and you may think, “Oh gosh. I don’t need to worry about technicalities,” it is just these technicalities that will trip you up. The days of just having a paragraph or a sentence in your partnership agreement or in your LLC operating agreement in which you just mouthed words, “taxpayer, representative, or personal representative, or tax matters partner,” those days are over because this is a whole regime and a whole mosaic requiring the drafter of your agreements to really think through the issues that Dan talk about, and then begin to address them in a systematic way.
Susswein: Yeah. I just want to say one thing. It doesn’t necessarily mean that there’s going to be an elaborate redrafting of the partnership agreement. It may be one sentence addition. The difficult part is thinking it through. That’s the hard part. Drafting it, in some cases, is going to be complicated.
In most cases, and it may not even have to be in a partnership agreement, it may just be a side agreement, or it may just be a handshake, or an understanding, but the point is if you don’t resolve this issues before 2018, and they arise, then they’re going to be much more difficult to resolve in many cases. Then, it won’t be a hypothetical. It will be real money. It’s always easier to get people to agree on what quote the reasonable approach is when they don’t have any real money at stake. Once it’s a real issue, a lot of times, it’s harder to get people to agree.
I’ll just make one other point. There’s no question that all the uncertainty in this area has not been resolved. That statute was not perfectly drafted. There’s a follow-on piece of legislation called the Technical Corrections Act. We’re all hoping that will pass. As you probably know, the Trump Administration put a suspension on regulations. There’s been a stop-and-start process with the IRS regulations. There was just an announcement the other day. They’re going to come out and issue another set of proposed regulations. Of course, those may be changed as well.
We can’t tell you that there’s no uncertainty in how the law will operate. However, you don’t need absolute certainty to take a small few steps, prudent steps to be prepared. We have an 80% likelihood of knowing what the final law is going to look like. No matter how it looks, whether it’s 100% the way we think it is or a slight variation, these fundamental issues of who makes the decision is, the tax liability going to be borne by the partnership or shifted to the partners? If it is shifted to the partners, to which partners? Who’s going to have a say? Who’s going to pay for any litigation or any long controversy work? These fundamental issues.
Another one, what level of cooperation do you need on procedural things? Let’s suppose the IRS says, “In order to avoid this, a particular form that has to be filed within 90 days.” We don’t know that. The rule doesn’t exist. Maybe you will need a provision in your agreement requiring everybody to cooperate in good faith, simply because we don’t know 100% what the rules are. Yes, there’s uncertainty, but we know enough to take a few or to recommend, at least, a few prudent steps to deal with the biggest problems even though we may not be able to resolve all of the problems before 2018 begins.
Snow: This is David Snow again. A quick follow-up question for Don and/or Fred. Do you, indeed, have clients who have said to you, “Gee, why don’t we just wait until we get audited? Then, we’ll deal with this.” If you do, how do you summarize the way that you correct their thinking?
Susswein: That is the normal reaction. First of all, the normal reaction is, “I don’t want to do anything until the regs come out,” or “I don’t want to do anything until the technical corrections are resolved.” That’s perfectly natural normal human nature, or, “Hey, there’s only a 3% chance I’ll be audited. Why don’t I wait until I’m audited?” We’ve only really begin. We still have more than six months before 2018 begins.
I think when you explain, or, actually, you don’t even have to explain. It’s just to a partnership as a partnership. Think of explaining it to a partnership as an investor. Again, just think about your private equity fund, and you’re considering investing in a partnership. When you invest in that partnership, are you taking a risk for your own investors that maybe you haven’t thought through? Maybe there’s some claim that maybe you were negligent in making an investment without your having made sure that that partnership had checked all the boxes, dotted all the Is, and crossed all the Ts.
I think the short answer is nobody wants to do work until it’s absolutely necessary. Nobody wants to pay professional service fees until it’s absolutely necessary. This is human nature. We all do exactly the same thing. As we discuss it, when you point out the risk that a manager could be subject to a claim, whether it’s negligence, breach of fiduciary duty, whatever, these are serious issues. If you don’t have that indemnification, for example, when you take the act or when you take the tax return position, if you ordered it later, it may be much more difficult to get a retroactive indemnification than it is to get it in advance.
Witt: Yeah. Don, I think that you need to plan ahead. Changing documents takes a long time. When is the last time that each of you on the phone has had its counsel, and tax counsel, and CPA firm all undertake a coordinated review of the documents for federal income tax purposes? I would imagine it’s been a while since that review has been undertaken, which means that the importance of reviewing now and getting this right is even more important.
Then, the next problem you’re going to face is that you’re going to be bombarded by advisers who want to do your work. The question is, how do they start? With what form? Where is a good form to start with? In order to solve that problem, I have actually created an online form company and a website, taxllc.com. It’s T-A-X-L-L-C dot com. Working with a professor, who’s now at Harvard Law School, Howard Abrams. We have created a form company, and put our forms online. You, now, can access them yourself. You can buy them yourself. You can be prepared for your own do-it-yourself review, or you can use our forms to help your advisers start at a higher level of work. I just offered that.
Susswein: Right. What I would say is I don’t want to exaggerate the complexity. Again, I wouldn’t think of this as a wholesale necessarily, involving a wholesale revision to partnership agreements. As I say, it could all be done in a handshake, or it could be a done a small paragraph, or just an agreement, or an investor and a partnership that say, “I just want to make sure we’re on the same page, but if this happens, this is what we’re going to do.”
It may be a very simple short conversation, maybe just an email back and forth, or, as Fred points out, it could be an elaborate redrafting. To just close your eyes and not even acknowledge that these issues are going to rise could be a misstep.
Snow: Question for both of you. Maybe this can be the final topic before we wrap things up. Don, why is it not enough to just tell the managing partner to do the right thing? Where are the traps for the unwary?
Susswein: That’s a great question. The answer is, typically, and Fred can speak to this I’m sure with great area addition, if you don’t say anything on the partnership agreement, it doesn’t mean that that’s the end of the answer. You revert to state law, so that the partnership agreement may not impose a responsibility on a particular party. The party says, “Hey, I’ve gotten a response. At least, here, it doesn’t tell me to do anything.”
If a controversy arises, the case could end up in court; not in tax court, but in a state court. Somebody would say, “Yes, it’s true that the partnership agreement didn’t obligate you to do this, but your general principles of state law, fiduciary duty, your responsibility as a partner, your responsibility as a member,” and God knows what those are, because this is an entirely new area of the law, you could have judges looking back at the cases from the 1800s. All of a sudden, they can say, “You know what, this case from the 1800 tells us that even though the partnership agreement was silent, you are still obligated to do something.”
If you do nothing you could be buying a pig in a poke in terms of just exposing yourself to whatever liability some state law judge determines is the so-called common law.
Witt: Yeah, Don, I agree. Also, there is a case, Interactive v. Vivendi. It’s now about 10 years old. It’s a Delaware case. Essentially, the case involved the most qualified lawyers in Wall Street. There was a drafting error in the document. The drafting error produced a $600 million difference between what one partner thought it was getting and what that partner actually got. They did go to court. Basically, the Delaware Court said, “You know what, we’re going to hold you to your language as written.” The other party that was less $600 million argued, “This is drafting error. This is a material mistake. There was no meeting of the minds of the parties,” and so and so forth. The Court basically said, “You know what, you’re going to be bound your words.”
Don, your point is well taken that while upfront, you may not worry about this, but once you get into a dispute, and then once that dispute manifests itself in some unpredictable way such as the $600 million drafting error, then you’re going to, I think, wish that you had been a little more aggressive and a little more thorough in the drafting of your documents.
Susswein: Right, and even if it says the general statement of good faith or general policy statement. It can be elaborate, it can be less elaborate, but to ignore it completely is probably not a wise idea.
Snow: Maybe final comments from both of you. Maybe I’ll summarize things like this. Talk about next steps, how painful will it be for, let’s say, private equity market participants to take some preemptive action leading up to this change versus the pain that they will experience if they fail to take preemptive action, and they find themselves unprepared and in an audit.
Witt: This is Fred Witt in Phoenix. Let me lead off on that one. The problem is that next March 15, either your partnership or your limited liability company has to file a tax return, an IRS form 1065. Already, the sand is running through your hour glass for the year 2017. Specifically, you have to determine who is authorized under your partnership agreement or your LLC operating agreement to sign the tax return.
Next, who actually is signing the tax return? Who is authorized under the written words and who signs may be two different people or there maybe confusion, or you may have someone who’s unauthorized signing, in which case, the service is going to take the position that that’s an invalid return.
Then, third and finally, on page three of your tax return is a designation of tax matters partner for this year. Then, it will be a designation of personal representative next year. Specifically, with respect to LLCs, it says enter below the name of the member manager designated as the tax matters partner for the tax year of this return. Next March 15, another return will be filed. On that return, a name of a TMP, and then soon a partnership personal representative must be written in on the form. There is a tax return component into the mix.
Susswein: Right. I agree with everything Fred said. I would also give a simpler answer, which is find your trusted adviser, and recognize that he or she doesn’t have an easy button, as you referred to it as a boiler plate, that there isn’t just some magic language or some button they can press and all your problems are solved.
It doesn’t have to be a huge deal. You probably have to spend a couple of hours, maybe a little bit more, depending on your complexity with the trusted adviser, and just sit down, and say, “What are my risks? What would be a prudent strategy to try to minimize my risk either if I’m a manager, I don’t want to get hit with liability for doing what I felt was the right thing. I want to protect myself. If I’m going into a partnership, I certainly don’t want to buy into somebody else’s tax liabilities. If I’m selling a partnership, I don’t want a partnership share. I don’t want to have somebody else controlling whether I end up having a tax liability.”
These are pretty simple concepts. It doesn’t necessarily require a complete revision. You do have to have what they sometimes call an adult conversation with your trusted adviser, and just say, “What would be a prudent series of, hopefully, simple steps that I can take just to be sure that the general rules governing these huge potential liabilities are addressed, at least, to the extent we can, given the state of the law?”
Witt: Yeah. Don, those are great points. Also, let me propose a very simple answer for, at least, some of the problems. That is the notion of creating reserves in your limited partnership agreement or your LLC operating agreement. The reserves are set annually. The reserves allow you to hold back money for uncertain tax positions, for audit fighting at the entity level. The concept of reserves is now going to come back. Of course, it was used in corporate deals all the time. Now, we may see that concept come back in the partnership standpoint. Just a thought.
Susswein: Yeah, very good. Hopefully, God-willing, we’ll avoid that. God-willing, through agreements, we can avoid those levels of complexity. I think, it’s a very good point that that’s what you want to avoid by dealing with as much contractual agreements as you possibly can. Dave?
Snow: Great. Yeah. Thank you, gentlemen, for your expertise today. I know I learned a lot. I’d like to remind our audience that this webinar will be available in a couple of different formats going forward. We will have a playback available, in case any of your colleagues want to listen to it again. We will also be producing a report based on the transcript of this conversation, which will be available to everyone who joined this webinar and also at privcap.com.
A big thanks to our partner on this webinar, RSM. We thank the audience. There were nearly 200 of you who showed up today. I’d like to thank all of you for listening. We hope you learned a lot. We hope to put out a lot more great content concerning how to be an excellent participant in the global private equity market. For now, we’re going to sign out. Thanks very much to Don and to Fred. Thanks for listening. Goodbye.