In coming months, partnerships (and limited liability companies taxed as partnerships) will begin filing tax returns which are, for the first time, subject to the new partnership audit rules Congress established in 2015. These new partnership audit rules went into effect for all tax years starting on or after January 1, 2018.
These new rules are a dramatic change in a variety of ways. Some—but not all—of these changes include:
- Taxation at the partnership level. Partnerships, long considered ‘pass-through entities’ taxed at the partner level, are now paying tax at the partnership level. On the one hand, this change creates greater efficiencies for the IRS – it no longer must determine changes at the partnership level, a time-consuming process limited by the statute of limitations. On the other hand, this change could create potential conflicts within the partnership. For example, the partners during the year the partnership pays tax to the IRS may not necessarily be identical to the partners in the partnership during the year under audit (yet they may well bear the consequences of the audit). The partnership can elect to opt out of this rule, pushing the consequences of the audit back onto the partners who were partners in the year under audit. Both options, however, will have tax implications, albeit for different sets of partners.
- The partnership representative has complete authority. Under the prior partnership audit rules, partnerships appointed a “tax matters partner” who served simply as the partnership’s contact with the IRS during the audit and had certain obligations to the partners during the audit. Under the new rules, partnerships must have a “partnership representative.” This role is not only the point of contact for the IRS during the audit but also has the exclusive authority to make decisions for the partnership concerning all aspects of the audit. Notably, the IRS will not look to state law or the partnership agreement for limits on the partnership representative’s authority, nor will it act in accordance with state law or the partnership agreement. Even more troubling, if the representative resigns the position, or the partnership replaces its representative, the IRS will wait 30 days to give effect to the change, providing the now departing partnership representative an entire month to make decisions for a partnership the representative no longer represents.
- The new rules apply to all partnerships…unless they don’t. The new partnership audit rules always apply to partnerships with more than 100 partners. They also always apply to partnerships (even those with 100 or fewer partners) if one of the partners is, itself, a partnership or a limited liability company. However, other partnerships with 100 or fewer partners whose partners are individuals, C corporations, S corporations, foreign corporations that would be treated as C corporations if they were domestic, and estates can opt out of the new partnership rules if they meet certain requirements. For instance, partnerships with an S corporation as a partner must count each shareholder in the C corporation as a partner when determining whether the partnership has 100 or fewer partners. Partnerships must also satisfy several other requirements in order to have the opportunity to elect out of the new partnership audit rules.
Since the first partnership audits under the new rules are unlikely to begin until late 2019 or into 2020, partnerships still have time to amend their partnership agreements to insure they are best positioned to handle an audit under the new rules – but time is drawing short and need to be made. Some considerations include:
- Partnership representative. Partnerships need to decide how to select a partnership representative, what obligations the representative will have to the other partners, the obligations partners will have to the partnership representative, and whether the partnership will indemnify partners for decisions made (correctly or not, with or without notice, with or without input or agreement by the partners) by the representative. Then, partnerships will need to select who will serve as the partnership representative.
- Opting out. Partnerships must determine whether they are eligible to opt out of the new audit rules and, if so, whether they should do so.
- Different partners. Partnerships will have to determine how to address the consequences of an audit taking place in a year when the partnership includes different partners than in the year under audit. For instance, whether the partnership should shift potential tax liabilities to its partners (either the partners in the year that is under audit or the year that the audit is taking place), what obligations (if any) the partnership representative will have to each group of partners, whether new partners will have to agree to accept tax liabilities for prior tax years, and whether departing partners might have to escrow a portion of their final distribution for a time in order to cover tax liabilities discovered in the future that relate to the years in which they were still partners.
The new partnership audit rules are a complete change, both in form and substance, to the rules in place for tax years starting on December 31, 2017 and earlier. The new rules are complex, require new types of decision-making, and impact both former and current partners.
Every partnership, and every member of a partnership, should review their partnership agreements and determine what types of changes the partnership may need to make. There is no single approach that will work for every partnership – different partnerships, and their partners, will have different goals, interests, and approaches. But, at a minimum, every partnership, and partner, needs to consider the issues, make decisions that are in their best interest, and amend their partnership agreements accordingly.
Fortunately, there is plenty of time for partnerships to think through their options, make necessary and appropriate changes to their agreements, and prepare themselves for the forthcoming new audit regime. Done properly, partnerships and their partners will put themselves in a position of strength and give themselves a better opportunity for success if, and when, the IRS comes knocking.
I devote the majority of my practice at the Forrest Firm to helping businesses, entrepreneurs, nonprofit organizations, and executives with IRS tax controversies and tax litigation, as well as helping companies take proactive strategies positioning them for tax compliance, appropriate attention to tax risk, and better growth opportunities. Please contact me to learn more about staying compliant with the new partnership audit rules or any other tax matter or IRS dispute on your plate.