Changes to Partnership Tax Audit Rules Will Impact Many Delaware Alternative Entities

New rules for partnership tax audits (the “New Rules”) were adopted that may require changes to the governing documents of existing and future partnerships, limited liability companies and other entities taxed as partnerships for federal income tax purposes. The issues relating to existing entities are likely to be particularly difficult as the governing documents for most existing entities do not contemplate the New Rules. Because so many private equity and hedge funds are formed as Delaware limited partnerships, the state law issues arising in connection with the application of the New Rules will primarily be issues of Delaware contract interpretation and construction.

The New Rules are included in the Bipartisan Budget Act of 2015, which was enacted on November 2, 2015. They are effective for partnership tax returns filed for tax years beginning after December 31, 2017, unless a partnership elects to have the new rules apply earlier. All entities taxed as partnerships are subject to the New Rules, provided that a partnership may opt out of the New Rules if it has 100 or fewer partners and all of its partners meet certain criteria. Importantly, a partnership cannot opt out of the New Rules if any of its partners are treated as partnerships for tax purposes.

The New Rules eliminate the designation of a “tax matters partner” and replace it with the designation of a “partnership representative.” Under the New Rules, partnership representatives are granted much broader authority than tax matters partners have under the existing rules, including the sole authority to act on behalf of the partnership in a partnership audit and the power to bind the partnership and its partners.

Another significant change from the existing audit rules is that, unless a partnership makes an election and certain procedures are followed, any additional tax and penalties arising from a partnership audit will be assessed and collected at the partnership level rather than against the partners individually. This will result in the responsibility for any such additional tax and penalties being borne by the persons who are partners at the time of the audit rather than the persons who were partners for the tax year under audit. In an entity such as a hedge fund where partners are frequently admitted and withdraw, this mismatching could be particularly problematic.

These and other changes resulting from the New Rules present many issues and unanswered questions as to the impact of the New Rules on existing and future Delaware entities taxed as partnerships. For example, in what ways can the governing documents of an existing entity taxed as a partnership be amended to address the New Rules? Alternatively, if such documents are not amended, for example, to contemplate the designation of a partnership representative, what effect will be given to the tax matters partner provisions following the effectiveness of the New Rules? Treasury rules and regulations are expected to be promulgated to address certain details under the New Rules, but the content and timing of these rules and implementing procedures is unclear. It also must be determined how Delaware contract construction principles including the implied covenant will apply to these questions.

Additional issues to consider addressing in the governing documents of existing and future Delaware entities taxed as partnerships include:

• The procedure for designating a partnership representative;

• Contractual modifications of the rights, duties, obligations and liability of the partnership representative, if permitted;

• Agreements to make certain elections in the event of a tax adjustment resulting from a partnership audit; and

• Changes to capital account allocation provisions and tax distribution provisions for consistency with the New Rules.

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