Partnerships and Limited Liability Companies Take Note: Significant Changes in IRS Audit Procedures Take Effect January 1, 2018
Under pre- 2018 rules, when a partnership (which for this Client Alert will include a limited liability company which is taxed as a partnership) was audited by the IRS, one of the partners acted as the “Tax Matters Partner” to interface with the IRS. If an adjustment was made to the partnership’s income, the additional tax liability, and all penalties and interest, was paid by the partners. Each partner had the right to participate in the audit, to disagree with the positions taken by the Tax Matters Partner, and to contest the partner’s additional tax liability. The IRS found that the rights afforded to each partner made it difficult to conduct partnership audits and to collect additional tax. The IRS therefore asked Congress to limit the rights of individual partners in and following a tax audit.
In 2015 Congress passed the legislation requested by the IRS, and the new rules become effective January 1, 2018.
Important changes to understand:
Each partnership must have a “taxpayer representative” rather than a “Tax Matters Partner.” This means that the representative need not necessarily be a partner or member. The taxpayer representative must have a U.S. address, a U.S. taxpayer identification number, and be available to speak with the IRS by telephone during normal business hours.
- The partnership must designate a taxpayer representative separately for each year on the partnership’s tax return. If different representatives are named for different years, an audit could involve multiple representatives. If the partnership does not appoint a taxpayer representative after notice of an audit, the IRS has the right to appoint one of the partners or any other non-partner.
- The taxpayer representative is the only person who will receive a notice of audit or other administrative proceeding.
- The decisions made by the taxpayer representative are binding on the partnership and all of its partners, without the current right of each partner to contest the matter in the courts.
- The tax liability, including all penalties and interest, resulting from the audit will generally be imposed directly on the partnership, and not on the partners individually, but charged to the partners’ capital accounts. The tax will be calculated using the highest marginal tax brackets.
- Interest is charged from the time tax returns were required to be filed for the year under review until the date payment is made.
- The partnership may be subject to tax not only for changes in the overall amount of tax due, but also for any improper allocation of income, gain, loss or deduction among the partners.
There are of course certain elections that may be made to mitigate the severity of these changes:
- Certain partnerships with fewer than 100 partners (including shareholders of S Corporations) may opt out of the new rules. However, if the partnership has another partnership or a limited liability company as one of its members, the Opt-Out option is not available.
- A partnership may elect, within 45 days after receiving an IRS final notice of a partnership adjustment, to “push out” to its partners the tax, penalties and interest which must be paid, if that would reduce the overall tax because the partners are in lower tax brackets than would be applied to the partnership.
Each existing partnership/LLC should amend its partnership/operating agreement to provide for:
- The appointment of the taxpayer representative, as well as for the possible removal of the taxpayer representative and a mechanism to appoint a successor.
- Notice requirements to the partners/members of any IRS audit proceeding and updates throughout the audit.
- Limitations on the ability of the taxpayer representative to take certain actions without the prior approval of either management or the partners/members of the partnership/LLC, including the agreement as to any tax return adjustment, the extension of the statute of limitations, hiring counsel for an audit, and making the “push-out election” referenced above, and incurring other substantial expenses.
If you have any questions about the application of these new rules, please do not hesitate to contact us.