An email from the IRS has shed light on the critical need for partnerships to maintain meticulous documentation when a partner lends money to a business. Released on November 1, the email describes how a lack of documentation can lead to a significant financial burden for partnerships, potentially resulting in a hefty imputed underpayment by the IRS. The email specifically describes a case where a partnership borrowed $5 million from two partners but failed to document the loan, allowing the IRS to designate one partner, Partner A, as the sole lender. This led to a reallocation of $5 million in loans and an imputed underpayment calculated at a 37% maximum tax rate, or $1.85 million.
Partnerships facing such situations can attempt to make a “push-out” election, which involves transferring the IRS-determined adjustments to individual partners for consideration within a 45-day window after receiving the IRS’s Final Partnership Adjustment notice. However, the process involves additional costs for compliance and representation before the IRS, as described in detail in the email documentation.
The consequences of failing to make a timely or valid push-out election are severe. In the IRS’s scenario, the lack of proper documentation resulted in an effective taxation rate of 74% against what is typically a non-taxable loan, leaving partnerships with substantial financial exposure.
The audit rules under the Bipartisan Budget Act highlight the need for partnerships to treat internal loans with the same diligence as arm’s length transactions. This includes setting terms such as market-based interest rates, fixed repayment schedules, and specific provisions for default. Such diligence can help to avoid the significant IRS examination costs and potential tax liabilities that result from undocumented loans.
Brett Bissonnette, who leads Plante Moran’s tax controversy services practice, argues that it is crucial for partnerships to invest in establishing proper loan agreements to safeguard against future IRS examinations and potential financial penalties. More on Brett’s insights can be found here.