New tax rules will make sweeping tax partnership audit changes impacting all tax partnerships, may cause substantial inequities between members and may result in surprising tax liabilities. The new tax audit rules are intended to enable the IRS to audit, assess and collect tax at the tax partnership level, and increase the frequency of IRS audits of tax partnerships. The IRS won an advantage in the 2015 Budget Act1 designed to help the IRS in auditing entities taxed as partnerships, including multiple member LLCs and state law partnerships.2 Recently re-released IRS regulations carry forward the new tax audit regime, that will be effective for partnership tax years beginning in 2018 (“New Rules”).3
The New Rules impact the most popular legal entity today, the limited liability company.4 Multiple member LLCs will face numerous considerations ripe for member negotiations, among them:
- exposures to new entity level tax liability;
- new elections and choices that will impact member liabilities;
- greater need for member information and cooperation;
- designation of the new tax partnership representative (to preclude IRS designation);
- broader authority for the tax partnership representative, including sole authority to act for the LLC;
- new notices from the tax representative to members;
- matters involving modifications of imputed tax partnership underpayments;
- electing alternatives to tax partnership payment of imputed underpayments;
- seeking judicial review;
- inability of members to object to partnership penalties;
- possible liability shifts from departed members to current members;
- new due diligence in purchases of member interests and in partnership tax terminations;
- new concerns for tiered partnerships, trust owners and for tax exempt members;
- and new indemnifications and security for new indemnifications.
Administrative challenges in auditing tax partnerships stimulated the IRS to seek rules to facilitate and enable more tax partnership audits. Under current rules, the IRS must seek payment of any deficiencies in tax, penalty and interest determined in audits of tax partnerships from individual owners, which has hindered tax partnership audits. Generally, under current law, tax partnerships with fewer than 10 members are subject to general taxpayer audit rules,5 and in some cases involve both tax partnership audits and member audits. Also, relatively fewer tax partnership audits of LLCs with more than 10 members have resulted, partially due to complex audit rules in place since 1982 that have been cumbersome to the IRS.6
The New Rules will substantially impact LLC governance issues. Tax partnership audits will encompass a broader scope of tax matters at the tax partnership level, with possibly less transparency to the members who are not the new “partnership representative.” The designated or IRS chosen partnership representative is granted broader powers under the new rules than the tax matters partner is granted under current law. Important new elections will have impact on determining which IRS audit regime applies (that is, if the tax partnership is eligible to, and whether to, opt out of the New Rules), if the members will be required to file amended returns, and in effect who pays tax, penalty and interest deficiencies. In some cases, the IRS will be able to collect audit deficiencies in tax, penalties and interest directly from tax partnerships.
The new tax partnership audit rules are important today for members to consider before their effective date in 2018, in negotiating, drafting and amending LLC Operating Agreements. The new rules will impact the balance of power and control over important tax obligations between members. At the time of an audit, different negotiating positions may prevail than exist currently, making changes to operating agreement provisions difficult.
We recommend that every LLC Operating Agreement be examined in light of the new tax partnership audit rules, and be revised to reflect the New Rules and control issues raised by these new rules.
1 The Bipartisan Budget Act of 2015.
2 Generally, the same tax rules apply to a state law LLC taxed as a partnership and a state law partnership taxed as a partnership. For simplicity, this article will refer to LLCs and LLC members only.
3 The re-released IRS regulations were issued on June 13, 2017. They are nearly identical in most respects to the earlier 2016 regulations that were frozen by the Trump administration and withdrawn by the IRS.
4 Background. If properly organized and maintained, a single owner or a multiple owner LLC will be a separate legal entity for Michigan law purposes that is useful in many transactions to separate and protect the owner member(s) from many of the LLC’s business liabilities and other exposures. For most federal income tax purposes, a single member LLC is not treated as a separate entity, but instead, is disregarded, and the member owner is treated as the taxpayer for the LLC’s business activities, asset acquisitions and sales. A multiple member LLC is most often taxed as a partnership, with special exceptions. A state law partnership is taxed as a partnership. Tax partnerships have been long valued among entity choices because a tax partnership is in many respects flexible and offers taxpayer friendly tax benefits to member/partner owners. A tax partnership is not a taxable entity. Instead, a tax partnership is a conduit. Partnership income, deduction, gain, loss and credit are reported for federal tax purposes, and taken into account by the owner partners (e.g. LLC members). A tax partnership files a partnership tax information return, and provides to each member partner a statement of partnership income tax information and allocations to the member partner for tax reporting.
5 Tax audits are conducted at the LLC/partnership or member/partner level, depending on the number of members/partners and types of items involved. Tax deficiency liabilities are imposed directly on individual members/partners.
6 Under the “TEFRA” rules, the IRS must notify the tax matters partner and some partners, and all partners may participate.
For further information regarding these matters, please contact Mr. Acker at 248.740.5665 or via email.