New partnership audit rules can apply to partnerships, LLCs with only a few partners, members

by Thompson Coburn LLP

Effective in 2018, changes in partnership audit rules may apply the following (and other) consequences to partnerships (including LLCs taxed as such):

  • If errors were made in the tax return, the entity could not just file an amended return and give amended K-1s to its owners. Instead, it would need to file an administrative adjustment request with the IRS, exposing the change to more scrutiny.
  • The highest income rate regarding that type of income would apply.
  • Because the entity pays the tax, the current partners essentially bear the burden of changes to tax items reported by whoever were the partners during the year being audited.
  • The entity may need to include as a balance sheet liability any taxes relating to adjustments for prior years.
  • Partner-level defenses would not apply.

A “push out” election can move the taxation to the people who were partners in the year being audited, but it does not solve all of the problems caused by the new regime.

Many entities would be better off simply opting out of the new partnership audit rules altogether. Because entities with no more than 100 owners may be able to opt out of the new rules, the new rules often are viewed as applying only to large partnerships. However, all of the owners must be eligible for the entity to be able to opt out.

To be eligible, an owner must be an individual, a C corporation, any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner.

However, the law allows the IRS to add to this group of eligible partners. A report issued by the staff of the congressional Tax-writing committees suggested authorizing single member LLCs and revocable trusts that are taxed as disregarded entities to be eligible if their owners are eligible. The report also authorized making eligible a former grantor trust that continues in existence for the two-year period following the death of the deemed owner, a trust receiving property from a decedent’s estate for a two-year period, and tiered partnerships. The report suggested rules that would apply if the IRS added to the group of eligible partners in this manner.

However, proposed regulations this past June declined to expand the list of eligible owners. Under the proposed regulations, a revocable trust, which is a commonly used probate avoidance tool, would not be an eligible owner, which would subject to these new rules any entity that has a revocable trust or other trust as one of the owners.I led a task force of the American College of Trust & Estate Counsel (ACTEC) that suggested that revocable trusts and other trusts be included in the list of eligible owners. The American Institute of Certified Public Accountants has asked Congress to postpone these new rules for a year to give everyone more time to think about the law and respond to it.

If the rules do not change and you know of a revocable trust that owns an interest in an entity that is taxed as a partnership, consider whether you should take additional steps if the entity would like to opt out of the new rules. It may be premature to take partnership or LLC member interests out of a revocable trust. However, if you are forming a new entity, consider whether applicable law will allow an individual’s interest to pass free from probate to that person’s revocable trust. Some states have laws that allow one to designate a beneficiary upon death -- for example, the Missouri Nonprobate Transfers Law.

Other states may allow such a beneficiary designation to be provided by agreement among the owners; however, one must carefully check to make sure that such an agreement does not violate the applicable state’s probate laws.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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