In 2018, the IRS is changing the audit procedures for businesses taxed as partnerships, which includes LLCs taxed as partnerships. Updated tax regulations were recently proposed and will be finalized after the public hearing on September 18, 2017, making this a good time for businesses to consider the new rules and begin taking proactive steps to ensure they are ready for possible future audits. Last winter, BrownWinick provided guidance about how the new rules will change the partnership audit process. Highlights of the changes include:
- The new rules appoint one person to serve as the “partnership representative” who will have the sole ability to bind the partnership and all of its partners without needing approval or giving notice before taking action.
- Every partnership must list a partnership representative on its partnership tax return.
- The new rules assess any tax deficiency to the partnership and the partnership must decide the method of collecting the deficiency from its partners. The default rule makes the current partners responsible for the deficiency incurred in a prior year, even if ownership has changed since the year being audited.
- Unless the partnership elects otherwise, the new rules generally assess any tax deficiencies at the highest individual tax rate, which is currently 39.6%. This creates the possibility that partners in lower tax brackets will pay deficiencies at a higher rate than normal.
Based on the changes listed above, this article recommends certain action items for businesses to take and highlights the consequences of inaction.
Recommended Action Items
First, determine if your business is able to elect out of the new partnership audit rules. Entities that have fewer than 100 partners, have only individuals, estates, C corporations, or S corporations as partners, and follow certain procedural requirements are eligible to elect out of the new rules, thereby continuing to be governed by the current partnership audit rules. Partnerships with trusts or other partnerships (including LLCs) as partners are not eligible to elect out of the new rules.
Second, determine whether your business should elect out of the new partnership audit rules. Partnerships comprised of high net-worth individuals and limited partner turnover might enjoy not participating directly in audits or amending their individual returns in case of needed adjustments. Partnerships with varied net-worth partners or recent partner turnover may prefer to elect out of the new rules. It should be noted that a business makes its “election out” decision on an annual basis. Consultation with your attorney and accountant would be prudent before making a decision.
Third, amend your partnership agreement to reflect your business’s wishes. All partnership agreements should be amended to describe how the partnership representative will be selected and removed and the scope of the partnership representative’s authority. If the partnership does not name a partnership representative, the IRS will select one and the selected partnership representative will have the broadest authority to unilaterally bind the partners. Other possible revisions include:
- Mandating an election out of the new rules on an annual basis unless a majority of the partners vote to be governed by the new rules.
- Requiring all partners to act together to limit the burden of the deficiency and specifying how the best course of action will be determined.
- Creating a procedure for determining whether the partnership will be liable for deficiencies or whether deficiencies will be “pushed out” and paid by the partners.
- Obtaining an agreement from all departed partners to pay their share of a tax deficiency incurred while they were involved with the partnership.
Consequences of Inaction
The new partnership audit rules were designed to raise approximately $10 billion over the next ten years, indicating that the IRS might conduct more partnership audits in 2018 and beyond. If no action is taken, all partnerships will be governed by the new default rules. Without advanced planning, you and your partners could incur unnecessary hassle and expense, face unexpected problems (both internally and externally), and ultimately be unable to appropriately control the audit process and outcomes.
For more information about the new partnership audit rules, including how to amend your partnership agreement to best protect the interests of your business and its partners, please contact your personal BrownWinick attorney or a member of BrownWinick’s Tax group.
NOTE: This article was written by BrownWinick’s summer law clerk, Colin Hendricks and reviewed by BrownWinick attorneys Chris Nuss and Cynthia Lande.