February 15, 2017
The procedures the IRS uses to audit entities that are taxed as partnerships will change for tax years beginning after December 31, 2017. The changes will apply to any entity that is treated as a partnership for tax purposes, and they are significant enough that existing partnership agreements and LLC operating agreements should be reexamined. The changes also have implications for those who are considering investing in an existing entity that is taxed as a partnership.
Dissatisfied with the existing procedures for partnership audits, Congress created a new system with the passage of the Bipartisan Budget Act in late 2015. The new procedures change who is liable for the additional taxes, and they curtail partners’ rights to participate in audits and any resultant litigation. There are also changes in the types of partnerships that are covered by the centralized audit process.
Who pays the additional tax?
Perhaps the most dramatic change is that when a partnership is audited, the IRS will now collect any additional tax from the partnership along with interest and any penalties, rather than making adjustments to individual partners’ returns for the relevant tax years and collecting from them.
- This means the economic impact of additional tax liability will fall on the current partners, not those who were partners in the relevant year or years under audit.
- If there has been turnover in the membership of the partnership or a change in partners’ relative interests, this can be inequitable.
- If you are considering an investment in an existing partnership, you may be buying tax liability.
Partnerships have a variety of options to protect the partnership from liability for additional tax, interest and penalties. The new regime authorizes a “push-out” election that the partnership can use to force the IRS to collect from those who were partners in the relevant years; partnerships that will want to follow this path should consider incorporating that decision in their partnership agreement to avoid future disputes.
- Another potential provision to consider in a partnership agreement would be a tax indemnity clause to protect the partnership in the event that the push-out election is ineffective.
- Partnerships may also want to reexamine the timing for repayment of capital to withdrawing partners.
What about partners’ rights?
Partners generally had the right to notice of the audit and any judicial proceedings and could participate if they wished to do so. Under the new procedures, authority over the audit and any litigation will be centralized in a partnership representative who can bind all of the partners without requesting their input.
- A partner no longer has any statutory right to participate in or challenge the results of an audit.
- A partner no longer has any statutory right to participate in litigation.
- Unless the partnership or the partnership representative informs the partners about the audit, they may not learn about it.
It remains to be seen how courts will react to these changes, which appear to raise some serious due process issues. In the meantime, partnerships may wish to consider whether they want mechanisms in place to control the discretion of the partnership representative and provide information to partners.
- Minority partners and former partners will have concerns about decisions that may affect their tax liability under either a push-out election or a contractual indemnity provision, as decisions may be made about an audit without their input.
- Majority partners and the partnership representative will have concerns such as who bears the cost associated with audits as well as the prospect of litigation with partners over tax issues.
Partnerships may want to consider setting up procedures to assure partners of notice in connection with audits and litigation and to provide affected partners with input into decisions made in connection with an audit or litigation.
What partnerships are covered?
Another key change in the new act is the way it treats smaller partnerships. Under existing law, partnerships of ten or fewer members were generally exempt from the centralized partnership audit procedure.
- Now, those partnerships will need to make an annual election to exclude themselves from the partnership audit regime.
- This change means that some small partnerships may find themselves covered by the partnership audit procedures by accident.
On the positive side, the new provisions in the Code offer an opportunity for partnerships of up to 100 partners to opt out of the new procedures and force the IRS to audit each partner individually. Only partnerships comprised of individuals, estates of deceased partners, C Corporations, S Corporations, and foreign entities that would be taxed as C Corporations under U.S. law are eligible.
- Congress granted the IRS discretion to expand the list of eligible partners, but the initial indications are that it will not do so.
- Consequently, the presence of a partnership, a disregarded entity, or a trust as a partner will preclude a partnership from opting out of the partnership audit procedures.
- Partnerships that currently qualify may want to incorporate transfer restrictions into their agreement to maintain their ability to opt out.
Disclaimer: This E-Flash is intended to highlight some issues that may be relevant to businesses operating as partnerships for tax purposes; it does not offer specific legal advice, nor does it create an attorney-client relationship. You should not reach any legal conclusions based on the information contained in this E-Flash without first seeking the advice of counsel.
About the Authors:
James R. Malone, Jr. is a Principal in the Firm’s Tax Controversy Practice. He represents clients in disputes with federal, state and local tax authorities. Mr. Malone represents clients – including businesses, individual taxpayers, accountants and tax preparers – in both administrative proceedings and in court. Learn More >
F. Traynor Beck is a Principal and Chair of the Firm's Corporate Practice Group. He concentrates his practice on corporate, mergers and acquisitions, and business law, and advises early stage companies with respect to their capital formation needs.Mr. Beck has more than 30 years of experience in public finance, mergers and acquisitions, general corporate and project finance. Learn More >