Fact: The Partnership Audit Rules Have Changed
New partnership audit rules for LLCs taxed as partnerships, and Partnerships, took effect January 1, 2018. These new rules, and the new position of partnership representative, greatly change the landscape of partnership audits. For the unweary, these changes appear to be a simple change to your tax filings. Unfortunately, the legal ramifications of these changes could be massive.
These rules only apply to partnerships and LLC’s taxed as partnerships. If you are a single member LLC or an LLC that files taxes as an S-Corp, you can stop reading this. On the other hand, if you work with business owners, you may want to add this knowledge to your repertoire.
(For clarity sake, in this article I will use the terms “partner,” “partnership agreement,” and “Partnership” in their normal usage and for their analogous terms in a limited liability company (i.e. member, operating agreement, and Company))
Under prior regulations, partners would elect a “tax matters partner” (“TMP”) who was the primary contact for the IRS. Under this prior system, that partner would inform the other partners of the Partnership and each partner had a right to intervene with the IRS. Moreover, the IRS typically needed every partner’s agreement to settle an audit. The reason behind the IRS’s need for all partner’s agreement? All tax burdens, or shifts, were made at the partner level (as in each partner). As you can imagine, audits became burdensome for the IRS, so they decided to make things easier.
Summary of New Rules
Under the 2018 rules, the IRS has shifted the burden of a partnership audit to the Partnership. Rather than deal with 5, 10, or even thousands of partners, the IRS now only deals with one representative. The “partnership representative” (“PR”). The partnership representative is nothing like its predecessor tax matters partner, which we will discuss in more detail below. Obviously, the IRS wins here, saving immense resources in tracking down the partners and allocating tax burdens to each partner, by consolidating tax issues onto the Partnership.
The partnership representative has the sole authority to deal directly and exclusively with the IRS during a partnership audit. This person, or entity, is typically appointed under the terms of the partnership agreement. However, a Partnership may also create a standalone PR agreement. If the Partnership fails to appoint a partnership representative, the IRS is at liberty to appoint, at it’s choosing, a PR. A scary proposition indeed. Since the PR is the sole link between the Partnership and the IRS, their role and duties should be cautiously drafted for the Partnership’s and PR’s sake. Remember, under the new audit rules, the IRS sees the PR as having absolute authority to bind the Partnership.
Under current law, the partnership representative does not have to be a partner of the Partnership. In fact, the PR merely has to have a substantial presence in the United States. The IRS Code also provides a mechanism for appointing the PR, simply place their name on your next tax return or let the IRS do it for you. Unfortunately, both of these options fail to address normal Partnership roles, responsibilities, and limitations on power to bind the Partnership. For example, as the Code is written, the PR has the absolute power to bind the Partnership to an IRS settlement without input from the partners. Which is why it is vital for all business entities being taxed as a partnership to sit down with their lawyer to get a better understanding of this new rule.
100 Partner Exception
Partnerships with 100 or fewer partners may elect out of the new partnership audit rules for any current, or future, tax year. Provided, of course, all the partners are: individuals, C corporations, S corporations with certain types of shareholders, or estates of deceased partners. Notice, single member LLCs and companies that have a member who is a “partnership” (i.e. 2+ member LLC or Partnership) are not eligible for electing out of the new rules.
The Push-Out Election
These new rules place the burden of a partnership audit, and any tax losses, on the Partnership. This may not be an important distinction for small businesses with relatively low ownership turnover. However, imagine the following situation. Partnership A is audited in 2020 for the 2018 tax year. In 2019, two partners representing 50% interest in the Partnership sold their interests to the remaining two partners. If there happened to be a $250,000 deficit in the tax debt owed, the 2020 partners would be on the hook and the two partners that left in 2019 would escape any tax liability for that debt. Talk about a great time to sell!
Fortunately, the IRS included a provision that allows the PR to “Push-Out” the tax adjustments to the then-partners of the Partnership in the audit year. Unfortunately, the IRS failed to account for how this Push-Out would operate inside the Partnership. Does the PR have a fiduciary duty towards the current partners? Or the former partners?
There are complicated tax filings and rules on how this Push-Out operates, so it is vital to work with a knowledgeable CPA and attorney. One remaining question on the Push-Out clause is whether subsequent companies (i.e. a partnership that is a partner) can then “push-out” its new tax liability to its members. This is an area to watch for multi-tiered companies such as holding companies and/or investment companies.
What Do You Need To Do?
If you currently own a partnership, or an LLC taxed as a partnership, you should discuss these new rules with your CPA and/or attorney. In the meantime, pull out, dust off, and read your current partnership agreement. Here is a short checklist to review with your partnership agreement:
- Has the Partnership appointed a partnership representative? (remember, this is not the same as a tax matters partner)
- If no, immediately contact your CPA and/or business lawyer
- If yes, then continue
- Does your PR have the authority to “Push-Out” imputed underpayments?
- If so, does it require approval of the managers or majority in interest
- Note, commercial lenders and others may require a Push-Out option to protect their interest in the company. So this could play a huge role in the future.
- Does your PR have the authority to hire Attorneys, CPAs, and other experts if needed?
- If so, what limitations are in place?
- Does your PR have a duty to notify all members of notices from the IRS?
- Does the PR have to seek prior approval of management or majority in interest to:
- File tax protests
- Make court filings
- Enter into settlement with the IRS
- Enter into material agreements with the IRS
- Does the PR have to give notice to partners of meetings with the IRS?
- If so, do partners or managers have the right to attend?
- Does the PR have to give regular status updates?
- Does the PR have a confidentiality agreement in place?
- Are there other restrictions or authorities that make sense for your Company?
The new partnership audit rules are a paradigm shift greatly impacting every partnership or limited liability company taxed as a partnership. If you have not talked with your attorney or CPA about the new rules and how they may impact your business, now is the time to do so. Even if your partnership qualifies for the 100 Partner exception, it may be wise to move to the new system based on other factors. If you have additional questions, or if we can do anything to help, please contact Scott Welch at (636) 352-1222 or online HERE.