The Internal Revenue Service (IRS) is changing the way partnerships (including limited liability companies taxed as partnerships) are audited, beginning with tax year 2018 and forward (also referred to in this article as the centralized audit rules).
Under the current rules, the partnership appoints a tax matters partner, to deal with the IRS on behalf of the partnership, and this designation is likely covered in your current partnership or operating agreement. Prior to 2018, other partners are still entitled to certain notices from the IRS or the tax matters partner and have certain rights during an audit. Following an audit, a deficiency is assessed by the IRS against each partner individually for their share. The IRS then proceeds to collect each partner’s share from that partner.
Under the centralized audit rules, the partnership must designate a partnership representative, and such partnership representative will have no obligation to communicate with other partners, but for any notice obligations imposed by the partnership or operating agreement. Additionally, the IRS will have no notice obligations to any partners. The partnership representative will have the authority to bind the partnership and its partners in a settlement agreement with the IRS. This increase in power may require rethinking the designee for the partnership representative position, and the partnership or operating agreement should contractually set out the duties and obligations of such representative to the other partners, including providing notice of an audit and copies of IRS communications to the other partners.
Certain partnerships will be eligible to elect out of the centralized audit rules if all of the partners in the partnership are “eligible partners” and the partnership has one hundred or fewer partners. Eligible partners include individuals, S-Corporations, C-Corporations, estates of deceased partners, or foreign entities that would be treated as C-Corporations. Partnerships with partnerships, trusts, disregarded entities (including grantor trusts and single member LLCs), and foreign entities that would not be C-Corporations under US law, will not be eligible to elect out of the centralized audit rules. In order for an election to be valid, the election must be made every year on the partnership’s timely filed tax return (including extensions) and the partnership must provide notice within thirty days to each partner of the election out.
Partnerships that do not elect out, or are ineligible to elect out, may make a “push out” election, whereby the audit determination will be made at the partnership level, and then the partnership will hand out a share of the deficiency to each partner. Such election must be made within forty-five days from the date the Final Partnership Adjustment is mailed by the IRS. This will place collection obligations on the IRS against each partner, however, the cost for shifting the burden from the partnership to its partners comes with an increased interest rate. Amounts “pushed out” will bear interest equal to applicable federal rate plus five basis points, compared to amounts not pushed out, which bear interest equal to the applicable federal rate plus three basis points. In addition, amounts not pushed out will be a partnership expenses (although not deductible) and would not be subject to self-employment tax, unlike distributions from the partnership which may be necessary to pay the tax.
Without edits to the partnership or operating agreement, IRS collections against the partnership may result in partners responsible for capital economically bearing the tax liability of profits interest partners, current partners bearing the burden for partners who have since left the partnership, or new partners becoming economically responsible for debts of partnership before becoming a partner.
New entities should consult tax counsel in drafting a partnership or operating agreement, and existing entities should consider amendments to their existing partnership or operating agreement, in order to address the issues created by the centralized audit rules, including imposing notice obligations on the partnership representative, determining whether to make an election out, or an election to push out liability to the partners, and what, if any, other liabilities or obligations the partnership representative should have to the other partners.