Changes to Partnership Auditing Rules
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Significant changes to the rules governing federal income tax audits went into effect on January 1, 2018. Due to these changes, it is more important than ever to review partnership agreements, LLC Agreements, and estate planning documents.
New partnership audit rules for LLCs taxed as partnerships, and Partnerships, took effect January 1, 2018. These new rules and the new position of partnership representative, change the landscape of partnership audits. For trusts that hold partnership assets (including LLC interests) the inability to opt out of the new rules may cause unforeseen and adverse tax consequences. Individuals who own LLC or partnership interests through a trust must pay careful attention to these new audit rules.
As of January 1, 2018, new partnership audit rules (New Audit Rules) apply for partnership tax returns for taxable years. The historic partnership audit rules (the “TEFRA Rules”) continue to apply for partnership tax returns for taxable years beginning before 2018. The New Audit Rules were enacted to facilitate the IRS’ ability to collect taxes arising from partnership audits. While partnership audits have been traditionally uncommon, the New Audit Rules may result in an increase in audit activities from the IRS in the future.
Contrary to the nature of partnerships as "flow-through" entities, and to the approach taken under the TEFRA Rules, the partnership rather than its partners have primary liability under the New Audit Rules for any tax adjustment arising from an audit, including penalties and interest. In addition, the "Tax Matters Partner” or “TMP” role under the TEFRA Rules is replaced with the “Partnership Representative” or “PR,” who has substantially greater authority than the TMP. For purposes of this advisory, the term “partnership” refers to general partnerships, limited partnerships, limited liability partnerships, and limited liability companies (“LLCs”) classified as partnerships for federal income tax purposes and the term “partner” refers to any equity owner of any of these entity types.
Given these significant changes, partnerships should consider amending their existing partnership or LLC Agreements to address these new rules.
The New Audit Rules replace the TMP with the PR, and the impact of this is far more than a simple name change.
- The PR is no longer required to be a partner but must have a "substantial presence" in the United States under rules described in the Treasury Regulations.
- The PR is the only person who will receive notice from the IRS. Partners of a partnership under audit are no longer entitled to receive notice or information regarding the status of the audit nor are they permitted to participate in the audit or other administrative or judicial partnership tax proceedings.
- The PR has the sole authority to act on behalf of the partnership during a tax audit or judicial proceeding. The PR’s decisions have a binding effect on the partnership and all of its partners in a federal income tax audit or judicial proceeding.
Consequently, identifying the appropriate person to serve as the PR, and establishing appropriate contractual responsibilities and restrictions on the actions of the PR, takes on much greater importance under the New Audit Rules.
Partnership Level Liability and “Push-Out Election”
Under the TEFRA Rules, all audit adjustments flowed through to the partners of the partnership for the taxable year(s) under audit and those partners were responsible for the resulting tax liability.
Under the New Audit Rules, primary liability for any audit adjustment (including the tax deficiency and any related penalty and interest) is imposed on the partnership, unless the PR makes a timely election on behalf of the partnership to “push-out” that audit adjustment to the partners for the taxable year(s) under audit (the “Push-Out Election”). Consequently, absent a Push-Out Election (or an Opt-Out Election, discussed further below), the partners in the year in which the audit is resolved will bear the economic burden of the audit adjustments. This is true even if they were not partners during the taxable year(s) under audit or if their interests in the partnership changed in the interim. The potential for future tax liability for past tax returns through the audit process should be considered in any business transaction where an individual is considering purchasing an interest in a partnership or an LLC taxed as a partnership.
Push-Out Elections, however, come with an administrative cost. Any partnership that makes a Push-Out Election must provide past partners with notice within stringent guidelines and the interest rate imposed on any tax deficiency resulting from the audit is increased by 2 percent.
Under the New Audit Rules, there is no longer an automatic exemption from the partnership-level audit rules. Under the final regulations, partnerships that are required to furnish less than 100 Schedule K-1s and whom all of their partners are “eligible partners” can elect out of the new audit regime by making an annual election to opt out of the partnership-level audit proceedings (the “Opt-Out Election”). The PR makes such an election on the partnership tax return for the taxable year in question. If the Opt-Out Election is made for a taxable year, the entity-level audit provisions of the New Audit Rules do not apply; instead, the audit is conducted at the partner level. Any partnership that has a partner/member Trust (including a grantor or revocable living trust) is disqualified from making the Opt-Out Election. Many closely held LLCs have membership interests that are owned through revocable trusts for estate planning purposes. Traditionally this was not a tax issue or event because both the partnership and the grantor trust had flow-through taxation to the individual grantor of the trust. However, because those membership interests being owned by the revocable trust will disqualify the company from making the Opt-Out election may want to rethink the ownership. Individuals who choose to own their LLC interests in the name of their revocable trust for estate planning purposes may distributing their LLC Membership Interests to themselves individually and avoid probate of those membership interests through some other method (for example, a transfer on death designation) so that the entity may not be disqualified from making the Opt-Out election.
Amending Existing Partnership or LLC Agreements
I strongly encourage clients to have their partnership or LLC agreements reviewed and revised to address the New Audit Rules, including:
- Identifying the PR or a mechanism for selecting the PR, as well as a process for replacing the PR. This is necessary even for partnerships that are eligible to make an Opt-Out Election because the PR is the person who must make the election on an annual basis on the partnership’s tax return. The PR should be carefully selected because they can bind the partnership and the partners. In many cases, the PR is an accountant, attorney or other professional advisor rather than a member or partner.
- Review LLC Agreements to ensure that no member of the LLC is a trust (including revocable trust, charitable remainder trust, grantor and non-grantor trusts). If any of these entities are a partner of the partnership, this will disqualify the partnership from opting out of the new audit regime.
- Establishing the authority, responsibilities, and any contractual restrictions or fiduciary duties imposed on the PR. Contractual restrictions might include requiring approval by the board or specific partners for material actions of the PR. While these contractual restrictions are not binding on the IRS, they are enforceable amongst the PR and members of the LLC or partners and can serve as a means of controlling the authority of the PR. Furthermore, the process of amending these agreements will help ensure that the partner/members of the business are aware of the broad authority of the PR and understand the authority of the PR.
- Establishing whether the PR is required to make available elections, including the Opt-Out Election and the Push-Out Election.
- Consider whether or not indemnification of the PR is desired or appropriate because under the new rules the PR will have an authority that he or she did not have when acting as TMP. Likewise, PRs may be unwilling to serve in such a capacity without such appropriate indemnification in place.
- For partnerships currently eligible to make the Opt-Out Election under the New Audit Rules, consider whether transfer restrictions should be imposed to preclude transfers that would prevent the partnership from making the election.
In the process of amending a partnership or LLC agreement as a result of the New Audit Rules, business owners may want to consider whether now is the time to add business succession plans including buy/sell agreements, rights of first refusal, etc. Likewise, it may be a good time to confirm that the partnership and LLC agreements accurately reflect how the business has been conducting itself and the owner's intentions for the future.