When the Bipartisan Budget Act of 2015 became law in November 2015, the effective date seemed far in the future. Now, the Jan. 1, 2018, effective date is fast approaching and, if we have learned anything in the past 14 months, it’s that these rules raise more issues than anyone (including the IRS) thought they would. That is why partners (which for purposes of this alert include members in a limited liability company) need to start discussing the implementation of the new rules now and amend their partnership/operating agreements appropriately before the effective date.
Under the new audit rules, the IRS will examine the partnership’s tax return, and if an assessment results, the partnership itself will (with a number of exceptions described in this alert) be responsible for any adjustments the year the audit is completed, or the year that any judicial proceeding relating to the audit becomes final. This is a significant change because partnerships have never before been required to pay tax at the partnership level. It is also significant because a partner who benefitted from an aggressive deduction (for instance) taken the year under audit but who leaves the partnership before the audit takes place will not have to pay their share of the assessment. Instead, the remaining partners or even worse, a new partner will be responsible for the tax liability since it will be paid out of partnership assets when the audit concludes.
The second major change included in the new audit rules is the implementation of rules requiring a partnership representative. Under the current rules, partners usually give little thought as to who will serve as the tax matters partner (TMP). The TMP is only relevant in certain types of partnership audit proceedings, and individual partners generally have the right to participate in these proceedings. Since the authority of the TMP is therefore limited, attorneys rarely have lengthy discussions about the ramifications of naming a TMP. Under the new audit rules, Code Section 6223 provides that the role of the TMP is replaced by a “partnership representative” who has complete authority to act on behalf of the partnership (and therefore effectively the partners) when dealing with the IRS. This authority includes the ability to bind the partnership and the partners with respect to audits and other proceedings, including settlement authority and decisions on procedural issues such as extending the statute of limitations and whether to proceed to litigation. The proposed Regulations make it clear that the partnership representative also has the authority to make the Section 6226 “push-out” election on behalf of the partnership. Significantly, there is no legal obligation under the IRS rules for the partnership representative to keep partners updated on the status of the audit or even to notify the partners of the audit. Finally, unlike a TMP, the partnership representative does not even need to be a partner of the partnership. If a partnership does not designate a partnership representative the IRS “may select any person as the partnership representative.” These changes in the role of the former TMP are significant and raise issues that every partnership agreement and operating agreement should address.
In light of the drastic changes to the partnership audit rules as described above, there are a number of changes that partnerships and LLCs should consider making to their partnership or operating agreements – and it’s important to begin considering these issues now.
One of the first issues to be considered by any partnership is whether the partnership should make one of the available elections under new audit rules, either by choosing to opt out of the new rules entirely (for eligible partnerships) or by choosing one of the alternative methods of reporting the assessment at the partner level. While the initial reaction might be that opting out is always desirable, the new audit rules may actually provide an administrative benefit for some partnerships. Although it is more difficult for the IRS to audit the returns of the individual partners rather than the partnership itself, an audit of the individual partners also means each partner will have to spend a significant amount of time complying with information requests and other audit-related matters. With the Section 6226 “push-out” election, assuming the partners have not changed during the years at issue, it may be easier for the partners, as well as the IRS, to simply have the IRS audit and assess the partnership instead of having the partnership satisfy the reporting obligation of that election by issuing information returns to each partner, then requiring each partner to make an amended filing. Allowing the IRS to audit the partnership would also avoid the additional two percent interest charge on underpayments required with the Section 6226 election.
Because of the requirements of the various opt-out alternatives, it is unlikely that the IRS will focus on auditing partnerships that do not opt out. For instance, with the Section 6226 push-out election, each of the partners receives an information return showing the amount of income allocated from the audit. Likewise, partnerships opting out completely under Section 6221 must supply the IRS with the taxpayer ID numbers of all of the partners, making it easier for the IRS to collect an assessment.
Despite the potential administrative benefits of not opting out, many partnerships will likely choose to do so either in part or in whole. This is especially true if it is likely that ownership of a partnership will change over time, since the new audit rules in effect impose the tax liability resulting from an audit on those who are partners at the time of the audit - not those who were partners in the year under audit.Also, partnerships with partners that are not in the highest tax bracket will generally find it beneficial to either opt out under Section 6221 or have the partnership pay the tax at their actual tax rate under one of the other elections.
The decision to completely opt out must be made annually on the partnership’s tax return. On the other hand, the Section 6226 election to “push out” the tax liability to the partners must be made 45 days after the IRS assessment. At a minimum, a partnership agreement should specify who has the authority to make these decisions and when. If the decision is made to make the annual Section 6221 opt-out election, the partnership agreement should provide for this, with the ability to revisit the decision if a specified percentage of the partners decide to do so. The same procedure could be implemented for the Section 6226 push-out election, with the partnership agreement providing that this election will be made after an IRS audit assessment – unless a specified percentage (presumably more than a majority) of partners decides to not make the election for a particular audit. It is critical that these provisions be added now – once the audit has happened, the partners may have differing interests depending on their ownership status during the year under audit.
Leaving this decision up to the partnership representative would usually not be desirable since he or she may have an interest in the audit procedure used. For instance, if the partnership representative had been a partner in the year under audit, but new partners have been admitted, not opting out under 6221 or not making a Section 6226 election would shift some of the burden of any assessment to the new partners since the tax would be paid out of current partnership assets and not out of the partnership representative’s pocket. The partnership agreement should therefore set forth the procedures for how the partners make this decision and should not leave the decision in the hands of the partnership representative. The agreement should also be clear that if the decision to opt out can be made without the consent of all the partners, that written notice of the decision be given to all of the partners.
A final issue with the Section 6221 opt-out election is that, as discussed above, only partnerships with less than 100 partners all of which are with individuals, corporations, or estates of deceased partners, are eligible. If a qualifying partnership decides to opt out using this election or wants it to be an option in the future, the partnership agreement should contain transfer restrictions to keep a partner from transferring an interest to a non-qualifying partner (such as a trust or another partnership or LLC) that would prevent the partnership from making this election.
Because of the significant authority granted to the partnership representative, every partnership and operating agreement should address the partnership representative’s status, authority and the limitations imposed on the exercise of this authority. It is important to remember that “opting out” of the new audit rules or making any of the elections described above impacts how the partnership is audited and how any additional tax is assessed; it does not mean the partnership is opting out of the rules applicable to the partnership representative.
One of the more alarming provisions of the new rules relates to audit adjustments to distributive shares. This happens when the result of the audit is not that the partnership has more overall income, but that the IRS determines that one partner should have been allocated more income (or fewer deductions) than was actually allocated to that particular partner. Under the current rules, this type of audit adjustment would essentially represent a “wash” between the partners as a whole, since an increase in income allocated to one partner implicitly results in a decrease in the income allocated to the other partners.
For example: If John and Dave are partners in AB partnership and the IRS determines that $100,000 of depreciation deductions allocated to John should have been allocated to Dave, John’s income increases by $100,000 – but Dave will have a corresponding decrease in taxable income due to the increased depreciation deduction.
Under the new audit rules, however, this “wash” does not work. The rules specify that if there is an adjustment to the distributive shares amongst the partners, any increase in deductions (or decrease in income) allocable to other partners is ignored. In the example above, the partnership would have a decrease in the $100,000 of deductions and the partnership would owe taxes based on this reduction. One way to fix this problem would be for the partnership to make the “push-out” election. Another fix would be for partners to each file their own amended returns under Section 6225. The key to this working, however, is that all partners must agree to file amended returns. In the example above, John will obviously be reluctant to do this since the amendment will result in higher taxes for him. The partnership/operating agreement therefore should compel all of the partners to file amended returns pursuant to Section 6225 in this situation.
Another area calling for potential agreement revisions relates to the fact that the adjustment made and tax assessed against the partnership will take place the year the adjustment is made. This means that the tax burden relating to an audit could be imposed on partners who were not the partners that received the benefit of the erroneous income calculation the year that was audited.
Once an assessment is made against the partnership, the calculation of the tax due is one of the more complicated parts of the new audit rules. A partnership will have the ability to reduce the tax due by showing that certain partners (tax-exempt organizations, for example) are subject to a lower rate than that used by the IRS in calculating the partnership’s liability. If the partnership does have the assessment reduced because a partner is subject to a lower tax rate, there are many unanswered questions on how the revised assessment affects the burden on the partners for the remainder of the tax liability.
For instance, assume an LLC has two equal members, one is tax-exempt and the other is taxed at the highest tax rate. While the LLC can have the tax on the assessment reduced by demonstrating that one member is not subject to tax, how do the LLC and the individual members take this difference into account? In the absence of the issue being addressed in the operating agreement, the tax-exempt member will essentially still pay for 50 percent of the remaining tax liability since the remaining liability would be paid by the LLC. Partnerships with partners in very different tax brackets should seriously consider either opting out of the new audit rules and have each individual partner pay his or her share of the assessment at whatever tax rate he or she is subject to, or provided for a “true-up” mechanism in the partnership/operating agreement to address this result.
These impending changes are not simply a retooling of the way the IRS handles partnership audits – they are a revenue raiser. The new audit rules were designed to raise almost $10 billion in tax revenues over the next 10 years - a clear sign that more partnership and LLC audits are on the way. The greater likelihood of audits makes it even more important that operating agreements and partnership agreements have language addressing the relevant issues, and that each partner understands the impact of this new audit structure. As changes will likely need to be made, partnership and LLC owners should review their agreements now and begin discussing these crucial issues.