In 2015 Congress enacted a new partnership tax audit regime, which became effective for all tax years beginning after December 31, 2017. The primary difference between the old rules and the new rules is that the IRS will audit a partnership on the entity level versus auditing each individual partner. Accordingly, the new rules affect the individual tax liability of partners, the responsibility of each partner during and after an audit and how the IRS conducts a partnership audit in general.
An LLC that has two or more members defaults to partnership tax status. Accordingly, the new audit rules will affect the vast majority of LLCs and all partnerships. Business owners should review their tax status and their operating or partnership agreements to ensure that they are compliant with the new rules. In particular, business owners should be aware of the following issues:
- Partnership Representative. The new rules require every partnership to designate a partnership representative on its federal income tax return. The partnership representative is given the sole authority to make elections and to represent and bind the partnership (and the partners) in all administrative and court proceedings involving adjustments to the partnership’s federal income tax return. An operating or partnership agreement should specifically set forth who will act as the partnership representative, who will elect that person and what happens if the person resigns or dies.
- Election Out of New Rules. A partnership may elect out of the new rules, which it needs to do on an annual basis, if the partnership does not have more than 100 eligible partners. Eligible partners include individuals, C corporations, foreign entities that the IRS would treat as C corporations if they were domestic entities, S corporations and estates of deceased partners. The IRS does not consider trusts and other partnerships to be eligible partners under the new rules. Accordingly, an operating or partnership agreement should contemplate the consequences of a partner being an ineligible partner and incorporate rules to ensure the partnership can elect out of the new rules, if so desired.
- Timing of Audits. The partnership level income tax liability resulting from an IRS audit, including penalties and interest, will be determined, assessed and collected from the partnership for the tax year in which the adjustments become final (the “Adjustment Year”) and not in the year that was audited (the “Reviewed Year”). What happens if the ownership of the LLC or partnership changed between the Adjustment Year and the Reviewed Year? An operating or partnership agreement should incorporate language to contemplate how the economic consequences of an audit will flow through to the partners.
- Push-Out Election. The push-out election permits the partnership to shift the responsibility for paying the imputed underpayment, penalties and interest from the partnership to the Reviewed Year partners. The Reviewed Year partners can elect to pay the aggregate additional adjustment amounts or the “safe harbor" amount, which is essentially the Reviewed Year partner’s share of the imputed underpayment.
Overall, the new partnership audit rules present a number of factor that business owners should discuss and contemplate in their governing instrument. Accordingly, the owners of any entity that the IRS taxes as a partnership should review their governing agreement to ensure that it is compliant with the new rules.
For more information please contact a member of the Business Finance, Formation & Restructuring Team at the Law Firm of Conway, Olejniczak & Jerry, S.C.