Tax Considerations are Key in Negotiating Settlement Agreements

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Frequently, the tax ramifications of litigating or settling a legal case are not considered by the litigants and their attorneys until after the fact.  As a result, litigants and attorneys often miss a valuable opportunity to improve their tax position at the time of reaching a settlement agreement with respect to a given legal dispute.  In many instances, tax treatment will have a significant and direct impact on the finances of a client.  Therefore, it is important for the litigants to do a preliminary tax analysis with respect to a potential settlement of a litigation claim.  In this regard, a recovery pursuant to a settlement or award agreement will be much more attractive to a plaintiff if such an award is taxed at capital gains rates versus being taxed as ordinary income, or better yet, if the plaintiff can treat the amount recovered from the defendant as completely tax-free.  The tax considerations associated with a settlement or judgment are usually just as important to defendants as they are to plaintiffs since payments by a defendant pursuant to a settlement agreement may be fully tax deductible, partially deductible, or entirely non-deductible. Consequently, it is crucial that the parties to a litigation settlement understand the applicable tax rules and address the tax consequences of a potential settlement prior to resolving litigation.

Whether a recovery is on account of a jury award or due to an out-of-court settlement, the tax rules affecting settlements and judgments will apply.  Seeking assistance in this area early will increase the chance of structuring the tax impact to maximize the benefits to litigants.  There are several questions that need to be answered when making determinations about the taxation of judgment awards and settlements.
  1. What recoveries need to be reported and what portion of the recoveries will be treated as taxable to the plaintiff?
  2. What provisions should be included in the settlement agreement in order to clearly allocate the recovery amounts among various categories of damages?
  3. Will any portion of the recovery be treated as a capital in nature, giving rise to capitalization issues or possible long-term capital gains tax treatment?
  4. How will attorneys’ fees paid by plaintiff be treated for tax purposes?
  5. How will the payments pursuant to the settlement agreement be reported for tax purposes?
The answers to the above questions are vital in determining the federal income tax liabilities for each of the parties to a given settlement agreement.  Each of the above questions is discussed in further detail below.

General Rules Regarding Whether a Settlement Amount is Taxable

In terms of settlement and judgments, the most important exception to the general income inclusion provision is for personal physical injuries and physical sickness under Section 104.  Under Section 104, if funds are recovered on account of a personal physical injury or physical sickness then the recovery is excludable from gross income.  Conversely, damages received on account of non-physical injury or sickness (i.e. defamation, age discrimination, housing discrimination, injury to personal or business reputation, etc.) are not excludable from gross income.  Clearly, there is an incentive to posture a recovery so that it fits under the §104 umbrella.  Nonetheless, the most enduring cannon in this area is the “origin of the claim” test, which states that the tax result of a settlement or judgment award should be determined by reference to the underlying claim the lawsuit seeks to redress.  The origin of the claim test plays a crucial role in determining the tax treatment of payments received or made under a judgment or settlement.  The origin and nature of the underlying claim is examined to determine each of the following:
  1. Whether the payment is excludible from gross income;
  2. If the payment is not excludible, whether it is ordinary income or capital gain;
  3. Whether the payment is deductible as a trade or business expense or a production of income expense; and
  4. Whether the payment must be capitalized.
Thus, for example, a recovery for back pay is treated in the same manner as salary or wage payments and therefore taxable as ordinary income since the origin of the claim is payment by an employer for services rendered by an employee.

What Tax Provisions Should be Included in a Settlement Agreement?

Although various considerations will affect the  tax provisions that should be included in a settlement agreement, one principle is very clear:  it is not wise to use a general release with no allocation among damages since doing so will likely cause the IRS to allege an allocation different from the allocation that may have been intended by the litigants.  Taxpayers are much more likely to get into trouble with respect to the tax treatment of litigation recoveries if the settlement agreement is silent as to both the specific claims being addressed and the tax treatment of any recovery of each claim.  The taxpayer is the party that must bear the burden of proof to demonstrate what portion of the recovery constitutes a nontaxable or a capital item.   Therefore, it is important to consult a tax attorney who is familiar with the taxation of settlements and judgments so that necessary provisions can be negotiated and included in the settlement agreement in a manner that will maximize the taxpayer’s ability to treat the payments in a manner that will be respected for federal income tax purposes.

Will Any Portion of the Recovery be Treated as Capital In Nature?

In business recovery cases, the issue is generally not whether the amounts received pursuant to a judgment or a settlement are includible in gross income, but whether such amounts are characterized as ordinary income, return of capital, or capital gain.  If, upon examining the nature of the underlying claim, it is determined that the recovery is a substitute for lost profits, then such amounts are includible by the taxpayer as ordinary income.  However, if the recovery is on account of loss of goodwill or harm to other capital assets, then the amounts are characterized as capital gain, provided the sale or exchange requirement is met.  In some cases, an allocation between ordinary income and capital gain may be required.

Generally, a recovery which compensates solely for harm to capital assets results in capital gain or a reduction of capital loss depending upon the taxpayer’s basis in the capital asset and provided the sale or exchange requirement is met.  In some cases, the recovery may be attributable to both lost profits and harm to capital assets. In such cases, the taxpayer is required to allocate the amounts received to lost profits (i.e., ordinary income) and damage to capital assets (i.e., capital gains).  Note, however, that the burden is on the taxpayer to show that a recovery (in whole or in part) is attributable to harm to capital assets.  Therefore, it is important to consult a tax attorney who can make sure that it gets documented in the settlement agreement what portion of the settlement will be allocated to items that are arguably capital in nature and should therefore not give rise to the taxpayer reporting such amounts as ordinary income.

How Will Plaintiff’s Attorneys’ Fees be Treated for Tax Purposes?

It is typical in most plaintiff’s lawsuits for the claimant to request the reimbursement of attorneys’ fees and costs and for the plaintiff’s attorneys fees to be a contingency fee arrangement whereby the attorney will be paid a certain percentage of the plaintiff’s total recovery.  Accordingly, in settling lawsuits, companies may specifically designate an amount to be paid as attorneys’ fees.  These fees may be paid to the claimant, to the lawyer or to the claimant and lawyer jointly.  The taxation of attorneys’ fees has generated much controversy, but the general rule is that the payment of attorneys’ fees is taxable to the claimant regardless of the type of fee arrangement (i.e., flat fee, hourly or contingent) and even if the fees are not paid directly to the claimant.

As part of settlement negotiations, it is important for the claimant to understand whether the impact of including attorneys’ fees in the claimant’s income (as described above) may be mitigated in some cases because a specific code section permits an “above-the-line” deduction for attorneys’ fees incurred in connection with certain lawsuits.  However, there are various limits on deductions for attorneys’ fees, such as certain attorneys’ fees that are only deductible as “miscellaneous itemized deductions” limited by the 2%-of-adjusted-gross-income limit and attorneys’ fees that may not be deductible for AMT tax purposes.  Therefore, it is imperative that any plaintiff who is deciding whether to accept an award (pursuant to a negotiated settlement agreement) fully understand whether he or she will ultimately receive the benefit of any income tax deduction with respect to the plaintiff’s attorneys’ fees that will ultimately be deducted from the plaintiff’s final recovery.

How Will Payments Pursuant to the Settlement Agreement be Reported for Tax Purposes?

All payments in excess of $600 that are taxable to the claimant (including attorneys’ fees) must be reported on either a Form W-2 or Form 1099.  All taxable amounts are reportable to the claimant even if the payments are made to the claimant’s attorney.  However, if a claimant receives only amounts that are nontaxable, no information reporting to the claimant is required.

A) Form W-2 Reporting to Claimant

All payments attributable to wage-related claims must be reported on a Form W-2 issued to the claimant.  The defendant should issue a Form W-2 to the claimant for the total amount of all such payments, even if the check is issued directly to the claimant’s attorney (or to the attorney and the claimant jointly), and even if a separate Form 1099 is issued to the claimant’s attorney for some or all of the amount.  Only payments attributable to wage claims are reportable on Form W-2.  All other taxable payments are reportable on Form 1099. For example, both punitive damages and attorneys’ fees are reportable on Form 1099, not Form W-2.

B) Form 1099 Reporting to Claimant

All taxable nonwage payments, such as punitive damages, liquidated damages, compensatory damages, payments for emotional distress, interest and attorneys’ fees and legal costs associated with the recovery of taxable amounts, must be reported on a Form 1099 issued to the claimant.  Companies should issue a Form 1099 to the claimant for the total of all such payments, even if the check is issued directly to the claimant’s attorney (or to the attorney and the claimant jointly) and even if a separate Form 1099 is issued to the claimant’s attorney for some or all of the amount.  In summary, the total amount reported on the Form W-2 issued to the claimant and the total amount reported on the Form 1099 issued to the claimant should equal the total amount of payments taxable to the claimant.

C) Reporting Amounts Paid to Claimant’s Attorney

Once a company determines its reporting obligations to the claimant, the company must also determine its reporting obligations to the claimant’s attorney. Treas. Reg. § 1.6041- 1(a)(1)(iii) states that: a person who, in the course of a trade or business, pays $600 of taxable damages to a claimant by paying that amount to the claimant’s attorney is required to file an information return under Section 6041 with respect to the claimant, as well as another information return under Section 6045(f) with respect to the claimant’s attorney.  The company should therefore issue a Form 1099 to the attorney for the full amount of the check, whenever the check is written in a manner that gives the attorney the right to cash the check.  This applies even if the check is for more than just attorneys’ fees and even if the entire amount or some of the amount is not taxable to the claimant. In addition, these rules do not vary depending on the nature of the underlying lawsuit. Thus, if the attorney has the authority to cash the check, a Form 1099 must be issued to the attorney in the settlement of class action lawsuits, fee shifting cases, injunctive relief situations, and so forth.

Conclusion

As this article demonstrates, there are numerous tax considerations that can potentially be of vital importance to the litigants and other various parties involved in the settlement of a legal dispute or ongoing lawsuit.  While this article gives a high level summary of the overall tax considerations with respect to negotiating the provisions that should be included in a settlement agreement, it is highly advisable to have a qualified tax attorney review the provisions of a proposed settlement agreement and recommend potential changes with respect to tax sensitive items that may not be addressed in the original draft of a given settlement agreement.

For further information, please contact Coby Hyman, a tax attorney in Houston, Texas. Mr. Hyman specializes in advising clients on important tax issues to be considered in negotiating the terms of settlement agreements.  Mr. Hyman can be reached by phone at (972) 740-0161 or via email at chyman@generaltaxcounsel.com.

Estate Planning Techniques using FLPs Become a Time Sensitive Matter Due to IRS’s Recent Issuance of Proposed Regulations that Attempt to Restrict Valuation Discounts

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Proposed regulations released by the IRS on August 2, 2016 would permanently and profoundly change estate planning for families that own a controlling interest in a privately held corporation, partnership, or limited liability company.  For these families, estate planning techniques often take advantage of valuation discounts often using so-called “family limited partnerships” in order to mitigate the estate and gift tax burden associated with transfers during life or at death.  If adopted, these proposed regulations would restrict or eliminate available discounts, thus directly increasing the tax associated with certain transfers.

The IRS has requested comments on the proposed regulations by November 2 and will hold a hearing on December 1.  Taxpayers should strongly consider taking action soon and before the end of 2016 in order to complete transfers under the current rules.  In addition, even if the regulations are finalized in something close to their current form, portions of the regulations likely will be subject to challenge on the grounds that they exceed the scope of the statute.

What Are Valuation Discounts?

Valuation discounts are downward adjustments to valuation.  Broadly speaking, they account for features that render the property less appealing to a hypothetical buyer.  There are many types of discounts, but the most common for estate planning purposes are “discounts for lack of marketability” and “discounts for lack of control.”  Following is a hypothetical illustration of each:

Andy, Bob, and Charlie form a partnership.  Their partnership agreement provides that no one can withdraw from the partnership nor sell his or her interest without the consent of the other two. Each of them has an equal vote in all matters relating to the partnership.

If Bob wanted to sell his interest, he cannot do so without the consent of both Andy and Charlie. This means that Bob can’t easily convert his interest into cash. As a result, it is worth less than its pro rata share of the total value of the partnership. This is a discount for lack of marketability.

If Bob did get Andy and Charlie’s consent to sell, Bob might have a hard time finding a buyer willing to pay him the full value of the underlying interests, even reduced by a marketability discount. This is because the prospective buyer would be only a minority interest holder and would not be able to control the direction of the entity. Therefore, the interest would be further discounted for lack of control.

These valuation principles are generally accepted in the law as reflective of business reality.  Nonetheless, the IRS is wary of discounts in the intra-family context for two primary reasons.  First, it is widely assumed that a senior generation would not exercise its rights in a manner that would harm the junior generation family members. Second, particularly with respect to non-operating investment entities, it is assumed that families place artificial restrictions on equity interests for the purpose of depressing the value, without affecting the value of the underlying assets. The impact of discounts is significant, with combined discounts for lack of marketability and lack of control often in the range of 25 percent to 50 percent off of the net value of the underlying assets.

What Do the Proposed Regulations Say?

On its face, the wording of the proposed regulations may obscure their plain impact. The Treasury Department’s summary indicates that the regulations “concern the treatment of lapsing rights and restrictions on liquidation” so as to prevent undervaluation of transferred interests. Although perhaps not obvious, the practical effect is to significantly curtail valuation discounts with respect to family held entities where those discounts rely on the normal inability of the owner of an interest in a private entity to quickly convert the interest to cash.

The regulations fall under section 2704 of the Internal Revenue Code. This section attempts to curb perceived valuation abuses associated with lapsing voting and liquidation rights. Even under current law, a transfer that results in a lapse of a voting or liquidation right is treated as a gift if it occurs during life, or is included in the gross estate if it occurs at death. Nonetheless, current law provides a number of exceptions that make planning with valuation discounts possible. The proposed regulations would eliminate almost all of these exceptions.

Briefly, each of the major categories of the proposed regulations is described below:

Applicable Restrictions Redefined.

As noted above, present law targets valuation abuses with respect to liquidation rights. Thus in valuing a transfer of an interest in a controlled entity, “applicable restrictions” are disregarded. “Applicable restrictions” are restrictions on the entity’s ability to liquidate, which restrictions either lapse or can be removed by the transferor’s family. They do not, however, include restrictions imposed or required by state law.

Under current regulations, applicable restrictions are those that are more restrictive than state law. The proposed regulations expand the definition of an applicable restriction, such that even state law defaults would be “applicable restrictions” – unless the law provided that they could not be modified, which is rare in practice.

Disregarded Restrictions.

Perhaps the most noteworthy section of the proposed regulations is the introduction of a class of “disregarded restrictions.” Like applicable restrictions, disregarded restrictions would be ignored in valuing an interest in an entity for estate and gift tax purposes. A disregarded restriction includes:
  1. Any restriction or limitation on the ability of the holder to liquidate or have his or her interest redeemed;
  2. Any restriction limiting the amount received by the holder to less than a minimum value, defined as a pro rata share of the entity value reduced by certain outstanding obligations;
  3. Any provision permitting deferral of redemption proceeds for more than six months; and
  4. Any provision that permits repayment in anything other than cash or property. Notably, a promissory note is not considered “property” unless the entity is engaged in an active trade or business, the proceeds are not attributable to passive assets, the note is adequately secured and the note is issued at a market interest rate.
The Three Year Rule.

This rule is intended to capture deathbed transfers. If a transfer made within three years of death results in the lapse of a voting or liquidation right, the transferor’s gross estate will be increased by the value of that lost liquidation right. This would occur, for example, if parent held 60 percent of the vote, transferred 10 percent to each of her two children (leaving her 40 percent), and subsequently passed away. Under the proposed regulations, if she passes away within three years after making the transfer (and indeed, if she made the transfer last month and dies one year from now after the regulations are enacted), that “lost value” attributable to her liquidation power will be added to her taxable estate. This effectively creates a phantom asset in the estate – it will be taxed, but the tax must be paid from other assets of the estate.

Who is Affected?

Anyone with an interest in a family controlled entity may be affected. Roughly speaking, an entity is controlled if family members collectively own greater than 50 percent of the entity. In a complex set of rules, interests held in trust are attributed to the grantors and beneficiaries of the trust.

For purposes of determining control, the proposed regulations would ignore interests held by nonfamily unless:
  1. The interest has been held by the nonfamily member for at least three years;
  2. The interest is at least a 10 percent equity interest;
  3. Nonfamily members in the aggregate hold at least 20 percent of the equity of the entity; and
  4. Each nonfamily has the right to put his or her interests to the company and receive a share of the underlying value.
The stated purpose of this provision is to limit taxpayers’ ability to give “insignificant” interests to nonfamily members in order to escape being subject to the rules.

When Would the Regulations Take Effect?

At this point, the regulations are in proposed format. The Internal Revenue Service has requested comments by November 2, and will hold a hearing on December 1. Thus, even though exact timing is uncertain, the regulations could not take effect before December of this year.

More likely, the comments submitted to the IRS will result in modifications and clarifications to the proposed regulations, which can take time. The IRS has indicated, however, that this is a high priority. Thus, it is possible that regulations would be finalized and effective in early 2017.

For the most part, the regulations would apply to transfers that take place after the effective date of the final regulations. However, the proposed regulations would allow a 30 day grace period for transfers of interests subject to “disregarded restrictions.”

Even after the regulations are finalized, they likely will be subject to challenges in court. In addition to challenges to the scope of the IRS’ regulatory authority under the statute, there will probably be litigation over what the appropriate level discount for lack of marketability is under these regulations. If the entity in question holds primarily non-marketable assets, such as real estate, can the valuation take into account that the property that hypothetically would be received by a liquidating owner is not liquid? What if the entity consists of both marketable and non-marketable assets?

Is Current Action Recommended?

Absolutely. Anyone considering a transfer of interests in a family controlled entity – whether an operating company or an investment company – should strongly consider doing so now. For this purpose, “transfers” includes gifts, sales to grantor trusts and any other change in ownership. Even though proposed regulations indicate a 30 day grace period for transfers subject to disregarded restrictions, the provisions concerning applicable restrictions would take effect immediately. Notably, the estate tax inclusion associated with deathbed transfers would apply for those who die after the regulations are enacted – even if they had given away their interests before the regulations came out.

For family business owners who have been considering succession planning alternatives, the clock is ticking to complete transactions that rely on the availability of valuation discounts. Because the most burdensome of the restrictions imposed by the proposed regulations will not take effect until 30 days after the regulations are finalized, families should consider implementing succession planning strategies prior to the first quarter of 2017. For those family businesses with succession mechanisms already in place, structures and governing documents should be reviewed in light of the proposed regulations to ensure existing documents do not trip over the technical requirements of the new rules. Despite the sea change ushered in by the proposed regulations, opportunities exist in the near term to maintain the ownership of family businesses for multiple generations without incurring burdensome or disastrous estate tax liabilities.

For further information, please contact Coby Hyman at General Tax Counsel, PLLC.  Mr. Hyman can be reached by phone at (972) 740-0161 or via email at chyman@generaltaxcounsel.com.

Significant Tax Planning Opportunities Available for Like-Kind Exchanges of Oil and Gas Properties

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The capital-intensive nature of companies engaged in oil and gas operations and the liberal tax rules that determine the like-kind nature of oil and gas properties combine to make IRC Section 1031 like-kind exchanges incredibly attractive to oil and gas companies.  This article discusses why the potential tax benefits available to companies in the oil and gas industry are so attractive and further discusses why it is important for oil and gas companies to hire a qualified tax attorney who is both familiar with the intricacies  involved in the like-kind exchange rules as they relate to oil and gas properties and can also provide taxpayers with flexibility of achieving tax-deferred treatment on a contemplated disposition of an oil and gas property.

Why are Like-Kind Exchanges So Attractive for Oil and Gas Properties?

Generally, the types of assets that are most suitable for a like-kind exchange are those assets with a a low tax basis relative to current fair market value, either due to appreciation in the asset’s value or as a result of the taxpayer having previously taken income tax deductions that enable the tax basis of the asset to be significantly reduced.

In the oil and gas industry, there are significant income tax incentives in place that encourage investment in oil and gas properties.  The two most significant items that receive favorable tax treatment in the oil and gas industry are intangible drilling costs and depletion.  These two items are discussed in further detail below.

Intangible Drilling Costs

The U.S. tax code provides an exception from the capitalization rules for intangible drilling and development costs for oil and gas wells.  The owner of an operating interest in a property may elect to immediately deduct such costs. The election applies only to those items that do not have a salvage value. Intangible expenditures include wages, fuel, repairs, hauling, supplies, and other items incidental to, and necessary for, the drilling of wells and the preparation of wells for the production of oil or gas. The election covers expenditures for the clearing of ground and geological work in preparation for the drilling of the well, and those expenditures incurred in the construction of derricks, tanks, pipelines, and other physical structures that are necessary for drilling and the preparation of the wells for production. These expenditures usually constitute the major part of the costs of drilling an oil or gas well prior to completion, and the election provides an incentive to develop the property.  Intangible drilling and development costs usually represent approximately 60 to 80% of the costs associated with an investment in an oil and gas well.

Depletion

Oil, gas, and other minerals are wasting assets, which are physically consumed or exhausted by development of, and production from, mineral properties.  In addition to the depreciation allowance for the use of physical properties, the U.S. tax code provides an annual allowance for the depletion of mineral reserves in determining the owner’s taxable income.  In order for a party to be entitled to claim depletion deductions, the party must have an “economic interest” in the minerals in place and look to the mineral produced and sold for cost recovery.  The taxpayer claims the greater of “cost depletion” or “percentage depletion.”  Cost depletion is based on the unit cost of the reserves that are sold and permits recovery of the taxpayer’s capital investment in the reserves consumed in the production of income.  Percentage depletion is based on a percentage of the income from the property, and can result in the recovery of more than the capital investment in the property (“excess percentage depletion”).  Percentage depletion of oil and gas properties is permitted only within narrowly defined parameters and is not available for integrated producers who also are large retailers or refiners.  Percentage depletion (sometimes referred to as “statutory depletion”) is a stipulated percentage equal to 15% of the gross income generated from the relevant oil and gas property during a given taxable year.  Percentage depletion usually results in accelerated tax deductions to a taxpayer who owns a working interest in an oil and gas property since percentage depletion is based on the gross income generated from the production of an oil and gas property even though the net income from such a property (after deducting both tangible and intangible drilling costs) is usually significantly less than the gross income from oil and gas production.

Recapture Rules

Once tax is triggered on a taxpayer’s disposition of an oil and gas property, historical tax deductions claimed for intangible drilling costs, depletion deductions, and depreciation deductions on drilling equipment are generally required to be “recaptured” — meaning that some or all of the tax owed could be treated as ordinary income.  Also, even if a taxpayer enters into a tax-deferred 1031 exchange with respect to a given oil and gas property, these deductions are generally required under the U.S. tax code to be recaptured if the taxpayer relinquishes property that is subject to recapture but receives replacement property that is not.  Therefore, it is extremely important for a taxpayer interested in entering into a 1031 exchange on a given oil and gas property to engage experienced tax counsel in order to make sure that the exchange is carefully structured to avoid triggering the recapture rules, while still enabling the taxpayer to meet its anticipated cash flow needs and other non-tax objectives.

Conclusion

When disposing of oil and gas properties, taxes can be deferred under a properly structured Section 1031 like-kind exchange. While the alternatives for structuring a like-kind exchange are quite flexible for oil and gas properties, the formalities of a like-kind exchange must be complied with. Due to the special circumstances of any specific mineral property and due to the wide range of property interests encountered in the oil and gas industry, there are pitfalls and traps specific to these properties that must be carefully navigated. The structure of a particular like-kind exchange and the documentation required varies from being fairly routine to being very complex, depending upon the circumstances. Planning should begin early and possibly even as soon as interests in oil and gas properties are acquired in order to better facilitate for the disposition of property through a like-kind exchange. Owners of oil and gas properties can greatly benefit by deferring taxes as tax savings can be reinvested. Section 1031 could defer taxes and enable tax-deferred compounding with respect to oil and gas investments, which is extremely valuable to companies and individuals who wish to participate in oil and gas investments due both to the significant tax incentives available with respect to oil and gas assets and the superior investment return that can potentially be generated on investments in oil and gas properties over a long-term time horizon.

For further information, please contact Coby Hyman at General Tax Counsel, PLLC.  Mr. Hyman can be reached by phone at (972) 740-0161 or via email at chyman@generaltaxcounsel.com.

IRS Issues Partnership Audit Temporary Regulations

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On August 4, 2016, the Treasury Department issued its first temporary regulations under the new partnership audit and collection regime found in the Bipartisan Budget Act of 2015 (“BBA”).  For partnership tax procedure practitioners, the regulations are interesting reading.  These new regulations provide insights into the internal deliberations and policy goals at Treasury and IRS headquarters.

The new regulations relate to the “early opt-in” option—that is, despite the January 1, 2018 effective date, the BBA provides that partnerships and LLCs may opt-in to the new regime before the January 1, 2018 date.

Interestingly, the new regulations provide that a partnership or LLC can only elect into the BBA rules early, if the IRS notifies the partnership or LLC that it has been selected for examination.  The regulations discuss how the early opt-in election is to be made, to whom the early opt-in election is sent, and what the early election opt-in must say.  Furthermore, the regulations require that the partnership certify that it is solvent, does not reasonably expect to become insolvent, and has the money to pay any potential tax underpayment.  If the partnership is not selected for audit, it can still do an early opt-in election if it wishes to file an administrative adjustment request (“AAR”).

Finally, the preamble states that “[t]he Treasury Department and the IRS expect to issue additional guidance regarding designation of a partnership representative, including who is eligible to be a partnership representative, under section 6223 as amended by the BBA.”  Of course, any entity that opts-in to the new regime must designate a partnership representative at that time.

For further information, please contact Coby Hyman at General Tax Counsel, PLLC.  Mr. Hyman can be reached by phone at (972) 740-0161 or via email at chyman@generaltaxcounsel.com.