Congress recently enacted significant changes to IRS rules regarding audits of partnerships and limited liability companies (LLCs) that will soon take effect. The changes are expected to dramatically increase the IRS audit rates for partnerships and LLCs and will require partners and LLC members to revise their partnership agreement (operating agreement for LLCs). The new rules generally apply to partnership tax years beginning after 2017.
In many cases, immediate adjustments to existing partnership or LLC agreements, or disclosures, may be necessary or useful to accommodate this change in the tax law, even though the new rules technically apply only to audits of tax years after 2017. In particular:
- The new term “partnership representative” replaces the prior “tax matters partner.” The designation of which partner or LLC member is the partnership representative requires a careful assessment; they will act as the single point of contact between the IRS and the partnership and will have full authority to bind the partnership and the partners during an audit. Partnership agreements and LLC operating agreements should expressly address the powers, responsibilities, and potential liabilities of the person selected as the “partnership representative.”
- Most importantly, new or existing partners may need to be assured, through appropriate provisions of the entity agreement or otherwise, that their rights and interests will be appropriately protected in any audits conducted under the new rules. Otherwise, they might be unwilling to invest or remain invested.
- Managing partners or members will want to ensure that they have the authority to properly represent the interests of the partnership and its partners, that their duties and responsibilities are clear, and that any necessary indemnifications are in place.
These issues are of concern because of the following major changes to the audit rules that will apply to all partnerships and LLCs after 2017:
- All direct and indirect partners in partnerships will be bound by any audit determination reached by the IRS and the partnership, without a requirement of notice to the partners and without any ability of a direct or indirect partner to elect out of the unified partnership-level determination.
- There is a potential conflict between the interests of current partners and former partners with respect to the costs of dealing with an IRS audit or judicial determination, as well as with respect to positions that may be taken in such proceedings.
- Certain partnerships with 100 or fewer partners may elect out of the new provisions. To do this, the partnership must make an annual “opt-out” election with their timely filed tax return (Form 1065). We can help you to determine if your partnership is eligible for the “opt-out” election and whether the election would be beneficial in your situation, and work with your legal counsel to ensure your agreement is properly updated to address the new rules. This is particularly important if you will be forming new entities or adding/reducing the number of partners/members.
- In the event a binding partnership adjustment is made, the partnership will be subject to an entity-level tax, which will be effectively borne by the current partners even though it relates to tax benefits enjoyed by former partners, unless the partnership takes affirmative steps to elect out of the new entity-level tax. Some partners or prospective partners may wish to be assured that such an election will be made.
- In the event a partnership elects out of the entity-level tax, which will protect current partners, former partners will potentially be subject to additional tax liabilities or compliance costs. It may be prudent to advise some partners or prospective partners in this regard.
We would be happy to discuss the strategic tax planning and tax compliance implications of the new law for you and the entities and investors with whom you interact and to provide tax advice regarding these issues. Of course, any changes or modifications to legal documents would need to be implemented by your attorneys.
