Changes to Partnership Tax Audit Rules Can Cost Partners Money, Rights vs. IRS - LLCs, LPs, and other Partnerships Should Review Their Partnership Agreements Immediately
Written by: Francis J. Sullivan and Matthew L. Devine
On November 2, 2015, as part of the omnibus agreement to fund the federal government, Congress passed the Bipartisan Budget Act of 2015 (“BBA”) which may have dramatic tax consequences for members of existing limited liability companies (“LLCs”), and partners in existing limited partnerships (“LPs”), limited liability partnerships (“LLPs”), general partnerships, and other entities electing to be taxed as partnerships (collectively, a “Partnership”) under the federal tax code. Among other things, these rules may effectively cause a “Partner” to bear the financial burden of another Partner’s (or prior Partner’s) tax liability and can also cause a Partner to lose rights to receive notice of or contest any tax settlement in the event of an Internal Revenue Service (“IRS”) audit.
Overview of the BBA
Beginning on January 1, 2018, all Partnerships are subject to the provisions of the BBA. However, Partnerships with fewer than one hundred (100) Partners and which have Partners solely consisting of individuals, estates of deceased Partners, or corporations (both C-corporations and S-corporations) are able to opt out of the impact of the provisions of the BBA by making a timely election with the IRS each year. Partnerships with a Partner that is a non-qualifying entity may not opt of the provisions of the BBA unless such entity either converts to a qualifying entity or is no longer a Partner of the Partnership.
Under the BBA, all adjustments to the Partnership’s income, gain, loss, deduction or credit will be made at the Partnership level, rather than at the Partner level as under pre-2018 law. If any adjustment is made imposing additional taxable income, the Partnership will be subject to a 37.5% tax on any increase to the Partnership’s income for the year reviewed. This tax will then be chargeable to the Partnership in the year the adjustment is made, even if the Partners are different in the adjustment year than the reviewed year. The following illustrates how this new tax regime will work under the BBA, absent a timely election to opt out:
Bob and Pat were Partners in Partnership X but retired effective as December 31, 2018, coinciding with the end of the Partnership tax year for 2018. On January 1, 2019, being one day later but the beginning of a new Partnership tax year, Jack and Rachel were admitted to the Partnership. In due course, Partnership X timely filed its Partnership tax return for year ending December 31, 2018. As luck would have it, in 2020, the 2018 Partnership tax return was selected for audit by the IRS resulting in a disallowance of $1,000,000 in business deductions no longer permitted under the Tax Cuts and Jobs Act of 2017.. The IRS issued a notice of adjustment increasing Partnership X’s taxable income for 2018 by $1,000,000.00. Since no election had been made to shift the tax liability to the individual partners for tax year 2018, Partnership X is required to pay in 2020 $375,000 in additional taxes as a result of the 2018 underpayment plus interest and applicable penalties. Despite not being Partners in 2018, Jack and Rachel are shocked to find out that the 2020 Partnership will have to pay for tax liabilities incurred by the 2018 Partnership, when they were not Partners. This tax payment not only reduces the available profit distributable to 2020 partners, like Jack and Rachel, but is also not deductible by the 2020 Partnership. Meanwhile the partners who retired in 2018, Bob and Pat, skate any tax liability.
However, the IRS does provide a limited safe harbor allowing Partnership X to elect to issue amended/revised 2018 K-1s to Bob, Pat, and the other 2018 Partners to offset the liability at the Partnership level and thus mitigate the impact of the 2018 adjustment on Jack and Rachel. However, such an election must be affirmatively made not later than 45 days after the date of the notice of the final partnership adjustment or it is waived. Additionally, Partnership X cannot take a deduction for any payments made in satisfaction of the 2018 adjustment.
Furthermore, the new BBA rules centralize all rights and responsibilities for the Partnership in a new “Partnership Representative,” which position replaces the former “Tax Matters Partner” existing under most Partnership agreements. Moreover, the IRS may choose someone to act for the Partnership if the Partnership fails to designate a person to act in this capacity on its behalf, since a Partnership Representative does not have to be a Partner of the Partnership. In all IRS or audit-related matters, the Partnership Representative will have exclusive authority to bind the Partnership and, if named, will be the only person who will receive notice of an audit.
Possible Amendments to Partnership Agreements
To protect itself against any adverse effects of the provisions of the BBA, Partners may want to consider making the following changes to the applicable partnership or operating agreement:
(1) Requiring the Partnership to affirmatively opt out of the provisions of the BBA each year if it qualifies to do so and /or requiring the Partnership to timely take advantage of any Safe Harbor rules to mitigate the imposition of any tax adjustments at the Partnership level.
(2) Requiring that the admission of a new Partner into the Partnership be a qualifying person or entity as a precondition to becoming a Partner so as to allow the Partnership to opt out of the BBA rules each year;
(3) Requiring that any adjustments paid by the Partnership in a current year as a result of adjustments for a prior year be paid back to the Partnership by all the Partners of that prior year;
(4) Indemnifying new Partners from any economic loss for any adjustments required to be paid by the Partnership for any prior period in which they were not a Partner;
(5) Ensuring that a Partnership Representative is designated on behalf of the Partnership.
(6) Limiting the authority of the designated Partnership Representative to agree to any audit adjustments without the prior consent of the Partners or its Management/Executive Committee.
(7) Requiring the designated Partnership Representative to provide to all the Partners copies of any Notices requiring action by the Partnership or any proposed adjustments to the Partnership’s filed tax returns for any period which would impose any tax liability on the Partnership or have a negative impact on the Partnership.
Additionally, if the Partnership would like to opt out of the provisions of the BBA but cannot because of a non-qualifying Partner, the Partnership may want to consider requiring the non-qualifying Partner reorganize into a qualifying entity or have a mandatory redemption of that Partner’s Partnership Interest.
Disclaimer: The information contained in this Client Alert is for general guidance on matters of interest only. The application and impact of laws can vary widely based on the specific facts involved. Accordingly, the information in this Client Alert is provided with the understanding that the authors and publishers are not engaged in rendering legal, accounting, tax, or other professional advice and services. As such, it should not be used as a substitute for consultation with professional accounting, tax, legal, or other competent advisors.
 Members of LLCs and partners of a Partnership are collectively hereinafter referred to as “Partners.”