Last week, President Obama signed H.R. 1314, the Bipartisan Budget Act of 2015 (the “Legislation”), which dramatically changes the manner in which partnerships (and LLC’s taxed as partnerships) are audited and taxed by the IRS. The Legislation is effective for tax years beginning on or after January 1, 2018, but partnerships may elect to be subject to the new rules immediately.
Historically, a partnership has not been separately subject to federal income tax, but instead passes through to its partners items of partnership income, gain, loss, deduction and credit in accordance with the partnership agreement. The partners, in turn, report on their respective tax returns such items and pay any resulting tax liability. The Legislation enables the IRS to not only conduct an audit at the partnership level (as is currently the case under the TEFRA partnership level audit rules), but allows the IRS to assess and collect any resulting tax deficiencies from the partnership rather than the partners. As a result, the Legislation’s default rule will result in the partnership and not the partners being liable for any income taxes, including interest, resulting from an audit adjustment. If the partnership has experienced any change in ownership during the period between the tax year to which the adjustment relates (the “reviewed” year) and the year in which the IRS assesses a tax deficiency against the partnership, the economic burden of the assessed taxes may be borne by partners who had little or no interest in the partnership for the year audited by the IRS. In addition, a partnership level audit will now be controlled by a “partnership representative” rather than the “tax matters partner.” The Legislation will cause partners to have fewer rights to contest any proposed assessments, and any action taken by the partnership representative, including any final decision resolving an IRS audit, will generally bind the partners.
The good news is that there are several means of electing out of or reducing the potentially harsh effect of the foregoing new partnership audit, assessment and collection regime. First, if a partnership has 100 or fewer partners and all of the partners are individuals, C corporations, S corporations or estates of deceased partners, then the partnership can annually elect out of the default rules if the names and taxpayer identification numbers of each partner and each shareholder of any S corporation partner are provided to the IRS with the filed partnership return. However, this election is not available if the partnership is unable to timely obtain this information or has any partners that are another partnership or an LLC taxed as a partnership. A second option requires the audited partnership to issue adjusted Schedule K-1’s to each of its partners within forty-five days of the partnership receiving a notice of final partnership adjustment from the IRS. If this option is elected, each partner from the reviewed year (rather than the partnership) will be responsible for his, her or its share of the resulting tax deficiency for that year and future years if also affected. This second alternative requires the partners to pay interest on any underpayment of tax at a rate two percent higher than the interest rate that would apply if the partnership remained liable for the tax, so continuing partners may have different preferences as to whether this election is made. Third, the Legislation provides a number of means of reducing what the partnership has to pay if electing out of the new rules is not possible. The Legislation makes certain assumptions about tax rates and character of income to maximize the amount owed to the IRS, and also ignores any reductions in tax for certain partners that might arise out a partnership level adjustment. However, the partnership can reduce the partnership’s tax liability by, among other things, (i) requiring partners to file amended returns for the reviewed year that reflect increased tax liability for those partners (who then actually pay the additional tax), and (ii) proving to the IRS that certain partners are tax-exempt or are entitled to a reduced rate of taxation on certain items such as capital gains or qualified dividends.
Even though the Legislation is effective for partnership taxable years beginning on or after January 1, 2018, if you are negotiating a partnership agreement or an LLC operating agreement now, you need to consider including provisions in the agreement that either ensure that the partnership can elect out of the new rules or address how to cause the partnership to have the partners, past and present, equitably share any partnership level tax liability. For example, you may want to build into the agreement (i) that only individuals, S corporations, C corporations and estates of deceased partners can be partners or members so that the 100 or less partner exception is available or (ii) a mandatory use of the 45-day rule referred to above. Even if you are considering investing in a preexisting partnership or LLC taxed as a partnership, you need to be thinking about negotiating provisions that make you whole with respect to federal income tax liabilities paid by the partnership on account of an IRS audit of 2018 or later years for which you would have no liability if the adjustments resulting from the audit passed through to the partners as is the case under current law. The members of the Womble Carlyle Tax Practice Team, whose names and contact information are listed below, would be happy to assist you in addressing these significant economic issues that arise from this radical departure from present partnership tax law.