Certain important changes took effect on January 1, 2018 regarding underpayment of taxes by partnerships as well as the handling of tax inquiries including audits.
The biggest change is that the IRS can now come to collect tax underpayments (and associated penalties and interest) from the fund, whereas previously they had to track down individual partners for repayment. For many reasons this can cause inequality at the fund level if the sub-allocation of expenses doesn’t properly track who really ought to be paying the underpayment. For example, U.S. tax exempt partners won’t want to be allocated any underpayment expense, and rightfully so. There is also the issue that by the time the tax man calls, relevant partners may be gone as they may have transferred their interests to transferees. Recent LPA provisions have effectively dealt with this issue, by laying out very specific ground rules to cover contemplated future scenarios. But even more rustic LPAs are very likely sufficient, inasmuch as they mostly contain generalized language saying that when the fund makes a tax payment associated with a particular partner, that partner has to pay. With a little manipulation of transfer agreement language, these more rustic LPAs may well suffice and not necessarily need amendment on this point.
The IRS is allowing fund managers to “push out” the collection of tax to the individual partners (and thereby not have the fund bearing primary liability for the underpayment). This will be done as part of a fund’s typical filing of its partnership tax return. This seems like a “no brainer” for the fund manager, however, the downside is that upon this election the penalty interest rate for the ultimate payors is higher by a couple percentage points. This is meant to reflect the increased difficulty and expense the IRS will have to go through in this case to collect what it is owed. I expect that many venture capital fund managers I work with will file this election.
The next related issue is that effective for 2018, the concept of a “tax matters” partner has gone by the wayside and has been replaced with the concept of a Partnership Representative. Substantively, other than a change in name, the role of the party is largely the same: to receive official IRS correspondence, whether regarding underpayments, audits or otherwise, and to be the designated party authorized to respond for the partnership.
Procedurally, there is a significant change in requirement: while the stipulated party need not be a partner, they must now be a U.S. person, either an entity or an individual. Many fund agreements set out that the fund’s GP is the tax matters partner, and almost as many tend to continue such nomination post- January 1, 2018 (whether directly, in the case of more modern LPAs, or indirectly by inference in the case of more rustic LPAs). I work with a number of GPs that will have to make some modification here, because, their GP entity is non-U.S. and thus not technically qualified to serve. The modification will need to be made by the March 15 filing deadline (the tax filing requires the designation of the Partnership Representative be set forth therein).
This leaves impacted managers to find some U.S. person to stand in and assume this role. So who will this be? I am aware that some service providers are gearing up to provide this service. The U.S. subsidiary operation of the Cayman parent company MaplesFS (which is the administrative services provider itself affiliated with Maples and Calder, the law firm), has indicated to me in early January 2018 that they will be willing to serve in this role. Pricewaterhouse Coopers (PwC) indicated to me that while they are not currently offering this service, they are considering it. Other firms may step in to do so on a paid provider basis as well – time will tell. In other, though not all, cases the GP has a U.S. person as an employee who they may task with taking on this obligation. The cost if a paid provider is very likely to be a qualified fund expense, and the serving party should be able under almost all LPAs to be indemnified and exculpated from liability absent egregious behavior.
Your firm will need to examine its LPAs against the above backdrop, determine any needed changes, decide upon the issue of the IRS election and if there are non-U.S. parties in the Partnership Representative role, make changes by the March 15 filing deadline.