by Richard Keyt, and Richard C. Keyt, LLC & partnership tax law attorneys
In 2015 the President signed into law the Bipartisan Budget Act that established new audit rules for entities taxed as partnerships. In this article we compare the obsolete audit rules known as the TEFRA audit rules with the new partnership audit rules that became effective on January 1, 2018. We also suggest steps partners of partnerships and members of LLCs taxed as partnership should do to protect themselves and their company from the adverse consequences of the new partnership tax audit rules.
FYI: When we use the term “LLC” in this article we mean an LLC that is taxed as a partnership for federal income tax purposes. When we use the term “member” we mean a member of an LLC that is taxed as a partnership. The new partnership tax audit rules do not apply to limited liability companies that are taxed as a sole proprietor, C corporations or S corporation or to their members.
The Revoked TEFRA Audit Rules
Under the TEFRA rules income, gain, deductions and credits are determined at the company level and included on the tax returns of the members. TEFRA audits were conducted as the individual member level, not at the LLC level. This meant that if an LLC had four members the IRS had to audit one or more members in separate audits. There potentially could be as many separate audits as there were LLC members.
If a member were audited by the IRS and the audit resulted in one or more LLC items being adjusted the adjustments were reported on the audited member’s federal income tax return. The result is that if additional income tax was owed the audited member had to pay the member’s share of the additional tax, interest and penalties.
The TEFRA audit rules lead to inconsistent results when one member’s audit with IRS agent #1 had a different result than a second member’s audit with IRS agent #2. It also created situations where not all members were audited.
The IRS and Congress believed that auditing every partner or member was very costly and inefficient, so Congress passed the Bipartisan Budget Act of 2015 that revoked the TEFRA rules and created the new partnership tax audit rules.
The New Partnership Audit Rules
Under the new audit rules the IRS audits at the LLC level rather than the individual member level and if any money is owed to the IRS the LLC must pay the tax, interest and penalties unless the payment liability is passed to the members. When an audit results in money owed to the IRS the amount is generally net audit adjustments times the highest applicable federal income tax rate in effect for the audited year.
The tax rate on assessed amounts can be reduced if the LLC shows that the underpayment would be less if it were based on:
- The tax rate applicable to members that are individuals, corporations and tax-exempt organizations; and
- The type of income being adjusted such as ordinary income, capital gain or cancellation of indebtedness income.
When the audit results in the LLC owing the IRS money the LLC may be able to do what is called a “push-out election.” When made this election causes each member of the audited LLC to report the member’s prorata share of the adjustments on the member’s tax return.
LLCs Must Have a Partnership Representative
TEFRA created something called the “tax matters partner.” The new partnership audit rules eliminate the tax matters partner. Warning: If your LLC’s Operating Agreement contains the term tax matters partner it is obsolete and needs to be amended for the new audit rules. If your Operating Agreement is obsolete your LLC should purchase my Tax Audit Agreement for $497 by completing my online audit questionnaire.
All partnership tax returns filed for tax years after 2017 must designate a “partnership representative.” The partnership representative has the sole authority to act on behalf of the partnership in IRS audits and other federal income tax proceedings.
If the partnership doesn’t choose a representative, the IRS can select an individual or entity to fill that role. If the partnership representative is an entity (as opposed to an individual), the partnership must appoint a designated individual through whom the partnership representative will act.
The new partnership audit regime applies to partnerships with more than 100 partners at the partnership level.
Under the proposed regulations, the partnership representative has a great deal of authority, and no state law, partnership agreement, or other document or agreement can limit that authority. Specifically, the partnership representative has the sole authority to extend the statute of limitations for a partnership tax year, settle with the IRS or initiate a lawsuit. Any defense against an IRS action that isn’t raised by the partnership representative is waived.
With all this authority comes the associated risk, which may mean that some partnerships will have a hard time finding someone willing to act as the representative. Partnerships should consider indemnifying or compensating their partnership representatives accordingly.
According to the proposed regulations, partnerships must designate a partnership representative separately for each tax year. The designation is done on the partnership’s timely filed (including any extension) federal income tax return for that year.
Partnerships should amend their agreements to establish procedures for choosing, removing and replacing the partnership representative. In addition, the partnership agreement should carefully outline the duties of the partnership representative.
The Push-Out Election
As noted above, under the new rules, a partnership must pay the imputed underpayment amount (along with penalties and interest) resulting from an IRS audit — unless it makes the push-out election. Under the election, the partnership issues revised tax information returns (Schedules K-1) to affected partners and the partnership isn’t financially responsible for additional taxes, interest and penalties resulting from the audit.
As the name suggests, the push-out election allows the partnership to push the effects of audit adjustments out to the partners that were in place during the tax year in question. This effectively shifts the resulting liability away from the current partners to the partners that were in place during the tax year to which the adjustment applies. The push-out election must be filed within 45 days of the date that the IRS mails a final partnership adjustment to the partnership. This deadline can’t be extended. The proposed regulations specify the information that must be included in a push-out election. The partnership must also provide affected partners with a statement summarizing their shares of adjusted partnership tax items.
Partnership agreements should be updated to address whether the partnership representative is required to make the push-out election or the circumstances in which a push-out election will be made. When deciding whether to make the election, various factors should be considered, including:
The effect on partner self-employment tax liabilities,
The 3.8% net investment income tax,
State taxes, and
The incremental cost of issuing new Schedules K-1 to affected partners.
Partnerships may want to require their partnership representatives to analyze specified factors to determine whether a push-out election should be made.
Option to Elect Out of the New Rules
Eligible partnerships with 100 or fewer partners can elect out of the new audit rules for any tax year, in which case the IRS must separately audit each partner. However, the option to elect out of the new partnership audit regime is available only if all of the partners are:
C or S corporations,
Foreign entities that would be treated as C corporations if they were domestic entities,
Estates of deceased partners, or
Other persons or entities that may be identified in future IRS guidance.
The election out must be made annually and must include the name and taxpayer ID of each partner. The partnership must notify each partner of the election out within 30 days of making the election out.
Eligible partnerships may want to amend their partnership agreements to address whether electing out will be mandatory. In most situations, electing out will be preferable. However, partnerships looking to maintain flexibility in their partnership agreements should include provisions indicating how the decision to elect out will be made.
Partnerships choosing to elect out may want to amend their agreements to prohibit the transfer of partnership interests to partners that would cause the option to elect out to be unavailable. They also may want to limit the number of partners to 100 or fewer to preserve eligibility for electing out.
Important note: Many small partnerships may assume that they’re automatically eligible to elect out of the new partnership audit rules because they have 100 or fewer partners. That’s not necessarily true. For example, the option to elect out isn’t available if one or more of the partners are themselves a partnership (including an LLC that is treated as a partnership for tax purposes). Also, if there is an S corporation partner, each S corporation shareholder must be counted as a partner for purposes of the 100-partner limitation.
Although the new partnership audit rules don’t take effect until next year, partnerships should start reviewing partnership agreements and amending them as necessary. At a minimum, partnerships that don’t expect to elect out of the new audit rules should appoint a partnership representative before filing their 2018 returns. Your tax advisor can help you get up to speed on the new partnership audit rules and recommend specific actions to ease the transition