Why Every RE Partnership Needs to be Rewritten

Changes to U.S. tax law likely mean more audits of private equity and real estate partnerships. Don Susswein, principal in the Washington National Tax office of RSM US LLP, talks about the consequences, which may be better than you think.

PrivcapRE: Partnership tax law has undergone significant changes. What’s the background?

Don Susswein, RSM: Partnerships and LLCs, or what we call pass-through entities, have really 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, accountants, because they had to be—or tax shelters.

And 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 actually made it very difficult for the IRS to audit partnerships or LLCs. Part of the problem is that partnerships have not only proliferated, but they have become multi-tiered entities.

It was almost impossible for the IRS to audit them—and those are words that Congress doesn’t like to hear. Everybody knew they had to do something. This was the year.

What is the biggest change, and when does it take effect?

Susswein: Beginning with the 2018 tax year, the cost and burden to the IRS of initiating an audit of a partnership has dropped precipitously.

Until the new law takes effect, the hurdles for the IRS to successfully and efficiently audit a partnership remain formidable. In theory, the partnership has always been subject to one set of tax rules, and there was only one right answer. But in practice, every partner could take a different position or could hire their own attorney or accountant to negotiate on their behalf.

Beginning with audits of the 2018 tax year, that is no longer the case. The partnership must speak with one voice. It must be represented by one party, and any settlements made with the IRS by that representative bind the partnership and every one of its partners.

The law will require simple technical changes to existing partnership agreements. But are there more fundamental changes that members of partnerships, particularly investors, should consider?

Susswein: There’s a whole new set of business issues that are presented, 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.

Let’s say you leave the partnership after a couple of years. [Looking at] the interest of current investors and the interest of former investors, it may be the former investors who are going to be hit with a tax bill if the partnership is audited today, because you’re audited for past tax years.

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, and yet somebody is there making decisions, cutting deals with the IRS as to what your ultimate tax liability is going to be.

In addition, that partner representative most likely is going to also have duties to the current partners. Let’s say the IRS says, “We think you did this wrong.” The lawyers and accountants say, “No, we think it was right, but it’s going to cost you $500,000 to contest the issue, and it may cost more if we want to go into court.” Well, who’s going to pay for that? If it’s done by the current partnership, it’s either going to come out of the current partners’ capital accounts, or perhaps the managers will dig into their pockets—but maybe not.

Is this all bad news?

Susswein: In some respects, this legislation is a tremendous win for the private equity community, for the investment-management community.

This could have been way worse. The original bill imposed an entity-level tax on the partnership. So even if all the people whose tax liability was an issue were no longer in the partnership and we were only dealing with current partners who never got any benefit from the position that’s challenged by the IRS, the current partners would still have to bear the cost.

In addition, the early legislation said, “What if the partnership has distributed everything, so the current partnership can’t pay?” It had a provision that if the partnership didn’t have the money, the IRS could go after any of current and former partners individually. And making matters worse, the IRS didn’t have to go after each individual for their allocable share. If they wanted to, they could go after one partner for everybody’s share and then leave it up to the individual partner to seek indemnification or contribution from other members.

If that provision had been put in effect, there’s a very good chance that the investment markets could have been frozen. Fortunately, it was killed.

How do you expect GPs to respond to this new reality?

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

In fact, the Government Accountability Office did a study, and they found that when the IRS did finally conduct an audit of similarly sized entities, they actually found far fewer errors or mistakes than they found in corporations.

It sounds counterintuitive, but now that the IRS is going to be much more aggressively auditing, some partnerships may decide to take more aggressive positions than they had before, so they have some bargaining chips during any subsequent investigation.