Partnerships and LLCs that are taxed as partnerships have traditionally been treated as flow-through entities and not directly subject to federal income tax, but this has changed as the result of a new federal law that took effect earlier this year.
Unfortunately, the new law is highly technical and complicated. The below description of the changes to the tax laws is only a brief summary and has been greatly simplified. The new law is quite complex and there are numerous other issues to consider.
While even this simplified summary is complex, it is extraordinarily important that anyone involved in a partnership or LLC taxed as a partnership be aware of the new law, because a failure to properly handle related matters could be extremely expensive.
Under the new law, partnerships are still flow-through entities, except that any taxes due after an audit can be collected directly from the partnership itself. The tax rate will be the highest rate in effect for individuals or corporations.
Any “adjustments” (credits, or, more likely deficiencies) will be taken into account by the partnership in the year the audit or judicial review is completed (the “adjustment year”).
This shifts the cost of the adjustment from the partners who benefited from the underpayment of tax in the audited year (the “reviewed year”) to the partners who own the business in the adjustment year
For example, in 2018, an LLC that has elected to be taxed as a partnership has two equal owners, Smith and Jones. In 2019, Smith sells his interest to Brown.
If the LLC is audited in 2020 for its 2018 tax year and is found to have underpaid its taxes, Brown will be responsible for half the underpayment (plus interest and penalties) even though she had nothing to do with the underpayment and was not even an owner of the LLC at the time.
Smith will have no liability, even though he, not Brown, was a member in 2018.
As you can see from this example, it is important that appropriate indemnification provisions be included in any purchase agreement for an ownership interest in a partnership or LLC.
There are some ways that this unfairness can be mitigated after the partnership or LLC receives a notice of proposed partnership adjustment. One involves the partnership or LLC electing to “push out” partnership adjustments to the reviewed year partners.
If a partnership or LLC makes a push-out election, the reviewed-year partners will calculate and pay any additional tax due for the reviewed year and the following years up to the adjustment year.
One significant downside of making the push-out election is that the interest rate for the tax deficiency will be increased by two percentage points.
Fortunately, some partnerships and LLCs can opt out of this centralized partnership audit regime. A partnership or LLC with 100 or fewer direct or indirect partners/members can elect out of the regime if all of the partners/members are individuals, C corporations, S corporations, foreign corporations treated as C corporations, or estates of deceased partners/members.
If the partnership or LLC has partners/members that are trusts, partnerships, or LLCs taxed as partnerships, the partnership cannot opt out of the new regime.
In this situation, the partnership or LLC may want to change its partners so that it can become eligible to elect out of the centralized partnership audit regime.
You may also desire to amend the partnership or operating agreement to prohibit transfers of ownership interests to those whose ownership would make the partnership or LLC ineligible for the opt-out election.
The opt-out election is only valid for one year and must be refiled annually.
Whether or not your partnership or LLC opts out, it should designate a partnership representative. Otherwise, the IRS may select one for you. The representative does not have to be a partner/member.
All communications to and from the IRS will go through this partnership representative.
This may sound similar to a “tax matters partner,” but the partnership representative will have complete authority over IRS matters when the centralized partnership audit regime applies.
Except for a partner acting as the partnership representative, partners will not be allowed to participate in audits and will not even receive notices from the IRS about the audit. The representative will have sole authority to bind the partnership or LLC and all its partners/members with respect to audit and tax litigation proceedings.
It is, therefore, a good idea to amend your partnership agreement or operating agreement to identify who will first serve as the partnership representative and to list the duties and obligations owed by the partnership representative to the partners/members.
The agreement should also set forth how the partnership representative will be appointed, as well as how she or he can resign or be removed.
In addition, the partnership agreement or operating agreement should state whether making a push-out election is mandatory or discretionary.
The agreement should also address how tax liability under the new rule will be funded and allocated. If the partnership or LLC makes tax distributions to partners/members, the agreement should also address how tax distributions will be made in the event of a push-out election.
Further, the agreement should require the partnership/LLC and its partners/members to cooperate and promptly share relevant information – even after they are no longer owners.
If you haven’t already, you should discuss your options with your accountant. Then, when a decision is made, your lawyer should be consulted for appropriate amendments.
Please feel free to contact us if you have any questions about the new partnership tax audit regime or if you will need help updating your partnership agreement or operating agreement.
