My last article dealt with the doctrine of “rescission”—the ability to go back in time to “re-do” a transaction for tax purposes. If you comply with the rescission requirements, you can fix anything as long as the fix occurs in the same tax year. But as pointed out in the article, once the tax year closes, you are stuck with the tax consequences for that year, even if you rescind the transaction in a later tax year.
This article addresses a little known provision of partnership tax law that blesses changing a partnership agreement after the close of a tax year, retroactively to the beginning of the prior tax year. You have until the original due date of the tax return for the partnership to amend the partnership agreement. This means that for the 2018 tax year, I can amend the partnership agreement for 2018 until March 15, 2019. Unfortunately, extending the partnership’s tax return doesn’t extend the deadline for amending the partnership agreement, but even so the rule is quite liberal.
Why is this important? The rule is set forth in Treasury Regulations Section 1.761-1 (c), in the definition of “partnership agreement”. The key points of this regulation are that the agreement, and any modification, “can be oral or written”. (Please, please, please—do not rely on an oral partnership agreement or amendment. Only litigators like that).
The regulation goes on to make it clear the partnership agreement “may be modified with respect to a particular taxable year subsequent to the close of such taxable year, but not later than the date (not including any extension of time) prescribed by law for the filing of the partnership return”.
The reasons for this rule are not stated, but it’s clear that after the close of a tax year, but before the original (not extended) partnership return due date, you can decide on how you want to allocate taxable income and other economic and tax attributes between the partners. From a planner’s perspective, it’s like knowing what cards your poker opponent is holding before you decide how to play your hand.
As an example, if you have a partnership with large losses, and one of the partners has a lot of income, you can amend the agreement to allocate all the tax losses to that partner, where the losses will do the most good. Or, if a partner has large net operating losses, you can do the opposite—allocate taxable income to that partner even though there will be no tax liability.
Caveat—there are limits to what you can do with such amendments, since there are a number of other partnership rules you must comply with. For example, tax allocations must have “substantial economic effect”. One of the limitations on allocations is you can’t shift taxable income and loss back and forth from year to year. So called “transitory allocations” don’t work. But if, for example, a partner has large net operating losses that will be in existence for some time, the regulations can be used to customize the agreement to achieve the lowest net tax cost in a way that satisfies the substantial economic effect tests.
These are old regulations. The term used in the regulations is “partnership”, but there is no reason why this rule wouldn’t apply to LLCs that are taxed as partnerships as well. To sum up, this “quirk” allows you to plan to minimize taxes after the end of the year, retroactively—with the government’s blessing.
My next few articles will deal with a recent tax law change—opportunity zones. As always, if you have any questions about this (or other) articles, feel free to email me at David.Keligian@brownandstreza.com.
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