New IRS Audit Rules for LLCs and Partnerships Take Effect for Tax Years Beginning After Dec. 31, 2017

The 2015 Bipartisan Budget Act repealed 35-year-old IRS audit procedures for LLCs and partnerships. In order to bring the new guidelines completely into effect, IRS audits of partnerships and LLCs will increase. It is important for LLCs and partnerships to begin planning now to minimize tax consequences.

What does this all mean?

The new IRS audit rules apply to all LLCs and partnerships with tax years beginning after Dec. 31, 2017, which means they will apply to most tax returns required to be filed in 2019 and thereafter. Tax returns for years before 2018 will still be subject to the old IRS audit rules.

Under the old rules, a 2015 partnership income tax return that incurs a 2017 audit and proposed adjustments would require the 2015 partners to pay any additional tax, interest, and penalties. With the new audit rules, all additional liabilities must be paid by the CURRENT partnership (this will affect all partnerships and LLCs existing after Dec. 31, 2017, and beyond).

Although IRS audits will not commence until 2020 at the earliest, now is the time for partners, LLC members, accountants, and lawyers to review business structures and amend partnership and operating agreements to prepare for the new changes. This is true because many tax year 2018 partnership tax returns will be filed in 2019 subjecting 2018 tax returns to the new audit rules. Some important items to note:

  • New partners coming into a partnership need to be aware of possible IRS audits for prior tax years. The economic impact indirectly falls on partners in years subsequent to the audited year. If partners have changed over the years, those who indirectly end up paying additional tax may be different from those partners who reaped any tax benefits in earlier years.
  • The IRS must apply the highest individual or corporate tax rate when computing additional tax, interest, and penalties. So, for instance, if IRS audits a partnership’s 2018 tax return in 2020, the highest tax rate would be 37 percent (i.e., the highest individual tax rate for 2018), and assessed and collected against the 2020 partnership. Thus, the 2020 partners indirectly are burdened by the additional tax, interest, and penalties.

Opting out

For smaller LLCs and partnerships, if certain “preconditions” exist, you may be able to opt out of the new rules, which then requires IRS to audit and collect using the old rules. Under the old rules, IRS must assess and collect any additional tax, interest, and penalties from the partners of the partnership that was audited. An LLC/partnership with 100 or less “qualifying partners” can opt out, but must make an annual opt-out election attached to its tax return.

To opt-out, the current partners must be “qualifying partners.” A “qualifying partner” is defined under the law as: an individual, a C corporation, an S corporation, OR an estate of a deceased member/partner. A trust, another LLC or partnership, foreign partner, or tax-exempt organization is not considered a qualifying partner.

Those who qualify need to advise current members or partners that they are opting out. Once you opt out, IRS must proceed against each member or partner separately to collect any additional tax, interest, and penalties. The opt-out election completely absolves the current partnership (and its partners) from any additional tax, interest, and penalties.

There are definite advantages to opting out, such as avoiding additional tax, interest, and penalties based on the highest individual or corporate tax rate. However, the entity itself must make an annual election to opt out when filing its partnership or LLC annual tax return with IRS. And, some businesses who have tiered-ownership structures or multiple partners for the purposes of asset protection or tax purposes may be ineligible to opt out.

Besides the opt-out election, the new rules contain complicated procedures that each partnership must be aware of. For example, they include a “push-out election,” an “imputed underpayment computation,” and a “modification” rule. These procedures can adversely affect all partners and severely limit their administrative appeal rights within IRS.

Steps to take now

  1. Determine whether or not each partner or member is eligible for an opt-out election. Then, assure the eligible entities don’t add non-qualifying partners or outgrow the opt-out. Finally, make sure the annual opt-out election is timely-filed.
  2. Decide if it’s best to restrict ownership to only qualifying partners, or if it is prudent to convert to a qualifying entity type or amend the partnership/operating agreement to protect existing partners/members.
  3. Amend existing partnership and operating agreements to indemnify new members/partners from the economic impact of an assessment based on an audit year when they were not members/partners. (Indemnification should be a standard item of discussion for each new agreement.)
  4. Amend existing partnership and operating agreements to specify rules for nominating the “partnership representative” (PR). Under the new rules, the PR has sole authority to make tax decisions binding the entity and all partners and members. Those amendments must also address: appointing the PR, the scope of PR’s duties, indemnifying the PR, removing the PR, resignation of the PR, appointing a successor PR, and how to involve partners in PR decisions. NOTE: If the partnership fails to identify a PR, the IRS must nominate one. And that would not be favorable to the entity or its partners.

Existing partnership and LLC operating agreements should be reviewed and amended sooner rather than later. While amendments can always be made to reflect further guidance, it may be difficult for existing partners to agree on tax allocations. So, the sooner the process begins, the less likely that problems will arise if a future IRS audit occurs.

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    Howard L. Richshafer

    Howard Richshafer joined Wood + Lamping in 2008, and his practice is focused on civil and criminal tax problems, estate planning and probate, tax court trial work, mergers and acquisitions, and general corporate business matters. Howard is also a licensed Ohio CPA. Over the past 40 years, Howard has represented clients experiencing all types of civil and criminal tax problems with IRS. Those problems include IRS audits, IRS criminal investigations, enforced collection of unpaid tax liabilities involving levies, liens, and seizures of assets and income.

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