The Bipartisan Budget Act of 2015 (the “BBA”), which was signed into law in November 2015, contains significant changes to the way the IRS will audit partnerships beginning in 2018. These changes will also have far ranging effects to the way members of many limited liability companies must prepare for a potential tax liability resulting from an IRS audit. Under the BBA, the TEFRA audit rules that have been in place for nearly thirty years were repealed and replaced with new “streamlined” entity-level audit rules. Since many healthcare limited liability companies and professional limited liability companies are relatively small entities (less than 10 members) and taxed as partnerships, the healthcare industry in particular must prepare for the new audit rules under the BBA.
The old TEFRA rules provided a “small partnership” was automatically exempt from an entity-level audit by the IRS. To be a “small partnership,” an LLC must generally have fewer than 10 partners and have no members who were an LLC or a corporation. Furthermore, the qualification of being a small partnership was determined on an annual basis, and it was possible for a partnership to be covered by the TEFRA entity-level audit rules in one year and not in a subsequent year.
Tax liability resulting from an IRS audit under TEFRA also passed through to the ultimate individual member’s tax returns. This requirement often caused significant difficulty for the IRS in both determining each partner’s share of the tax liability adjustment, as well as collecting the tax owed from each member. The difficulty in collecting outstanding amounts owed was further complicated by the IRS being unable to apply any tax liability to the entity, even though members of an LLC could change multiple times during the period being audited.
Although the new audit rules under the BBA were designed to make the IRS’s collection of tax liabilities simpler, this simplification will require a significant redesign of the way members must look at their relationship with their company, and with the company’s current and former members. The key features of the new audit rules are as follows:
- Rather than assessing a tax to individual partners, the IRS will assess the partnership an “imputed underpayment,” which will be subject to the individual or corporate tax rate regardless of the actual tax rate applicable to individual members.
- Any tax liability from an audit will be assessed at the company level in the year of the adjustment (when the audit occurs) rather than the tax year under audit. As a result, subject to two exceptions, current members may be liable for the tax errors that benefited the company’s prior members.
- The new law requires an LLC to appoint a “Partnership Representative.” It is not yet known whether the IRS will treat this person the same as the Tax Matters Member.
Small Partnership Exception
LLCs with fewer than 100 members, and which have no member that is an LLC or a C-Corp (S-Corps are allowed) may opt out of the new audit rule. To opt out, an LLC must:
- Submit to the IRS the names and TINs of each of the members, including the names of each of the shareholders of an S-Corp member.
Implications for Healthcare LLCs
As a result of the BAA, each healthcare LLC will need to update its operating agreement to remain in compliance with the law, protect members, and ensure that any tax liability is allocated equitably. These changes should include:
- Requiring managers of companies that meet the small partnership exception to elect out of the audit rules on an annual basis and comply with the member notification requirements;
- Creating rules limiting who can be a member for those companies wishing to remain eligible to opt-out as a small partnership;
- Establishing rules for electing a Partnership Representative as well as defining actions the partnership representative may take;
- Allocating any assessed tax liabilities in accordance with agreed upon measures;
- Providing procedures that members must follow to allow the company to qualify for one of the two exceptions to the entity level tax assessment.
Even though the new rules will not take effect until January 1, 2018, the BBA will have a substantive impact on tax planning for healthcare limited liability companies being taxed as partnerships. As a result, companies need to take proactive steps to prepare for the new IRS audit requirements by reviewing their operating agreements to determine which changes are needed.