Recently, changes to partnership tax audit rules were added to Sections 6221 through 6241 of the Internal Revenue Code (“IRC”). These changes will allow the IRS to more easily audit and collect taxes from partnerships and LLCs. These new partnership audit rules are effective for taxable years beginning on or after January 1, 2018.
Accordingly, partners in partnerships, and members of limited liability companies that are taxed as partnerships should amend their operating agreements/ partnership agreements to address the rule changes and to name a partnership representative. Careful consideration should be taken when making changes to your documents because if a partnership does not designate a partnership representative, the IRS may select any person as the partnership representative.
What is Partnership Representative?
Changes to the partnership audit rules include replacing the “tax matters partner” with a “partnership representative.” It will now be necessary to update governing documents naming your partnership representative. This designated person will communicate with the Internal Revenue Service (“IRS”) in the event of an audit. When choosing your partnership representative, keep in mind that this person does not have to be a partner of the partnership or member of the limited liability company. This person can be anyone with a substantial presence in the United States.
Although the partnership representative can be anyone, you will want to choose the representative carefully. Keep in mind that the partnership representative can bind the partnership and the partners, and the partnership is bound by the partnership representative’s actions. To maintain control, partners or members would most likely want to adjust the partnership representative’s authority through the partnership agreement or operating agreement. For example, partners or members may want to require their approval of certain actions of the partnership representative so that the partnership representative cannot make decisions without the group’s approval.
Options with Regard to the Assessment and Collection of Taxes Under the New Rules
Under the new rules, partnerships have three options with regard to the assessment and collection of taxes attributable to an adjustment in the partnership’s income, gain, loss, credit, or a partner’s distributive share resulting from an audit of the partnership. When it comes to a partnership-level audit, the three options are: (1) the partnership pays the tax; (2) “push out” the adjustments to the “reviewed year” partners; or (3) elect out of the new rules.
Option 1: The Partnership Pays the Tax (Default)
Under the first option, which is the default option unless the partnership elects out, generally, any tax attributable to an adjustment to items of income, gain, loss, credit, or a partner’s distributive share in a partnership taxable year is assessed and collected at the partnership level. For example, unless an election is made to “push out” the imputed underpayment to the “reviewed year” partners, any imputed underpayment with respect to an adjustment must be paid by the partnership in the adjustment year. Accordingly, the partnership and its partners likely will want to be indemnified by each current and former partner of the partnership for the portion of any imputed underpayment attributable to that partner and for any costs and expenses relating to any audit or proceeding.
Option 2: Push Out Adjustments
Under the second option, instead of the partnership paying any audit adjustments, the partnership can elect to “push out” the audit adjustments to each “reviewed year” partner, and the “reviewed year” partners will be responsible for taking into account any adjustments made by the IRS and be responsible for payment of any tax due as a result of those adjustments. The partnership must make the election no later than 45 days after the date of the final partnership adjustment and furnish a statement of each partner’s share of any adjustment as determined in the final partnership adjustment to all of its reviewed year partners. Such election would cause the reviewed year partners to carry the weight of any tax that results from those adjustments. For example, each reviewed year partner must pay, with respect to the adjustment year, any increase in the tax imposed in the reviewed year and any subsequent years as a result of taking its share of the adjustments into account with respect to the reviewed year. Further, any penalties, additions to tax, or additional amounts are determined at the partnership level, and the reviewed year partners of the partnership are liable for their proportionate share of any such penalty, addition to tax, or additional amount.
Option 3: Elect Out of New Partnership Rules
Under the third option, subject to certain requirements stated in the IRC and corresponding regulations, a partnership may elect out of the new partnership audit rules. If a partnership elects out of the new rules, the IRS must open deficiency proceedings at the partner level to adjust items associated with the partnership, resolve issues, and assess and collect any taxes that may result from any adjustments. A partnership that wishes to elect out of the new rules may want to designate a partnership representative in case the partnership does not qualify to elect out or to have the partnership representative act as a liaison to the IRS.
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