Sellers and Buyers of Partnership Interests Should Address Centralized Partnership Audit Provisions and Push Out Elections in Membership Interest Purchase Agreements

Under the Bipartisan Budget Act of 2015, P.L. 114-74 (“BBA”), all entities classified as partnerships, including limited liability companies and limited partnerships, became subject to the centralized partnership audit regime for taxable years beginning January 1, 2018, unless otherwise elected (the “BBA Rules”). Whether or not the parties choose to revise their partnership agreements to provide for the application of the BBA Rules, buyers and sellers should negotiate and include in the Membership Interest Purchase Agreement (“MIPA”), or any equivalent sale agreement, express provisions related to the BBA Rules, the push out election and indemnification from any future tax liability arising from a BBA audit.

The BBA Rules replaced prior audit procedures implemented under the Tax Equity and Fiscal Responsibility Act (“TEFRA”). Under TEFRA, once the IRS made a determination of tax deficiency at the partnership level, it made corresponding adjustments and imposed the tax liability on the individual partners who were partners in the year under audit. The BBA Rules implemented a more streamlined audit process pursuant to which the Internal Revenue Service (“IRS”) may assess and collect tax at the partnership level, the partners do not have the right to notice of audit or the right to participate in the audit proceeding, and the “partnership representative”, designated to represent the partnership in an audit proceeding, has exclusive authority to bind the partnership vis-à-vis the IRS. Pursuant to the BBA Rules, buyers and sellers of partnership interests must now include in their due diligence consideration of the risk of audit of the partnership’s federal income tax returns for prior years and exposure to assessment of imputed underpayment by the IRS, which may affect former and current partners differently based on how the BBA Rules are implemented by the partnership.

Under the BBA Rules, any tax deficiency (“imputed underpayment”) arising from the year under audit (“reviewed year”) is calculated at the highest income tax rate in effect for the reviewed year and assessed in the tax year the audit is finalized (“adjustment year”) and not the reviewed year. Since a partnership operates as a pass-through entity, the imputed liability assessed on the partnership in the adjustment year will directly affect the economic returns of the adjustment year partners. Thus, a buyer of a partnership interest may be liable for imputed underpayment of a tax liability for a prior year, with respect to which the buyer was not a partner, and did not derive any economic benefits from the partnership.

However, the BBA Rules provide that a partnership may make an election to push the imputed liability to the reviewed year partners (the “push out election”), in which case the reviewed year partners would be responsible for the payment of the tax deficiencies, interest and penalties applicable to all the years between the reviewed year and the adjustment year. In addition, the interest imposed on the imputed tax liability of a partner is two percentage points higher than the interest imposed on the imputed liability of a partnership. The push out election must be signed by the partnership representative, filed within 45 days of the final adjustment and include detailed information about each reviewed year partner. Thus, under the BBA Rules and unless the partnership agreement provides otherwise, the partnership representative has exclusive authority to make the push out election, which does not require consent from the reviewed year partners. Consequently, if a seller sells its partnership interest, the seller may still be subject to future tax liability pursuant to the push out election.

Pursuant to the enactment of the BBA Rules, many businesses classified as partnerships sought to amend their operating agreements to include specific provisions regarding the BBA Rules, including designation of a partnership representative, indemnification, payment and collection of imputed underpayment and election provisions. However, these revisions do not always address the application of the rules to former partners or the push out election. In addition, partners with controlling interests may revise BBA provisions of a partnership agreement in the future, which may adversely affect the interests of sellers who were former partners or who kept minority interests in the partnership. Thus, buyers and sellers of partnership interests should not rely on the BBA provisions in the partnership agreement alone and should also carefully review, negotiate and include express provisions in the MIPA addressing the BBA Rules, as further discussed below.

A seller of a partnership interest should consider and perhaps include any or all of the following in its MIPA:

1. The seller should ensure that it is not subject to any liability with respect to imputed underpayment under the general indemnification provisions of the MIPA with respect to prior years during which the seller was a partner of the partnership.
2. In the case of a BBA audit of any tax year in which the seller was a partner of the partnership, the seller should ensure that the partnership insulates the seller from any tax liability arising from such audit by either not making the push out election without the seller’s consent or by indemnifying the seller with respect to any imputed underpayment, including interest and penalties, that the seller would incur in connection with a push out election.
3. To the extent the seller is requested to cooperate with the partnership in connection with a BBA audit, such as providing information that would permit certain adjustments and modifications to the imputed underpayment, the partnership should reimburse the seller for any costs incurred pursuant to such cooperation.
4. In the case of a BBA audit and resulting partnership adjustments of certain tax attributes, the seller should seek assurances from the buyer and the partnership that such adjustments would be fairly attributed and will not create a windfall for the buyer and/or disadvantage the seller.
5. If, pursuant to any change in the law or otherwise, the partnership elects to file an amended tax return which includes the years during which the seller was a partner of the partnership, the partnership would need to obtain prior written consent to file from the seller.
   
   

A buyer of a partnership interest should consider and perhaps include any or all of the following in its MIPA:

1. The buyer should ensure that it will not be subject to any future tax liability with respect to the partnership’s prior years during which the buyer was not a partner of the partnership. The buyer could do so by requesting to make a push out election in the case of a BBA audit for prior years and by seeking specific indemnification from the seller with respect to any tax liability, including interest and penalties, resulting from the BBA audit of the reviewed year and any year between the reviewed year and the adjustment year.
2. To the extent any imputed underpayment for the reviewed year is assessed at the partnership level (for example, if a push out election was not timely made), the buyer should ensure that the seller would indemnify or promptly reimburse the partnership or the buyer for any costs incurred in connection with the BBA audit or the payment of the imputed underpayment.
3. In the case of any BBA audit of a prior year during which the seller was a partner in the partnership, the buyer should require that the seller cooperate with the partnership and provide any requested information, including detailed information that would allow certain adjustments and modifications and reduce the imputed underpayment.
4. In the case of a BBA audit and resulting partnership adjustments of certain tax attributes, the buyer should ensure that such adjustments will be fairly attributed, will not create a windfall for the seller, and will not disadvantage the buyer.
   
   

As evident from the above discussion, buyers and sellers of partnership interests will often have and pursue opposing interests in negotiating the application of the BBA Rules, the use of the push out election by the partnership representative and indemnification of any tax liability arising from a BBA audit by the parties. Thus, the relevant MIPA terms may vary based on the position of either the buyer or the seller and other considerations, including their financial exposure and individual perspective of fairness. If the parties do not negotiate and provide for the application of the BBA Rules in the MIPA, they may be increasing their exposure to future conflict, including costly litigation, which could have been avoided. This is especially true for those partnerships which do not have updated partnership agreements with the BBA provisions. Thus, it is important that buyers and sellers address the centralized partnership audit provisions and push out elections with experienced counsel before entering into a MIPA, which will help them avoid the potential for an unpleasant surprise later.

If you have any questions about the information in this alert, please contact Michael Cumming (248-203-0740 or MCumming@dykema.com), Asel Lindsey (210-554-5298 or ALindsey@dykema.com), or your Dykema relationship attorney.