New federal partnership audit rules become effective for tax years beginning on or after January 1, 2018. The new rules are extensive, and they present fairly radical changes in the way partnerships and LLCs will be audited. With 2018 fast approaching and the number of IRS audits expected to increase, members of “Subchapter K entities” (typically, multi-member LLCs, partnerships and joint ventures) should – if they haven’t done so already – immediately take steps to prepare.
Members of Bradley’s Tax Practice Group have been closely monitoring recent developments in this area. Below is a discussion of the most common questions we receive, which we hope will assist you in better understanding the surprisingly broad impact of these rules.
1. Why should my partnership or my clients be concerned about the new rules?
In late 2015, Congress hurriedly enacted a comprehensive new partnership audit regime to replace the cumbersome unified audit procedures of TEFRA and rules for electing large partnerships. Beginning in 2018, there will no longer be a “tax matters partner,” nor the fundamental principle that partnerships aren’t responsible for their partners’ income tax. All partnership audits will take place at the partnership level, and, with two exceptions, all underpaid taxes, penalties, and interest will be assessed and collected directly from the partnership – not the partners. Thus, the current partners may be on the hook for someone else’s income tax liability. Additionally, the partners will no longer have audit participation rights. Instead, a so-called “partnership representative” will have sole authority to speak for both the partnership and its partners.
2. To which business entities do the new rules apply?
All pass-through entities treated as partnerships for federal income tax purposes are subject to the new audit rules. Treasury Department officials indicate that the rules will apply to as many arrangements as possible. In addition to traditional partnerships and multi-member LLC’s, many joint ventures and other sharing arrangements will be included. Co-investment funds and special purpose vehicles set up to hold particular assets could potentially be covered. The new rules, however, do not apply to partnerships dissolved before 2018, single member LLCs that have elected tax treatment as a corporation, or S corporations.
3. Why is my business or client covered by these rules? We only have 3 partners!
Although all partnerships are subject to the new rules by default, the new regime gives certain “eligible” partnerships the option to opt-out annually. To qualify, the partnership cannot have more than 100 partners, and all partners must fall within the proposed regulations’ narrowly defined class of “eligible partner”: individuals, estates of deceased partners, S corporations and C corporations. Be careful, if the partnership has even one ineligible partner, or fails to timely file its annual Form 1065 with the new opt-out box checked, the business will remain subject to the new rules for that year.
4. So, what do we do now?
First and foremost, all members of Subchapter K entities (big or small) should promptly contact their tax advisers and develop a strategy to address the impending new partnership audit regime. Because many eligible partnerships can elect-out of the new rules – and most tax advisors suggest that if a partnership is eligible to opt-out, it should – some ownership changes may need to be implemented. For example, consider transferring ownership of a partnership interest from a trust, IRA, or SMLLC to an individual-- by December 31, 2017.
Also, every partnership agreement should be reviewed ASAP. Because a partnership must designate a partnership representative for each tax year, on a timely filed Form 1065, you need to consider who is best suited for this role and update your partnership agreement accordingly. It’s extremely important that every partnership carefully choose a competent and trustworthy individual for this position.
Although it will be some time before 2018 tax returns are due, don’t wait to start preparing for these new rules. They’ll be here sooner than you think.
Bruce Ely and Will Thistle are partners with Bradley Arant Boult Cummings LLP in its Birmingham office. They are also co-chairs of the ABA State & Local Tax Committee’s task force on these rules.
Republished with permission. This article first appeared in the Birmingham Business Journal on November 3, 2017.