The January 1, 2018 effective date of the new federal partnership audit rules is almost here, and we encourage all entities taxed as partnerships to consider addressing the issues posed by these new rules as soon as possible. These rules are applicable not only to partnerships, but also to multi-member LLCs classified as partnerships and their members where appropriate. Below are answers to some frequently asked questions about the new rules.
1. Why should I be concerned about the new rules?
The Bipartisan Budget Act of 2015 created a comprehensive and radically new partnership audit regime. The current rules are repealed effective for tax years beginning after December 31, 2017. Going forward, there will be no such thing as a “tax matters partner” or the fundamental principle that partnerships are not taxpayers for income tax purposes. The partnership audit will be performed by the IRS (and perhaps by the states) at the partnership level, and by default, the partnership will be directly liable for any income tax deficiency, interest, and penalties.
Obviously, traditional partnerships and multi-member LLCs are covered by the new rules, but here’s the first surprise: so are joint ventures and other business arrangements that the IRS will try hard to classify as partnerships. Indeed, Treasury officials have stated publicly that they want these new rules to apply to as many arrangements as possible.
2. What do you mean my partnership (or joint venture) is covered by the new rules? We only have 3 partners!
Many of you may be surprised to learn that your partnership or joint venture is covered by the new rules. That could result from having one or more ineligible partners, or failing to make the annual opt-out election on a timely-filed Form 1065.
The new rules provide relief from the risk of entity-level tax assessments only for partnerships that (a) have 100 or fewer eligible partners, (b) are owned by some combination of individuals, estates of deceased partners, C corporations, and S corporations, and (c) timely file their Form 1065 and check the correct box to opt-out each year. (There are special headcount rules for partners that are S corporations.) So far, if even one member of the partnership is an LLC or a trust – even a disregarded single-member LLC or a grantor trust – the opt-out election is not available. And, any tiered partnership structure won’t be permitted to opt-out.
3. Who controls the audit? Will partners have a say-so?
Under the new rules, each partnership must designate a “partnership representative” (“PR”) for each tax year, and that individual or entity will make the opt-out election if it’s available and, if not, control the audit and any settlement or appeal. By statute, the PR is the only person empowered to work with the IRS.
However, the partnership agreement may require the PR to provide notice of and updates on audit proceedings, to obtain partner votes on various issues, and otherwise restrict the actions of the PR. Obviously, it’s extremely important to appoint a qualified PR (and a designated individual if the PR is an entity). Failing to do so will allow the IRS to appoint one.
4. So what do we do now?
Examine your ownership structure. If, for example, one of your partners is ineligible (e.g., an LLC or family trust), consider transferring its membership interest to an eligible partner or buy it back. This must be done by December 31, 2017 since eligibility will be determined as of each January 1 thereafter.
Each partnership agreement needs to be amended to address your particular situation, but here is one common theme: every partnership/LLC (big or small) should have a PR, who must be officially appointed and in place before the 2018 tax return is due. So consider now who would be the best PR.
There are a number of issues that need to be addressed in any new or amended partnership agreement, and this column only scratches the surface. Our July 2017 Federal Tax Alert provides a list of items that should be considered for inclusion in any new or amended agreement. These amendments should be made before December 31 to be safe. Any new partnership or LLC agreement should also address these issues.