By Russell J. Stein
Recently passed changes in IRS partnership audit rules could have unintended economic consequences for partners and may require revisions to partnership agreements and LLC operating agreements. Acting now to revise partnership and LLC agreements could allow partnerships to immediately take advantage of some of the new procedures.
On November 2, 2015, the Bipartisan Budget Act of 2015 (the “Act”) was signed into law. The Act repeals the methods and procedures the IRS uses for auditing partnerships and limited liability companies and replaces it with new procedures effective for taxable years beginning January 1, 2018.
Under the Act, the new audit procedures will generally have the partnership, not individual partners, pay tax attributable to any audit adjustments. These new procedures could have unexpected economic consequences for certain partners, and accordingly, partnership agreements should be reviewed and revised to reflect the new procedures and the economic arrangements between the partners.[1]
Every partnership agreement will likely have to be reviewed and possibly amended to take into account the new audit procedures.
For most partnerships, the new audit procedures will be significantly different from the current audit procedures. Since 1982 there have been three different regimes controlling how the IRS audits partnerships:
- Small partnerships (defined as partnerships with fewer than 11 partners that generally have only individuals, estates or corporations as its partners) are audited at the partner level and not the partnership level. Audits are conducted and assessments made for each individual partner unless such partnership elects into the “TEFRA” procedures below.
- Partnerships with more than 10 partners and small partnerships that don’t qualify for the small partnership regime are audited under the “TEFRA” procedures. Generally under TEFRA audits, the IRS audits a partnership and passes on assessments to each individual partner who was a partner for the reviewed year. The partnership appoints a “tax matters partner” who acts as the centralized point for the audit and is able to settle the audit, but is subject to certain limitations such as notice provisions.
- An “electing large partnership” elects to have the IRS conduct the audit on the partnership level, but assessments are passed onto its partners who are partners in the year of the assessment (not the reviewed year).
For taxable years starting on or after January 1, 2018, the IRS will audit the partnership and assess taxes on the partnership itself; such taxes are called “imputed underpayment amounts.” The imputed underpayment amount is calculated “by netting all adjustments of items of income, gain, loss or deduction and multiplying such net amount by the highest rate of tax in effect for the reviewed year…”[2] Although certain modifications to this amount are allowed, in general the amount does not take into account any individual partner’s specific tax situation. Therefore, the amount of tax the partnership pays as a result of a tax audit under these new procedures could be higher than the aggregate amount all the partners would have paid if the audit changes were originally reported in the applicable taxable year.
This shift in tax liability from the partners to the partnership presents various business issues for partnerships to contemplate:
- Does the partnership have sufficient cash to pay a tax assessment or the ability to make a capital call to pay a tax assessment?
- How should the economic effect of the tax assessment be shared among the partners?
- What happens if the partnership has different partners in the year of the assessment from the reviewed year, or the partners are the same but the ownership percentage has shifted among the partners?
- What happens if certain partners are tax-exempt entities or otherwise taxed at a lower rate than the maximum statutory rate?
In general, audit adjustments could shift the economic effect of tax liabilities from certain partners (i.e., old partners) to other partners (i.e., new partners).
Drafting issue: Many partnership agreements just treat taxes as an operating expense. In certain situations it may be appropriate to provide a mechanism in the partnership agreement to specially allocate certain tax expenses to certain partners.
Alternative treatments
The Act expands the definition of small partnerships and allows them to elect out of the new audit regime. Under the new rules, the definition of a small partnership is expanded to include partnerships with no more than 100 partners. Individuals, corporations, S corporations, foreign entities taxable as a C corporations and estates are eligible partners for this test, but if the partnership has as one of its partners another partnership, the partnership is not eligible to elect out.[3] It is uncertain how disregarded entities affect the 100 partner calculation. If a partnership elects out and follows certain notification and disclosure requirements, audits will be conducted on the individual partner level.[4] It appears that a small partnership must make this election each year it desires to opt-out of the new audit regime.
Drafting issue: Consider whether the partnership agreement should allow, or even require, this election to be made (if eligible).
Two other options allow a partnership to minimize the partnership level tax and push the tax directly to its partners. The first option is a partnership may elect to issue amended K-1s to each partner who was a partner for the reviewed year incorporating the partnership audit adjustments. If a partner files an amended tax return and pays the taxes attributable to such partner’s share of the imputed underpayment amount, then such amount would be deducted from the amount the partnership owes at the entity level.[5] To take advantage of this option, partners must file amended tax returns for the reviewed year reporting their distributive shares of partnership adjustments and pay all applicable taxes within 270 days of the partnership receiving notice of a proposed partnership adjustment.
Important Note: Just issuing amended K-1s is not sufficient to reduce the partnership’s tax liability. The individual partners must actually file an amended tax return and pay the tax prior to the 270 day deadline in order for the partnership to get credit for the taxes paid and reduce its imputed underpayment tax liability.
Drafting issue: Consider whether or not the partnership agreement should require all partners to file amended returns in order to take advantage of this election.
Drafting issue: The partnership agreement should contemplate what happens if only some of the partners file amended tax returns. The partnership may want to have the ability to allocate the economic effect of the imputed underpayment tax liability only to those partners who do not file amended tax returns.
The second option is a partnership can elect to have the audit adjustments taken into account by the partners who were partners during the reviewed year. However, instead of requiring such partners to amend their tax returns to include the audit adjustments, each partner is required to include the audit adjustments in the year in which the audit concludes.[6] Under this provision, if the partner is in a different tax bracket for the year in which the audit concludes, the partner would be paying a higher tax than if such partner amended his tax return for the reviewed year and included the audit adjustments. To take advantage of this option, a partnership must make an election and furnish to the IRS and to each partner of the partnership for the reviewed year a statement of the partner’s share of any adjustment to income, gain, loss, deduction, or credit no later than 45 days after the date of the partnership’s notice of final partnership adjustment.
Partnership Representative
Under current rules, in a TEFRA audit the tax matters partner has the ability to negotiate with the IRS, extend the applicable statute of limitations, and bind the partnership into a settlement agreement, although partners also have certain participatory rights in an audit. The Act replaces the “tax matters partner” with a “partnership representative” and gives the partnership representative exclusive authority to represent the partnership in an IRS audit. The only requirement for a “partnership representative” is that the person (or entity) has a “substantial presence” in the United States, there is no requirement that such representative be a partner or even be a U.S. person.
Drafting issue: Clients should consider what, if any, contractual limits they should put on the partnership representative’s dealings regarding an IRS audit. Should the partnership agreement indicate that the representative has fiduciary duties to the other partners? Should the representative have to get consent from the partners before settling?
The IRS is expected to issue more detailed regulations regarding the new partnership audit regime.
Why partnerships should consider revising their partnership agreements as soon as possible.
Although the new audit procedures do not become mandatory until taxable years beginning on or after January 1, 2018, partnerships may elect into some of the new procedures prior to January 2018. The new procedures could benefit certain partnerships over the current procedures, so electing-in early may be beneficial (for instance, if amended K-1s would increase partner income triggering AMT for an individual partner). Additionally, partnerships that intend to qualify as a small partnership under the new rules starting in 2018 should consider revising certain provisions in the partnership agreement now relating to information partners are required to give the partnership and the transfer provisions to assure the partnership will be able to make the new election.
Partnerships should also consider adopting provisions to address tax liabilities for prior years when a partner transfers its interests to a new partner. If after the transfer the IRS assesses an imputed underpayment amount on the partnership, partnerships should consider whether former partners should be liable for their allocable portion of the taxes or whether the successor partners should be liable.
We can assist you and your clients in understanding the new rules and the economic and business implications regarding the various options. If you would like further information, please reach out to either Russell Stein at 617-897-5638 or Peter Beach at 603-627-8185.
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This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice.
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[1] Limited Liability Companies are generally taxed as partnerships under the Tax Code. Accordingly, references herein to “partnerships,” “partners” and “partnership agreements” also includes “LLCs,” “members” and “operating agreements.”
[2] 26 U.S.C. 6225(b).
[3] The Act provides the Commissioner with the ability to issue regulations relating to pass-thru entities, so it may be possible for certain partnership to still qualify as eligible partners for the purposes of the small partnership test.
[4] 26 U.S.C. §6221(b)
[5] 26 U.S.C. §6225(c)(2).
[6] 26 U.S.C. §6226(b).