President Obama signed into law last year the Bipartisan Budget Agreement of 2015 and it changed, among other things, the manner in which the IRS will audit partnerships. This change will also apply to Limited Liability Companies (LLCs) that elected to be treated as partnerships for tax purposes. While this new law goes into effect for taxable years beginning after December 31, 2017, clients need to consider now how this impacts their current partnership agreement and whether changes need to be made in advance.

Partnership Audit Rules Today

Under the rules in effect today, IRS audits of partnerships and LLCs are primarily conducted under a single administrative proceeding at the business entity level. The ultimate tax liability is decided at the entity level and any adjustments decided by the IRS flow through the entity (remember-the partnership is a pass through for tax purposes) and are allocated to the individual partners or members. In addition, the law in effect today requires that certain members of the partnership need to be notified of major findings during the audit process. Finally, the partnership level audit does not necessarily bind all partners.

Partnership Audit Rules for 2018 Tax Year

Under the new audit process, the partnership will designate a “partnership representative” in its partnership agreement for dealing with the IRS during the audit process. Individual partners no longer are required to receive notification of developments that occur during the audit process. Should the IRS make an adjustment as a result of its audit, the business entity will be responsible for the tax. This is a significant change from existing law where partnerships and LLCs were treated as flow-through entities and usually were not subject to entity level taxes. In addition, any additional tax will be assessed against the entity in the year the audit was completed. In other words, the entity will not file amended returns but rather just include this liability going forward. There are ways in which the entity can still shift the audit adjustment to individual partners, such as the issuance of adjusted schedule K-1s, but this getting beyond the scope of this post.

Practical Insights

The new law has an annual opt-out provision for business entities with less than 100 partners so long as certain other membership restrictions are met. Current partnership and LLC operating agreements need to be reviewed to consider what, if any, changes need to be made with respect to admitting prospective member in light of the new law. In addition, new members need to be cognizant of the fact that under the new law, new partners will be responsible for the tax sins of the past. New indemnification provisions need to be added, or at the very least considered, from both the existing individual partner perspective and potential new partner as well. Does the partnership want to require that all entity level audit assessments be shifted to the individual partners/members to maintain pass–through treatment? Should the organizational documents be amended to require that partners and members be required to receive notification of significant developments during the audit process? All these considerations are just that-considerations. No one solution will fit all scenarios and discussions over what is best should occur to prevent any unwanted surprises in upcoming tax seasons. To review your company’s organizational agreements, or if you have any questions, please feel free to contact Doug Leavitt at Danziger Shapiro & Leavitt, P.C.

This entry is presented for informational purposes only and does not constitute legal advice.

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