- mergers & acquisitions
- tax strategy
- real estate
What is it?
The IRS enacted new partnership audit rules (“New Partnership Audit Rules”) in 2015 that take effect for all partnership tax returns filed for partnership tax years beginning on or after January 1, 2018. The New Partnership Audit Rules also apply to LLCs taxed as partnerships.
This new law provides for a centralized system for tax audits that applies to all partnerships that either do not qualify, or do not elect, to opt out. Under these New Partnership Audit Rules, the partnership, not the partners, is generally liable for any tax deficiencies, penalties or interest assessed in an IRS audit. These rules were adopted to make it easier for the IRS to audit partnerships, as too few partnerships were being audited, the IRS had difficulty tracking down individual partners, and audits that actually were conducted resulted in little or no additional tax.
A partnership or LLC may elect to opt out of the new rules if it meets certain requirements. For instance, each of its partners must be an individual, a domestic C-Corp, a foreign entity taxable as a C Corporation, an estate of a deceased partner, or an S-corporation, and the partnership must issue no more than 100 Schedule K-1s. However, you must opt out on an annual basis.
Why do you care?
Under these new rules, a company’s partnership representative can make decisions that bind not only the partnership, but also the partners. Thus, it is important to address limitations to that authority in the company’s partnership or operating agreement. Also, if a company does not designate its own partnership representative, the IRS can choose one for you, and such person does not even have to be a partner. A partnership representative has a great deal of authority to make decisions on behalf of the partnership, and thus it is important to carefully choose that representative and revisit that decision on a regular basis.
Also, the New Partnership Audit Rules impute underpayments to the year in which the adjustment is made, as opposed to the year under review, which means that current partners could bear the tax burden for liabilities from years in which they owned no interest in the partnership. Since an assignee of a partnership interest could become responsible for an assignor’s tax liabilities, buyers of any partnership interest should focus on this in their tax due diligence and should make sure a provision is added to the purchase agreement that properly shifts this potential tax liability to the appropriate party.
Although the deficiencies, penalties and interest will be assessed against the partnership, the partnership can elect to send out amended K-1s to all partners, which would be effective as of the year under review. The partnership should consider how to handle these situations in advance and address it in the partnership or operating agreement.
What should you do?
All owners of existing LLCs and Partnerships should immediately review their partnership or operating agreements and add a provision addressing the New Partnership Audit Rules. The partnership or LLC needs to consider who should act as the “partnership representative” and should also carefully consider whether they should opt out of the New Partnership Audit Rules and revert to the existing Tax Matters Partner framework. Either way, this decision needs to be addressed in the partnership or operating agreement.
You should also consider adding other provisions to the partnership or operating agreement to determine how the partnership representative is selected and removed in the future, how major decisions during an audit will be made, and what limits will apply to the representative’s authority to act without partner approval. You should also address communications requirements, and clearly lay out circumstances and timeframes where the representative is required to communicate IRS actions with the partners.
You should reach out to your attorney and CPA and make sure they are focused on the New Partnership Audit Rules on your behalf.