Significant Changes in Federal Tax Law Affecting Partnerships and LLC’s
Author: Frank L. Brunetti
The Bipartisan Budget Act changed the procedures for auditing tax returns filed by partnerships. The TEFRA partnership audit procedures which were adopted in 1982 and the electing large partnership rules are repealed effective for returns filed for partnership tax years beginning after 2017.
These rules will be replaced with a new set of rules for auditing partnerships and their partners at the partnership level.
TheChanges in Federal Tax Law rules
Under the new approach, adjustments to a partnership’s items of income, gain, loss, deductions, and credits will be made at the partnership level. This means that the partnership for the first time in 75 years will be subject to a partnership level income tax. The tax rate will be the highest individual or corporate rate. Any additional tax, penalty, or additional amount related to the tax will also be determined at the partnership level [IRC Sec. 6221(a), effective after 2017]. If an adjustment to the partnership items is made, the partnership will be required to pay tax equal to the imputed underpayment, which is generally the net of all adjustments for the year under audit multiplied by the highest individual or corporate tax rate.
However, partnerships that can show that the underpayment would be lower if it were based on certain partner-level information can pay the lower amount. The information needed to show that a lower underpayment amount should apply could include amended returns of partners, the tax rates applicable to specific types of partners (e.g., individuals, corporations, or tax-exempt organizations), and the type of income subject to the adjustments ( IRC Sec. 6225, effective after 2017).
Partnership Adjustments and Requirements
Instead of taking the adjustment into account at the partnership level, a partnership can elect, not later than 45 days after receiving a notice of final partnership adjustment, to issue adjusted Schedules K-1 to the partners who were in the partnership in the year under audit. Those partners would then take the adjustments into account in the adjustment year by filing amended returns through a simplified amended return process (IRC Sec. 6226 , effective after 2017). This is called a “push out elections” which countermand the default rule above and makes the partners individually subject to the tax liability. Under this rule the interest rate on any deficiency paid by a partner is 2% higher than it would otherwise be.
Under the revised audit rules, partners generally must treat each item of income, gain, loss deduction, or credit attributable to a partnership consistently with the partnership’s treatment of the item. Any underpayment of tax by a partner due to failure to comply with this consistency requirement will be treated as a mathematical or clerical error (subject to the summary assessment procedures of IRC Sec. 6213(b)(1), and that the abatement requirement underIRC Sec. 6213(b)(2) will not apply. The consistency rule will not apply if (a) the partnership has filed a return but the partner’s treatment of the item is (or may be) inconsistent with the treatment on the partnership’s return or (b) the partnership has not filed a return, provided the partner files a statement with the IRS identifying the inconsistency [IRC Sec. 6222, effective after 2017].
“Opt out” of new rules
Partnerships with 100 or fewer partners can “opt out” of the new rules for any tax year, in which case the partnership and its partners will be audited under the general rules for individual taxpayers. Generally, to elect out, each of the partners has to be an individual, a C or S corporation, a foreign entity that would be treated as a C corporation were it domestic, the estate of a deceased member, or another person identified in future IRS guidance [IRC Sec. 6221(b), effective after 2017]. Notwithstanding if a partnership has a partnership or trust as a partner, they cannot elect out and they are subject to the new audit default rules.
Instead of waiting for the new rules to come into effect, partnerships generally can elect to apply them to returns filed after November 3, 2015.
Partnership Representative (PR)
The position of “Tax Matter Partner” has been replaced with “Partnership Representative. The “PR” need not be a partner. This person will have exclusive power to deal with the IRS. This means that the Partnership Representative will decide on resolving the tax issue and can allocate the additional tax in a manner that he, she or it deems reasonable.
Under the new rules, partners who are in the partnership in the year an adjustment is finalized bear the economic burden of any imputed underpayment paid at the partnership level, regardless of whether they were partners in the year the adjustment arose. This means that if a partnership’s tax year of 2018 is audited in 2020 and an adjustment is made in 2022, the partners who exist in 2022 will bear the economic burden of the adjustment for 2018 even though they might not have been partners in the audit year.
Adding an indemnification agreement to partnership agreements, under which partners who sell or liquidate their interest before an audit agree to be responsible for any adjustment attributable to years they were a partner, could address this problem.
Impact on Business Deal
The repeal of the TEFRA audit rules will have significant impact on every Partnership and LLC Operating Agreement and business deal.
Significant Impact on Preparation of Partnership Agreements
- Designation of partnership representative.
- Partner approval of certain decisions made by partnership representative.
- Contractual notice/participation rights.
- Indemnification by current and former partners of partnership tax liability under default rule (including method of allocating liability among partners).
Significant Impact on Partnership Transactions
- Acquisitions of partnership interests.
- Partnership M&A transactions.
- Due diligence/representations/indemnification
- Should partners seek to include in the agreements rights similar to those
notice rights of beginning of administrative proceeding and final partnership administrative adjustment (former 6223(a)); - PR is required to keep each partner informed of all administrative and judicial proceedings of partnership items (former 6223(g));
- Right to participate in the proceeding (former 6624);
- Petition for judicial review (former 6626);
- Petition for an administrative adjustment (former 6627).
Planning Ahead for 2018
All existing and newly-formed partnerships should be considering provisions to be included in amended or new partnership agreements.
Because the audit rules have changed, the economic exposure of partners and members in LLCs have changed as well. Partners and LLC members will have to rethink their agreements, and come up with indemnifications, deal with indemnification by former partners, consider escrows in the event of purchase of partnership interests, and so on and so forth.
Do you have any questions? Would you like to discuss the matter further? If so, please contact me, Frank Brunetti, at 201-806-3364.
