An IRS Wrecking Ball is Swinging Your Way
(Ready yourself for new partnership/LLC audit rules before they hit on January 1)
Tax legislation enacted in late 2015 and recently re-released proposed regulations are scheduled to affect partnership tax years beginning just a few months from now, dramatically changing the way Internal Revenue Service (IRS) audits of partnerships and LLCs taxed as partnerships are administered. All partnerships (and LLCs) should become familiar with these new rules, and consider updating their partnership and operating agreements before January 1, 2018. Those who fail to do so are at risk of encountering some unexpected (and possibly contentious) tax issues and consequences later on.
Description and current status of the new rules
The Bipartisan Budget Act of 2015 (BBA), enacted into law November 2, 2015, repealed and replaced the current audit rules established under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) with a new set of partnership audit rules. On June 13, 2017, the IRS re-released proposed regulations (REG-136118-15) to implement these new audit rules. The new rules generally are effective for partnership returns filed for tax years beginning after December 31, 2017. However, partnerships may elect to apply the new rules to returns filed for tax years beginning after November 2, 2015 and before January 1, 2018 upon receiving a notice of selection for examination.
Coincidentally, on the same day that the IRS re-released its proposed regulations, the American Institute of Certified Public Accountants (AICPA) requested a one-year delay of the effective date of the rules, to address the complexities and challenges created by the new law. (That request may or may not be honored.) Also, a task force of the Multistate Tax Commission (MTC), which is a 47-state member agency that promotes uniformity in state tax laws, released a draft model statute and regulations on June 8, 2017 addressing the new rules’ impact on state income tax returns.
What the new rules do
The most significant impact of the new rules is that they allow the IRS to make tax assessments and collections at the partnership level, rather than partner level. Furthermore, the tax will be assessed and collected against the partnership in the year the audit concludes, rather than the earlier year that is under examination. This will shift the burden of payment onto current partners, rather than those who were partners during the year under audit. The tax will be assessed at the highest federal income tax rate, regardless of the potentially lower rates that may otherwise apply.
The new rules also retire the role of the “tax matters partner” and create the position of a new “partnership representative,” who will have sole authority to act on behalf of the partnership under the new audit rules. Unlike the tax matters partner who handles a similar role under the current rules, the partnership representative need not be a partner. However, such person must have a substantial presence in the United States. If the partnership representative is an entity, the partnership then must also designate an individual to act on behalf of the partnership representative entity.
The new rules provide alternative elections and modifications (discussed below) that can alter the amount and method of an assessment made against a partnership, more equitably allocating the tax, and lowering the overall liability assessed. These alternatives may mitigate some of the harsh results under the default rules (discussed below), and partnership and LLC operating agreements should be updated accordingly to take advantage of them.
It is anticipated that the number of IRS audits of partnerships and LLCs will increase significantly once the new rules are in effect, as the new rules will allow the IRS to assess and collect more tax with far less time and effort.
Three alternatives to choose from
Some elections are available, that together with the default rules provide three basic alternatives under the new audit regime. These alternatives deliver very different outcomes, each with its pros and cons.
Alternative number one: Default rules – partnership pays tax, penalties and interest
Under the new rules, partnerships, rather than the partners, will pay any tax, penalties, and interest attributable to audit adjustments of a partnership’s federal income tax return. The tax assessed will be calculated at the highest statutory corporate or individual income tax rate in effect for the year being audited. The amount of tax assessed against the partnership may be reduced if any partner of the partnership for the year under audit files an amended return reflecting his or her share of partnership adjustments, and pays any tax due, or if the partnership can establish that a portion of the assessed tax is either allocable to a tax-exempt partner, or subject to a lower rate of tax (for instance, capital gain or qualified dividend income). The tax will be assessed against the partnership in the year the audit concludes (rather than the year under audit), thus potentially indirectly shifting the economic burden of the tax deficiency from any former partners (owners during the year under audit) to those who are partners during the year the audit is closed.
Alternative number two: Elect out of the new rules
Partnerships that are required to furnish 100 or fewer Schedules K-1 and that have as partners only individuals, corporations (including certain types of foreign and tax-exempt entities), or estates may elect out of the new audit rules. Thus, partnerships that have partnerships, trusts, disregarded entities, or nominees as partners cannot elect out. The existence of an S corporation as a partner will not invalidate this election, but each S corporation shareholder must be counted separately when computing the “100 or fewer” limit described above.
This election out of the new rules is not made at the time a partnership or LLC receives notice of an audit; it instead must be made annually with a timely filed return. If a partnership elects out of the new audit rules, any potential audits in the future will be conducted and assessments will be made at the partner level – impacting the taxpayers who were partners during the year that is under exam, rather than the partners of the year the audit is closed. This election closely matches the superseded “old school” rules, but as noted above, it is limited to certain partnerships.
Alternative number three: Make a “Push-Out” election
If a partnership cannot or does not elect out of the new audit regime, a second election (creating the third alternative) is available to any partnership, and the decision to use it can be made after the audit is well underway. But it comes at a cost.
As an alternative to the partnership paying the assessed tax deficiencies resulting from audit adjustments, a partnership may elect to furnish a statement of the partner’s share of audit adjustments to (1) each partner of the partnership for the year under audit and (2) the IRS. Each partner would then determine the additional tax, penalties and interest owed as if the adjustments had been properly reported in the year under audit, and report and pay such amounts owed with his or her return for the year in which the statement of adjustments is furnished from the partnership. (In other words, compute the additional tax due as if the adjustments had landed on the earlier year’s tax return, but report it on, and pay it as part of, the tax return to be filed for the current year.)
The partnership must make this so-called “push-out” election no later than 45 days after the date of the notice of final adjustment. The cost of making this election, however, could be significant, as the underpayment rate of interest assessed to each partner on the amount of tax owed will be the applicable federal short-term rate plus five percentage points, instead of the normal three percentage points otherwise assessed under the default rules.
The new rules are a dramatic departure from the prior partnership audit rules. They are designed to create efficiencies for IRS auditors, who no longer have to devote as much time to pushing entity-level income and expense audit adjustments down to numerous partners, and assessing and collecting the additional tax from each one of those partners. However, the new rules may pit new partner against old, by sticking a new partner with the bill for the “sins” of a former partner.
By using the highest existing tax rate, the new default rules ignore the fact that a portion of the assessed tax might otherwise qualify for a lower rate of tax. Additionally, some partners might have suspended prior year losses – a scenario which under the old rules could allow additional partnership income to have no incremental effect on their taxes. In these cases, unless modified, the new default rules will result in excessive tax relative to the old rules or the new alternatives.
The new rules may impact “conventional” acquirers of partnership interests (new partners) once they go into effect, by potentially exposing them to previous tax year tax adjustments upon audit. Likewise, the new rules may similarly affect and should be considered by any party to a merger or acquisition involving a partnership.
It is unclear at this time how state tax laws will accommodate the new rules. As noted above, the MTC is currently working on this matter, but it is not an agency with any authoritative powers. Each state is free to make its own rules.
While these new rules may currently be of greater interest to tax practitioners, they also may represent a new concern for audit practitioners and executives involved with the issuance of financial statements for partnerships and LLCs. Why? Because the possibility for an entity-level tax assessment will now exist in the partnership realm.
Most of these thoughts drive home the primary purpose of this article, which is intended as a call to action: Partnership and LLC operating agreements should be reviewed and updated with the help of legal counsel to account for the repeal of the old rules and replacement with the new rules. These actions should be undertaken before the new rules go into effect on January 1, 2018. Based on industry guidance from other experienced practitioners and our own observations, below is a list of items to consider.
Suggested items to consider addressing in partnership and LLC operating agreements by January 1, 2018 include:
- Whether the partnership will elect early adoption of the new rules
- The designation and removal of the new partnership (and possibly state partnership) representative
- The designation and removal of the individual that may be appointed if the partnership representative is an entity
- Limiting the partnership representative’s powers to make elections, settle audits, or extend statute of limitations without partner participation or, alternatively, having partners acknowledge the partnership representative’s broad powers
- Appropriate indemnifications for the partnership representative
- Deciding whether and when the partnership will “pay” (perhaps under a specified dollar amount), “push out” or “elect out”
- Restrictions on transfers of partnership interests to entities that are ineligible partners (for purposes of the “elect out” alternative)
- The requirements for the partnership representative and partners to obtain and provide information that may reduce the partnership’s imputed underpayment liability
- The potential for filing amended returns by those who were partners in the reviewed year(s)
- If the partnership “pushes out,” the ability to contact former partners
- Partners’ notice and participation rights in connection with federal or state audits
- Extending partner indemnification obligations for a period of time after the sale of a partnership interest
- Terms and conditions for amending partnership or LLC operating agreements to address possible changes or updates to the new rules
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.