If you are a partner in a partnership or a member of a limited liability company (LLC) taxed as a partnership, or you are entering into a new partnership or LLC, you may have some important decisions to make in 2017 in light of impending changes to the rules governing federal tax audits.
The new rules call for auditing partnerships and their partners at the partnership level. With limited exceptions, any additions to tax and related penalties as a result of the audit will now be determined, assessed, and collected at the partnership level and will be taxed at the highest corporate or individual rate at that time. This means that all current partners could bear economic responsibility for improper tax reporting in prior years, even if they were not a partner at the time.
For example, let’s say in 2020 (the adjustment year) the IRS issues a notice of final partnership adjustment that increases the partnership’s taxable income for 2018 (the review year) by $1 million. Under the new act, the partnership (not its partners) is subject to $396,000 in income tax (the imputed underpayment using the 39.6 percent rate), plus interest and possible penalties.
To avoid these unintended tax consequences, partnerships and LLCs will have several new options and elections that will need to be addressed in their partnership agreement for these new rules. Here are five things to consider:
- Partnerships have the option to push out any audit adjustment to the partners on record for the audit period. This is an election that is made by the partnership within a certain timeframe of receiving the proposed adjustment from the IRS. The partnership or LLC operating agreement should address whether the “push out” election is mandatory or optional. If it’s optional, consider the fairness between the current vs. prior partners, accuracy of the adjustment, and additional partner-level expense.
- A partnership must designate a partner (or another person with substantial presence in the U.S.) as the partnership representative. The partnership representative has sole authority to act on behalf of the partnership and may bind the partnership and all partners in IRS audits as well as in any court proceedings. It is important to update the partnership agreement with the process used to identify the representative and the governance around this person’s decision-making ability.
- For mergers and acquisitions involving partnerships, the purchase agreement should address who will bear the economic cost of partnership-level tax liabilities for pre-closing years assessed post-closing, who controls the audit examination of pre-closing years, and elections the partnership is allowed to make.
- New purchasers of a partnership interest or new partners could be directly or indirectly liable for tax paid by the partnership for previous years. These new partners should perform additional due diligence to understand the potential tax liabilities from prior years.
- Certain partnerships have the option to elect out of these new rules. This election must be made on a timely-filed partnership return beginning after December 31, 2017. If the election is made, then any audit adjustment that is made at the partnership level will be passed through to the individual partners and taxed at their respective tax rate. However, those with partnerships or trusts as partners may not opt out of these rules. Partnerships that currently qualify to make this election should be careful of future ownership changes that could negate their ability to elect out.
The new partnership audit rules shift the economic burden for past years’ tax liability to the adjustment year, leaving partners potentially responsible for tax attributable to years in which they did not have an ownership interest. Partnerships will need to take these provisions into account and make appropriate revisions to their partnership agreements. Partnerships, including LLCs and other business entities treated as partnerships for federal tax purposes, should carefully consider today how they will navigate these new rules in the future.
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