Consideration of Recent Partnership Audit Rule Changes a “Must” for New and Existing Partnership and LLC Operating Agreements
February 26, 2016
By Richard J. Shapiro
As we reported in 2015, the Bipartisan Budget Act of 2015 contained a provision which significantly changes how partnerships (and limited liability companies taxed as partnerships) will be audited in the future. While the changes made by the Act are generally effective for tax years beginning after December 31, 2017 (certain partnerships can elect to have the new regime apply for partnership tax years beginning after the date of enactment), it cannot be emphasized enough that all partnerships, existing as well as those being newly formed, should carefully consider the impact of these changes and respond accordingly. The impact will vary from situation to situation, so the response will no doubt vary too. However, the point is that a dialogue amongst interested parties should take place with respect to existing partnerships and as part of the formation process for new partnerships in advance of the effective date of the rules. Waiting for 2018 is not recommended. Also, as the uncertainties of the new partnership audit rules become more concrete through notices, revenue procedures, regulations, etc., such additional guidance will impact decisions to be made.
The following are illustrative of issues that should be carefully evaluated—
- Opting Out of New Rules. Partnerships with 100 or fewer partners are able to elect out of the new regime for any tax year provided that each partner is an individual, a C corporation, certain foreign entities, an S corporation or an estate of a deceased partner. If the partnership is eligible to elect out, the entity’s governing document might address whether such election out is to be mandatory, permissible or forbidden, and who is responsible for making decisions with respect to this issue. If this election out is utilized, consideration should be given to whether admission of new partners should be restricted to only those that do not adversely impact the use of the election out and to whether transfers that would terminate its availability should be forbidden.
- Imputed Underpayment. Under the new audit regime, the IRS will examine a partnership’s items of income, gain, loss, deduction, credit and partners’ distributive shares for a particular year of the partnership (the “reviewed year”), with adjustments taken into account by the partnership in the year the audit or any judicial review is completed (the “adjustment year”) rather than the reviewed year. Any tax deficiency arising from the partnership level adjustment (the “imputed underpayment”) is calculated using the maximum statutory individual and corporate income tax rates. However, the imputed underpayment may be reduced (a) to the extent partners voluntarily file amended returns for the reviewed year, the returns take into account all adjustments properly allocable to such partners and any tax due by such partners for the reviewed year is paid with the returns, or (b) if the partnership demonstrates that a portion of the imputed underpayment is allocable to partners that are tax-exempt or are taxed at lower than the maximum corporate or individual tax rate used in computing the imputed underpayment. The partnership agreement should address how any such partnership level tax should be shared, and, it should provide a mechanism for the partnership to obtain information necessary to make and substantiate modifications to the imputed understatement amount.
- Departed Partners. As just noted, under the imputed underpayment regime, any adjustments will be taken into account by the partnership in the adjustment year and not the reviewed year. The partnership agreement should address how the partnership will deal with partners who are no longer partners in the adjustment year as well as with partners whose interests have been reduced -- for example, through some form of indemnification for their appropriate shares of the tax adjustment.
- Adjusted Form K-1s. In lieu of taking adjustments at the partnership level, the partnership can elect to issue adjusted Form K-1s to the reviewed year partners (and the IRS). Those partners would then take their share of any adjustments into account on their individual returns in the adjustment year, together with interest and penalties running from the reviewed year. The partnership agreement should address whether and/or how it would be determined whether this election is to be made. As of the present, it is not clear what happens if/when a partner does not pay with respect to an adjusted K-1. For example, might the partner liability, for example, default to the partnership if the partner fails to pay the tax. Accordingly, partnerships should consider having partners indemnify the partnership, the general partner(s) and others for all taxes, interest and penalties that might be imposed if the partner fails to file a tax return with the partner’s share of the adjustments and fails to pay the taxes associated with the adjustment.
- Partnership Representative. Each partnership is required to designate a person, even a non-partner, as the “partnership representative,” who will have sole authority to act on behalf of the partnership. The partnership and partners are bound by the decisions made at the partnership level. And, apart from the partnership representative, the IRS is not required to provide notice to partners at the beginning of an administrative proceeding or in connection with an adjustment. Partners may wish to consider defining the powers and responsibilities of the partnership representative in the partnership agreement – for example, when and under what circumstances the partnership representative can extend the statute of limitations or take certain specified actions on behalf of the partners and the partnership, and whether the partnership representative can act under his own discretion or must obtain the authority to make decisions, say, from some percentage of the partnership interests. Further, the partnership agreement might mandate that the partnership representative provide notice to partners with respect to all audits and other proceedings.