New Partnership Audit Rules
Effective for tax years beginning after December 31, 2017, the Federal income tax audit rules applicable to tax “partnerships” have been substantially modified. These new rules apply to any entity classified as a “partnership” for Federal income purposes, including limited liability companies with more than one member that have not made an election to be treated as something other than a partnership. If you own or operate a business through a partnership, a limited partnership or a limited liability company, or otherwise hold an interest in such an entity, it is likely these new rules have a potential impact on you and your liability for income taxes attributable to the income of the entity.
What are the new rules and why should I care?
Under prior law, the liability for partnership audit adjustments and related assessments were applied at the partner level and to those partners who were partners during the audit year in question. The new rules permit the IRS to assess the partnership (rather than the individual partners) and the assessment is applied to the partnership for the year in which the adjustment is finally determined. What this means is that current partners of a tax partnership (including current members of a limited liability company) might bear the economic burden of an assessment for an audit year in which they were not a member and for which they received no economic benefit. Fortunately, the new rules generally permit tax partnerships to avoid the application of the new rules and push the economic burden onto the partners who were the partners during the audit year. However, to ensure such treatment, an amendment to the Operating Agreement or other governing document of the entity is generally required.
If my partners and I are comfortable with the new rules, do I need to do anything?
Even if you and your partners are comfortable with the new rules, you may still want to consider amending your Operating Agreement (or other governing document) to name and address certain issues relating to the new rules. In particular, you should consider adding a provision naming and clarifying responsibilities and duties for the “partnership representative.” Under the new rules, the “partnership representative” replaces the “tax matters partner” under prior law. Your Operating Agreement likely contains a provision naming a tax matters partner. This provision will be inoperative with respect to tax years subject to the new rules. While the partnership representative is similar to the tax matters partner, the new representative has much broader powers and authority. Thus, the selection of the partnership representative is of much greater potential consequence than the selection of the tax matters partner under prior law. In addition, in the event a partnership fails to name a partnership representative, the IRS has the power to appoint such person.
I have a single-member limited liability company, do I need to do anything?
No. The new rules only apply to entities taxed as partnerships. A single-member limited liability company is a “disregarded” entity for Federal income tax purposes and, accordingly, is not subject to the new rules.
I have a limited liability company that has made an election to be treated as an S corporation, do I need to do anything?
No. As noted above, the new rules only apply to entities taxed as partnerships. Although a limited liability company with more than one member is generally classified as a “partnership” for Federal income tax purposes, such an entity can make an election to be treated as an S corporation or a C corporation for tax purposes. In either case, such an election would result in the entity not being a “partnership” and, therefore, not subject to the new rules.