How New IRS Audit Rules May Affect Your Partnership Operating Agreement
| October 15, 2018
If you own an interest in a partnership, or in a limited liability company that is taxed as a partnership, you should consider whether to update your partnership or operating agreement to deal with the new IRS audit rules under the Bipartisan Budget Act of 2015 (BBA). Effective as of January 1, 2018, BBA replaced the partnership audit rules in the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”).
The most dramatic change under the new audit rules is to make the partnership or LLC liable for “imputed” income tax on any adjustment of the partnership’s taxable income following an audit of the partnership. The imputed tax will be calculated at the highest marginal rate applicable to corporations and individuals then in effect. This assessment of imputed tax can be particularly harsh if some of the partners at the time of the assessment were not partners in the audited year. A partnership or LLC can escape this potential liability only if it makes either of two elections that may be available under BBA: the small partnership election or the push-out election.
Small Partnership Election
If the partnership or LLC qualifies as a “small partnership,” it can elect to opt out of the new rules for any tax year during which it has 100 or fewer partners or members, and every partner during that year is an individual, a corporation, or the estate of a deceased partner. If it qualifies, a partnership or LLC must file the election annually with its tax return. However, a partnership or LLC that has a trust, another partnership, or an LLC as a partner cannot qualify as a “small partnership,” no matter how many partners it has.
Push-Out Election
If there is an imputed tax assessment, the partnership can elect to “push out” the imputed tax assessment on a pro rata basis to the persons who were partners in the year that was under review in the audit. The partnership must make this election within 45 days after receiving the final adjustment notice and must provide each partner for the reviewed year with a statement of the partner’s share of the adjustment. The benefits of making this election include avoiding paying the tax at the partnership level and shifting the liability from current partners to the persons who were partners during the reviewed year.
If a partnership wants to make either of these elections, the partnership or operating agreement should be revised to require an election, or to specify who has the right to make an election.
Difference Between TEFRA and BBA
Another difference between TEFRA and BBA is to replace TEFRA’s concept of a “tax matters partner” with a “partnership representative” under BBA.
Under TEFRA, the designated “tax matters partner” was responsible for coordinating the audit, but each individual partner retained the right to participate in the audit and negotiate such partner’s own settlement regarding any underpayments.
Under BBA, the designated “partnership representative” has the sole authority to participate in an audit, does not have to give notice of an audit to the partners, and binds the partnership and all of the partners with his decisions regarding the audit.
If a partnership fails to designate a partnership representative, the Internal Revenue Service can select any person. However, a partnership or operating agreement should describe how the partnership representative is chosen and can require that a partnership representative have fiduciary duties to the partners, including the duty to act in the best interests of the partners, to consult with the partners, and to obtain the partners’ consent for his actions. Similarly, partnership representatives will want provisions that protect them from claims by the partners who are displeased with how the audit was handled.
Author Bio
May Lu’s practice focuses on business disputes, corporate and business planning and formations, mergers and acquisitions, and may other transactional needs of businesses and their owners.
James Reynolds is a Harvard Law School graduate (1974) whose practice focuses on many areas of business solutions, including business planning, formation and financing, business disputes and mergers and acquisitions.
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