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In September 2016, I wrote an article in the Central Valley Business Journal about the new partnership audit rules titled “Partnership Audit Rules Are Changing.”
That article goes into the basic mechanics of the rules established by the Bipartisan Budget Act of 2015 signed by Barack Obama in 2015, and, for your reference, I recommend you review it free online at the CVBJ website.
Those rules make it easier for the IRS to conduct a partnership audit, but they were slim on the specific details. The IRS has now published proposed regulations (as of June 13) which describe the rules in greater detail.
These rules apply to general and limited partnerships and LLCs taxed as partnerships. In this article, I am going to go into more depth about what planning issues you should consider before the new rules start for the tax years beginning after December 31, 2017.
First, we know that partnerships with less than 100 “eligible” partners can annually elect out of the new partnership audit rules. Eligible partnerships consist of partners that are individuals, C corporations, S corporations and estates of deceased partners.
This means that there cannot be any trusts, other partnerships or disregarded entities as partners in the entity.
Commentators expressed concern to the Treasury Department the issue of partnerships and trusts not being eligible partners and the problems that come with that, but the Treasury Department declined to expand the definition of “eligible partners” for purposes of electing out.
This brings up the issue of whether current partnership agreements should have a provision that prevents non-eligible partners from ever being owners of the partnership to prevent the new rules from being applied to a partnership.
If non-eligible trust partners are excluded, some partners may have a hard time with their estate planning since many people put their partnership interests in trusts without telling the other partners. Partners need to determine how important the new audit rules are, and whether the partnership agreement should be amended to prevent non-eligible partners from gaining ownership.
Unfortunately, it is likely more important for estate planning issues that a partnership interest is held in a trust versus being subject to the new audit rules, but it is an issue to be aware of so an informed decision can be made.
Second, the “Partnership Representative” now replaces the former “Tax Matters Partner,” and can be anyone who has a U.S. presence. Under the new rules, a partnership must designate the Partnership Representative for each tax year on the partnership’s filed return and a designation for one tax year is not effective for any other tax year.
The Partnership Representative has the ultimate power to make all decisions regarding the audit, what partners learn of the audit and who will be assessed any tax deficiency. This is because the default assessment of tax resulting from a partnership audit will now be against the partnership and not the partners. Rather than the partnership itself paying the assessment, the new rules allow the partnership representative to make a “push out” election to make the partners liable for the tax on their personal tax returns instead. Partnerships have now become a hybrid pass through entity that can sometimes act as either a C corporation or a partnership, depending upon the elections made.
A Partnership Representative now acts in a similar capacity to that of a trustee of a trust or an attorney representative, but without the legal fiduciary standards in place. Only the Partnership Representative may raise defenses to IRS assessments, even defenses that only relate to an individual partner. Due to the power given to the Partnership Representative, the partnership agreement or LLC Operating Agreement should carefully outline who that person is and what they have to do in case of an audit. This should include a clause as to whether there will be a “push out” election of the tax or not.
If partnership agreements are not amended to address the issues brought up above, this could result is costly lawsuits.
Partnership disputes could be especially magnified if the IRS audits tax years where former partners had sold their partnership interest and are now no longer part of the partnership. This is because the tax returns filed by the former partners may have a new tax liability that the new partners owe, and without an agreement in place as to what to do in this scenario, the tax representative may make the new partners liable for the old partners’ tax assessment. However, these problems can all be remedied with a proper partnership agreement amendment and provisions in partnership interest buy sell agreements that outlines what will happen in case of audit.
It is quite likely that there could be lawsuits filed in the upcoming years regarding these types of disputes. Even though these proposed regulations are not final yet, and likely will not become final until later this year or even next year, they give an excellent planning opportunity for taxpayers right now.
– Jason W. Harrel is a Partner at Calone & Harrel Law Group, LLP who concentrates his practice in all manners of Taxation, Real Estate Transactions, Corporate, Partnership and Limited Liability Company law matters. He is a certified specialist in Taxation. Mr. Harrel may be reached at 209-952-4545 or [email protected]