New IRS Rules Govern Audits of Partnerships and LLCs Treated as Partnerships: You May Need to Revise Your Entity’s Governing Documents1/29/2018 | By: David N. Milner, Esq. & Asher Rubinstein, Esq. | GDB 2018 Winter Newsletter
Effective for partnership tax years beginning after December 31, 2017, the IRS has adopted new rules which apply to audits of income tax returns filed by partnerships, limited partnerships and limited liability companies treated as partnerships for tax purposes (all of which are referred to in this article as partnerships). These new audit rules are important because they have the potential to expose those who were not partners during the tax year being audited to the tax errors and liabilities of the partnership, which, under the prior rules, would have been the responsibility of those who were partners during the year under audit.
Under the old rules, if the IRS determined that taxable income had been incorrectly decided, the amount of the IRS adjustment would be allocated to each partner using that partner’s profit sharing percentage for the year in question. The partner would then file an amended return (or the IRS would do so for him) and pay any additional income tax that may have been due (or receive a refund if the IRS’ determination was that income had been underreported by the partnership).
The new rules provide that the additional tax will be determined at the partnership level by applying the highest corporate income tax rate for the year in which the adjustment is made (not the highest rate for the year under review.) The tax will be payable by the partnership, effectively reducing the amount of distributions that will be available to the partners for the year of the adjustment. There will be no impact on those who were partners during the year being audited who had the “benefit” of the adjustment who are no longer partners.
The new rules also require that the partnership designate a “partnership representative” who will have the sole authority to act on behalf of the partnership in an IRS proceeding. This includes the audit, the appeal and any tax or other court proceeding. In the past, while partnerships were required to designate a “tax matters partner,” the IRS was required to notify each of the partners of the audit and to open an audit of each of the partners’ income tax return. The other partners had the ability to participate in the audit.
There are ways that partnerships can avoid the new rules in whole or in part:
- Partnerships that are required to issue 100 or fewer Schedule K-1s whose partners consist entirely of individuals, estates of deceased partners, C corporations or S corporations (however, each of the shareholders of the S corporation must be a “qualified partner” and will be counted in determining the number of partners who are required to receive a Schedule K-1) can annually elect to “opt-out” of the new rules when the partnership files its partnership income tax return. The old rules will apply to partnerships that opt-out.
- Partnerships that do not opt-out can elect to “push-out” the adjustment to their partners. Partnerships that elect to do so must make the election within 45 days after the date of the notice of the final partnership adjustment. Partnerships making a “push-out” election must compute a “safe-harbor” income tax amount that the partner can elect to pay as opposed to including the adjustment on the partner’s tax return and paying the tax calculated to be due.
Partners of partnerships should consider the following:
- Amending the partnership’s governing documents to require that:
- The partnership “opt-out” if permitted, or in the alternative, the partnership will “push-out” any adjustments.
- New partners be indemnified by the partnership and former partners against any negative tax consequences or cash flow that may result from audits or assessments of tax returns filed before they became partners.
- Conversion of the partnership into a corporation that elects to be taxed as an S-corporation.
- Selecting a “partnership representative” and agreeing upon a method of replacing the person so designated.