By Robin Gilden and Daniel Cousineau
The new partnership audit rules substantially change the audit procedures for partnerships (including multi-member LLCs) and may require that you update certain provisions within your partnership or LLC agreement to maintain compliance.
In partnership audits, the IRS has historically adjusted the returns of partners, rather than the partnership, because partnerships do not actually pay an entity level tax but pass through their income and losses to the partners. The Bipartisan Budget Act of 2015 (the “Act”) substantially changed these rules for partnerships with tax years beginning after December 31, 2017.
Under the Act, the IRS will examine partnerships and make any adjustments at the partnership level in the year that the audit is completed rather than the year under review. The partnership will pay the tax, interest and penalties on any underpayments at the highest statutory rate for each partner’s distributive share of the underpayment (i.e., the highest corporate rate for corporate partners and the highest individual rate for individuals). This change in the rule shifts the cost of the adjustment to the partners holding a partnership interest at the time of the audit rather than those partners who held a partnership interest in the year of underpayment.
The Act provides for an opt-out election for some partnerships with 100 or fewer partners. In order to qualify for this opt-out, the partners must all be individuals, C corporations, foreign entities that would be characterized as C corporations if incorporated in the United States, S corporations, or certain estates. Partnerships with partners that are partnerships (including multi-member LLCs) or trusts (including revocable living trusts) are unable to utilize this opt-out election. In addition, it may be possible to make an election to shift the burden of any adjustment to those partners who held a partnership interest during the year of examination.
Partnership audits are handled by a “Partnership Representative” designated by the applicable partnership or LLC agreement. The Partnership Representative can be a partner in the partnership or a non-partner with a substantial presence in the U.S. The Partnership Representative is granted broad authority to resolve any partnership audits and this resolution will be binding on all of the partners. Talk to your attorney about what changes need to be made to your partnership or LLC agreement in 2018 to make sure that the appropriate Partnership Representative language is contained within your agreement. If a Partnership Representative is not appointed in the agreement, the IRS has the authority to appoint the Partnership Representative and this appointment cannot be changed without IRS approval. It is unclear if either the courts or the IRS will find that a person appointed as a “Tax Matters Partner” in an agreement entered into prior to the new partnership audit rules is equivalent to a Partnership Representative given the far greater duties and powers afforded Partnership Representatives. Consideration should also be given to how and to what extent current partners can seek indemnification from former partners for any audit adjustments. Please feel free to contact any member of the MSK Tax Practice Group if we can be of assistance.