By Jack C. Butler, Partner, Carlile Patchen & Murphy LLP
As of January 1, 2018, new IRS rules regarding audits of partnerships became effective. These rules, adopted prior to and not part of the Tax Cuts and Jobs Act, apply to any entity or arrangement that is a “partnership” for tax purposes, which includes limited liability companies with two or more members if the LLC has not elected corporate tax treatment.
The rules are rather complex, but the most significant effect of the rules is to impose tax liability on the entity itself, e.g., on an LLC taxed as a partnership unless the entity is eligible to “opt out” of the new rules AND has elected to opt out. “Opting out” means that the old rules regarding partnership tax audits will apply, which are rules that have historically applied to any tax adjustment by the IRS made directly at the partner (LLC member) level.
Many entities taxed as partnerships are not be able to opt out, e.g., entities with trusts or other LLCs as members. In addition, if there is a tax adjustment pursuant to an audit, the adjustment will be based on the highest individual tax rate of the applicable members/partners notwithstanding the fact that some of the owners may have a lower tax rate applicable to them.
Multiple issues arise if the entity is liable for tax that arises from an audit-adjustment with the entity obligated to pay such tax. How does the entity recoup its tax payment from its individual owners? How is the tax obligation apportioned among such owners? What about former entity owners who were owners in the audited tax year, but are no longer owners? These issues impact transfers of ownership interests, indemnifications in sales of entities taxed as partnerships, withdrawal of owners, and admission of new owners. Without properly addressing the issues by agreement among the entity owners, the consequences of an audit can be greatly inequitable and unfair to the current, as well as former, owners.
The new rules are extensive and complex. If you are involved in an entity that is taxed as a partnership, you are encouraged to seek advice on whether to amend the applicable entity documents in order to address these issues, and to consider restructuring ownership of the entity if doing so can make the entity eligible to “opt out” of the new rules.