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BOB BOX — New IRS audit rules and the need to revise your partnership/LLC agreement now

BOB BOX

The IRS’s new partnership audit rules took effect this year creating the need for all partnerships and most LLCs to review and revise their partnership agreements and LLC agreements. The manner in which the IRS will audit partnerships and LLCs under the new rules has dramatically changed the landscape for these entities. It is easier now for the IRS to audit them by requiring the designation of a single partnership representative as the sole authority to act on behalf of the partnership/LLC in an audit. It is also easier for the IRS to assess and collect any additional taxes by making the partnership/LLC, in addition to its partners/members, liable for payment. Partnership/LLC agreements need to address the designation, duties and authority of the partnership representative and the making of certain elections on the partnership income tax return.

Which Partnerships and LLCs are Impacted

The new audit rules apply to all partnerships and all LLCs taxed as partnerships. If the entity qualifies and elects to opt-out, these new rules will not apply, and the IRS must audit, assess and collect any additional tax separately from each partner/member, not the partnership/LLC.

A partnership/LLC may elect to opt-out of the new audit rules only if it has 100 or fewer partners/members who are individuals, corporations or estates of a decedent. If any partner/member is a partnership, an LLC (including single member LLC), a trust (revocable or irrevocable) or a nominee of an individual, the partnership/LLC cannot opt-out. The IRS has indicated that it intends to carefully review opt-out elections to ensure that they meet the eligibility requirements (i.e., It does not want partnerships/LLCs to opt-out). Thus, the vast majority of partnerships and LLCs are impacted by the new audit rules.

Partnership Representative

Previously, partnerships and LLCs (other than those with 10 or fewer partners/members) were required to appoint a tax matters partner to represent the partnership/LLC in connection with federal income tax audits. This was somewhat a benign event because the partners received notice of the audit, and each partner had the statutory right to participate in the audit, appeal and judicial proceeding. That is no longer the case.

The new audit rules replace the tax matters partner with a partnership representative. Partners and LLC members no longer have the right to receive notice of or participate in the audit. The partnership representative is the only person with authority to act on behalf of the partnership/LLC in connection with a federal tax audit, appeal or related judicial procedure. This person has authority to bind the partnership/LLC and its partners/members without their consent, as well as make (or choose not to make) any elections that are available.

Identifying the appropriate person to serve as the partnership representative, and establishing appropriate contractual responsibilities and restrictions on the actions of the partnership representative take on much greater importance. Thus, it is crucial that the partnership representative be chosen with care and that the partnership/LLC agreement addresses his contractual rights and obligations. Such responsibilities and restrictions may include covenants requiring the partnership representative to (i) provide partners/members information and notices relating to audits, appeals and judicial procedures and (ii) obtain consent from the partners/members before acting in any way that would bind the partnership/LLC.

The partnership representative must be designated each year on the partnership tax return. If not, the partnership/LLC loses its right to make the designation, and the IRS may select the partnership representative of its choosing. No partnership/LLC agreement existing before the enactment of the new audit rules (i.e., 2015) addresses the designation of the partnership representative, and most partner/members don’t know that they no longer have the right to participate in an audit. If the partnership/LLC agreement is not amended, it is unclear who, if anyone, has authority to designate the partnership representative without consent of all the partners/members.

Responsibility for Payment

The IRS is no longer required to collect from each partner/member his share of the underpayment of tax determined in a partnership audit. Pursuant to the new audit rules, it will impose and collect the underpayment of tax, interest and penalties (the “underpayment”) directly from the partnership/LLC in the year the audit concludes and the assessment is made (the “adjustment year”). As a consequence, the partners/members in the adjustment year will bear the economic burden of the underpayment even if their interests in the partnership/LLC have changed since the year under audit (the “reviewed year”) or if they were not a partner/member during the reviewed year. If the partnership/LLC agreement does not require a former partner/member from the reviewed year to pay his share of the underpayment, he will not be obligated to do so.

Alternatively, the partnership representative may elect to push-out the tax underpayment to the partners/members. The affected partners/members from the reviewed year then become liable for payment of the tax, not the partnership/LLC.

Partnership/LLC Agreements Should be Revised Now

The new partnership audit rules simplify partnership audits and significantly reduce the burden on the IRS by making assessment and collection of underpayments much easier and thereby enabling the federal government to raise an estimated additional $10 billion in revenue. These factors likely signal a significant increase in IRS audits of partnerships and LLCs for years to come.

The new rules also fundamentally alter the obligations of the partnership/LLC and the partners to each other and to the IRS creating potential conflicts of interest among the partners/members and between the partners/members and the managers. Therefore, it is very important that all existing partnership/LLC agreements be amended to address the impact of these rules. At a minimum, the amendment should address (i) the designation of the partnership representative, (ii) the authority granted to the partnership representative, (iii) the duties and obligations of the partnership representative to the partnership/LLC and the partners/members and (iv) the authority to make, or decline to make, available elections, including the opt-out election and the push-out election.

Partners/members that ignore the new partnership audit rules risk losing control in the event of an audit forgoing the opportunity to designate the their representative before the IRS and make certain elections that may be beneficial for them. Hence, they need to be proactive and amend their partnership/LLC agreements now before the 2018 partnership income tax returns are filed.

» BOB BOX is a partner for Jones Walker’s Jackson office and the Tax and Estates Group. Bob advises clients on a broad range of corporate, partnership and individual tax matters, and also estate planning and business succession matters.

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