New Federal Budget Law Includes Major Changes in Partnership Taxation

Photo credit: Alan Dean [CC BY 2.0 (https://creativecommons.org/licenses/by/2.0/)], via FlickrOn November 2, 2015, President Obama signed H.R. 1314, the Bipartisan Budget Act (BBA) of 2015. Most of the news coverage of the new law dealt with its role in averting a default by the United States on its outstanding debts, and in warding off the threat of another federal government shutdown. New Jersey and New York business owners, however, should pay particular attention to the provisions of the BBA dealing with partnership taxation, since they could significantly change Internal Revenue Service (IRS) collection practices.

New Jersey law defines a “partnership” as “an association of two or more persons to carry on as co-owners a business for profit.” N.J. Rev. Stat. § 42:1A-2. When two or more people go into business together, they are typically deemed to have created a “general partnership,” in which each partner is jointly and severally liable for the partnership’s debts and obligations. N.J. Rev. Stat. § 42:1A-18. They may also set up their business using a variety of business forms allowed by New Jersey law, such as a limited partnership or a limited liability partnership. For the purposes of federal income tax, most partnerships receive similar treatment from the IRS.

Federal law defines “partnership” broadly to include various business ventures that are not, based on the definitions established elsewhere in the Tax Code, a corporation, trust, or estate. 26 U.S.C. § 761(a). Corporations must pay federal income tax directly to the IRS, and shareholders must pay tax on dividends received from the corporation. This is often known as “double taxation,” since it imposes income tax twice on the same money. Partnerships, along with corporations that elect to be taxed under Subchapter S of Chapter 1 of the Tax Code, generally avoid this tax treatment. The Tax Code expressly states that partnerships are not liable for income tax themselves, but instead the partners pay taxes for the partnership “in their separate or individual capacities.” 26 U.S.C. § 701.

When the IRS conducts an audit, it may find that the amount of tax paid was insufficient, or that the amount refunded was excessive. In either case, it assesses an amount owed by the taxpayer, called a “tax adjustment.” The changed tax law will affect partnerships that are subject to tax adjustments after an IRS audit.

Tax adjustments, just like other partnership taxes, have generally been considered obligations of the individual partners. Section 1101 of the BBA, however, allows the IRS to collect tax adjustments from the partnership itself. By making the partnership itself liable for tax adjustments, former partners may escape liability for certain tax debts if they were partners when the tax debt was incurred, but not when the tax adjustment was assessed. This also burdens new partners. Partnerships may want to address this concern in partnership agreements and other documents. The BBA’s partnership taxation provisions will take effect on January 1, 2018.

Business law attorney Samuel C. Berger represents New York and New Jersey business owners and entrepreneurs by offering fixed-fee legal-service packages covering a wide range of legal needs. Contact us online or at (212) 380-8117 today to schedule a confidential consultation to see how we can help you and your business.

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Converting an S Corporation to a C Corporation Eliminates Certain Tax Benefits, According to the IRS, Even If the Corporation Converts Back to S Status, New York & New Jersey Business Lawyer Blog, February 19, 2015

Transfers of Funds Between Businesses with Common Ownership May Be Deemed Loans under New Jersey Tax Law, New York & New Jersey Business Lawyer Blog, February 5, 2015

Photo credit: Alan Dean [CC BY 2.0], via Flickr.