Be prepared to update LLC operating agreements and partnership agreements to comply with new partnership audit rules
For returns for tax years beginning on or after Jan. 1, 2018, new comprehensive rules will go into effect in connection with partnership audits and proceedings. The new rules are designed to make it easier for the Internal Revenue Service to audit partnerships and collect taxes from partnership operations, particularly in the case of large partnerships and tiered partnerships.
These new rules will necessitate consideration by all partnerships and LLCs taxed as partnerships of amending their partnership agreement or operating agreement. A brief summary of the new rules is as follows:
1. Audit adjustments, court proceedings, assessments, and collection of tax deficiencies arising from partnership items will take place at the partnership level. Accordingly, tax deficiencies arising from partnership items will be assessed against and collected from the partnership and not the partners. This will be so even if the persons who were partners for the year under audit are different from those persons who are partners at the time of the audit or proceeding.
Partnerships will be permitted to elect out of these provisions on a year-by-year basis if certain conditions are met. The conditions are generally:
- there must be 100 or fewer partners; and
- each partner must be an individual or a corporation.
It is unclear whether single member LLCs or grantor trusts will be permitted for this purpose. For years for which an election out is in effect, audits and proceedings will take place separately for each partner at the partner level, as was the case prior to the adoption of the TEFRA audit rules in 1982.
2. Instead of a tax matters partner, as in the case of the current TEFRA rules, each partnership will need to appoint a partnership representative. Under the new rules, as between the IRS and the partnership and its partners, the partnership representative will have broad authority to act on behalf of the partnership and partners will be largely without statutory rights to notice, participation, or consent.
3. As an alternative to electing out, as noted above, a partnership might be able to escape liability for these taxes in several possible ways, including:
- the partners amending their individual returns for the year under audit and paying the taxes;
- the partnership electing to push the tax liability out to the partners at the cost of an additional 2 percent interest charge; or
- the partners agreeing to indemnify the partnership for an agreed-upon share of any tax liability.
With the effective date of these changes impending, it is important that all existing partnership agreements and operating agreements of LLCs taxed as partnerships be revised to address these new rules as soon as possible.