If you are a partner of a partnership or a member of a limited liability company (LLC) taxed as a partnership, or are entering into a new partnership or LLC, you may have some important decisions to make in light of impending changes to the rules governing federal tax audits. Here’s what you need to know to prepare for the new rules.
In November 2015, President Obama signed into law the Bipartisan Budget Act of 2015 (the Act). The Act repealed the “TEFRA” partnership regime and replaced it with an entirely new regime for federal tax audits of partnerships (including LLCs taxed as partnerships) for tax years beginning after December 31, 2017. While the new audit regime is similar to TEFRA in some ways, there are significant changes — including the imposition of tax at the partnership level — that require careful review and revisions to certain tax provisions of partnership and LLC agreements. References to a partnership and its partners include references to an LLC and its members for an LLC taxed as a partnership for federal income tax purposes.
Current Partnership Audit Rules
Under current rules:
If a partnership incorrectly reported its income or loss in a given year, the adjustment would generally “flow through” to the partners in the same year. The partners would be responsible for any deficiency on their own tax returns, which would be revised to include their share of the flow-through adjustment.
Each partnership must have a designated tax matters partner. The tax matters partner must be a partner of the entity and will represent the partnership in dealings before the IRS, manage audit investigations, and provide tax information to other partners.
Partners who qualify as “notice partners” have the right to receive notices of adjustments from the IRS, and to begin tax proceedings if the tax matters partner has not done so.
New Partnership Audit Rules
For tax years beginning after December 31, 2017, the Act creates a new audit regime that applies to all entities taxed as partnerships, except those that are (1) eligible to elect out of the regime and (2) affirmatively do so, as discussed below. Under the new audit regime, the IRS generally will conduct audits and make any resulting adjustments at the partnership level, and if the IRS finds a deficiency, it will impose tax on the partnership itself (rather than on the partners) at the highest individual or corporate tax rate in effect for the year under examination.
That means that all current partners could bear economic responsibility for improper tax reporting in prior years, even if one or more of such partners was not a partner in the year in which the improper reporting occurred. The Act authorizes the IRS to prescribe rules that will allow a partnership to reduce the liability by demonstrating, for example, that some of its partners are tax-exempt or subject to a lower rate for capital gain or qualified dividend income.
The new audit procedures provide two alternatives to requiring the partnership to pay the adjustment at the entity level:
Within 45 days after receipt of the notice of final partnership adjustment, the partnership may elect to furnish adjusted Schedule K-1s to each person who was a partner in the “reviewed year” stating such partner’s share of any partnership adjustments. Those partners would then take the adjustments into account on their own returns in the year in which they receive their adjusted Schedule K-1s (rather than by amending their returns for the reviewed year), using a simplified amended-return process.
Alternatively, the partners may self-report the amounts due by filing amended returns for the reviewed year that take into account their share of the adjustment. If one or more partners self-report their share of a proposed adjustment, the imputed underpayment at the partnership level is reduced.
Partnerships with 100 or fewer partners consisting solely of individuals, corporations (C or S), foreign entities taxable as corporations, and estates of deceased individuals may elect out of the new audit procedures. Shareholders of subchapter S corporations that are partners are counted as partners and the election must disclose their names, addresses and taxpayer identification numbers. Partnerships with partnerships or trusts as partners may not opt out of these rules. The opt-out election must be made annually with the partnership’s tax return for that year. If the partnership elects out of the new procedures, the partnership and the partners would be audited under the general rules applicable to individual taxpayers — i.e., the IRS must issue a separate audit report to each partner, and each partner can act independently to challenge its own audit report under the deficiency procedures that otherwise apply to individuals.
Another important change made by these rules is the elimination of a tax matters partner. Under the new rules, each partnership must designate a “partnership representative.” Unlike the tax matters partner, this individual need not be a partner, but must have a substantial presence in the United States. The partnership representative will have sole authority to act on behalf of the partnership in audit proceedings before the IRS and will bind both the partnership and the partners by its actions in the audit. Only the partnership through the actions of this representative can contest proposed adjustments in court. In addition, the IRS will no longer be required to notify partners of partnership audit proceedings or adjustments unless the partnership or LLC agreement so provides. If no partnership representative is designated, the IRS may appoint one. The partnership representative’s exclusive right to resolve partnership audits and disputes may create conflict among the partners if the partnership representative’s rights are not specified in the partnership agreement.
While the new rules apply to partnerships beginning after December 31, 2017, a partnership may elect to have the new rules apply to partnership tax years beginning after the date of enactment and before January 1, 2018. However, it is unlikely many partnerships will make such an election, at least until further guidance is provided by the government.
Why All of this Matters
These new rules will lead to new provisions in partnership and LLC agreements and amendments of existing agreements to, among other things, designate a method for selecting a partnership representative and its rights and obligations of the partners, address whether certain tax elections will be made, and provide for indemnification and other contractual provisions (e.g., in the case of a withdrawing partner).
The imposition of partnership-level liability for income taxes has significant implications in the context of mergers and acquisitions involving partnerships (or the sale of a partnership interest). Parties to a purchase and sale of a partnership interest will need to address who will bear the economic cost of partnership-level tax liabilities for pre-closing years assessed post-closing, who controls the audit examination of pre-closing years, and the elections the partnership is allowed to make.
Given the various changes to the partnership audit rules and potentially significant shift in benefits and burdens of tax adjustments, partnership and purchase/sale agreements need to take into account these new audit procedures. All effected partnerships and LLCs should address these issues to avoid being caught off guard when the new rules become effective.