Amending LLC and Partnership Agreements to

Address Tax Reform and the New IRS Audit RulesQualified Business Income Deduction, Former Partner Contributions to

Tax Liability, Push-Out Elections and More

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WEDNESDAY, MAY 16, 2018

Presenting a live 90-minute webinar with interactive Q&A

Jonathan S. Brenner, Member, Caplin & Drysdale, New York

Elizabeth J. Stevens, Attorney, Caplin & Drysdale, Washington, D.C.

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Jonathan S. Brenner & Elizabeth J. StevensMay 16, 2018

2017 Tax Reform Act – Key Provisions for Partnerships and LLCs− The Pass-Through Income Deduction− Limitation on the Deduction of Net Interest Expense− New Rules Relevant for Operating Partnerships− Other Partnership-Related Changes

New Partnership Audit Regime – Overview and Recent Developments− The New Default Audit Procedure− Alternative Procedures

Advising Partnerships and LLCs – the 2018 Tax Landscape

Drafting and Amending Agreements – New Considerations

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Allows any non-corporate taxpayer a deduction of up to 20% of eligible income—− Qualified Business Income (“QBI”)− Qualified REIT dividends− Qualified publicly traded partnership income− Qualified cooperative dividends

Effective for tax years beginning after 12/31/2017 and ending before 1/1/2026

These slides focus on QBI generated by a partnership.− But bear in mind: At the taxpayer level, qualified REIT dividends, PTP

income, and cooperative dividends are taken into account in computing the final deduction amount.

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Qualified Business Income (“QBI”): the net amount of items of income, gain, deduction, and loss with respect to a Qualified Trade or Business of the taxpayer included or allowed in determining taxable income for the taxable year; does not include:− Income not effectively connected with a U.S. trade or business− Investment income (e.g., capital gain/loss, dividends, investment interest, etc.)− Reasonable compensation for services rendered− Guaranteed payments − To the extent provided in regulations, I.R.C. § 707(a) payments

Qualified Trade or Business (“QTB”): any trade or business other than a Specified Service Business (unless taxable income ≤ Threshold Amount) or the performance of services as an employee− Specified Service Business:

• Defined by reference to I.R.C. § 1202(e)(3)(A): listed service industries (e.g., health, law, accounting) and any business “where the principal asset . . . is the reputation or skill of 1 or more of its employees” or owners

• Also includes performance of investment services, trading, dealing, etc.− Threshold Amount = $157,500 (single) / $315,000 (joint)

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Limitations on the amount deductible apply at both the taxpayer (e.g., individual) and QTB levels, in each case determined by reference to the taxpayer’s total taxable income

At the Taxpayer Level, the total deduction equals the aggregate of the QBI Amounts for all QTBs of the taxpayer, not to exceed 20% of the taxpayer’s taxable income in excess of net capital gain− If for any tax year the aggregate of the QBI Amounts for all QTBs is less than zero, the loss is carried

forward and netted against the aggregate QBI Amount for the following tax year

At the QTB Level, the QBI Amount for any QTB equals 20% of QBI for the QTB, if the taxpayer’s taxable income is less than the Threshold Amount− If the taxpayer’s taxable income exceeds the Threshold Amount by more than $50,000 ($100,000 for

joint filers), the QBI Amount for a QTB is capped at the greater of:• 50% x Wage Factor

• 25% x Wage Factor + 2.5% x Capital Factor

− For taxable incomes that exceed the Threshold Amount by a lesser margin, the cap is phased in

Wage Factor: W-2 wages paid by the QTB (including to the Taxpayer) Capital Factor: Unadjusted basis immediately after acquisition of depreciable property

held by the QTB and used in the production of QBI

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Special rules for application to partnerships:− Pass-through deduction applies at the partner level• Limitation on total deduction applied on a partner-by-partner basis

• Limitation on QBI Amount for any QTB applied on a partner-by-partner basis

• Wage Factor and Capital Factor for any QTB determined at the partnership level and allocated on a partner-by-partner basis▪ Wage Factor for any partner determined in same manner as that

partner’s allocable share of QTB’s W-2 wage expense

▪ Capital Factor for any partner determined in same manner as that partner’s allocable share of QTB’s depreciation

− Each partner must take into account its allocable share of each qualified item of income, gain, loss, or deduction from a QTB

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Old Version – applies for taxable years beginning on or before 12/31/2017− IF taxpayer’s debt-equity ratio > 1.5:1,

− THEN net interest expense in excess of 50% of EBITDA was disallowed, to the extent that—

• The interest was paid to a related party, and

• No U.S. tax was imposed on the lender’s interest income

− Disallowed interest expense carried forward indefinitely; excess limitation carried forward 5 years

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New Version – applies for taxable years beginning on or after 1/1/2018

− Debt-equity ratio dropped

− Certain businesses / types of interest exempt: • Small businesses (average annual gross receipts for 3 preceding tax years ≤ $25 million)

• Performance of services as an employee

• Real property trade or business or farming business (by election)

• Certain regulated utilities

• Floor plan financing interest (relevant for, e.g., auto dealerships) not limited

− For all other taxpayers, net interest expense in excess of 30% of Adjusted Taxable Income is disallowed• For tax years beginning before 1/1/2022, Adjusted Taxable Income = essentially, EBITDA,

• For tax years beginning on or after 1/1/2022, Adjusted Taxable Income = essentially, EBIT

• For all tax years, any NOL carryforward (I.R.C. § 172) or pass-through deduction (I.R.C. § 199A) is not taken into account in computing Adjusted Taxable Income

− Disallowed interest expense carried forward indefinitely; no carryforward of excess limitation• Notice 2018-28 (4/2/2018): Pre-1/1/2018 disallowed interest expense may be carried forward to 2018 but

will be subject to disallowance under the new rule; no carryforward of pre-1/1/2018 excess limitation

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Limitation generally applies at the taxpayer (individual / corporate) level

But special rules apply to partnerships:− Limitation applies twice:

• At the partnership level, for purposes of determining partnership net interest expense, which is included in the partnership’s non-separately stated taxable income or loss (and partners’ distributive shares thereof)

• At the partner level, taking into account the partner’s net interest expense and Adjusted Taxable Income from all sources, but without regard to the partner’s distributive share of all partnership items (to prevent double-counting)▪ Notice 2018-28 (4/2/2018): in effect requires consistent allocations of interest income and expense

− Excess Deduction Capacity:• Any excess deduction capacity at the partnership level is allocated among the partners in accordance with

their distributive shares of partnership net interest expense

• Increases the base for determining partner’s 30% deduction limitation at the partner level, allowing cross-netting of non-partnership interest expense against partnership excess deduction capacity

− Disallowed Interest Expense:• Interest expense disallowed at the partnership level is allocated among the partners in accordance with their

distributive shares

• Carried forward at the partner level, where it can be used only against future allocations of partnership net interest income (from same partnership)

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100% Expensing− Elective first-year “bonus” depreciation percentage under I.R.C. § 168(k)

= 100% for tangible property acquired after 9/27/2017 and placed in service before 1/1/2023 • Also applies to used property (“new” to the taxpayer)• Percentage phases down by 20% per year from 2023, reaching zero as of

1/1/2027, but− First-year expensing election in I.R.C. § 179 now more generous• Annual maximum for property placed in service in tax years beginning after

12/31/2017 = $1,000,000• Maximum phases down for total new investment > $2,500,000

NOL Deductions – I.R.C. § 172− Limited to 80% of taxable income− Carrybacks eliminated (except for farms and insurance companies)− Carryforwards indefinite

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Meals & Entertainment Deductions – I.R.C. § 274(n)− Entertainment expenses incurred on or after 1/1/2018 in connection with the active

conduct of a trade or business (e.g., client entertainment) not deductible− Expenses incurred on or after 1/1/2018 in connection with meals provided at the

convenience of the employer (e.g., on-premises cafeteria) not deductible

Employee Fringe Benefit Deductions – I.R.C. § 274(l)− Expenses incurred on or after 1/1/2018 for qualified transportation fringe benefits (e.g.,

employee parking or commuting subsidies) not deductible

Accounting Method Simplification – I.R.C. § 448− Taxpayers with average annual gross receipts for three preceding tax years ≤ $25 million

(other than most C-corporations and partnerships with C-corporation partners)• May use the cash method of accounting• Need not account of inventories pursuant to I.R.C. § 471 but may instead treat inventories as

incidental supplies or follow book accounting• Are exempt from UNICAP (I.R.C. § 263A)

− Any change in a taxpayer’s method of accounting requires IRS consent (I.R.C. § 446)• Rev. Proc. 2015-13 prescribes procedures for obtaining consent (which may be automatic –

see Rev. Proc. 2017-30); guidance not yet updated post-tax reform

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Carried Interest – I.R.C. § 1061− Gain with respect to an Applicable Partnership Interest (i.e., a profits

interest) is treated as short-term capital gain if holding period ≤ 3 years, regardless of I.R.C. § 83 and any I.R.C. § 83(b) election

− Applicable Partnership Interest: transferred to or held by the taxpayer in connection with the performance of substantial services by the taxpayer or a related person, in an Applicable Trade or Business• Applicable Trade or Business: any activity conducted on a regular, continuous

and substantial basis which consists in whole or in part of raising or returning capital and either investing in, disposing of, or developing Specified Assets

• Specified Assets: certain financial assets and real estate held for rental or investment; tiered partnership look-through applies

− Does not apply to a partnership interest held by an employee of another entity (e.g., portfolio company manager/executive) if—• That other entity conducts a trade or business that is not an applicable trade

or business, and• The employee only provides services to that other entity

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Technical Terminations – I.R.C. § 708(b)(1)(B)− Repealed; change of control no longer triggers partnership

termination

Substantial Built-In Losses – I.R.C. § 743(d)− Definition expanded; partnership has substantial built-in loss

with respect to transfer of a partnership interest if either inside basis > FMV of partnership property + $250,000 or transferee partner would be allocated loss > $250,000 in a hypothetical liquidation

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Sales of Partnership Interests – I.R.C. § 864(c)(8) − Grecian Magnesite override; essentially codifies Rev. Rul. 91-32− Applies to dispositions on or after 11/27/2017− Gain (or loss) from the disposition of a partnership interest treated as effectively connected with the

conduct of a U.S. trade or business to the extent of the effectively connected gain (or loss) that would be allocated to the transferor partner in connection with a hypothetical liquidation

Related Withholding Obligations – I.R.C. § 1446(f) − Transferee (or partnership, if transferee does not) must withhold 10% of amount realized—i.e., gross

purchase price—unless transferor partner provides a non-foreign affidavit− Notice 2018-08 (12/29/2017) suspends withholding for dispositions of certain interests in publicly-

traded partnerships− Notice 2018-29 (4/2/2018) provides additional guidance and administrative simplifications, as well as

several exceptions; • Withholding not required if—

▪ Transferor certifies that disposition will not result in gain

▪ Transferor certifies that less than 25% of its total taxable income from the partnership for each of the 3 preceding tax years was effectively connected income

▪ Partnership certifies that less than 25% of its gain on a hypothetical liquidation would be effectively connected income

▪ Disposition is a non-recognition transaction

• Authorizes reliance on certificates from the transferor/partnership in determining transferor’s share of partnership liabilities

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Bipartisan Budget Act of 2015, Pub. L. No. 114-74 (2/2/2015)− Repealed TEFRA and replaced I.R.C. §§ 6221-6234 for partnership taxable years

beginning on and after Jan. 1, 2018− Introduced centralized partnership audit regime under which underpayments

are collected at the partnership level

Consolidated Appropriations Act, 2018, Pub. L. No. 115-141 (3/23/2018)− Made numerous, substantive “technical corrections” to I.R.C. §§ 6221-6234

Final Regulations− Election out – 83 Fed. Reg. 24 (1/2/2018)

Proposed Regulations− General / broad-scope – 82 Fed. Reg. 27334 (6/14/2017)− International aspects – 82 Fed. Reg. 56765 (11/30/2017)− Push-out election, procedural aspects – 82 Fed. Reg. 60144 (12/19/2017)− Adjusting tax attributes – 83 Fed. Reg. 4868 (2/2/2018)

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Broader than TEFRA− Partnership level-adjustments authorized for “any item or amount with

respect to the partnership . . . which is relevant” in determining any person’s federal income tax liability, whether or not shown on partnership’s return

− Extends to, e.g., items related to disguised fees or disguised sales

Partnership Representative (“PR”) replaces tax matters partner− More powerful• Other partners no longer entitled to notice or participation• PR has exclusive authority to bind the partnership in settlement, litigation,

etc.; actions are binding on the partners− Must have a substantial presence in the United States (phone number

and address)• Need not be a partner• Can be an entity, but entity PR must designate an individual to act for it

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Unless an election is made:− Assessment and collection, in addition to audit, occur at the partnership level

• Audit conducted and adjustments determined • Adjustments grouped and netted• Highest tax rate in effect for the year under audit (“reviewed year”) applied to determine one

or more Imputed Underpayments • Penalties and additions to tax determined and computed as if partnership were an individual• Imputed Underpayment(s) paid by the partnership; audit-year (“adjustment year”) partners

secondarily liable• Partnership can dispute adjustments and penalties at IRS Appeals or in court (Tax Court,

refund courts)

− Adjustment-year partners bear economic consequences of reviewed-year partners’ tax

Proposed regulations generally provide for adjustments to partners’ tax attributes (capital accounts, outside basis) to be made in the adjustment year− May create permanent economic distortions

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Imputed Underpayment = rough proxy for additional tax that would have been paid had the partnership and partners reported correctly

Myriad avenues to modify an Imputed Underpayment

− Amended Returns: Partner files amended return for the reviewed year (and any intervening years for which tax attributes are affected) taking into account that partner’s allocable share of the adjustments and pays any tax due• Imputed Underpayment redetermined, without regard to the partner’s share of the adjustments

• Procedure may be followed iteratively through a tiered partnership structure

− Pull-In Procedure: Partner simply pays any tax due, without filing amended return and agrees to adjust tax attributes• Procedure may be followed iteratively through a tiered partnership structure

− Carve-Out for Tax-Exempt Partners: Upon partnership’s request, IRS recalculates Imputed Underpayment without regard to portion of adjustments allocable to any tax-exempt partner(s)• Tax-exempt defined as in I.R.C. § 168(h)(2)(A), (C), (D)

− Modification for Lower-Rate Partners: Upon partnership’s request, IRS recalculates Imputed Underpayment to reflect portions of adjustments allocable to, e.g., corporate partners (subject to 21% rate vs. 37%) or individual partners (eligible for preferential capital gains rate)

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Election Out

− Partnership with 100 or fewer partners, all of which are individuals, corporations, or estates of deceased partners, may elect out on a year-by-year basis (box-tick on return)• Partnership is ineligible if any partner is a partnership, trust, disregarded

entity, nominee (or similar), or estate other than of a deceased partner

− Number of partners = number of Forms K-1 required to be issued under I.R.C. § 6031(b)• For S-corporation partner, all shareholders to which S-corporation is

required to issue Forms K-1 under I.R.C. § 6037(b) also count toward the 100 K-1 limit

− Partnership that elects out must still abide by the new regime in respect of its role as a partner in any lower-tier partnership

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Push-Out Election

− Any partnership can elect to “push out” adjustments, additions to tax, and penalties to the reviewed-year partners via amended Forms K-1• Must file a “partnership tracking report” providing each partner’s TIN• Adjustments can be pushed out through a tiered partnership structure, with the option to

push-out or pay at each tier

− Reviewed year partner pays additional tax due with its adjustment year return• Determines the additional tax (if any) that would have been paid for the reviewed year, had its

allocable share of the adjustments, additions to tax, and penalties been taken into account in that year▪ Any additional tax due for intervening years determined by rolling the adjustments forward

▪ Sum of additional tax due for reviewed year and intervening years included on adjustment year return

• Partner may assert personal penalty defenses (but not challenge adjustments) via a refund claim

• If partnership would have a withholding obligation with respect to items that are the subject of adjustments, it must withhold▪ Even if foreign partners’ liability is fully satisfied through withholding, foreign partners must still file U.S.

tax returns reflecting the adjustments

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Strategies for Optimizing the Benefit- Separate the QTB into labor-intensive and capital-intensive components

Viable only if components would be distinct QTBs

- Spin off the QTB’s non-Specified Service Business component Viable only if non-Specified Service Business component will stand on its own

Open Issues - Scope of QTB

What activities can (or must) be treated as a single QTB? Can activities be further aggregated at the partner level? How to allocate expenses and income among separable activities?

- Scope of Specified Service Business Does authority interpreting I.R.C. § 1202(e)(3)(A) apply? How broadly/narrowly to read the “reputation or skill” clause?

- Will special allocations of depreciation and/or W-2 wage expense be respected?

- How to apply the rules in a tiered partnership context?

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Considerations for Electing Full Expensing- Limitation on NOL deduction may result in lost benefit; careful planning/tracking

required- Implications for pass-through deduction are complex; new investment in depreciable

property increases capital factor but may generate tax loss that reduces benefit

Uncertain Withholding Obligations - Calculating effectively connected gain is complicated—and potentially impossible

Transferee / partnership may not know transferor’s outside basis or share of partnership liabilities; reliance on Forms K-1 permitted only during a limited time window

Classifying partnership assets as generating effectively connected income or non-effectively connected income may be challenging

- “Relief” provided in Notice 2018-29 may entail withholding of entire purchase price

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Key Decisions

- When return is filed Who to designate as PR? Elect out?

- Upon receipt of Notice of Proposed Partnership Adjustment (“NOPPA”) Partners file amended returns or pay pursuant to “pull-in” procedure? Seek other modifications? Enter into settlement / closing agreement?

- Upon receipt of Notice of Final Partnership Adjustment (“FPA”) Make the push-out election? File Tax Court petition? Pay and file refund claim?

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Key Timelines

- NOPPA must be mailed no later than 3 years after latest of: Date reviewed year return filed

Reviewed year return due date

Date AAR filed with respect to reviewed year

- Modification request must be submitted no later than 270 days after NOPPA mailed

- FPA must be mailed no earlier than 270 days after NOPPA, and no later than the latest of: Last day to mail NOPPA

270 days after all documents submitted in connection with a request for modification of an Imputed Underpayment

330 days after issuance of NOPPA

- Push-out election must be made no later than 45 days after FPA mailed Amended Forms K-1 must be issued no later than 60 days after partnership adjustments are finally

determined (i.e., time to petition Tax Court expires, or court judgment becomes final)

Higher-tier partnerships that choose to push out must issue amended Forms K-1 by the extended due date for the adjustment year return of the audited partnership

- Tax Court petition must be filed no later than 90 days after FPA mailed

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Pre-2018 years remain open to audit; existing provisions should be amended, not replaced

Management and Control− Consider whether to require Partnership Representative to obtain

authorization from the partnership’s management (e.g., Board of Managers, Managing Member, or the partners) for elections, audit settlement, etc.

Partner’s Obligation to Contribute Money− Consider whether to require partners to pay their allocable shares of any

imputed underpayment paid by the partnership• Partners’ payments would be treated as capital contributions• Partnership’s payment would be treated as an advance against distributions

and a reduction to the partners’ capital accounts

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Allocations − Require allocation of items arising from an audit adjustment as provided in applicable

Treasury Regulations− Treat such allocations as Regulatory Allocations, to be offset if and to the extent possible by

Curative Allocations aimed at preserving the partners’ economic deal

Distributions− Consider whether tax distributions tied to highest marginal rate should take into account

anticipated pass-through deductions− Consider whether to modify the tax distribution scheme to account for reduced corporate

income tax rate

Transfers− Require that the transferee furnish proof of withholding or a certificate from the transferor

as a condition of valid transfer (i.e., otherwise, void)− Consider whether to restrict permitted transferees (including in an estate planning context)

to preserve eligibility to elect out of the centralized partnership audit regime

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Partner’s Information Rights/Obligations− Require the partnership to supply information that partners will need to compute the pass-through deduction

• Identify each Qualified Trade or Business of the partnership

• For each QTB, state the partner’s allocable share of Qualified Business Income items

• For each QTB, state the partner’s allocable share of the partnership’s Wage Factor / Capital Factor

− Require a foreign partner to certify as to its outside basis in connection with any distribution of money that could result in effectively connected gain

− Require the partnership to certify upon request of a foreign transferor partner as to transferor’s share of liabilities

− Require the Partnership Representative to keep partners informed of audit or litigation proceedings and to provide copies of notices received

− Require partners to provide information to facilitate imputed underpayment modification requests, to determine the allocation of any partnership adjustment among the partners, and to determine partnership’s eligibility to elect out of the centralized partnership audit regime

Tax Matters− Appoint the Partnership Representative− Consider whether to require the partnership to elect out in any year when it is eligible to do so, and/or to make

the push-out election in connection with any audit adjustment− Provide for treatment of any payment by the partnership in connection with any audit adjustment as a non-

deductible expense (I.R.C. § 705(a)(2)(B))

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______________________________________________

DisclaimerThis communication does not provide legal advice, nor does it create an attorney-client relationship with you or any other reader. If you require legal guidance in any specific situation, you should engage a qualified lawyer for that purpose. Prior results do not guarantee a similar outcome.

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© 2018 Caplin & Drysdale, CharteredAll Rights Reserved.

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Jonathan S. Brenner(212) 379-6050

jbrenner@capdale.com

600 Lexington Avenue, 21st FloorNew York, New York 10022

Elizabeth J. Stevens(202) 862-5039

estevens@capdale.com

1 Thomas Circle NW, Suite 1100Washington, DC 20005