IMGCAP(1)]A radical revamping of the partnership audit rules will impact every partnership and LLC taxed as a partnership, starting in 2018.
Although mandatory compliance is nearly two years away—and many unknowns exist—now is the time to begin to educate clients, review business structures, and amend partnership and operating agreements in preparation for the impact.
To raise additional revenue and increase audit effectiveness, the Bipartisan Budget Act of 2015 (P.L. 114-74) repealed the 33-year-old Tax Equity and Fiscal Responsibility Act (TEFRA) regime and the decades-old Electing Large Partnership (ELP) provisions. The new regime dramatically changes the pass-through landscape by making the partnership, not the partners, liable for payment of the assessment. Further, the audit adjustments are reflected on the return for the year the adjustment is finalized, not the year under review.
Current Law: TEFRA and ELPs
In 1982, TEFRA changed the partnership tax audit landscape by shifting the focus of a partnership audit from the individual partner returns to the partnership return. This eliminated the inconsistencies that had plagued the process when each partner’s return was examined individually, with the partnership itself merely an addendum to the process. However, any adjustments passed through to the partners’ returns, keeping collection at the partnership level.
TEFRA’s approach became increasingly unwieldy as the number of large partnerships grew. Legislative and administrative tinkering attempted to reduce administrative headaches and speed revenue collection. As a result, currently there are three audit procedures for partnerships and LLCs taxed as partnerships:
• For 10 or fewer partners: Audits are at the partner level, much as was the case pre-TEFRA.
• For 10 to 99 partners: The TEFRA procedures apply. The partnership return is the focus of the audit; any adjustments are binding on the partners, who must file amended returns for the year under audit.
• For 100 or more partners: TEFRA applies, unless the partnership is one of the very few that opted to be an ELP. If the ELP rules apply, the focus is the partnership return but any adjustments are taken into account on the partners’ current year returns, rather than the amended prior year returns.
New Law: Partnership-Level Liability
The rules under the Bipartisan Budget Act break new ground in pass-through taxation. While the audit focus continues to be on the partnership return, the approach to adjustments and payments is radically different. Once the law is in effect:
• Required adjustments are taken into account at the partnership level—not by the individual partners.
• Adjustments are reflected in the year the audit is completed (or subsequent court proceeding is concluded), not the year under review.
• The IRS will collect the assessed amount, plus penalties and interest, from the partnership—not the individual partners.
These new provisions transform a pass-through entity into a tax-paying entity, with respect to adjustments arising on audit. Plus, the economic impact falls on partners in the adjustment year, not those in the year under review. If the partners have changed, those who pay the price may be different from those who reaped the benefit.
There are options that enable the partnership to pass the adjustments through to the partners. However, short timeframes for making the election and increased interest rates are among the factors that limit the desirability and utility of this option.
Opt-out for Small Partnerships
Partnership-level audits and collection proceedings are the default for all partnerships, even those with only a few members. However, a partnership with 100 or fewer qualifying partners can opt out by making an annual election on its partnership return. This is a true “opt-out.” Affirmative action is required on each tax return. If the partnership opts out, the audit will proceed against each partner separately.
As the law stands now, even a very small partnership might not be able to opt out. To opt out, every partner must be a qualifying partner. A qualifying partner is
• an individual;
• a C corporation (or non-U.S. corporation that would be a C corporation under U.S. law);
• an S corporation; or
• an estate of a deceased partner.
This may be particularly significant for businesses that have tiered structures, whether for asset protection or tax purposes. For instance, an LLC that has multiple LLCs as members in order to shield operating assets from risk may be unable to elect out of the new audit rules.
Delayed Effective Date Means Ample Time for Planning
Although the impact of the new rules is significant, there is ample time to consider planning strategies. These new rules will apply to returns for partnership tax years beginning after 2017, although most partnerships can elect to apply them to any partnership tax year that begins after Nov. 2, 2015.
Practitioners should begin to act now because the new rules will affect all partnership and LLC clients, regardless of size. Partnerships must either comply with the rules or make an annual election to opt out. In either case, client education and modification of partnership and operating agreements in advance of issues arising are crucial. The following issues should be considered:
• Identify clients that are candidates to opt out of the new rules. Monitor them to ensure they do not add non-qualifying partners or outgrow the opt-out, and that the annual opt-out election is filed. Also, determine whether membership should be restricted to qualifying partners.
• Identify clients barred from the opt-out because of non-qualifying partners. Determine if it is prudent to convert to a qualifying entity type or to amend the partnership/operating agreement to protect existing partners.
• Amend existing agreements to indemnify partners from the economic impact of an assessment based on a review year when they were not members. (Indemnification should be a standard item of discussion for each new agreement.)
• Amend agreements to specify rules for electing a partner-level assessment, given the short timeframe for the decision and the possibility of a disproportionate impact on the partners. The agreement also should designate a “partnership representative” for the audit process and the representative’s duties to the partners.
Your plan of action will vary based on the number of partnership/LLC clients, each individual client’s size and complexity. However, the new rules are game-changing. Now is the time to review all partnership and operating agreements so no one is caught off guard when the rules kick in.
Jason Erb, J.D., is a lawyer, entrepreneur, and director of strategic alliances for small business at Wolters Kluwer’s
