Effective 1/1/2018 – The manner in which the IRS (and some but not all states) will audit entities taxed as a partnership (including most LLCs) will change substantially as of January 1, 2018. These changes have significant implications for individual liability for partnership/LLC tax and will require a consideration of whether an opt out is available and, if so, advisable, and otherwise will require changes to the wording of most partnership/limited liability company agreements. Under current rules (known as the TEFRA rules), the IRS conducts audits at the entity level but collects the tax at the PARTNER/MEMBER level. The new rules (the BBA rules) move to a regime that allows the IRS to collect the tax from the ENTITY. Proposed regulations implementing the BBA rules were published in June.
Audits under the BBA rules will be binding on both the entity and the partners/members. This means that unless various elections are made under the BBA rules, the owners who are owners in the entity for tax purposes at the time of audit will ultimately bear the tax and cost of the audit even if they were not an owner in the entity for the year being audited. For example, if an investor becomes a member of an LLC in 2020, and if the IRS later audits the LLC for tax year 2018 and finds that additional tax is due, that investor will bear the risk and cost of additional tax, penalties and interest (which the LLC is forced to pay) even though not a member in 2018. The rules currently in effect impose that tax liability on those who were partners/members during the tax period, not on the entity, and so a new partner/member has not historically had to worry about personal liability for prior year taxes.
The reasons that the BBA rules were adopted are to streamline the very cumbersome TEFRA rules, reduce the burden on the government and enable the government to raise an estimated $10 billion in additional revenue since audits and collections will be much easier.
Why is doing nothing not an option? There are two primary reasons:
- No entities taxed as partnerships are grandfathered from these rules. They will apply to all entities taxed as partnerships regardless of when formed unless the entity qualifies for the opt-out election and actually makes the election. An entity can opt out (meaning that the old TEFRA rules will apply to audits) only if it sends out 100 or fewer K-1s AND if the recipients of those K-1s are individuals, C corporations, a deceased partner’s estate and certain S corporations. The entity cannot opt-out (and thus the BBA rules will apply) if any of the partners/members are partnerships, LLCs, disregarded entities, trusts, nominees, or the estate of a person other than a deceased partner. The reason for this is that the IRS does not want to have to “chase” indirect owners of the entity to collect tax. Thus for the vast majority of entities taxed as partnerships, they will not be able to opt-out of the new BBA rules. The IRS has indicated that it intends to carefully review an entity’s decision to elect out of the BBA rules to ensure that the entity meets the eligibility requirements.
- All entities taxed as a partnership will need to designate a Partnership Representative (PR) who will be the sole point of contact between the IRS and the entity and who will have much broader authority than the TEFRA tax matters partner. Under the TEFRA rules entities have been required to designate a tax matters partner (who must be a partner) who can bind an entity to audit adjustments but who cannot bind the partners. Further, the tax matters partner must notify partners of an audit and the partners have certain rights in connection with the audit. However, under the new rules, the PR will have very broad power to make virtually all decisions and elections for the entity under audit and, therefore, may affect a partner/member's individual tax liability. The PR is not required by statute or the proposed regulations to give notice of the audit to any partner/member and the PR’s actions will bind the partnership/LLC and the partners/members. As to the IRS, the PR’s authority cannot be limited by state law or the partnership/operating agreement. If an entity fails to designate a PR (done annually on the IRS Form 1065), then the IRS may select any person to serve as PR. Thus, it is extremely important that the PR be chosen with care and that the partnership/operating agreement address the contractual rights and obligations that the PR has vis-a-vis the entity/partners (members).
Under the proposed regulations, an entity may designate any person, including an entity, to be the PR; provided that such person has a substantial presence in the U.S. The PR does not need to be a partner or member of the entity. The proposed regulations set forth a three-prong test to determine the PR’s eligibility (i) the person must be able to meet in person with the IRS in the U.S. at a reasonable time and place, as determined by the IRS; (ii) the PR must have a U.S. address and telephone number where the PR can be contacted during normal business hours; and (iii) the PR must have a taxpayer identification number (TIN). If the partnership/LLC designates an entity to be its PR, the partnership/LLC also needs to appoint an individual with a substantial presence in the U.S. to act on behalf of the entity.
Many of the BBA rules are complex and beyond the scope of this alert; however, each entity taxed as a partnership promptly needs to take the following actions:
- Determine eligibility to elect out of the BBA rules, if desired.
- Determine who should be the PR.
- Consider what limitations will be put on the PR’s authority? How will the PR be indemnified? What fiduciary obligations will the PR have to the members/partners?
- Consider and address what will happen on dissolution. A separate agreement or escrow may be necessary to address future audits where the statute of limitations remains open. Under the proposed regulations, the last partners owning the partnership/LLC interests at the time of dissolution will be responsible for paying any allocable share of any partnership/LLC underpayments.
- Amend the partnership/operating agreement to reflect the new BBA rules.
- Consider what other agreements will be affected by the BBA rules. For example partnerships that are Private Equity or Hedge funds likely will have to update offering materials to disclose the new rules and their effect, including that the entity, and current partners, could be liable for taxes that relate to prior years.