In the past partnerships and limited liability companies that have elected to be taxed as partnerships[1] have rarely faced an Internal Revenue Service (“IRS”) audit. In part, this is because of the administrative burden faced by the IRS in attempting to collect tax resulting from partnership audit adjustments. The current partnership audit scheme requires partnership audit adjustments to flow through to the partners and requires separate collection actions against each individual partner.
Recently enacted partnership audit rules provide for the assessment and collection of tax liability resulting from partnership audit adjustments directly against the partnership at the highest tax rate applicable to any of the partners. This requires all current partners to bear the cost of the additional tax and penalties in proportion to their current partnership interest even if they were not partners in the year for which the adjustment was made and/or were in a lower income tax bracket at that time. These new rules permit certain elections by the partnership and the partners to alleviate any unfairness caused by the new audit scheme and make it prudent for partners to plan for and agree upon how they wish the new rules to apply to them. It is also prudent to review and amend partnership agreements and limited liability company operating agreements to incorporate provisions which spell out the rights and obligations of partners in the event the entity is faced with a tax audit. If the new provisions accomplish their intended purpose, audits are likely to be more frequent than in the past.
Issues that need to be considered are:
- Should an election be made to have the current audit scheme continue to apply? Partnerships with fewer than 100 partners are entitled to make an affirmative election to have any adjustments to partnership items continue to be made only at the individual partner level. If a timely election is not made, partnerships will be bound by the new rules.
- If adjustments are to be made at the partnership level, how should (i) any excessive tax liability resulting from imputing tax to the partnership at the highest tax rate and/or (ii) inequities in the allocation of the liability among the partners be alleviated?
(a) The imputed tax to the partnership can be eliminated if each of the partners agrees to file an amended return for the taxable year of the adjustment which includes his share of the adjustment and pay the additional tax. It is permissible to allocate a proportionate part of the additional income to tax exempt partners and thereby lower the overall tax liability.
(b) Instead of partners filing an amended return and paying tax in the year for which the audit adjustment is made, tax liability can be shifted from the partnership to individual partners by the partnership reporting the audit adjustments to the partners with the partners including the additional income in their returns for the year of the audit and paying the tax in the current year with interest and penalties computed from the audited year. This requires an election by the partnership no later than 45 days after the date of the notice of the final partnership adjustment.
(c) If, instead of passing the tax liability through to the partners, the partnership elects to pay the tax, the partnership is entitled to lower the tax rate by demonstrating to the IRS that the partners are in less than the highest tax bracket and, in effect, pay a tax based upon the sum of the demonstrated additional tax liability of each of the partners. This option would require partners to agree to divulge their individual tax information to the Partnership Representative handling the audit.
- Who should be the “Partnership Representative”? The “tax matters partner” under the old scheme has been replaced by a “Partner Representative” who does not need to be a member of the partnership. The new scheme curtails the rights of the individual partners and no longer requires them to be notified of an audit or related judicial proceedings. The Partnership Representative is given broad powers and has sole authority to act on behalf of the partnership in the audit proceeding and can bind both the partnership and the partners with his actions during the audit.
Fortunately, decisions regarding the above issues do not have to be made immediately. The new provisions don’t go into effect until January 1, 2018. In the meantime, we can expect guidance from the IRS in the form of regulations fulfilling their mandate to establish procedures to carry out the intent of the statute. Nevertheless, thought should be given to the above issues now so that once the IRS guidance is published partnerships are able to discuss the issues with their accountants and attorneys and amend their governing documents to ensure that partners and limited liability company members are obligated to meet their chosen responsibilities under the new audit scheme.
[1] Limited liability companies have the option to elect to be taxed as a corporation, a partnership or, if they have only one member, as a sole proprietorship. The references to partnerships and partners herein are equally applicable to limited liability companies that have elected to be taxed as partnerships and to their members.