Changes to IRS Partnership and LLC Audit Rules
Recent history has seen a proliferation of health care organizations—including tax-exempt organizations, for-profit companies, and physician practice groups—that have joined together to take advantage of different synergies between and among the organizations. The combined operating entity often takes the form of an entity that is taxed as a partnership, such as a multi-member LLC. The Internal Revenue Service’s (IRS’) ability to audit partnerships1 will be greatly enhanced due to changes made by the recent Bipartisan Budget Act of 2015 (Budget Act). The new rules apply to tax years beginning after 2017, which may seem far away, but partnerships need to use this time to prepare for the changes by amending their governing documents (i.e., partnership agreements and operating agreements), selecting a new “Partnership Representative” (PR), and making decisions that will affect internal operations for years to come. Speaking at a conference on March 15, IRS Chief Counsel William Wilkins confirmed that the IRS will be ramping up its partnership audit efforts. Congress projects these new procedures to generate more than $9.3 billion in new revenue over a 10-year period.
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 Budget Act requires the IRS to assess the partnership if filing errors are detected during an audit, and the 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. The PR 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. Notably, the partnership and all its partners will be bound by actions taken by the PR in connection with partnership audits.
Although it is not entirely clear, it appears that the PR makes the initial decision about whether the partnership will opt-out of the new rules. In making that decision, the first step is to determine whether the partnership is eligible to opt-out, which is 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 the partnership has an S corporation partner, then each of its shareholders must be counted separately for this purpose. And 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. This will preclude many health care organizations from opting out.
A partnership’s current tax matters partner or tax matters member is automatically removed for tax years after 2017, and if a new PR hasn’t been designated, the IRS will have the authority to designate one for the entity. Partnerships should start thinking about: (1) who the new PR should be; (2) what level of indemnification will be afforded to them against any costs or liabilities that may be incurred in acting in that role; (3) whether the acts and/or omissions of the PR will be covered by insurance; and (4) the level of accountability they will have to the partnership and its partners. The PR need not be a partner.
A final warning: Anyone that is either (1) contemplating a new health care business that will be classified as a partnership for federal tax purposes (including an LLC or joint venture) or (2) needing to amend an existing agreement should strongly consider incorporating these changes into the new or revised agreement immediately, even though detailed guidance from the IRS on many aspects of the Budget Act isn’t expected to be released until later this year.
1 The term “partnership” is used to refer to any entity or business arrangement classified as a partnership for federal income tax purposes.
Republished with permission. This article first appeared on an AHLA Alert on April 21, 2016.