Our last post talked about the changes that the Bipartisan Budget Act of 2015 (the “BBA”) made to the partnership audit rules. As we mentioned, these rules affect all partnerships, including LLCs taxed as partnerships. Luckily, Congress did include some relief for certain partnerships from the new rules.
How can you opt out?
A partnership can elect out of the entity-level audit if:
- None of its partners are partnerships or trusts (including, it seems, grantor trusts, although it is expected that the IRS will issue guidance on this issue); and
- It has fewer than 100 partners (including all shareholders of S corporation partners).
This election must be made each year when the partnership return is filed and the partnership must provide the IRS with the names and tax identification numbers of each partner, including each shareholder of any S corporation partners. Thus, the Congress has shifted to the partnership the responsibility (and difficulty) of notifying and identifying all of the partners.
What if you have partners that are trusts or other partnerships?
For partnerships that are ineligible to elect out of the new entity-level audit, Congress provided some relief. First, if a partnership is audited and receives a notice of final partnership adjustment, the partnership has 45 days in which to elect that all of the partners from the audited year pay the tax assessment. As part of this election, the partnership must:
- Issue adjusted Schedule K-1s to both the IRS and to each partner of the audited year.
- Each partner is then required to pay the adjusted tax.
- If any of the partners do not pay the tax, it appears that the partnership may still be on the hook for the unpaid portion of the tax assessed. The IRS is expected to issue guidance on this issue.
Second, a partnership may apply to reduce the tax underpayment that the IRS collects at the partnership level. A partnership is eligible to have the IRS adjustment calculated based on the correct tax liability of the partners, rather than the default 39.6%, if:
- At least one partner from the audited year files an amended return and pays the tax in full;
- At least one partner from the audited year is tax exempt; or
- A lower rate should apply because the partner is a C-corporation or the adjustment is made to a qualified dividend or capital gain.
While these options take the sting out of the new audit rules, meeting the strict deadlines may prove difficult for partnerships. Therefore, it’s best to plan ahead for how to handle an audit if one comes.
The IRS appears to be signaling that it will be paying more attention to partnerships in the future. You now have 20 months to get ready for this post-TEFRA world. During this time, we recommend taking the following steps:
- Reconsider whether to allow LLCs and Trusts to be partners/members of your entities. By restricting partnership to only nondisqualified partners, you will ensure that your entity may make the annual election to be audited at the partner level. Currently, nondisqualified partners include individuals, S corporations, C-corporations, and estates of a deceased partner.
- Nominate a Partnership Representative. If you do not name a Partnership Representative, the IRS will pick one for you. In addition, even if the partnership is eligible to elect out of the entity-level audit, only the Partnership Representative has the authority to do so. Therefore, if you do not identify a Partnership Representative not only can the IRS choose one for you but you may lose the opportunity to opt out of the strict, entity-level audit procedure.
- Amend your partnership agreements. You can amend your entity documents now so that they are effective in both the TEFRA and post-TEFRA regimes. We recommend amending your partnership or operating agreements to address the following issues:
- Nomination/Appointment of Partnership Representative.
- Specifically bind partners to require that they pay any later assessed taxes regardless of whether they are still partners at the time the tax is assessed.
- Require that the company affirmatively approve the admission of any new partner who would cause the partnership to lose its eligibility to opt out of the entity-level audit procedure. These new partners would include trusts and other LLCs.
For more information about how the TEFRA repeal affects your partnership or LLC, please contact Lori at firstname.lastname@example.org.