Please note: Throughout this article, reference to “partnerships” includes LLC’s taxed as partnerships, and reference to “partners” includes members of LLC’s taxed as partnerships.
For tax years 2018 and beyond, the IRS will begin implementing new audit rules directed at partnerships as part of the Bipartisan Budget Act of 2015. A primary purpose of the new audit rules is for the IRS to be able to more effectively collect tax deficiencies from partnerships. The new audit rules are expected to significantly increase the audit rates for partnerships. It is estimated that the new rules will raise approximately $9.3 billion over the next 10 years.
THE OLD AUDIT RULES
The Tax Equity and Fiscal Responsibility Act (“TEFRA”) has governed the procedures for auditing partnerships since 1982. Under TEFRA, if the IRS audited a partnership, any federal income tax liabilities remained with the applicable partners rather than the partnership. Under the old audit rules, the IRS would apply any audit changes to the existing partners and in turn the partners would amend their tax returns to reflect these changes.
THE NEW AUDIT RULES
For tax years 2018 and beyond, the Bipartisan Budget Act of 2015 and final regulations issued by the Treasury Department in August of 2018 repeal the TEFRA audit rules. The new rules provide for the assessment and collection of tax deficiencies at the partnership level; i.e., the IRS can now target the partnership itself to collect a tax deficiency. This is a significant change from the old audit rules which required the IRS to track down individual partners to pay the deficiency. This change makes the process of collecting tax deficiencies much simpler for the IRS but can lead to significant difficulties and challenges for partnerships. If the IRS conducts an audit and finds a deficiency, the imputed underpayment is computed based on the highest individual or corporate income tax rate.
IMPACT OF NEW RULES
The old TEFRA audit rules required partnerships to designate one partner as the Tax Matters Partner. Under TEFRA, the Tax Matters Partner was functionally limited to acting as a liaison between the IRS and the partners and had limited power to bind partners to the final resolution of an audit. The new rules replace the concept of a Tax Matters Partner with a Partnership Representative which comes with much greater authority. Under the new audit regime, the Partnership Representative has sole authority to act on behalf of the partnership. All partners are bound by the actions of the Partnership Representative, and partners have no statutory right to receive notice of or to participate in the partnership-level proceedings. This is a significant change from the TEFRA procedures, under which partners generally retained notification and participation rights in partnership-level proceedings.
The Partnership Representative is to be designated by the partnership on its annual tax return. The Partnership Representative may, but is not required to, be a partner of the partnership. The Partnership Representative must have a substantial presence in the United States, have a U. S. address, and a U. S. Tax ID number.
The new audit regime may present some complications and conflicts for partnerships, but there are options available to deal with the changes. First, partnerships may elect to “push-out” any tax deficiency. This means that the partners may decide to shift the assessment to the partners who had an ownership interest in the partnership during the year of the audit. This election to push out the entity-level adjustments to the members relieves the partnership of any entity-level adjustments. In many cases, this election should be considered to avoid entity-level taxation. Second, a partnership may be allowed to make an annual opt-out of the new audit rules with its timely filed tax return (Form 1065). If a partnership opts out, any audit changes would apply to the existing partners and in turn the partners would amend their tax returns to reflect these changes. The opt-out election is available to partnerships that (a) issue 100 or fewer Schedules K-1 annually, (b) are owned by some combination of individuals, estates of deceased partners, C corporations, and S corporations, and (c) timely file their Form 1065 and check the correct box. If any partner is another partnership or a trust, then that partner is not eligible, and the opt-out election is not available to the partnership.
ACTION ITEMS FOR LIMITED LIABILITY COMPANIES AND PARTNERSHIPS
Consideration should be given to whether a Partnership Agreement (or LLC Operating Agreement) should be amended in order to deal with the new audit rules. Specifically, consideration should be given to appointment of a Partnership Representative and inclusion of new provisions regarding the push-out and opt-out options described above. In addition, consideration should be given to the various rights and duties of the Partnership Representative including notice of and updates on audit proceedings and voting requirements.