IRS Email Shows Importance of Documenting Partnership Loans

An email from IRS counsel rarely gets publicity, but one particular email released Nov. 1 demonstrates the potential consequences of failing to maintain documentation when a partner lends money to the partnership.

Even when partnerships can avoid the tax from an imputed underpayment by pushing out the tax liability, they’re often forced to pay thousands of dollars in fees to professionals who represent them before the IRS and help them make push-out elections. Individual partners would have extra compliance costs associated with the push-out election as well.

The alternative is much simpler: Get proper advice early and have a loan document in place. A loan agreement goes a long way toward proving that a bona fide obligation exists, particularly regarding money loaned from partners.

In the email referenced above, a partnership borrowed $5 million from 50/50 partners in a business and reported the loans as equally owed to each partner. The partnership didn’t have documentation for the loan, which allowed the IRS to decide who was the true lender. The IRS decided to reallocate 100% of the loan to just one partner, referred to as Partner A.

The IRS then increased the loan from Partner A by $2.5 million while decreasing the loan from Partner B by the same amount, creating a total “adjustment” of $5 million. The $5 million was then multiplied by the 37% maximum tax rate to obtain an imputed underpayment of $1.85 million.

Unless the partnership took appropriate action, this amount (plus interest and penalties) would be due—all for misstating the correct liability amount due to each partner on the return.

The partnership could have made a push-out election—"pushing” the items in question to the partners, allowing them to take the items into account— within 45 days of the mailing of the IRS’s Final Partnership Adjustment notice. If the partnership was even a day late in making the election, it would be stuck with the bill. Even if it was made on time, the business would have had to navigate the IRS partnership maze to have the agency recognize the validity of the election.

A failure to make a valid push-out election is significant. In this case, even if the IRS was correct in its determination that Partner A lent an additional $2.5 million, any imputed underpayment would be effectively taxed at a 74% rate—on a loan that ordinarily doesn’t have income tax consequences.

The partnership audit rules under the Bipartisan Budget Act have taken on a life of their own, and taxpayers must deal with this reality. Many taxpayers would be surprised that the simple issue of naming the wrong partner on a liability would result in the potential of a significant liability to the partnership, but that’s what the IRS would determine.

Taxpayers should consider ensuring that any loan agreements contain terms such as those found in arm’s-length transactions, such as a market-based interest rate, a fixed repayment schedule, and default provisions. The costs of developing a loan agreement are seemingly small compared to the potential IRS examination costs without the loan agreement. It’s better to be penny-wise up front to avoid being pound-foolish later.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Brett Bissonnette leads Plante Moran’s tax controversy services practice and frequently represents clients before the IRS.

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