New Audit Rules Require Planning For Entities Taxed As Partnerships

The Bipartisan Budget Act (BBA) of 2015 changed the rules governing federal tax audits of entities taxed as partnerships for federal income tax purposes, including LLCs (collectively “partnerships”). This article will summarize the mechanics and application of the new rules and describe the benefits of electing out.

Partnerships are flow-through entities such that income and loss flow through to individual partners or members (collectively “partners”) who report such items on their individual tax returns. Prior to 1982, if the IRS wanted to audit a partnership, the IRS had to audit the partnership and individual partners.

To streamline the audit process, Congress enacted the Tax Equity and Fiscal Responsibility Act (TEFRA) in 1982. Under TEFRA, the IRS conducts audits and determines the treatment of partnership tax items at the partnership level, but must generally collect deficiencies from the partners. The collection of individual tax deficiencies has resulted in fewer audits because of administrative complexities.

BBA was signed into law to reduce the administrative burdens associated with partnership audits, increase the number of audits and raise revenue. The BBA rules represent a dramatic departure from the TEFRA rules. Although the new rules will not go into effect until January 2018 (unless affirmative election is made), attorneys need to start advising clients now about the impact of these rules and amending entity documents, where appropriate.

Under the new audit rules, adjustments and collections must be taken into account at the partnership level creating a host of new issues for entities taxed as partnerships.

Under the default deficiency collection method, the partnership must pay any deficiency in the “adjustment year,” rather than in the reviewed year. Generally, the deficiency amount will be taxed at the maximum federal income tax rate, and the partnership will be liable for any associated interest and penalties. Since the deficiency is determined at the partnership, rather than the partner, level each partner’s specific income tax bracket will be disregarded, unless the partnership files a request to lower the deficiency by showing that a lower tax rate applies to specific partners, within 270 days of notice of final partnership adjustment issued by the IRS.

To avoid the default collection method, partnerships may also choose to “push out” tax liability to the reviewed-year partners. To do this, the partnership must make the proper election within 45 days after the notice of final partnership adjustment. The partnership must issue amended K-1 returns for the adjustment year to reviewed-year partners. The partnership can also avoid the default collection method if every reviewed-year partner files an amended federal income tax return for the reviewed year, within 270 days of final partnership adjustment, including his or her share of the adjustment, and pays any additional tax due.

The BBA also creates a “Partnership Representative” that replaces the “Tax Matters Partner” under TEFRA. The Partnership Representative will have far more authority than the Tax Matters Partner, including the sole authority to represent the partnership before the IRS. The Partnership Representative can be any person with a substantial presence in the United States and does not have to be a partner.

Fortunately, small partnerships with 100 or fewer partners can affirmatively elect out of the new audit rules, if the entity only has partners that are individuals, C corporations, foreign entities that would be treated as C corporations if domestic, S corporations or estates of deceased partners. If a partnership elects out, IRS audit adjustments will be made at the partner level and will only be binding on that specific partner. To elect out, a partnership must make an election each year by timely filing a Form 1065.

Forming a New Partnership

If a client is forming a new partnership, attorneys need to make sure that the formation documents strategically address the new audit rules. Assuming the client wants to elect out, the governing documents should contain provisions stating the entity’s desire to elect out, specifying the deadline and method for such election, indicating who has the authority to elect out and restrictions to avoid transfers that would compromise the partnership’s eligibility to elect out. Attorneys should carefully counsel clients regarding the advantages and procedure for electing out, emphasizing the need to affirmatively elect out annually.

The partnership agreement should name a Partnership Representative who has the requisite substantive knowledge to represent the partnership before the IRS and should include standards for selecting, terminating or replacing the Partnership Representative. The agreement also should contain provisions creating a duty on the part of the representative to inform the partners of audit notice receipt and status of the audit process and to obtain consent from the partners before settling a matter.

Purchasing an Interest in a Partnership

Under the new audit rules, a new partner can be affected by a deficiency that occurred prior to becoming a partner. This situation naturally arises from the fact that, under the default collection method, a partnership must pay deficiencies for a reviewed year in the adjustment year. If a client is purchasing an interest in a partnership, the client should make sure the partnership has properly elected out for the last several years, and if not, seek indemnification from the selling partner and the partnership.

Perhaps the best advice is for attorneys to advise eligible entities to elect out of the new rules. The benefits of electing out include, but are not limited to, the allocation of deficiencies to the appropriate partner to be taxed at that partner’s tax rate, preventing future partners from being impacted by deficiencies occurring prior to joining the partnership and preserving the marketability of the partnership interest for prospective partners.

Although the new audit rules do not go into effect until Jan. 1, 2018, attorneys should start advising clients now regarding the benefits of electing out and amending entity documents where appropriate. Attorneys should also be on the lookout for additional IRS guidance regarding the new rules.