Changes to IRS Partnership and LLC Rules

You may have heard that the IRS’s ability to audit partnerships (including multi-member LLCs) will be greatly enhanced due to changes made by the recent Bipartisan Budget Act of 2015. The IRS will be ramping up its partnership audit efforts and training auditors. Congress projects these new procedures to generate over $9.3 billion in new revenue over a 10 year period. The new rules apply to tax years beginning after 2017, and will apply to partnerships of 100 or more partners. It will apply to other partnerships as well, if one or more members fit certain categories (i.e., a member itself has more than one hundred partners).

Partnerships need to begin preparing now for these changes by amending their agreements, selecting a new “Partnership Representative,” and making decisions that will affect internal operations for years to come.

Currently, few partnerships are audited by the IRS, in large part because the agency cannot assess partnerships directly, but instead must pursue each partner for its share of any assessment, often through multiple tiers. The default rule under the new Budget Act requires the IRS to assess the partnership if filing errors are detected during an audit, and a Partnership Representative (“PR”) must then quickly decide whether the partnership itself (the current partners, indirectly), or those who were partners during the audit period, should pay the assessment.

First and foremost, a PR should be designated well before the end of 2017. He or she will be the sole contact person with the IRS auditor and is authorized to make all decisions regarding how to handle the audit, whether to appeal the assessment or settle, and whether the partnership will “push out” the assessment to the former partners or pay the assessment itself. The partnership and all its partners will be bound by actions taken by the PR in connection with partnership audits.

Initially, the PR (we think) makes the decision whether the partnership can opt-out of the new rules – and the first step is determining whether that option is available based on head count. The partnership must have 100 or fewer partners, and all partners must be either individuals, S corporations, C corporations, or estates of deceased partners. If you have an S corporation partner, then you must count each of its shareholders for this purpose. If even one of the partners is another partnership/LLC, a disregarded single member LLC (unless future guidance says otherwise) or a trust, the partnership is automatically thrown into the new regime. No opt-out.

Your company’s current tax matters partner or tax matters member will need to be replaced, as the old law is being repealed for tax years after 2017. If a new PR hasn’t been designated, the IRS will have the authority to designate one for you. So start thinking about (1) who the new PR should be, (2) what level of indemnification will be afforded them against any costs or liabilities that may be incurred in acting that role, and (3) the level of accountability they will have to the company and its partners. The PR need not be a partner.

Your LLC or partnership agreement may require review for how one handles a past tax liability for a retiring partner or member. Or for how your JV will deal with a late audit, long after the JV’s single-purpose project is completed.

A final warning: if you are contemplating a new business venture that will be classified as a partnership for tax purposes (including an LLC or joint venture), or if you need to amend an existing agreement, then these changes should be incorporated into the new or revised agreement immediately, even though detailed guidance from the IRS on many aspects of the Budget Act is not expected to be released until later this year.