New audit rules require careful review of partnership and operating agreements
Businesses are increasingly being formed as partnerships (for the purpose of this alert, this includes LLCs), and partnership audits have become a more pressing issue for the IRS. Because the IRS must generally assess and collect any deficiencies from the individual partners after a partnership audit, enforcement has been difficult. The new audit rules will allow the IRS in most cases to assess any additional tax against the partnership itself – eliminating the need to proceed against the individual partners. Since this assessment will be made against the partnership in the year that the audit is concluded, and payment will be made from the partnership assets in that year, the assessment will effectively be the responsibility of those who are partners in the year the audit is concluded, as opposed to those who were partners in the year under audit. Partnership owners need to understand these and other changes in the partnership audit rules, and in most cases will want to consider amendments to the partnership agreement to address these changes.
Current audit rulesUnder the current audit rules (which are generally still effective until 2018), there are essentially three different types of partnership audits.
- Electing Large Partnerships (ELPs) – ELP audits are done at the partnership level, with any adjustments reflected on the partners’ current year returns (as opposed to having to amend prior year returns). A partner in an ELP cannot take a position inconsistent with the partnership return with respect to any partnership tax items. Partners have no right of notice from the IRS and have no right to participate in the audit proceedings.
- Partnerships with more than 10 partners – Partnerships with more than 10 partners are audited under the Tax Equity and Fiscal Responsibility Act of 1982 unified partnership audit rules. Under these rules, after an audit of the partnership, any assessment must be made against (and collected from) the individual partners. The IRS is required to give notice of the proceedings and the results of the audit to all partners whose names and addresses are provided to the IRS.
- Partnerships with fewer than 10 partners – A partnership with fewer than 10 partners (none of which is another partnership or nonresident alien) is generally audited by auditing the individual partners. These partnerships can, however, elect to have the unified partnership audit rules apply.
New audit rulesThe new legislation eliminates the distinctions under the current partnership audit rules and provides a single set of rules. Under the new audit rules, the IRS will examine the partnership’s tax return, and the partnership will (with a number of exceptions) be responsible for any adjustments in the year that the audit was completed, or in the year that any judicial proceeding relating to the audit becomes final. The partnership will generally pay tax on any assessment at the highest individual tax rate, although procedures will be available to allow a partnership to reduce this rate if any of its partners would be subject to a lower rate. This is a significant change because partnerships have never before been required to pay tax at the partnership level.
The new rules are complex, and the IRS has acknowledged that additional guidance will need to be issued with respect to many of the provisions. However, there are a number of basic concepts that are critical to understanding the new audit rules and how they will impact new and existing partnership agreements (including operating agreements).
- Calculating the tax due
The most significant change under the new audit rules is that the partnership, and not the partners, will generally be responsible for additional taxes resulting from the audit. A key issue is the rate of tax imposed on the additional income that results from the audit. The tax resulting from the audit adjustment is referred to as the “imputed underpayment,” and is calculated by multiplying the net increase in income resulting from the audit by the highest individual tax rate. This rate and the resulting tax liability can be modified if the partnership shows that a lower amount is appropriate based on the tax rates of certain individual partners. Modifications to the imputed underpayment can be made in instances where:
- An individual partner files an amended return for the tax year at issue reflecting the partnership level adjustments, and the resulting tax is paid by the partner. In other words, a partner taxed at a rate lower than the highest individual rate could file an amended return and pay the tax at the lower rate. In this case the partnership is not responsible for tax on this part of the additional income resulting from the audit.
- The partnership shows that part of the underpayment is allocable to a tax exempt partner.
- The partnership shows that part of the underpayment is allocable to a C corporation (in the case of ordinary income) because C corporations generally are taxed at a rate lower than individuals.
- The partnership demonstrates that part of the underpayment is allocable to an individual (in the case of capital gains income) because individuals generally are taxed at lower rates on capital gain income.
- New regulations are issued providing additional procedures for modifying the amount due.
- Opting out of the new rules
There are several ways that partnerships will be able to opt out of the new audit rules. First, a “Section 6226 election” will be available, where the partnership can choose to issue adjusted information returns to its partners instead of having the partnership pay the tax liability. The partnership must make this election within 45 days of receiving notice of the final audit adjustment. If the election is made, the partners can report the income and pay the additional taxes through a simplified amended return process. Importantly, the adjusted information is issued to those who were partners in the year under audit, even if they are not partners in the year that the audit is performed and the assessment is made against the partnership. This ensures that new partners will not be responsible for taxes of partners who have left the partnership after the year under audit, but prior to the audit itself.
In addition, partnerships with 100 or fewer partners that meet certain criteria (generally individuals, corporations and estates of deceased partners) would be allowed to opt out of the new audit rules and have audits performed at the individual partner level. To take advantage of this exception, the partnership must make a “Section 6221 election” on its tax return for the year it wishes to opt out, and the names and taxpayer identification numbers (TINs) of each partner must be provided to the IRS. Additionally, each partner must be given notice of the election. If an S corporation is a partner, the names and TINs of each shareholder of that S corporation must also be provided.
- The role of the partnership representative (formerly the tax matters partner)
Partners often give little thought as to who will serve as the tax matters partner (TMP). The TMP is only relevant in TEFRA unified audit proceedings, and individual partners have the right to participate in these proceedings. Since the authority of the TMP is limited under current law, attorneys rarely have lengthy discussions about the ramifications of naming a TMP. Under the new audit rules, Code Section 6223 provides that the role of the TMP is replaced by a “partnership representative” who has almost complete authority to act on behalf of the partnership (and therefore effectively the partners) when dealing with the IRS. This authority includes the ability to bind the partnership and the partners in audits and other proceedings, including settlement authority and decisions on procedural issues such as whether to proceed to litigation. Unlike a TMP, the partnership representative does not need to be a partner of the partnership. If a partnership does not designate a partnership representative the IRS “may select any person as the Partnership Representative.” This change in the role of the former TMP is significant and is an issue that every partnership agreement and operating agreement needs to address.
Partnership/operating agreement amendments may be neededIn light of the drastic changes to the partnership audit rules as described above, there are a number of changes that partnerships and LLCs should consider making to their partnership or operating agreements – and it’s important to begin considering these issues now.
Opting out of new audit rulesOne of the first issues to be considered by any partnership is whether the partnership should opt out of the new audit rules. While the initial reaction would be that opting out would always be desirable, the new audit rules may actually provide a benefit for some partnerships. Although it is more complicated for the IRS to audit the returns of 10 partners than it would be to audit the partnership itself, an audit of the individual partners also represents a significant amount of time in the aggregate for each of the partners to comply with information requests and other audit-related matters. It may well be easier for the partners, as well as the IRS, to simply audit and assess the partnership. Also, the statute of limitations would be based on the filing of the partnership return and not the return of an individual partner, so the period when the IRS could initiate an audit would presumably be decreased since partnership returns are generally filed before individual returns.
Despite the potential benefits of not opting out, many partnerships will likely choose to opt out of the new audit rules. This is especially true if it is likely that ownership of a partnership will change over time, since the new audit rules in effect impose the tax liability resulting from an audit on those who are partners at the time of the audit -- not those who were partners in the year under audit.
The decision to opt out can be made either annually or within a set period of time after the IRS assessment. At a minimum, a partnership agreement should specify who makes this decision and when. If the decision is made to make the annual Section 6221 election, the partnership agreement should provide for this, with the ability to revisit the decision if a specified percentage of the partners decide to do so. The same procedure could be implemented for the Section 6226 election, with the partnership agreement providing that this election will be made after an IRS audit assessment – unless a specified percentage (presumably more than a majority) of partners decides to not make the election for a particular audit.
Leaving this decision up to the partnership representative would not be desirable since he or she may have an interest in the audit procedure used. For instance, if the partnership representative had been a partner in the year under audit, but new partners have been admitted, not opting out would shift some of the burden of the assessment to the new partners since the tax would be paid out of current partnership assets and not out of the partnership representative’s pocket. The partnership agreement should therefore set forth the procedures for making this decision and should not leave the decision in the hands of the partnership representative. The agreement should be clear that if the decision to opt out can be made without the consent of all the partners, that written notice of the decision be given to all of the partners.
A final issue with the opt out provisions is that only partnerships with less than 100 partners that are not themselves taxed as a partnership qualify for the Section 6221 election (the annual opt out). If a qualifying partnership decides to opt out using this election, or even if it is decided that the opt out should be an option in the future, the partnership agreement should contain transfer restrictions to keep a partner from transferring an interest to a non-qualifying partner (such as an LLC) that will prevent the partnership from making this election.
The partnership representativeBecause of the significant authority granted to the partnership representative, a partnership agreement should address the partnership representative’s status, authority and the limitations imposed on the exercise of this authority. Provisions similar to those limiting the authority of a manager, for instance, will in most cases be appropriate with respect to the partnership representative. Provisions could require that some percentage of the partners must agree to certain actions to be taken by the partnership representative. Provisions should also be included for how a partnership representative is elected and removed, and how a replacement partnership representative is chosen. It is important to remember that “opting out” of the new audit rules impacts how the additional tax is paid; it does not mean the partnership is opting out of the rules applicable to the partnership representative. Since it is possible that a partnership representative would have a conflict of interest in acting on behalf of the partnership, consideration should also be given to imposing some level of fiduciary duty on the partnership representative or at least provide for the possible replacement of the partnership representative if it appears that there is a conflict of interest.
Purchase and sale issuesAnother area calling for potential agreement revisions relates to the fact that the adjustment made and tax assessed against the partnership will take place in the year the adjustment is made. This means that the tax burden relating to an audit could be imposed on partners who were not the partners that received the benefit of the erroneous income calculation in the prior year which was audited.
Accordingly, partners buying into a partnership will need to be especially careful with the new audit rules. If the partnership has not opted out of the rules, a new partner buying in during the current year would essentially be responsible for taxes that relate to a year prior to the purchase, effectively paying a tax liability that was the responsibility of the former partner(s). Because the Section 6226 election to opt out is made only after the assessment, a new partner has no assurance that the partners in the year under review will agree to elect to bear the tax burden of the audit. This issue can, of course, be dealt with by contract, either in the partnership agreement or in the purchase agreement for the acquired interest. Some options include:
- The partnership agreement could provide that the partnership has recourse against partners who have left the partnership if a tax is assessed for a year during which they were a partner.
- The partnership agreement could mandate that if there has been an ownership change between the year under audit and the audit itself, that the partnership makes the Section 6226 election to opt out of the audit rules and issue amended K-1s to those who were partners in the year under audit. These partners must then take the adjustments into account on their own tax returns.
- A partner buying a partnership interest can address the issue in the purchase agreement. A representation from the selling partner or the partnership itself that all tax returns are correct and all taxes have been paid, with indemnification provided for a breach of the representations would be appropriate. While this is typical in larger deals, in small purchase transactions this issue is often not raised since the assumption is that the selling partner would (under the current rules) pay any additional tax relating to an audit of a prior year.
Imputed tax calculations and reconciliationAs noted above, once an assessment is made against the partnership, the calculation of the tax due is one of the more complicated parts of the new audit rules. A partnership will have the ability to reduce the tax due by showing that certain partners (tax-exempt organizations, for example) are subject to a lower rate than that used by the IRS in calculating the partnership’s liability. If the partnership does have the assessment reduced because a partner is subject to a lower tax rate, how does this affect the burden on the partners for the remainder of the tax liability?
For instance, assume an LLC has two equal members, one is tax-exempt and the other is taxed at the highest tax rate. While the LLC can have the tax on the assessment reduced by demonstrating that one member is not subject to tax, how do the LLC and the individual members take this difference into account? In the absence of the issue being addressed in the operating agreement, in the fact pattern above the tax-exempt member will essentially still pay for 50 percent of the remaining tax liability since the remaining liability would be paid by the LLC. Partnerships with partners in very different tax brackets should seriously consider opting out of the new audit rules and have each individual partner pay his or her share of the assessment at whatever tax rate he or she is subject to.
Increased potential for auditsThe new audit rules were designed to raise almost $10 billion in tax revenues over the next 10 years - a clear sign that more partnership and LLC audits are on the way. The greater likelihood of audits makes it even more important that operating agreements and partnership agreements have language addressing the relevant issues, and that each partner understands the impact of this new audit structure. As changes will likely need to be made, partnership and LLC owners should review their agreements now and begin discussing these crucial issues.
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