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Partnerships and LLC Audit Rules Change: Time to Revisit That Operating Agreement

New partnership audit rules impact your business by changing how the IRS audits partnership entities, increasing the burden and tax cost by shifting the tax impact from the individual partner to the partnership/LLC entity.  LLC’s and partnerships may need to revisit and amend your operating agreement now due to this change in law.

While this discussion is not meant to provide all the details of the new audit procedures, some of the main changes to note are as follows:

  • Any adjustment to income, gain, loss, deduction, or credit will be determined, and assessed and collected at the partnership level,
  • Tax calculated at the partnership level is taxed at the highest tax rate applicable to the partners and charged to the current partners/members; and,
  • Tax Matters Partner is replaced by the Partnership Representative (“PR”).

The rules allow for an eligible partnership to elect out of the new audit regime. To qualify as an eligible partnership, an entity must have one hundred (100) or fewer partners and have only eligible partners, which are individuals, C-corporations, S-corporations, and estates of deceased partners.  Note that disregarded entities are not eligible partners.  The partnership, if eligible, would elect out on a timely-filed tax return.  If a partnership does not elect out or is not eligible to do so, the new audit rules will result in any adjustments from an audit to be taxed at the partnership level at the highest tax rate.  Previously, the adjustments were made at the individual partner/member level at their personal tax rate.  Note that the IRS has stated that there may be an increase in the numbers of audits of partnerships that make the election.

Any tax assessed as a result of an IRS investigation against the partnership will be at the highest applicable rate.  Depending on the type of entity the partner/member is, and what tax bracket applies, the tax at the partnership level can result in a substantially higher tax bill than if the assessment occurred at the partner/member level.  The economic impact of the new procedure places the tax burden of prior years under audit to be assessed against the current partners/members in the current tax year.  This means that a partner/member admitted to the partnership may bear a tax assessment from a prior tax year when he/she wasn’t an owner.  However, the rules do allow for a partnership to make a push out election, which requires the review year partners/members to be responsible for any adjustment and pay any tax due.  The availability of the push out option may have benefits in some instances, but each case should be examined given the particular set of circumstances acing the entity.

Potential Operating Agreement ChangeThe PR has the sole authority to elect out of the new audit rules, and despite language in an operating agreement to the contrary, a PR can bind the partnership by his or her actions.  Regardless, it may be advisable to amend the operating agreement to require the PR to confer and obtain consent with the partners/members regarding the opt-out election and the push out option.  In addition, in order to ensure the partnership remains eligible, partnerships/LLCs should consider restricting transfers to ineligible partners/members.

The new rules create the PR role, replacing the Tax Matters Partner, and grant the PR substantial authority. The PR has the authority to bind the partnership and the partners in settlement agreements with the IRS, the power to elect to elect out of the new rules, elect to push out liability to the partners, litigate adjustments, agree to the final adjustments, etc.  The PR, who does not have to be a partner, is designated each year on the entity’s tax return.  Due to the broad authority of the PR and the impact of the PR’s decisions, it is extremely important that partnerships choose the PR carefully.  Although neither state laws, nor operating agreements may limit the broad authority of the PR, there are ways to maintain some control over who is designated PR, how to remove the PR, and certain actions the PR makes.

Potential Operating Agreement ChangeAlthough the PR is designated annually on a tax return, it may make sense for some entities to list the PR within the agreement.  It is important to include language in the operating agreement regarding the manner in which a PR is chosen and removed.  An operating agreement should require that the PR notify and inform the partners of proceedings and require approval over major decisions.  The operating agreement can limit indemnification of the PR solely to actions taken by the PR that were within the scope of the PR’s authority.   Thus, while the broad authority of the PR will remain, there are ways for the partners to ensure the PR works with them to make decisions and limit the PRs actions to the appropriate scope.

The new audit regime will impact potential tax audits for years beginning in 2018.  The impact of the changes may be vast for some partnerships/LLCs and their partners/members.  As with all changes in tax law, there are many uncertainties and complexities.  LLC’s and partnerships should take the time now to plan.  For many, the best approach may be to amend existing operating agreements to protect the partners.  Managing partners should take the first step now and discuss these changes with their CPA and legal counsel.

Article Written By: J.D. Matchett-Robles

Tax Planning

Jdmatchettrobles@nullWaterfallAttorneys.com

Published 2/27/2018