Increased Limited Liability Company Tax Audits Are Coming
January 7, 2016
By: Robert G. Tweel
The increase in usage of limited liability companies (“LLCs”) as the business form of choice has led to changes in the IRS statutes concerning audits of LLCs. On November 2, 2015, President Obama signed the Bipartisan Budget Act of 2015 (“BBA”) into law. The BBA brings drastic changes to the audit process of partnerships which will allow the IRS greater enforcement and collection authority in connection with partnership audits. Note, any entity which files IRS Form 1065 is viewed as a tax partnership which would include most LLCs. While the new LLC audit rules apply to the taxable years beginning after December 31, 2017, their inclusion in the BBA clearly signals a desire in Congress and the IRS for increased LLC audit activity. Accordingly, any LLC (or other entity which files IRS Form 1065) should be prepared for increased audit activity, and we strongly recommend that all clients consider reviewing these changes thoroughly to appropriately plan for the future.
The Current Legal Landscape: Where Are We Now?
Under the current law before the BBA takes effect, three separate audit regimes exist for LLCs. First, most LLCs can be audited at either the LLC level or the member level, meaning the IRS could either audit the LLC to challenge a deduction or income item reported on IRS Form 1065 or audit LLC members individual for the income and loss reportable from the LLC. Second, under the “TEFRA” rules, any LLC tax deficiency is determined at the entity level but passes through the entity to the members in the reviewed year. Notice must be provided to all members and each member may participate in the audit process. But, the “TEFRA” rules do not apply to an LLC with 10 or fewer members (unless the LLC elects otherwise) with the individual taxpayer audit rules applying instead. Lastly, LLCs with 100 or more members (termed an electing large partnership) could elect for the adjustments to take effect in the adjustment year and flow through to the members in the adjustment year.
The BBA’s Effect: Where Are We Headed?
- LLC Representative in Charge. The LLC will be bound by the actions of the appointed “partnership representative” during the IRS audit process. The LLC representative must have a substantial presence in the United States and does not need to be a member of the LLC. Members will no longer be entitled to receive notices regarding the LLC audit and are bound by the determinations made at the entity level. Members will not be able to participate in the LLC audit or any judicial proceedings.
- Entity Level Tax Created. If the IRS makes an audit adjustment, the LLC will be taxed at the entity level using the maximum statutory income tax rate. This new entity level tax is a drastic change from the established principles of an LLC being treated as a tax partnership in which the adjustments would “pass-through” the LLC to the members with no entity level tax.
- Adjustments Made in Adjustment Year. Any imputed underpayment will be assessed in the year of the adjustment, not in the prior year that was reviewed. Thus, a member who left the LLC prior to the adjustment year will not be liable for the assessment. But, a new member who joined the LLC may be liable for an assessment for a year preceding the member’s admission to the LLC.
- Alternative to Entity Level Tax. An LLC may avoid the entity level tax in the adjustment year by electing to issue adjusted information returns to the reviewed year members. The reviewed year members would amend their individual tax returns in the reviewed year to account for this adjustment.
- Complications for Tiered LLCs. A tiered LLC (an LLC with an LLC as a member) may have complications in utilizing the alternative to the entity level tax. If the LLC (Lower Tier Partnership) has an LLC as a member (Upper Tier Partnership) in the reviewed year, the Upper Tier Partnership is required to recognize the adjustment in the adjustment year. But, the Upper Tier Partnership may have different members now from the reviewed year which subjects new members of the Upper Tier Partnership to the adjustments. In a tiered LLC, the law is unclear whether or not an Upper Tier Partnership may elect to issue adjusted information returns to the reviewed year members instead of being required to subject the adjustment year members of the Upper Tier Partnership to the audit adjustment.
- Opt-Out Election for Small LLCs. An LLC with 100 or less members may elect to opt-out of the new audit regime. The election is limited to LLCs who only have members that are individuals, C corporations, foreign entities that would be treated as a C corporation if domestic, S corporations, or estates of deceased members. Thus, LLCs with an LLC or other partnership or a trust as a member cannot utilize the opt-out election.
Planning for the Future: What Should We Do About It?
While the BBA’s new LLC audit rules will not take effect until taxable years after December 31, 2017, LLCs and other tax partnerships must begin to plan now. Many uncertainties exist in the application of the LLC audit rules and Treasury Regulations may give guidance in the future. But, the delayed start of the rules provides LLCs time to consider the impact of the rules on their organization. A few practical considerations include:
- The LLC will need to determine which audit regime to elect. The LLC could pay an entity level tax in the adjustment year, require reviewed year members to amend their tax returns, or opt-out of the new audit regime altogether if the LLC qualifies.
- An LLC would need to address the additional duties and authority for a “partnership representative” in the operating agreement other than the statutory duties in order for the rights of the members (and the partnership representative) to be clearly protected and defined
- The operating agreement could address how members will share any entity level tax that is incurred as a result of a future audit.
- Upon a member entering or leaving the LLC, the LLC will want to account for potential audit adjustments and who should bear the responsibility of any additional tax liability.
2018 is still a few years away. We will continue to monitor any updates in the statutes or regulations concerning LLC audits, but it is clear that LLCs should anticipate increased audit activity from the IRS.