ADP Lunch & Learn

Course Materials

More Things Change: Reasonable

Compensation and Partnerships

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ADP has partnered with SmartPros (a Kaplan Company) to provide

this program and SmartPros has prepared the

material within. www.smartpros.com

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one 1. More Things Change:

Reasonable Compensation and Partnerships

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LearningObjectives:

SegmentOverview:

Field of Study:

RecommendedAccreditation:

RequiredReading(Self-Study):

Running Time:

VideoTranscript:

Course Level:

CoursePrerequisites:

Advance Preparation:

Expiration Date:

Taxes

August 31, 2017

Work experience in tax planning or tax compliance, or an introductory course in taxation

None

1 hour group live2 hours self-study

Update

“Major Changes in Partnership Audit Procedures Contained in2015 Budget Act”By Richard J. Shapiro, of EisnerAmper LLPFor additional info, go to: www.eisneramper.com

“Why Professional Practices Should Consider Being S Corporations”By Robert W. Wood, of Wood LLPFor additional info, go to: www.woodllp.com

See page 1–12.

See page 1–18.

38 minutes

It is not unusual for the IRS, or for the courts, to focus on thereasonableness of compensation. As a result, many tax advisersstruggle with advising businesses – particularly personal servicecorporations – on how to distribute year-end bonus payments.In our opening segment, EisnerAmper’s Richard Shapiroexamines a recent compensation controversy and also explainshow the new rules on partnership audits will affect your clients.

Upon successful completion of this segment, you should be able to:● Identify the factors that lead to investigations of the

reasonableness of compensation;● Distinguish between the unreasonably high compensation of C

corporation executives and the unreasonably low compensationof S corporation owners;

● Recognize why Congress chose to change the tax audit rules forpartnerships;

● Determine how small partnerships can “elect out” of the newpartnership audit rules.

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A. IRS Believes Owners of C Corporations

1. Prefer high compensation

a. Taxed at personal rate

2. Rather than dividends, subject to“double tax”

a. Entity level

b. Individual level

B. Courts Decide Reasonableness ofCompensation Based on

1. Employee’s position, hours, duties

2. What similar companies pay forservices

3. Company’s financial condition

4. Possibility of “disguised” dividends

5. Internal consistency of compensation

C. Frequency of Reasonable CompensationControversies

1. They are not highly technical in taxterms

2. They typically involve a significantamount of earnings

I. Reasonable Compensation: Frequency and Factors

A. Independent Investor Test

1. Would a hypothetical independentinvestor approve the compensation

a. Based on dividends paid

b. Based on return on equity

2. Adopted in Exacto Springs Corp.decision by 7th Circuit

a. In 1999 by well-respected JudgePosner

B. Use of Catch-Up Pay

1. Accepted by Tax Court in ChoateConstruction Co.

2. Reasonable pay for CEO takes prioryears’ underpayment into account

C. Unreasonably Low Compensation

1. By owner/employees of Scorporations

2. Have payroll tax incentive tominimize their compensation

II. Reasonable Compensation Controversies

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A. Personal Service Corporations (PSC)1. Pay tax at a flat rate of 35%2. Principal activity must be

a. Healthb. Lawc. Engineeringd. Architecturee. Accountingf. Actuarial scienceg. Performing artsh. Consulting

3. Substantially all stock must beowned bya. Employeesb. Former employeesc. Estates of former employees

B. Midwest Eye Center, T.C. Memo2015-531. Deducted a $2 million bonus

paymenta. To CEO, who was sole

shareholder2. Tax Court: disallowed $1 million

of salary deductiona. Considered a “disguised

dividend”3. Affirmed imposition of accuracy-

related penaltiesa. More than $62,000

III. Controversy over Midwest Eye Center

A. Analysis of Midwest Eye Case1. Negative result: based on failure to

substantiate bonus payment2. Likely motivation: a bonus

payment avoided 35% corporatetax

B. Going Forward1. Consider how aggressive you want

to bea. Knowing IRS will likely impose

accuracy-related penalties2. Go in with your eyes open

“Taxpayers have to understand thatreasonable compensation is almostan automatic issue for theTreasury.”

- Richard Shapiro

IV. Lessons Learned from Midwest Eye

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eA. For Partnerships with 100 or Fewer

Partners1. You can elect out of the new rules

a. At entity level2. You will be audited under current

rulesa. Applicable to individual

taxpayers3. Annual election is only available to

partnershipsa. That do NOT have other

partnerships as partnersB. Approach of New Streamlined Audits

1. IRS will examine partnership’sitems of incomea. Rather than individual partners

2. Adjustments will be assessed topartnershipsa. For year that adjustments are

finalized3. Effective date: returns filed for tax

years after 2017

C. Earlier Attempts at StreamlinedPartnership Audits1. Imposed in 1982 by TEFRA

legislationa. On partnerships with 10 or more

partners2. Rules for TEFRA and large

partnerships are difficult toadminister

V. New Streamlined Partnership Audits

A. Which Entities Are Subject toPartnership Audit Rules?

1. Limited liability partnerships (LLP)

a. Yes, since they are taxed aspartnerships

2. Limited liability companies (LLC)

a. Yes, unless they elect to be taxedas companies

3. Master limited partnerships (MLP)

a. No, since they are generallytaxed as corporations

B. Impact of New Partnership Audit Rules

1. Audit now affects all currentpartners

a. Rather than one individual underaudit

C. Timing of Partnership Audit Rules

1. Old: reviewed or audited year

a. Affected those who werepartners in year activities tookplace

2. New: audit adjustment year

a. Affects those who are partners inlater year

b. When audit adjustment is made

VI. New Audit Rules: Subject; Impact; Timing

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A. Who’s Liable?

1. Partnership will be liable for tax inyear of adjustment

a. Based on maximumindividual/corporate tax rates

2. Individual partners are NOT jointlyand severally liable for tax

B. Partnership’s “ImputedUnderpayment” Will Be Reduced by

1. Amount of individually-filedreturns

2. Amount of actual tax rates belowmaximum rate

3. Amount of adjusted K-1 forms sentto individual partners

C. Goodbye, Tax Matters Partner!

1. Partnerships will now appoint aPartnership Representative

a. Does not have to be a partner

b. To represent partnership in alltax matters

D. Consistent Positions

1. New law requires consistentpositions to be taken, by

a. Partnership

b. Partners

VII. Liability for Audit Findings

A. Who’s Liable?

1. Partnership will be liable for tax inyear of adjustment

a. Based on maximumindividual/corporate tax rates

2. Individual partners are NOT jointlyand severally liable for tax

B. Partnership’s “ImputedUnderpayment” Will Be Reduced by

1. Amount of individually-filedreturns

2. Amount of actual tax rates belowmaximum rate

3. Amount of adjusted K-1 forms sentto individual partners

C. Goodbye, Tax Matters Partner!

1. Partnerships will now appoint aPartnership Representative

a. Does not have to be a partner

b. To represent partnership in alltax matters

D. Consistent Positions

1. New law requires consistentpositions to be taken, by

a. Partnership

b. Partners

VIII. Going Forward

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1. More Things Change: Reasonable Compensation andPartnerships

● As the Discussion Leader, you shouldintroduce this video segment with wordssimilar to the following:

“In this segment, Richard Shapiroexamines a recent compensationcontroversy and also explains how thenew rules on partnership audits willaffect your clients.

● Show Segment 1. The transcript of thisvideo starts on page 1–18 of this guide.

● After playing the video, use thequestions provided or ones you havedeveloped to generate discussion. The answers to our discussion questions are on pages 1–8 and 1–9 . Additionalobjective questions are on pages 1–10and 1–11.

● After the discussion, complete theevaluation form on page A–1.

1. Why do issues of reasonableness ofcompensation arise in the S corporationarena? How has this trend affected yourclients and practice?

2. Why do issues of reasonableness ofcompensation arise in connection withpersonal service corporations? How hasthis trend affected your clients andpractice?

3. Richard Shapiro discusses issues thatarise in considering the reasonablenessof compensation, such as the use of“catch-up” pay for earlier years ofundercompensation and the use of ahypothetical independent investor test.How applicable are these strategies toyour clients and practice? How often,

and in what detail, should we addressthem on future programs?

4. What can and should tax advisers do toavoid reasonable compensation issuesfor their clients? What are you doing?

5. On this month’s program, RichardShapiro highlights the new tax auditrules for partnerships. Why didCongress institute these changes? Whatimpact will they have on your clientsand practice?

Discussion Questions

You may want to assign these discussion questions to individual participants before viewingthe video segment.

Instructions for Segment

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6. The streamlined partnership audit rulesprovide an opportunity for “smaller”partnerships to elect out of the newrules. To what extent are your clients’partnerships likely to opt out of thestreamlined procedures? How and whenwill you inform them of theopportunity?

7. Our coverage of the partnership auditrules is fairly unusual: because of thecomplexity of the partnership taxprovisions, we often do not go intodetail into the intricacy of tax rules forentities that are taxed as partnerships.Does this make sense for your practiceand your knowledge? How often shouldwe feature partnership tax issues on ourprogram?

Discussion Questions (continued)

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s1. Why do issues of reasonableness of

compensation arise in the S corporationarena? How has this trend affected yourclients and practice?● Many S corporation owners prefer to

downplay their compensation in favorof owner distributions. However,while pigs get fat, hogs getslaughtered. The IRS is activelyinvestigating those S corporationswhere the owners took little or nocompensation in past years.

● Participant response is based on yourclients, their choice of entity, theirpersonal financial needs, theirownership agreements, and their taxaggressiveness, as well as on yourperspective and experience.

2. Why do issues of reasonableness ofcompensation arise in connection withpersonal service corporations? How hasthis trend affected your clients andpractice?● Many PSC owners prefer to avoid the

flat 35% tax on the profits of personalservice corporations. As a result, theIRS looks for substantiation ofexecutive compensation and bonusesthat appear to be overly generous.

● Participant response is based on yourclients, their choice of entity, theirpersonal financial needs, theirownership agreements, and their taxaggressiveness, as well as on yourperspective and experience.

3. Richard Shapiro discusses issues thatarise in considering the reasonablenessof compensation, such as the use of“catch-up” pay for earlier years ofundercompensation and the use of ahypothetical independent investor test.How applicable are these strategies toyour clients and practice? How often,and in what detail, should we addressthem on future programs?● Participant response is based on your

practice, on your clients’ taxcompliance, as well as on yourperspective and experience.

4. What can and should tax advisers do toavoid reasonable compensation issues fortheir clients? What are you doing?● Richard Shapiro urges tax advisers to

“keep their eyes open.” He urgesadvisers to have a contemporaneousdiscussion of the issue with clients, aswell as reminding clients of potentialaccuracy-related penalties inconnection with return filing.

● Participant response is based on yourclients, their choice of entity, theirpersonal financial needs, theirownership agreements, and their taxaggressiveness, as well as on yourperspective and experience.

5. On this month’s program, RichardShapiro highlights the new tax auditrules for partnerships. Why did Congressinstitute these changes? What impactwill they have on your clients andpractice?● Congress was well aware of the “gap”

in audit rates between partnerships(very low) and other business entities(moderately high). As a result, thenew rules are expected to lead toincreased IRS audit activity involvingpartnerships, resulting in increasedrevenue to the government.

● Participant response is based on yourclients that are actively engaged inpartnerships and their tax compliance,as well as on your perspective andexperience.

6. The streamlined partnership audit rulesprovide an opportunity for “smaller”partnerships to elect out of the new rules.To what extent are your clients’partnerships likely to opt out of thestreamlined procedures? How and whenwill you inform them of the opportunity?● Participant response is based on your

clients that are actively engaged inpartnerships and their tax compliance,as well as on your perspective andexperience.

Suggested Answers to Discussion Questions

1. More Things Change: Reasonable Compensation andPartnerships

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7. Our coverage of the partnership auditrules is fairly unusual: because of thecomplexity of the partnership taxprovisions, we often do not go intodetail into the intricacy of tax rules forentities that are taxed as partnerships.Does this make sense for your practiceand your knowledge? How often shouldwe feature partnership tax issues on ourprogram?● Participant response is based on your

practice, on your clients that areactively engaged in partnerships andtheir tax compliance, as well as onyour perspective and experience.

Suggested Answers to Discussion Questions (continued

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1. In cases involving employee ownersdealing with C-Corporations on a lessthan arms length basis, the IRS may viewdistributions to the owners as:

a) constructive dividends.

b) compensation.

c) a below market rate loan.

d) a disguised loan.

2. In determining reasonableness ofcompensation to employees, Tax Courtstend to base their decisions on all of thefollowing factors EXCEPT:

a) the financial condition of thecompany.

b) internal consistency of compensation.

c) the employee’s education.

d) the employee’s position, hours workedand duties performed..

3. Instead of applying common law factorsto determine reasonableness ofcompensation paid, some appellate courtsare applying a(n) _______test.

a) fair market value

b) market rate

c) independent investor

d) none of the above

4. When it comes to compensation of S-corporation shareholders, when comparedto C-Corporations, the government’sperspective is generally that thecompensation should be:

a) lower.

b) higher.

c) There is no difference between thetwo from the government’sperspective.

d) The answer depends on a case by casebasis.

5. Personal service corporations (PSCs)such as the one in the Midwest EyeCenter Case:

a) are taxed like C-Corporations.

b) are taxed like S-Corporations.

c) pay tax based on a progressive taxscale.

d) are classified as a different type ofentity from C or S corporations.

6. Under the Bipartisan Budget Act of 2015:

a) the burden will be on partnerships toopt out of the audit rules.

b) adjustments to partnership items ofincome, deductions, gain or loss willbe assessed directly to the individualpartners.

c) it is the IRS’s responsibility to issueadjusted informational returns.

d) Congress replaced the old currentpartnership rules with a two tierstructure.

7. To allow the IRS time to issueimplementing regulations the effectivedate of the new audit provisions will be:

a) June 30, 2017.

b) December 31, 2017.

c) June 30, 2016.

d) December 31, 2016.

8. Which of the following entities is NOTsubject to the new partnership auditrules?

a) Limited Liability Partnerships

b) Limited Liability Companies

c) Master Limited Partnerships

d) Master Limited Partnerships inminerals and natural resources only

You may want to use these objective questions to test knowledge and/or to generate furtherdiscussion; these questions are only for group live purposes. Most of these questions are basedon the video segment; a few may be based on the required reading for self-study that starts onpage 1–12.

Objective Questions1. More Things Change: Reasonable Compensation and

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9. With respect to unreasonablecompensation paid by not for profit(NFP) organizations:

a) any imposed excise tax is imposed onthe individual, not the NFPorganization.

b) unreasonable compensation paid byNFPs is not an area of concern for theIRS.

c) the IRS may impose an excise tax of10% on unreasonable compensationamounts.

d) any excise tax imposed is on the totalamount of compensation received.

10. In the Midwest Eye Care case, the IRSdetermined that the Petitioner’s bonus_____constitute reasonablecompensation because_________.

a) did, Petitioner showed comparableevidence of comparable salaries.

b) did not, it was not paid for servicesactually rendered.

c) did, Petitioner provided anappropriate methodology to showhow the bonus was determined inrelation to Petitioner’sresponsibilities.

d) did not, Petitioner failed to showhow the bonus was determined andwhy it was divided into fourpayments.

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Objective Questions (continued)

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By Richard J. Shapiro, of EisnerAmper LLPFor additional info, go to:www.eisneramper.com

Contained in the Bipartisan Budget Act of2015 (the “BBA”), signed by PresidentObama on November 2, is a rathercomplex provision that materially changeshow partnerships are audited. Generallyeffective for tax years beginning afterDecember 31, 2017, the so-called“TEFRA” and “Electing LargePartnership” rules under current law arerepealed and replaced by a single set ofrules for auditing partnerships and theirpartners at the partnership level. The IRSand Treasury anticipate that the new auditprocedures will make it easier to collectdeficiencies. Indeed, the CongressionalBudget Office scored this provision as asignificant revenue raiser over the next 10years.

Certain partnerships will be able to opt outof the new rules, in which case thepartnership and partners would be auditedunder the general rules applicable toindividual taxpayers. Specifically,

partnerships with 100 or fewer partnerswill be able to elect out of this regime for ataxable year, provided that each partner isan individual, a C corporation, a foreignentity that would be a C corporation if itwere domestic, an S corporation (eachshareholder being treated as a partner forpurposes of the 100 partner limit and thedisclosure requirement, noted below) or theestate of a deceased partner. Such electionwill be made with a timely filed return forthe taxable year and include a disclosure ofthe name and taxpayer identificationnumber of each partner. The partnershipwill also be required to notify each partnerof such election.

Today’s RulesCurrently, there are three possible sets ofrules for auditing partnerships. The mostcommon is the “TEFRA” rules. Under theTEFRA rules, although the treatment ofpartnership items is determined at theentity level, the IRS assesses the partnersindividually for any balance due, based onthe partner’s share of the adjustment. The

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Self-Study Option

Required Reading (Self-Study)

1. Viewing the video (approximately30–35 minutes). The transcript of thisvideo starts on page 1–18 of this guide.

2. Completing the Required Reading (approximately 25–30 minutes). TheRequired Reading for this segmentstarts below.

3. Completing the online steps (approximately 35–45 minutes). Pleasesee pages iii to v at the beginning ofthis guide for instructions oncompleting these steps.

When taking a CPA Report segment on a self-study basis, an individual earns CPE credit bydoing the following:

Instructions for Segment

MAJOR CHANGES IN PARTNERSHIP AUDIT PROCEDURESCONTAINED IN 2015 BUDGET ACT

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partners affected are those who werepartners in the tax year being audited.

In addition, partnerships with over 100partners can elect to be use simplified auditrules, under which partnership-leveladjustments flow to those who are partnerswhen the adjustment occurs, as opposed topartners in the tax year being audited. Veryfew large partnerships elect to use thesesimplified rules.

Finally, for certain small partnerships,adjustments are determined in separateproceedings for each partner undergenerally applicable audit procedures.

New “ImputedUnderpayment”

Under the new audit regime, the IRS willexamine a partnership’s items of income,gain, loss, deduction, credit and partners’distributive shares for a particular year ofthe partnership (the “reviewed year”). Anyadjustments will be taken into account bythe partnership (NOT the individualpartners) in the year the audit or anyjudicial review is completed (the“adjustment year”); the partnership will beliable for related penalties and interest. Thetax deficiency arising from the partnershiplevel adjustment (the “imputedunderpayment”) will be calculated usingthe maximum statutory individual andcorporate income tax rates. Partners willnot be subject to joint and several liabilityfor any liability determined at thepartnership level.

Procedures will be established under whichthe imputed underpayment amount may bereduced: (i)(a) to the extent partnersvoluntarily file amended returns for thereviewed year, (b) the returns take intoaccount all adjustments properly allocableto such partners and (c) any tax due bysuch partners for the reviewed year is paidwith the returns; or (ii) if the partnershipdemonstrates that a portion of the imputedunderpayment is allocable to partners thatare tax-exempt or are taxed at lower thanthe maximum corporate or individual (i.e.,qualified dividend or capital gain) tax rateused in computing the imputedunderpayment amount. In the case of any

adjustment which reallocates thedistributive share of any item from onepartner to another, all partners affected bysuch adjustment must file amended returnsfor the imputed underpayment amount tobe modified through the filing of amendedreturns under item “(i)” above.

A partnership will generally have 270 daysto submit information to the IRS whenrequesting a modification of the imputedunderpayment amount following themaking of a proposed partnershipadjustment, unless the period is extendedwith the consent of the IRS.

Alternative to ImputedUnderpayment

As an alternative to taking the adjustmentinto account at the partnership level, apartnership can elect to issue adjustedinformation returns – adjusted Form K-1s –to the reviewed-year partners (and theIRS). Those partners would then take theirshare of any adjustments (as determined ina notice of final partnership adjustment)into account on their individual returns inthe adjustment year and would be liable forrelated penalties and interest, withdeficiency interest calculated at anincreased rate and running from thereviewed year.

A partnership would be required to electthis alternative to the payment of theimputed underpayment amount not laterthan 45 days after the notice of finalpartnership adjustment.

Adjustment Requested byPartnership

The new regime allows a partnership to filea request for an administrative adjustmentin the amount of one or more items ofincome, gain, loss, deduction, or credit ofthe partnership for any partnership taxableyear, with the adjustment taken intoaccount for the partnership taxable year inwhich the administrative adjustmentrequest is made. The partnership wouldgenerally be permitted to take theadjustment into account at the partnershiplevel or issue adjusted information returns

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(as described above) to each reviewed-yearpartner; in the case of an adjustment thatwould not result in an imputedunderpayment, a partnership would issueadjusted information returns to reviewed-year partners.

A partnership may not file such a requestmore than 3 years after the later of (i) thedate on which the partnership return forsuch year is filed or (ii) the last day forfiling the partnership return for such year(determined without regard to extensions).In no event could a partnership file arequest after a notice of an administrativeproceeding with respect to the taxable yearis mailed to the partnership and“partnership representative” (see below).

MiscellaneousThe enacted provision also contains thefollowing:

● Consistent Treatment. A partner, onthe partner’s return, is required to treat eachitem of income, gain, loss, deduction orcredit attributable to a partnership in amanner consistent with the partnershipreturn, unless the IRS is notified of theinconsistent position. If a partner fails tonotify the IRS, the IRS may assess andcollect any resulting underpayment as if theunderpayment were on account of amathematical or clerical error on thepartner’s return. A determination as to aninconsistent position in a proceeding towhich the partnership is not a party is notbinding on the partnership.

If a partnership is a partner in anotherpartnership, any adjustment on account ofsuch partner’s failure to file consistentlywith respect to its interest in the otherpartnership will be treated as amathematical or clerical error, with norequest for abatement permitted.

● Designation of PartnershipRepresentative. Each partnership isrequired to designate a partner (or otherperson, even a non-partner) with asubstantial presence in the U.S. as thepartnership representative who will havethe sole authority to act on behalf of thepartnership. In the absence of such

designation, the IRS may select any personas the partnership representative. Apartnership and all partners are bound bydeterminations made at the partnershiplevel. Apart from the partnershiprepresentative, the IRS is not required toprovide notice to partners at the beginningof an administrative proceeding oradjustment.

● Electing Early Effective Date. Apartnership will be permitted to elect tohave the new audit regime apply (other thanthe 100 or fewer partner “election out” ofthe new rules) to any return of a partnershipfiled for partnership taxable yearsbeginning after the date of enactment (i.e.,November 2, 2015) and before January 1,2018.

● Treatment When Partnership Ceasesto Exist. If a partnership ceases to existbefore a partnership adjustment takeseffect, the adjustment will be taken intoaccount by the former partners underregulations to be issued.

● Judicial Review of PartnershipAdjustments. Within 90 days after the dateon which a notice of a final partnershipadjustment is mailed, the partnership mayfile for a readjustment for such taxable yearwith the Tax Court, the federal district courtfor the district in which the partnership’sprincipal place of business is located, or theClaims Court. If it wants to file in districtcourt or the Claims Court, the partnershipmust deposit the amount of the imputedunderpayment with the IRS. The court mayby order accept a good faith effort to meetthe deposit requirement.

ObservationWith the recent enactment of the BBA,there remain numerous questions withrespect to the implementation of thisprovision. For example, how will it beapplied to tiered partnerships? How will“technical terminations” be treated? Withpotential partnership level tax liability, whatabout FIN 48 tax accruals? Comprehensiveregulations, notices and revenueprocedures, and perhaps technicalcorrections, will be required in advance ofthe effective date. In any case, partnerships

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and partners, both existing and new,together with their professional taxadvisors, will now need to carefullyconsider the various alternatives availablein dealing with partnership audits and theconsequences of adopting one methodologyover another.

The new partnership audit rules represent adramatic change from existing law and willlikely have a significant impact on manyaspects of partnership transactions. Manyof the details of these rules are reserved forfuture guidance from the IRS. Additionally,there may be technical corrections tocertain aspects of these rules. We will bestudying these developments very carefully,and will keep you informed.

Although the rules will generally not takeeffect until 2018 for most partnerships,LLCs and other partnerships should takesteps ahead of time to prepare for potentialaudits under the new rules. Specifically:

● Existing LLC operating agreements andpartnership agreements should bereviewed and potentially revised inlight of these new rules.

● Purchasers of partnership interests willneed to be aware of the increased riskfrom audits of tax years prior to theacquisition and obtain appropriateindemnities from sellers.

● Disclosures regarding these new rulesshould be added to offering documentsfor investment funds.

● Once these rules take effect, there willlikely be an increase in audit activityinvolving partnerships, whichhistorically have been audited muchless frequently than C corporations.

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By Robert W. Wood, of Wood LLPFor additional info, go to:www.woodllp.com

As the IRS increases scrutiny of executivecompensation, CPAs need to proactivelyadvise their clients on how to withstandthese inquiries.

As a result of IRS training initiatives, threetypes of entities draw the most attentionand therefore need good advice from CPAs.First, closely held C corporations areexamined to determine whether they haveoverpaid their shareholder-employees.These corporations are allowed to deductonly “reasonable” compensation paid toshareholder-employees. So, examiners arelooking for a disguised dividend, which iscorporate profit being treated ascompensation. Since a dividend is notdeductible, but compensation is, the IRSmay treat the portion of the compensationthat it considers excessive as a dividend.

The result is that the corporation loses itsdeduction for that amount and is assessedtax, interest, and penalties on the resultingincrease in income.

Conversely, S corporations are audited todetermine whether they have underpaidtheir shareholder-employees. Theseshareholders may have set their own paylevels unreasonably low andsimultaneously increased their profitdistributions. Since compensation is subjectto payroll taxes, but distributions are not,some tax savings can be realized by simplyreducing a shareholder’s compensation andincreasing his or her distributions. But, likeC corporations, S corporations are expectedto pay reasonable compensation to theirshareholder-employees.

Not-for-profit organizations are the IRS’sthird area of focus. Because key employeesmay be able to increase their own pay,these organizations are often audited to

WHY PROFESSIONAL PRACTICES SHOULD CONSIDERBEING S CORPORATIONS

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determine whether they have paid excesscompensation. If the IRS finds that insidershave abused their authority by setting theirown compensation at unreasonable levels, itwill treat the payment of the unreasonablecompensation as an “excess benefittransaction” subject to excise taxes underSec. 4958. This section imposes a 25%excise tax on the recipient of theunreasonable compensation and, inaddition, imposes a 10% excise tax on theorganization’s managers who permitted theunreasonable compensation payment. Thesetaxes are applied to the portion of thecompensation that exceeds the amountconsidered reasonable. Note that bothexcise taxes are imposed on individuals, notthe charitable organization. Therefore,CPAs should caution any charitable boardsthey may serve on, as well as theirnonprofit clients, of the potential forpersonal liability.

Executives are often surprised and feelpersonally insulted when an IRS auditorchallenges their pay. In response, they mayblame their CPA for not warning them. Toprevent such frustration, a few simple stepscan be followed.

First, CPAs should make sure theappropriate people are aware of this issue.Clients and their board members do notneed to become compensation experts, butthey should know that this is a major hotpoint in audits. To reduce the likelihood ofsuch a challenge and to minimize thedamage if one occurs, CPAs should adviseclients to carefully document eachexecutive’s qualifications, duties, and keyaccomplishments. This documentation isextremely helpful when responding to anIRS challenge. Advise clients to take timeto include more than just the most apparentfactors when describing an individual’squalifications. Education and experienceare obvious, but one of the most importantfactors may be professional goodwill,which includes reputation and relationshipsin the industry. Effective communicationskills are another critical leadership talentsometimes left out of documentation. Inmaking note of duties andaccomplishments, clients should considerthe importance of intangibles such asstrategic decision-making, leadership, and

impact on employee morale. If anindividual personally guarantees theemployer’s debts, a guarantor fee should beseparately computed to keep anycompensation issue out of the equation.

The Midwest Eye CenterControversy

If you viewed the Tax Court decision in thecase of Midwest Eye Center as a wake-upcall for people who have highly profitableprofessional practices inside Ccorporations, I think you would bemistaken. The wake-up call was in 1986.This decision is hitting them over the headwith a two-by-four, particularly coming ontop of the Vanney Associates, Inc decisionlate last summer.

Midwest Eye Center is a substantialoperation. According to its website, thereare eleven physicians and four locations.But only one shareholder though: thatwould be Dr. Afzal Ahmad. During 2007,one of the physicians in the practice leftsuddenly and another was phasing out inthe hope of starting a new practice,requiring Dr. Ahmad to pick up some of theslack. So for that year, Dr. Ahmad’scompany paid him a larger than normalbonus which brought his total compensationto $2.78 million. Yowzers!

Back to the Tax ProblemsDr. Ahmad’s bonus was large enoughrelative to the pre-bonus profit to create anet operating loss of $50,434. The IRSdetermined that the bonus did not constitutereasonable compensation and disallowed$1,000,000. That resulted in a deficiency of$313,062 for 2007 and $7,608 for 2008. Asis routine, the Service also threw in theaccuracy penalty, which adds over $60,000to the 2007 tab.

Since Dr, Ahmad had entirely wiped out thecorporate profit, his salary would not standup to the “reasonable investor standard.”That then led to a reasonableness inquirythat did not go well:

“Petitioner produced no evidence ofcomparable salaries. Instead, petitioner

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g argues that there are no “like enterprises”under “like circumstances” from which todraw comparisons. Petitioner argues thatDr. Ahmad’s large bonus was reasonablefor several other reasons. Petitioner pointsto Dr. Ahmad’s increased workload during2007 and the various roles that Dr. Ahmadperformed, such as CEO, CFO, and COO,and the corresponding managerial duties ofthose positions. However, petitioner did notprovide any methodology to show how Dr.Ahmad’s bonus was determined in relationto these responsibilities.

“Petitioner did not explain how theamount of the bonus was determined andwhy it was divided into four payments. Dr.Goyal left in June, and Dr. Ahmadincreased his surgeries and thereforebillings as a result. Petitioner did notexplain how the increased billingstranslated to bonus payments. Petitioner didnot provide evidence to show that the full$2 million bonus was reasonable.Accordingly, petitioner did not meet itsburden.

“Because petitioner failed to show thatthe bonus constituted reasonablecompensation, we do not reach the issue ofwhether it was paid or incurred for servicesactually rendered.”

Of course, the real reason for the bonus isso that Dr. Ahmed is not taxed twice on thesame earnings. He could have had that ifMEC had made an S election. Had he donethat he would have done even better tax-wise had he not taken any bonus, since hewould have avoided 2.9% Medicare tax bytaking the earnings as a dividend. In hiscoverage of this case, Joe Kristan notedthat this case is something of a double-edged sword that can be used against theIRS by S corporation professionalpractices:

“As in any two-front war, a victory onone front might cause problems on theother. A Tax Court victory yesterday for theIRS over an eye doctor who took ‘toomuch’ compensation may give ammunitionto S corporation professional practices thattake corporate earnings out via their K-1sand distributions – free of Medicare taxes –rather than as salary and bonus.”

Pretty much every case I have noted whereS corporations have been hit for salariesbeing too low, the salaries have beenabsurdly low or non-existent. So DoctorAhmad would probably have been let aloneif he had taken no bonus and a $2 milliondividend, thereby saving around $60,000 inpayroll tax, if he had run as an SCorporation. Instead, as a C corporation,he is hit with over $300,000 in corporateincome tax. He should get a little of thatback as an individual since dividends aretaxed at a more favorable rate, but it is stillpretty costly.

If he ever decides to sell his practice, thecontrast will be even more striking.

An Odd Feature of the CaseIn fighting the penalty it was argued thatMEC had hired a professional to prepare itsreturn, which should get it out of theaccuracy penalty. The answer to that was:

“Petitioner failed to provide anyevidence about the identity of its tax returnpreparer, the information it provided to itstax return preparer, or whether it relied onthe preparer’s judgment. Moreover, the taxreturn preparer did not testify at trial.Petitioner has not shown that it hadreasonable cause or acted in good faith.”

I’m scratching my head trying to figurehow a top-notch medical practice like MECdoes not at least have a medium-notch CPAfirm that, having failed to convince DoctorAhmed to make an S election would nothave somebody ready to go fall on hissword to try to help him save sixty grand inaccuracy penalties.

The Bottom LineAnybody with a professional practicenetting anywhere above the very low sixfigures needs to have an extremely goodreason to consider continuing as a Ccorporation in light of this and similardecisions. Also this is probably anothersign that using S corporations to avoidsome, but not all, payroll tax is a very solidstrategy.

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SURRAN: Unfortunately, there seems to be no end to our discussions about thereasonableness of compensation, particularly in cases involvingclosely-held businesses. After all, in those cases, the person receivingthe compensation typically controls the company. As a result, theemployer and the employee are not dealing with each other on anarm’s-length basis. In addition, viewers will recall that the IRS – incases involving C corporations – views these situations as disguised orconstructive dividends.

The Service’s perspective is that individuals – who are owners as wellas employees – would prefer to receive additional income from thecorporation in the form of compensation, which is taxed at theirpersonal rate, rather than as dividends, which are subject to so-called“double taxation.”

Traditionally, courts – including the Tax Court – tend to travel a middleroad, preferring to examine four or five “common law” factors thattypically determine the reasonableness of compensation. Of course,when these disputes reach the courts, which they frequently do, thedecision has often been based on:

One, the employee’s position, hours, and duties;

Two, what similar companies pay for similar services;

Three, the company’s financial condition;

Four, the possibility of disguising dividends as salary; and

Five, the internal consistency of compensation.

QUINLAN: Joining us this month is Richard Shapiro, tax director at the firm ofEisnerAmper. It’s great to see you again, Richard.

SHAPIRO: Mike, good to see you.

QUINLAN: I’m curious, Richard: why does this issue of reasonable compensationcome up so frequently in tax controversies?

SHAPIRO: Mike, reasonable compensation is a very factual issue. It is an easyissue for an IRS agent to put his arms around. It does not really involvereally heavy-duty technical tax provisions. Any reviewer is going tocomprehend reasonable compensation, or think he or she does.

And so, it is sort of low-hanging fruit for the IRS when it comes toexamining taxpayers.

QUINLAN: Tell me, is this issue high on the IRS’ enforcement agenda? Is that whywe see it contested, and litigated, so often?

SHAPIRO: Mike, I cannot say whether it is high on the priority list. It is alwaysthere, again, because it is an easy issue to address and there is realmoney involved. There is real money involved as to whether or not themoney that is being paid is compensation or is a distribution ofearnings or is a dividend, depending on the kind of entity we arelooking at. So, as a result, it is always going to come up.

It is always going to come up in an audit process, particularly ofcompanies that have had significant earnings, or partnerships or S

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1. More Things Change: Reasonable Compensation andPartnerships

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pt corporations that have significant dollars flowing into them, and out of

them to shareholders, partners, or employees, as the case may be.

QUINLAN: I suppose the starting point is IRC sec. 162, which says that you may“deduct ordinary and necessary business expenses, including areasonable allowance for salaries and other compensation for personalservices actually rendered.” It sounds as if the determination ofreasonable compensation is, by definition, incredibly subjective, doesn’tit?

SHAPIRO: Mike, absolutely. Reasonable compensation is probably one of the mostsubjective concepts in the entire Internal Revenue Code.

One of the reasons why reasonable compensation is so litigated isbecause the stakes are so high to the IRS. For corporations,compensation is deductible to the corporation. On the other hand, adividend paid by the corporation to shareholders is not.

If you are able to sustain a payment as compensation, then thecorporation has a deduction. On the other hand, if it were challenged andrather treated as a dividend, then the corporation does not get a deduction– which would have the impact, therefore, of raising the income of thecorporation and therefore increasing the amount of tax that thegovernment is going to collect from corporate taxpayers.

QUINLAN: Well, if you go back through the case law, there are certainly a numberof so-called “common law factors” that courts typically use in analyzingthe reasonableness of compensation. I suppose these can be used tojustify – and to attack – any executive salary, can’t they, Richard?

SHAPIRO: Mike, there are a number of factors that courts can look at and do lookat. And all courts do not use the same lists. Some use the short list. Somecan use as many as 20 different factors. They can cover such things, as:the nature of the activity that an employee is engaged in; the nature ofthe business of the employer; the scarcity of employees doing thisparticular kind of work. It can be the particular contribution that theemployee makes to the corporation.

There are a whole variety of things, and there is no right or wrong list.There is no particular weighting that is used. There is a whole litany ofthings that a particular court is going to look at, evaluate and, based onthat compendium of items, come to some conclusion. There is no black-and-white answer to whether or not a particular situation is going to beviewed as reasonable or not under this common law approach.

QUINLAN: Thanks, Richard. We’ll return to your commentary in a minute.

SURRAN: Instead of relying on the so-called common law factors, some appellatecourts have been moving toward a much simpler and more basic test: theindependent investor test. Of course, many closely-held businesses areowned by key executives and family members, and not by independentor disinterested shareholders. In these cases, the court assesses thesituation from the perspective of an independent investor, even if it is ahypothetical one. Given the dividends paid and the return on equityenjoyed, would that independent investor approve of the compensationthat is being paid to the employee in question?

When we last discussed this area of controversy, we noted that twoinfluential appeals courts – the ninth circuit in California and the secondcircuit in New York – had adopted the independent investor test as thelens through which other tests or criteria are viewed. For many disputes

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Court of Appeals for the Seventh Circuit adopted the independentinvestor test. In reversing a Tax Court decision involving the privately-held Exacto Spring Corporation, well-known and respected Judge Posnerheld, that the CEO of a closely-held business did receive reasonablecompensation, after the lower court improperly used a “multi-factor” test.

QUINLAN: In recent years, Richard, I heard that some courts were examining thesecontroversies almost solely through the lens of a so-called “hypotheticalindependent investor test.” Does that change the focus somewhat?

SHAPIRO: Mike, it does change the focus a little bit. A number of courts are startingto use this other approach, namely thinking in terms of having an owneremploy a manager to run a business and grow the company’s assets.What kind of return can that manager obtain? And what does that convertto in terms of compensation level?

QUINLAN: Well, let me ask you: to what extent can – or should – reasonablecompensation for a CEO include so-called “catch-up pay” for start-upyears of low-pay or no-pay?

SHAPIRO: Mike, actually there is some case law. I believe, one case is ChoateConstruction is the name of the case, in which they actually did take intoaccount the early years of low or no earnings, and factored that into thecalculation of what reasonable compensation would be for a current year.

QUINLAN: On one hand, executive compensation in a C corporation is oftenconsidered by the IRS to be unreasonably high. On the other hand, theService has really brought the issue of underpayment of S corporationemployee/shareholders to the forefront in recent years. In thosesituations, the executive’s compensation is considered to be unreasonablylow, right?

SHAPIRO: Mike, it may seem a little odd that, in certain circumstances, thegovernment is going to argue that compensation is too low. And inanother situation, they are going to look at compensation as unreasonablyhigh. But when it comes to S corporations in particular, the questionbecomes often one of the application of payroll taxes. And the Scorporation, by having the compensation lower, the goal would be tominimize the application of payroll taxes to those situations.

And from the government’s perspective, they say: “No, no, no, thecompensation should be higher,” thereby being in a position to applypayroll taxes to the higher level of compensation that is being paid.

SURRAN: Most viewers are aware that a corporation is an artificial “person”created by state law. Although the tax law often does not distinguishbetween types of corporations, Congress did become aware that somebusinesses – professional service corporations – were being used toshield income from their employee-owner’s higher tax rates. As a result,since 1987, the benefits of lower tax rates have been denied to personalservice corporations, which pay tax at a flat rate of thirty-five percent.

Of course, not every business that performs personal services isconsidered a PSC. First, their principal activity must be in the fields ofhealth, law, engineering, architecture, accounting, actuarial science, theperforming arts, or consulting. And second, substantially all of their stockmust be owned by employees, former employees, or their estates.

In a recent case, the Tax Court upheld an IRS- imposed tax deficiencydetermination, as well as an accuracy-related penalty, on a personalservice corporation.

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pt In this case, Midwest Eye Center was not able to show that the $2

million deduction it claimed for bonus payments made to its soleexecutive and shareholder represented reasonable compensation forservices rendered. As a result, the Tax Court agreed that the paymentswere disguised dividends and disallowed $1 million of the salarydeduction, while also imposing more than $62,000 of accuracy-relatedpenalties on the business.

QUINLAN: Let me ask you specifically, Richard, about personal servicecorporations. Are PSCs – such as Midwest Eye Center – taxed like a Ccorporation, where we’re concerned about unreasonably highcompensation? Or like an S corp., where we’re concerned withunreasonably low compensation? Or is a PSC really sui generis?

SHAPIRO: Mike, personal service corporations are a subset of corporations for taxpurposes. They have certain of their own unique rules, for example,applying a standard 35% tax rate. But they are corporations. They arenot some other type of tax entity.

QUINLAN: Well, in Midwest Eye Center, the IRS disallowed $1 million of the $2million bonus paid to its sole shareholder and medical director. Howcome? I mean, he was a surgeon who had to increase his workloadsignificantly and unexpectedly.

SHAPIRO: Mike, that is true. Those were the facts, but there was no substantiationof the expenditures that were made. There was no real informationprovided in the audit context, certainly to the desire of the courts, tojustify the taking of these larger deductions.

In addition, there was not any methodology or indication of how thetaxpayer came upon the amount of the bonus that they claimed as adeduction as compensation.

QUINLAN: Okay, the Service is always looking for substantiation and forcomparability. Knowing that, why would Midwest Eye – and their taxadvisers – let something like this happen?

SHAPIRO: Well, Mike, in the end, they did not want to subject that income to the35% rate of tax on a personal service corporation. So, by paying a largerbonus, they are bringing their taxable income significantly lower, andtherefore reduce the amount of tax and minimize the application of that35% tax rate to the income of the business.

Plus, as we get to the end of a tax year, businesses do not necessarilyknow exactly where they are in terms of the amount of income that theyhave. And so, you automatically have to wait until you get relativelynear year-end in order to have a really good sense of what your incomeis. So, you have to wait. Practically, you really do not have any choice,but to make some of these determinations really, really late in the year.

QUINLAN: In this case, we’re also talking about an accuracy-related penalty of morethan $62,000. That certainly gets your attention, doesn’t it?

SHAPIRO: Mike, it certainly does. Understand that with any tax controversy today,it’s almost automatic that the Service is going to attempt to imposepenalties. We are not normally talking about interest anymore. Almost asa rule of thumb, the Service automatically looks at penalties. And in thisparticular case, they were alleging that there was a significantunderpayment of tax, which creates a penalty in and of itself. So, yes, a$62,000 amount is going to catch your attention without doubt andmaterially increases the load. And I would also say that the use of

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taxpayers are trying to consider how aggressive or conservative they wantto be in filing their tax returns.

In the old days, if you were concerned with tax liability and interest, andyou could understand what the cost of interest is, that alone might indicateto a taxpayer that he, she or it can be a little more – rather than a little less– aggressive. But once we start as a regular activity from the government,alleging and aggressively alleging penalties of one kind or another, thatdoes impact taxpayers in how they conduct themselves in the tax world.

QUINLAN: If our viewers could take away one thought from this discussion onreasonable compensation, what would you like that to be?

SHAPIRO: I think, Mike, taxpayers have to understand that reasonable compensationis almost an automatic issue for the Treasury and for the IRS. As I said alittle earlier, it is an easy issue for the IRS for agents to “put their armsaround.” It is not complicated. The answer may not be black-and-white. Itis extremely subjective. But you do not have to be a rocket scientist to atleast think about reasonable compensation as an issue.

So, my word of advice would be: go into questions of reasonablecompensation with your eyes open. Understand that aggressive positions,whether it is on the high side or the low side, depending on which kind ofentity we are talking about, is likely to catch somebody’s attention. Solong as you, the taxpayer, understand that, go for it. But understand whatyou are doing, because the likelihood is, it is not going to fall between thecracks. It is going to be looked at.

SURRAN: Over the past two years, we’ve heard several proposals to streamline theway that partnerships are audited by the IRS. First, there were proposednew rules for auditing partnerships with more than one hundred partnersfrom Dave Camp, then chair of the House Ways and Means Committee.At the same time, President Obama included similar changes for auditingpartnerships as part of his Administration’s budget proposals.

In both proposals, the purpose was the same: to respond to IRS difficultyin assessing the tax owed at the partnership level, particularly in casesinvolving complex and multi-tiered partnership arrangements.

Just a month ago, in enacting the Bipartisan Budget Act of 2015,Congress repealed the current partnership audit rules and replaced themwith a two-tier structure.

The first or lower tier is for partnerships with one hundred or fewerpartners. These partnerships could elect out of the new rules and, similarto the current TEFRA rules, be audited under the general rules applicableto individual taxpayers.

Unlike the current law, the onus will now be on the partnership to opt outof the rules, rather than either automatically being excluded under TEFRAor being offered the opportunity to opt in.

The election to opt out must be made on an annual basis, and it will onlybe available to those partnerships that do not have other partnerships ortrusts as partners.

Partnerships that do not opt out – along with all partnerships of more than100 partners – will be subject to the new streamlined audit approach.

Under the new rules, the IRS will examine the partnership’s items ofincome, gain, loss, deduction, credit, and partners’ distributive shares forthe year under audit. And any adjustments will be assessed directly to the

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pt partnership – rather than to the individual partners – in the year that any

audit adjustments are finalized.

Although the partnership may shift the tax liability to the individualpartners, it will then be up to the partnership – rather than the IRS – toissue adjusted information returns, such as amended Form K-1s.

Of course, it’s going to take time for partnerships and their tax advisersto adjust to the new rules.

And in order to allow sufficient time for the IRS to issue implementingregulations, the effective date of the new provisions is delayed untilreturns filed for tax years beginning after December 31, 2017. However,a partnership may elect to apply the new rules for earlier tax yearsbeginning after the enactment date.

In case you were wondering, the Congressional Budget Office (CBO)estimates that the new rules will raise approximately $9 billion inadditional revenue over the next ten years.

QUINLAN: Tell me, Richard: why did Congress change the rules on howpartnerships are audited for tax purposes? Was there a great hue and cry?

SHAPIRO: Mike, there really was not a big hue-and-cry to change the rules. At theend, it really became a question of money. In connection with thepassage of the 2015 budget, Congress needed to raise some money. Andthe perception has been that there is money to be raised from changingthe audit regime of partnerships – that money was being left on the tablein terms of how partnerships get audited. So, scoring some $10 billionoff of changing partnership audits seemed a good way to pay for thebudget bill. So, we got a budget bill that had partnership audit changes.

QUINLAN: That makes sense. But tell me: since partnerships are considered pass-through entities, doesn’t it make sense that they would just be auditedunder the rules that are applicable to individual taxpayers?

SHAPIRO: Mike, that sounds right, but partnerships are much more complicatedentities, requiring a different approach. And historically, the rules weredeveloped actually going back to the early 1980s, where partnerships hada number of partners – 10 or more.

Partnerships with 10 or more partners had a different tax regime imposedon them in terms of audit: the so-called TEFRA audits.

QUINLAN: Well, for more than a decade, we’ve had separate audit rules for the so-called TEFRA uniform partnerships and for electing large partnerships.How have those rules worked from your perspective?

SHAPIRO: Mike, I probably cannot, or should not, speak for other tax professionals.But from my perspective, I think that, by and large, the TEFRA rules andthe large partnership rules have been considered to be cumbersome,difficult to administer, and created many of the problems that theyperhaps were supposed to solve.

And so, it was felt that the time had probably come to adjust those rulesa bit. And that is why we now have some new rules that have beenimposed through the Bipartisan Budget Act.

QUINLAN: Okay, let’s turn to the new procedures. First of all, do they really apply toall partnerships?

SHAPIRO: Mike, technically, they do. They apply to all partnerships, unless apartnership elects to opt out of the application of the rules. Not allpartnerships can opt out.

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corporations, regular corporations, foreign corporations – if they weredomestic, they would be corporations, estates of deceased partners andpartners of partnerships.

QUINLAN: And I know there are lots of different types of entities that – for federalincome tax purposes – are taxed as partnerships. Are all of them, whetherthey’re LLCs or LLPs, going to be subject to these new audit procedures?

SHAPIRO: Mike, if they are taxed as partnerships, they are covered by the rules.Now, you mentioned LLCs.

Obviously, an LLP – a limited liability partnership – is a partnershiplegally and for tax purposes. LLCs, understand that limited liabilitycompanies can be taxed as companies. So, to the extent that they are taxedas companies, they are not going to be subject to the rules.

But an LLC that is treated as a partnership is a partnership for taxpurposes and, so therefore, will be covered by these rules.

Mike, master limited partnerships structurally are partnerships. But youare right, most of them are treated as corporations for tax purposes. Andfor those entities, these rules are not going to apply. They are corporationsfor tax purposes.

However, there is one small subset of MLPs that are taxed as partnerships.And they are generally in the mineral and natural resource areas.

QUINLAN: Okay, so tell me: what difference does it make if the Service is examiningthe partnership’s items of income as opposed to examining individualpartners?

SHAPIRO: Mike, if individuals are being examined, then only the individuals aregoing to be subject to the determination that the agent, and that theService, concludes as part of the audit.

Whereas, if the partnership – the entity – is the one that is beingexamined, then the impact of that audit is going to flow through to theunderlying individuals.

So, therefore, it makes a very big difference. So, we are looking at who iscovered. You are looking at consistency, a big issue when it comes to thereview of partnerships from an audit perspective.

QUINLAN: In a similar vein, Richard, what difference does it make WHEN thoseadjustments are taken into account?

SHAPIRO: Mike, it makes a very big difference which year we are talking about. Ifwe are talking about the year of the audit – the reviewed year – thenparties that are going to be affected are going to be those partners, whowere partners in the year of the audit or the audited year.

On the other hand, if we are talking about making an adjustment relatingto an audit year, but we are making it in the year of the review – a laterperiod of time – what is going to happen is that you may impact partnerswho were not even partners in the year of review or, at the very least, youmay have partners whose percentage interests are different.

So, whether we are making the adjustment in the original year – theaudited year, or in the audit adjustment year – the later period, is going tomake a huge difference.

QUINLAN: Let’s make sure I understand you, Richard: how – at what rate and at whattime – is the partnership going to be liable for these adjustments?

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It will be liable for the tax in the year of the adjustment. The tax rate thatwill be imposed will be the maximum tax rate under the individual taxrules and under the corporate rules, depending on who your partners arein the partnership, as it is being audited.

QUINLAN: As pass-through entities, partnerships are not usually liable for taxes, arethey?

SHAPIRO: Mike, that is absolutely true, normally. But under the new rules, as aresult of the Bipartisan Budget Act, partnerships themselves are going tobe liable for the tax, unless of course they exercise the opt-out that wehave previously discussed.

QUINLAN: As a general rule, individual partners are jointly and severally liable forthe debts of a partnership. Will that be true for the liabilities that aredetermined at the partnership level?

SHAPIRO: Mike, no, that will not be true under the new rule. If the partnership isthe one liable for the tax, that is, there has not been an opt-out, then thepartnership will be liable.

Individuals will not be jointly and severally liable. They will not bejointly and severally liable under the new rules.

QUINLAN: Speaking of individual partners: what happens if some partnersvoluntarily file amended returns for the year in review? Will they stillface what the new statute calls “an imputed underpayment”?

SHAPIRO: Mike, that is a good question. If individuals file amended returns, theamount of liability relating to those individuals will be deducted from theamount of liability of the partnership.

The liability of the partnership is referred to as the imputedunderpayment. That is going to be reduced to the extent that individualsfile amended returns.

There will not be a double-count, in other words.

QUINLAN: You said that the imputed underpayment is at the highest tax rate. So,what happens if one of those individual partners can demonstrate the heor she is, in fact, taxed at a rate that is lower than the maximum tax rate?

SHAPIRO: Mike, if the partnership can prove to the Service that partners within theaudited partnership are subject to tax rates that are less than themaximum individual or corporate rates or are tax-exempt, then theimputed underpayment will be reduced for purposes of the auditadjustment.

QUINLAN: You mentioned what happens if the partners voluntarily file amendedreturns. But what if the amended returns are adjusted Forms K-1 filed bythe partnership? Is that also an alternative to the imputed underpayment?

SHAPIRO: Mike, that is absolutely correct. Under the statute as written, there is analternative to the mechanism that we have just been discussing. Namely,a partnership, as a means of avoiding paying at the partnership level, canissue these adjusted K-1 returns, and that then pushes down theobligation to pay the tax back to the individual partners.

QUINLAN: I keep saying “by the partnership,” Richard. Tell me: are mostpartnerships still going to be designating a “tax matters partner” – orTMP – to act on behalf of the partnership?

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no longer be a Tax Matters Partner. That will go out with the end of theregime of the TEFRA partnership audits or the large electing partnershipaudits.

We will now simply have a partnership representative. And different fromexisting law, that partnership representative does not even have to be apartner.

That is a big change.

QUINLAN: Let’s say that you represent one partner, but you don’t prepare the K-1forms for the partnership. Can the individual partner – or the tax preparer– still file a Form 8082, notifying the Service of an inconsistent treatmentwith the partnership return?

SHAPIRO: Mike, that is a fair question to ask. Whether under the new regime, wewill be using that form is a question that I cannot answer, and nobody cananswer it at this point. What I can say, however, is that, under the newregime, partnerships and their partners are required to use consistentpositions. Inconsistent positions are not permitted unless there is notice tothe IRS that there is in fact an inconsistent position being claimed.

QUINLAN: So far, you’ve been reporting on – and interpreting – the statutorylanguage from the Bipartisan Budget Act. At some point, the Service willissue some more expansive regulations. What’s the most important itemthat still needs to be addressed?

SHAPIRO: Mike, I think that probably the most important area for which somesignificant help is required will be the area of partnerships that are tiered:tiered partnerships. What do we do when we have a partnership that is apartner in another partnership? What happens is you work up and downthe chain.

I do not know what the answer to that is. And I think particularly today,where there are so many situations where partnerships have otherpartnerships as partners, that seems to me to be a significant problem thatneeds to be cleaned up.

QUINLAN: That makes sense. Are there other issues?

SHAPIRO: Mike, there are a lot of details that need to be filled out from the law.There are many areas of the law in which the Congress says, “underregulations to be issued.” So, to that extent, normal kinds of housekeepingthat is required would have to be done here, as in any piece of legislation.I would say, for example, what do you do with technical terminations?Technical terminations can happen, for example, when, in a 12-monthperiod, there is a 50% or more change of ownership.

How is this new law going to deal with those situations? How do they fitin? To me, anyway, it is not entirely clear. That would be one of the bigthings that strike me that that has to be done, in addition to the tieredpartnerships which we have already discussed.

QUINLAN: You probably know, Richard, that a lot of our viewers are corporatefinancial executives. As a result, they’ve become very familiar with FIN48, now codified as ASC 740-10. I suppose these procedures could alsohave an impact on tax accruals for book purposes, couldn’t they?

SHAPIRO: Mike, that is absolutely true. And a lot of our clients have been asking thatspecific question, because we are looking at situations where partnershipsthemselves may now be liable for tax.

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how this law would interact with FIN 48 is unclear.

But it is certainly an issue of some significant concern and interest bymany of our clients.

QUINLAN: In a similar vein, there have been occasions when Congress has enactedstatutory language for the Internal Revenue Code, and then wanted a“second bite at the apple.” Besides guidance from the Service, are thereany so-called “technical corrections” to this law that Congress mightalready be considering?

SHAPIRO: Mike, technical corrections almost always follow the approval andenactment of legislation. It sort of comes with the territory. And I amsure that this is no exception.

It should be pointed out that the effective date of this in general is twoyears forward for years ending after December 31, 2017. So, there is abit of time with which to work here.

I would say that we are going to get a lot of input from interested partieson one aspect or another that they feel is of particular importance tothem to tweak the law a little bit. It is a little hard to prognosticate at thispoint. We do have a lot of time.

I think, however, that, between now and the time that this legislationgoes into force, there will be some tweaking and some technicalcorrections that will supplement whatever notices and regulations andrevenue procedures that are likely to come down the pike.

I think we are going to look at a whole package of ways of attacking thisnew legislation: technical corrections; revenue procedures; maybe somerevenue rulings and notices; and regulations, of course. So, that is what Isee coming down the pike on this.

QUINLAN: EisnerAmper’s Richard Shapiro, thanks for bringing us up-to-date.

SHAPIRO: Thank you, Mike.