New Tax Law Affecting Partnerships and LLCs
In 2015, a fundamental change was made to the law dealing with IRS audit procedures for partnerships and multi-member LLCs that are taxed as partnerships. This new law is slated to go into effect on January 1, 2018, and will have a significant impact on partners and partnerships.
Under the prior audit regime, which still applies for tax years beginning before 2018, most partnerships are subject to the unified audit procedures established by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under these procedures, an IRS audit is conducted at the partnership level but audit adjustments are made at the partner level. If there is a resulting tax liability, the IRS must attempt to collect it from the individual partners. The TEFRA audit procedures apply to most partnerships that have 10 or more partners, but there is an exception that permits special audit procedures to apply to certain small partnerships and electing large partnerships (ELP).
However, for tax years beginning in 2018, the Bipartisan Budget Act of 2015 generally repeals the TEFRA and ELP audit procedures and replaces them with centralized rules for auditing partnerships and their partners at the partnership level. This change is expected to increase the number of partnerships that the IRS will audit because of the increased efficiency in dealing with the partnership rather than each of the partnership’s partners. Under this centralized audit approach, the IRS will audit a partnership’s items of income, gain, loss, deduction, credit, and each partner’s distributive share for a particular year of the partnership (i.e., the “reviewed year”). Any adjustments that follow are taken into account by the partnership, and not the individual partners, in the year that the audit or judicial review is completed (i.e., the “adjustment year”).
What this means is that, if the IRS conducts an audit of a partnership’s 2018 tax return and completes the audit in 2020, any underpayment of tax is paid by the partnership in 2020 and is thus borne by the 2020 partners. This is true even if the partnership interests of the 2020 partners may have changed since 2018, and even if the 2020 partners were not partners at all in 2018. Moreover, the payment of tax, interest, and penalties by the partnership is not deductible by the partners.
There is an alternative, however, to taking an audit adjustment into account at the partnership level. A partnership can issue an adjusted information return (i.e., adjusted Schedule K-1) to each reviewed year partner, in which case those partners take the adjustment into account on their individual returns in the adjustment year through a simplified amended-return process. Thus, for an audit of a 2018 partnership that concludes in 2020, the 2018 partners would be issued an adjusted Schedule K-1 and would report the adjustments on their 2020 tax returns. To make this election, the partnership must furnish the adjusted Schedule K-1 to each partner and to the IRS within 45 days of having received a notice of final partnership adjustment.
Of critical importance is a provision in the new law that permits a partnership with 100 or fewer qualifying partners to elect out of the rules for determining audit adjustments at the partnership level if certain conditions are met. One of the eligibility requirements to make this election is that each of the partners must be an individual, a deceased partner’s estate, a C corporation, a foreign entity that would be required to be treated as a C corporation if it were a domestic entity, or an S corporation (subject to special rules). Note that, in its current form, the law does not permit a partnership to elect out if it has among its partners a trust or another partnership.
If a partnership chooses to elect out of the new rules, it must do so annually on a timely-filed tax return for the tax year to which the election relates. The effect of electing out of the new audit rules is that the partnership and partners will be audited under the general rules applicable to individual taxpayers. This election is of great consequence and should not be ignored.
Another important change under the new law is that the “tax matters partner” has been replaced by a “partnership representative.” The partnership representative has far greater authority to act on behalf of the partnership during an IRS audit, including the ability to bind both the partnership and the individual partners. It is prudent, therefore, to carefully consider not only who should serve as partnership representative but also how the duties and obligations of the partnership representative should be delineated. The partnership representative must be designated annually on a timely-filed tax return and the designation may be required even if the partnership elects out of the new audit regime.
As a result of these changes in the law, partnership and LLC operating agreements will need to be amended to take into consideration the impact of the new rules. For most agreements, it will be necessary to add provisions not only for electing out of the centralized audit regime, but also for preserving the partnership’s eligibility to make the election. Furthermore, virtually every agreement will need to be amended to address the detailed rules pertaining to designating and establishing the duties of the Partnership Representative. Given the potential to elect out of the new audit regime and the availability of the election to push a tax liability out to reviewed-year partners, both retiring partners and prospective partners will likely take a keen interest in how the partnership agreement addresses these issues.
If you have any questions or would like to discuss the issues in more detail, please do not hesitate to contact GKH tax attorney Doug Smith, or the GKH attorney with whom you have worked in the past.
DISCLAIMER: The foregoing does not constitute legal advice and has been prepared for informational purposes only. Please contact us directly with questions about how these and other nonprofit laws and procedures relate to your specific organization.
Prepared by GKH attorney Doug Smith. Attorney Smith practices in the areas of Estate Planning and Administration, Business Succession Planning, Nonprofit Organization, Corporate and Commercial Law, and Tax Law.