global Tax Mastering Partnership Taxation: Avoiding Costly Mistakes and IRS Scrutiny February 10, 2025 Are you aware of how your partnership agreement is impacting your tax return? Partnerships are flexible, but with that flexibility comes complex tax rules—here's how to avoid IRS scrutiny. Partnerships provide the greatest level of flexibility of all business types, but that flexibility is why partnership taxation is often considered the most complex area of tax law. To put it simply, tax law allows partners to do whatever they want as long as the transactions have substantial economic effect. Let’s dive into the details. The benefits and challenges of the partnership structure One of the primary reasons for choosing an entity taxed as a partnership is for the flexibility in allocations of income, deductions, credits, and other items. All that tax law requires is that the allocations are provided for in the partnership agreement (AKA operating agreement) and the allocations have substantial economic effect. Failure to meet either of these requirements could result in the IRS not respecting the allocations and reallocating the items based on a facts and circumstances analysis. What is substantial economic effect? Substantial economic effect is a key concept in partnership taxation that ensures allocations of income, deductions, and other items among partners reflect the partnership's actual financial arrangement—not just a strategy to reduce taxes. In simpler terms, it ensures that these allocations have real economic consequences that align with the partners' true financial stakes in the business. For an allocation to meet this standard, two main criteria must be satisfied: Economic Effect: The allocation must impact the partners' capital accounts, which represent their equity in the partnership. These capital accounts determine how assets would be distributed if the partnership were liquidated. Substantiality: The allocation must meaningfully affect the partners’ economic positions. It cannot be designed solely for tax benefits; instead, it should reflect legitimate financial arrangements that influence the partners’ actual financial outcomes. By requiring substantial economic effect, tax law ensures that the allocations are not just creative accounting maneuvers but truly represent the economic realities of the partnership. What is the importance of the partnership agreement? The partnership agreement is the most important document to your tax preparer. It specifies how the income should be allocated, how capital accounts should be maintained (especially important in the case of a sale or liquidation), how distributions must be handled, who has decision-making authority and will represent the partnership in IRS proceedings, certain elections that should or should not be made, and many other regulatory requirements essential to the preparation of the tax return. A knowledgeable tax practitioner will not only understand the implications of the partnership agreement to ensure the tax return reflects the economic arrangements of the partners, but will also identify potential risks far beyond the tax return and advise on how to remedy those risks before they become a problem. What other risks can a tax practitioner identify? Distributions Not Following the Agreement- This common risk can lead to substantial economic losses and partner disputes, including litigation. In many instances, in order for liquidating distributions to be made in a manner that corresponds to the economic agreement of the partners, the normal distributions during the operating years of the partnership must follow the agreement precisely. The cash loss to a partner can be significant, potentially millions. Tax practitioners who diligently track capital accounts as required under the tax regulations, as well most operating agreements, can identify the risks well in advance and advise their client before it’s too late. Negative capital accounts- If a partner’s capital account is trending negative, it could result in a surprising tax bill when curative allocations are required. This generally happens when other provisions in the agreement were not closely followed. Tax law requires that liquidating distributions are made according to positive capital accounts. These capital accounts are maintained according to the partnership agreement with some specific adjustments required under the tax code. Many issues can arise over time in the capital accounts, and tax practitioners who specialize in partnership taxation can spot these issues before they become a problem. What should you do next? Ensure your tax preparer has the most up-to-date copy of your partnership agreement. Consider engaging your tax preparer to maintain the partners’ capital accounts according to the regulations. Most partnership agreements require this, but it is often overlooked. Confirm your CPA firm has specialists in partnership taxation. The complexity of partnership tax law often requires special knowledge and mistakes made by generalists can prove costly.
