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Last November, President Obama signed the Bipartisan Budget Act of 2015, which overhauls how the IRS audits and collects tax from partnerships or entities taxed as partnerships, such as LLCs (collectively referred to in this article as “partnerships”).
The new law goes into effect in 2018 and repeals the partnership audit rules enacted back in 1982, known as TEFRA. The prior rules created huge roadblocks that often kept the IRS from auditing partnerships. Passing partnership adjustments through to the partners was a costly and inefficient process, and the IRS does not audit many partnerships because of it.
However, the new legislation will soon allow the IRS to collect taxes associated with audit adjustments
at the partnership level rather than passing adjustments through to the individual partners. This will likely increase the rate at which partnerships are audited in the future.
The new Entity-Level Tax rule allows the IRS to assess the partnership an “imputed underpayment,” which will be subject to the individual or corporate tax rate.
The new law also requires the IRS to assess the partnership in the year of adjustment rather than the year under audit. Therefore, it is possible for current partners to be liable for tax errors that benefited former partners.
To correct this outcome, the new law allows for two possible exceptions to transfer partnership-level tax liabilities back to the prior-year partners. One option allows partners to file amended tax returns that report their shares of partnership adjustments and pay all applicable taxes.
The other options lets the partnership issue what amounts to amended K-1s to the former partners, which reflect the partners’ share of adjustments.
Partnership operating agreements should address how any new taxes assessed against the partnership are dealt with.
For example, let’s say a majority owner partner sells his interest to a new partner and the partnership is later audited, and a large tax is assessed. If neither the partnership agreement nor partnership interest sales agreement puts the liability on the outgoing partner, the new partner is stuck with the bill for something the old partner did.
This situation could cause an expensive lawsuit over the issue. There are a couple ways to prevent that. The partners can add a clause to the purchase and sale agreement, whereby the seller partner remains liable for income tax issues for his period of ownership. Another option is to include a provision in the partnership agreement which states who is liable for the tax.
The new partnership audit regime applies to all partnerships. However, partnerships with 100 or fewer partners can elect out of the new audit rules. That only applies if none of the partners are other partnerships or trusts.
To elect out, the partnership must opt out on its partnership return each year, must inform each of its partners of the election and submit the names and taxpayer identification numbers of each of its partners.
The IRS is not making it easy to opt out. That may create some problems for partnerships that thought they had elected out but did not meet the requirements.
For example, say a partner decided to transfer their interest into an irrevocable trust for estate planning purposes. The partnership would now be subject to the new audit rules and tax assessment if the IRS conducts an audit, even though the partnership followed the procedures to elect out.
Partnerships should draft their partnership agreement to prevent unqualified owners from holding an interest to prevent such a problem or recognize the ramifications of same.
The new law also requires partnerships to appoint a person or entity to serve as the partnership representative before the IRS. That person does not have to be a partner. This representative has the sole authority to act on behalf of the partnership. That means partners will no longer have the right to participate in a partnership audit. In fact, they will not even have the right to receive notice of the partnership audit or be able to raise partner defenses.
With that in mind, partnerships should choose their representative wisely to prevent a bad audit outcome due to an ineffective representative.
For example, in a situation where the partnership representative dies or sells their interest, unless the partnership agreement states who the replacement is, there could be a disagreement amongst the partners as to who will become the partnership representative. Presumably, without specifically designating that person or procedure in the partnership agreement, majority rule will control the election of the new person.
Therefore, the partnership agreement should address the procedures for establishing the partnership representative.
With the partnership audit changes coming soon, partnership agreements should be drafted or amended to take into consideration the change in the audit regime.
While regulations and other guidance will be coming over the next two years, existing and new partnerships need to start thinking how they will address the new audit rules. I expect it will take many years of litigation for the various rules to be flushed out.
Until then, partnerships should plan accordingly by addressing these issues in the written partnership agreement.
If you currently own an interest in a partnership or are considering buying into one, we recommend that you seek counsel to make sure that outdated partnership agreements don’t cause costly problems down the road.
Jason W. Harrel is a Partner at Calone & Harrel Law Group, LLP. He is a certified specialist in taxation. Mr. Harrel may be reached at firstname.lastname@example.org.