Question Presented: What should LLCs do in preparation of the new IRS partnership tax audit and assessment rules?
As of December 31, 2017, the IRS will require all entities taxed as partnerships to pay for imputed taxes on partners for prior tax years at the partnership level. Most LLCs elect to be treated as partnerships for tax purposes. These LLCs and other partnerships should:
- ensure their operating agreement provides that former members are required to indemnify the company for assessed taxes paid by the company in connection with imputed underpayments of taxes by members; and
- consult with legal counsel and accountants for advice on their ability to opt out of the new rule and whether an opt-out is appropriate;
3) prepare to comply with the new rule and select a Partnership Representative.
New Partnership Audit Rules
Beginning December 31, 2017, the IRS will administer new laws (26 USC §6221) governing audits and assessments of entities taxed as partnerships. A partnership, for federal tax purposes, is any company that elects to be taxed as a partnership, has more than one partner or member and is not a corporation. The new law applies to all entities taxed as partnerships, which includes most LLCs. It states:
“[a]ny adjustment to items of income, gain, loss, deduction, or credit of a partnership … (and any partner’s distributive share thereof) shall be determined, any tax attributable thereto shall be assessed and collected, and the applicability of any penalty … [that] relates to an adjustment to any such item or share shall be determined, at the partnership level….”
This means that adjustments pertaining to an LLC’s tax items in connection with the company will be applied and collected at the company level. Historically, adjustments were imposed at the member level, and unaffected members were generally not exposed to loss because of any such adjustment. The new law will expose current members to increased, adjustment-related tax losses at the time the adjustment is due, without regard for whether or not the members were involved with the company during the period to which the adjustment relates. In other words, the new law imposes tax liability on the company, and thus indirectly on all current members, even if the current members did not hold equity in the company during the period in which an imputed tax underpayment occurred.
The new law replaces the traditional member or partner designee to address such adjustments with the IRS (the “Tax Matters Partner”) with a new position (the “Partnership Representative”). The Partnership Representative (which, unlike the Tax Matters Partner, does not have to be a partner of the company) has the sole authority and responsibility to administer the company’s tax matters. Even if not a partner, a Partnership Representative must have a “substantial presence in the United States.”
LLCs or partnerships required to submit 100 or fewer K-1s during the tax year may elect to opt-out of the rule changes on an annual basis, in accordance with 26 USC §6221(b). The opt-out provision, however, only applies if all members or partners are individuals, estates of a deceased partner, or certain S or C corporations. Accordingly, not all LLCs will be eligible to opt-out.
We recommend implementing language in every operating agreement that ensures the partnership is, and individual partners are, protected to the greatest extent practicable. An operating agreement should include language that will permit the company to deduct adjusted tax liability, when applicable, from future distributions to the responsible member. The agreement should also allow the company to seek indemnification from any former members to whom any imputed underpayments may be properly attributed.
Opting out, if permitted, will likely be advantageous. An LLC or partnership that cannot opt out should discuss plans for compliance with the new audit regime with its attorneys and accountants, and begin to identify a designee to name as Partnership Representative.
The new law will apply to all partnerships and all entities taxed as partnerships, which includes most LLCs. Even though this memo focuses on LLCs because they are more common, partnerships are equally affected and will have to consider the same issues as LLCs.