The IRS will now require all entities taxed as partnerships, to pay for imputed taxes from audits. This will apply for prior tax years at the partnership level as well as for tax years beginning after January 1, 2018 (26 USC Section 6221).
A partnership, for federal tax purposes, is any company that elects to be taxed as a partnership, has more than one partner or member and is not a corporation. Most LLCs (with 2 or more members) elect to be treated as partnerships for tax purposes. So both LLCs and partnerships are affected by this law change.
Under the new law the partners of a partnership during the year of assessment i.e. 2018 are burdened with the liability not the partners who were partners in the year under audit.
Some history starting with TEFRA:
In 1982, Congress passed the Tax Equity and Fiscal Responsibility Act (“TEFRA”):
Partnership Level Determination
TEFRA shifted the audit of partnership items from each individual partner to the partnership level by mandating that the tax treatment of any partnership item must be determined at the partnership level.
Consistency Requirement
TEFRA mandated that each partner’s tax treatment of partnership items must be consistent with the treatment of those items at the partnership level.
Unified Partnership Audits
After TEFRA, the audit of certain partnerships were unified proceedings. The IRS was required to issue formal notice of the audit directly to all partners at the start of the audit.
Tax Matters Partner
TEFRA created “Tax Matters Partner” (“TMP”), a partner charged with coordinating the audit and any judicial proceeding and tax updates for the partnership. Individual partners still had the right to participate in any audit or judicial proceeding and to negotiate his own settlement with the IRS.
Final Partnership Administrative Adjustment
TEFRA audit concluded when the IRS mailed to the TMP a notice of final partnership administrative adjustment with the tax updates. Individual partners could challenge the IRS’ administrative adjustment if the TMP failed to do so.
Small Partnership Excluded from TEFRA audit procedures
More information on Small Partnerships:
- The partnership must have 10 or fewer partners at all times during the tax year.
- Married couples filing jointly and their estates are treated as a single partner.
- All partners in the partnership must be U.S. persons, resident aliens, C corporations, or estates of deceased partners.
Bipartisan Budget Act of 2015 (“BBA”) enacted on November 2, 2015
This act established new rules located in Sections 6221 through 6241 of the Code and established 3 Regimes in the BBA effective for all partnership audits for tax years commencing January 1, 2018, describing the following tax updates:
Default Regime (Partnership liable directly for tax) - Section 6221(a)
Any adjustment to items of income, gain, loss, deduction or credit of a partnership for a partnership taxable year (and any partner’s distributive share thereof) shall be determined, any tax attributable thereto shall be assessed and collected, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to any such item or share shall be determined, at the partnership level pursuant to this subchapter.
Small Partnership Opt-Out Regime - Section 6221(b)
The partnership can elect to opt out of the Default Regime for any tax year that it issues 100 or fewer K-1s in the taxable year.
Alternative Regime (Partner liable directly for tax) -- Election to Pass the Imputed Underpayment on to the Partners – Section 6226
The partnership can elect out of the default regime with respect to any underpayment if, within 45 days of receiving the final audit adjustment notice, the partnership elects the alternative regime and furnishes to each partner for the reviewed year with a statement of such partner’s share of any adjustment.
The election allows the partnership to push the burden of an imputed underpayment to reviewed-year partners and have such partners report additional tax on their current year return.
Partnership Representative
The new law replaces the traditional member or partner designee to address such adjustments and tax updates from the IRS (the "Tax Matters Partner") with a new position (the "Partnership Representative,').
The Partnership Representative (which, unlike the Tax Matters Partner, does not have to be a partner of the company) has the sole authority and responsibility to administer the company's tax matters. Even if not a partner, a Partnership Representative must have a "substantial presence in the United States."
Tax updates on the new partnership audit rules
Under the Default Regime as defined above, adjustments pertaining to an LLC's tax items in connection with the company will be applied and collected at the company level. Historically, adjustments were imposed at the member level, and unaffected members were generally not exposed to loss because of any such adjustment.
The new law will expose current members to adjustment related tax losses at the time the adjustment is due, without regard for whether or not the members were involved with the company during the period to which the adjustment relates.
In other words, the new law imposes tax liability on the company, and thus indirectly on all current members, even if the current members did not hold equity in the company during the period in which an imputed tax underpayment occurred.
Opt-Out Regime
LLC’s or partnerships required to submit 100 or fewer K-1s during the tax year may elect to opt out of the rule changes on an annual basis, in accordance with 26 USC Section 6221(b). The opt-out provision, however, only applies if all members or partners are:
- individuals,
- estates of a deceased partner,
- or certain S or C corporations.
Alternative Regime
The reporting mechanics to the partners are complex. But this method:
- Avoids entity level tax and shifts liability between current and former partners.
- Causes shifting of burden coming at the cost of 2% higher rate than if the partnership paid the imputed underpayment directly.
In light of these tax updates, what should LLCs do in preparation of the new IRS partnership tax audit and assessment rules?
Partnerships, and those taxed as partnerships, should:
- Ensure their operating agreement provides that former members are required to indemnify the company for assessed taxes paid by the company in connection with imputed underpayments of taxes by members; and
- Consult with legal counsel and accountants for advice on their ability to opt out of the new rule and whether an opt-out is appropriate; and
- Prepare to comply with the new rule and select a Partnership Representative.
Our Suggestions:
We recommend discussing with appropriate advisors whether you should implement language in every operating agreement that ensures the partnership is, and individual partners are, protected to the greatest extent practicable.
An operating agreement should include language that will permit the company to deduct adjusted tax liability, when applicable, from future distributions to the responsible member. The agreement should also allow the company to seek indemnification from any former members to whom any imputed underpayments may be properly attributed.
Opting out, if permitted, will likely be advantageous. If your LLC or partnership cannot opt out, you should discuss plans for compliance with these new tax updates with your attorneys and accountants, and begin to identify a designee to name as Partnership Representative. And of course, contact a professional at Smolin for assistance with these complex tax matters.
Note: This law affects federal audits of an entity taxed as a partnership. If there are adjustments the state tremont may not be consistent.
Phil Drudy, CPA, ESQ, is a Member of the Firm at Smolin, Lupin & Co., PA. To find out more he can be reached via email pdrudy@smolin.com or by phone at 973- 461-7338.