Businesses across the nation are buzzing about Congressional action on tax reform - action that may not even occur. And yet, many partnerships and limited liability companies (LLCs) have not yet delved into significant IRS audit rule changes that are certain to go into effect next year. The changes, which will impact the 2018 tax year for partnerships and LLCs, will present owners with new decisions about how to handle IRS audits and any adjustments that may be required.
The updated IRS audit rules include new terminology, and will require such steps as new elections and changes to partnership agreements to account for a new audit landscape. The legislation driving the rule changes was passed two years ago. The new rules, embodied in proposed regulations re-issued last week, require changes in partnership agreements and LLC operating agreements. Starting with partnership returns for the 2018 tax year, partnerships will experience changes in how IRS audit adjustments are made to its partners' returns.
Current Law (prior to 2018):
The audit procedures currently in effect allow a partnership to designate a "Tax Matters Partner" to represent the partnership in the course of an IRS audit. The audit is conducted at the partnership level. Any changes stemming from a partnership audit then flow through to the partners' separate returns, with any resulting tax, interest and penalties being paid by the partners themselves.
Coming Soon (in 2018 and after):
The changes coming next year will replace the Tax Matters Partner with a "partnership representative," who, unlike the Tax Matters Partner, does not have to be partner or member of the partnership/LLC. In connection with an audit, the Partnership Representative will have sole authority to act on behalf of, and bind the partnership.
More importantly, under the new rules once the IRS audit is completed, the partnership will have several options for satisfying any assessment. The default rule will be that the partnership itself will pay the assessment (at the highest rate of tax.) This is a significant change, because partnerships are not otherwise tax-paying entities, but rather flow-through entities.
While it may seem beneficial to have the entity write the check instead of multiple partners, there are several potential pitfalls. For example, the partnership will be paying the assessment based on the highest rate of tax, which may exceed the tax rate to which the partners themselves are subject. In addition, a partnership that is issued an assessment in, say, 2020 for the 2018 tax year may no longer have precisely the same partners as it had in 2018, or perhaps the partners' interests may have shifted. A partnership can reduce the assessment it must satisfy, however, if any of its partners file their own amended returns, taking into account their share of the IRS adjustments.
The new rules are notable for two other significant changes:
Push-out Election: Instead of having the partnership satisfy any assessment, the partnership under the new rules can elect, within 45 days after final IRS adjustments, to "push out" the adjustment to all of its partners from the year under audit, so that the partnership is no longer liable for the assessment. However, under the push-out election, any tax assessment will be subject to an interest rate that is 2% higher than it would be if the partnership were to pay the tax.
Small Partnerships Can Opt Out: The new law allows certain partnerships of no more than 100 partners to opt out of the new default rule, as long the partnership has only individual partners (or their estates) and corporate partners. Opting out is not permitted if any partners are themselves partnerships, trusts or disregarded entities. If the partnership does elect to opt out, the IRS will have to audit each partner separately.
What Partnerships and LLCs need to do: Every partnership and LLC should consider revising their agreements to adapt to these new rules. For example, they must determine who will have decision-making authority over the elections that can be made, such as opting out of the new audit regime, or electing to push out adjustments to the partners. In addition, current partnership agreements do not provide for reserves for taxes, indemnifications, or holdbacks or clawbacks if there are any assessments. Failure to address these important issues may lead to disputes among partners, and could also impact buyers and sellers of partnership interests.