By: Clifton B. Clark
Overview.
Effective for tax years beginning on January 1, 2018, the IRS has a new set of rules to govern partnership audit procedures. Since the vast majority of limited liability companies (LLCs) are taxed as partnerships, these new rules may require amendments to LLC operating agreements as well as partnership agreements to ensure that the economic burden of future tax assessments are allocated among the correct owners.
Background.
Prior to 1982, the IRS did not audit partnerships directly. Instead, partnership items were audited at the partner level. This process led to a great deal of inconsistency among the tax treatment of partnership items. In an effort to bring some consistency to this area of the law, Congress enacted the Tax Equity and Fiscal Responsibility Act (“TEFRA”) in 1982. TEFRA generally required that the tax treatment of partnership items be determined at the partnership level and that partners consistently report these items on their own income tax returns.
Although TEFRA helped increase consistency in the treatment of partnership items, it did not allow the IRS to collect tax deficiencies directly from the partnership itself. Instead, partners were generally required to file amended returns for the years audited and the IRS was required to pursue collection efforts at the partner level. As a result, the process of auditing partnership returns, and collecting the resulting tax deficiencies, remained complex and burdensome and, consequently, there were very few partnership audits conducted.
All of this is now changing. Under new rules the IRS will conduct partnership audits at the entity level and collect the associated tax deficiencies directly from the partnership or LLC itself. Since the new audit rules will eliminate much of the complexity previously associated with the partnership audit and collection procedure, taxpayers can expect to see a significant increase in audit activity for these entities.
The New Audit Rules.
Effective for tax years beginning on January 1, 2018, a partnership or LLC taxed as a partnership will be required to pay any “imputed underpayment” (calculated using the highest applicable tax rate) directly to the IRS unless special elections are available to, and made at, the entity level. While this process may work well for partnerships and LLCs that have had no change in their owners, or the respective percentage of ownership, between the year under audit (the “reviewed year”) and the year in which the deficiency is assessed (the “adjustment year”), it can result in a shifting of the economic burden of a tax deficiency from one owner to others in situations where there have been changes in ownership during the interim period.
For example: Assume that A, B and C are all equal members in an LLC taxed as a partnership during taxable years 2018 and 2019 and that C withdraws from the LLC effective December 31, 2019. If the IRS subsequently audits the LLC for the taxable year 2018 (the reviewed year) and issues a final audit adjustment during 2020 (the adjustment year) in the amount of $30,000, A and B (as the continuing members) will effectively pay the entire $30,000 deficiency even though one-third (1/3) of this amount is attributable to income that would have been taxed to C if the original 2018 return had been filed in a manner consistent with the IRS determination on audit.
This is only one example of many issues that arise under the new audit rules. Other issues arise in the context of audits that result in the issuance of refunds or the reallocation of partnership items among owners of the entity.
Special Elections.
Although certain small partnerships (i.e. those issuing K-1’s to no more than 100 partners) may be able to opt-out of the new audit rules under IRC §6221(b), this special election must be made annually on the partnership tax return and is available only to partnerships with certain types of partners (i.e. individuals, C-Corporations, foreign entities that would be taxed as C-Corporations, S-Corporations, and estates). Partnerships and LLCs that have trusts or other partnerships (including other LLCs taxed as partnerships) as owners, are ineligible to make this election. This limitation will prevent many tiered partnerships (which often have other partnerships or LLCs as members) from making this election. While it may be advantageous for an eligible entity to make this election, the owners will need to specify in their partnership agreement or operating agreement whether such an election is required or who within the organization has the authority to make the election.
Even if an entity is ineligible to make the election under IRS §6221(b), it may still have an opportunity to shift the tax liability for any imputed underpayment from the entity itself to its owners if it makes an election under IRC §6226(a) within forty-five (45) days from the date the IRS issues a final audit adjustment notice. If this election is made, liability for payment of the additional tax is shifted to (or pushed-out to) the partners or members for the reviewed year. In such situations, the entity is required to provide the owners with a statement detailing their share of any adjustments. However, rather than requiring these owners amend their prior year tax returns (as was the case under prior law), the new rules require that the owners pay their share of the additional tax liability by making an adjustment on their current year returns. In the absence of either election, the partnership or LLC itself will be required to pay the imputed underpayment and any owners bearing more than their proportionate share of this tax liability will have no recourse against the other owners unless the partnership agreement or operating agreement itself requires that they be reimbursed for such amounts by the other owners.
The Bottom Line.
What all this means is that effective for tax years beginning January 1, 2018, the IRS will conduct audits of partnerships and LLC’s, and collect the associated tax deficiencies, directly from the partnership or LLC itself unless special elections are available and made at the entity level. As a result, these entities will need to review their governing documents to address a number of issues that may arise under the new rules. Among the items to be considered in this process are the following:
Designation of Partnership Representative. Under the new rules partnerships and LLCs are required to designate a “partnership representative” who will have sole authority to act on behalf of the entity in connection with an audit. While the designation of a partnership representative is conceptually similar to the designation of a “tax matters partner” under current (TEFRA) rules, there is no longer any requirement that the partnership representative be a partner or member of the entity so long as such person has a substantial presence in the United States. If the entity fails to designate a partnership representative the IRS may select any person to serve in this capacity. Since the partnership representative will have authority to act on behalf of the entity in ways that significantly impact the tax liability of its owners, those owners will need to carefully consider the mechanism by which this person is selected and the circumstances under which he or she can be removed and replaced.
Special Elections. If a partnership or LLC is eligible to make an election to opt-out of the new audit rules under IRC §6221(b), it may be advantageous to do so since the effect of such an election (in the absence of TEFRA which is replaced by the new rules) is that the IRS will conduct audits, and collect the associated tax deficiency, at the partner or member (rather than entity) level. While opting out of the new rules could lead to inconsistency in the way partnership items are treated on audit, it gives authority and control to handle such matters back to the individual partners or members who are more directly affected by the results.
Even if a partnership or LLC is ineligible to make the election to opt-out of the new rules under IRC §6221(b), the partners and members will want to address the circumstances under which the entity will be expected to make an election under IRC §6226(a) to effectively push out the tax liability to its owners and the rights and obligations of the parties if such an election is not made in a timely manner. This election will be particularly important in situations where ownership of the entity has changed in the interim period between the reviewed year(s) and the adjustment year.
Contractual Indemnification. In situations where the partnership or LLC is ineligible to make, or does not make, either of the elections discussed above, the owners of these entities will need to address the question of whether owners paying more than their proportionate share of any tax liability for a reviewed year will be entitled to reimbursement from the other owners. If such reimbursement is desired, these contractual obligations will need to be spelled out in the partnership agreement or LLC operating agreement which should also provide adequate remedies in the event these obligations are not fulfilled.
While there are many other issues raised by the new audit rules and several unanswered questions, one thing that is clear is that partnerships and LLCs can expect to see an increase in audit activity in this area and may need to amend their partnership agreements or LLC operating agreements to be prepared for the implementation of these new rules.
This article was written by Clifton B. Clark. For questions regarding this, or other tax related issues, please contact a member of Jackson Kelly’s Tax Practice Group.