New Partnership and Limited Liability Company IRS Audit Rules Become Effective in 2018

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Gerard J. Kassouf CPA, PFS, CFP®, AEP Managing Director of Healthcare Services Group

Kassouf & Co. Managing Director, Gerard J. Kassouf, CPA, discusses new audit rules for 2018, as announced by the IRS, for partnerships and limited liability companies in his most recent article for Birmingham Medical News.

Article from Birmingham Medical News:

The Internal Revenue Service has announced new rules for auditing partnerships and their partners for Partnership and Limited Liability Company returns filed for partnership tax years which begin after December 31, 2017.

EXAMINATION UNDER NEW RULES
Under the new rules, if an entity taxed as a partnership is selected for examination, the IRS will audit items of income, gain, loss, deduction, or credit, and any distributive share of these items for the tax year in question. Adjustments will be calculated at the partnership level (and not at the partner level, as is the current case) and all payments for additional tax, interest and penalty will be assessed to the partnership. The IRS in not required to provide individual partners any information or opportunity to participate in the audit process.

ELECTING OUT OF NEW RULES
In some cases, the partnership will be allowed to elect out of these new rules. These rules provide that the partnership representative may elect to have the partners make payment of any amount due. The election must be made no later than 45 days after the IRS mails the notice of final adjustment. By making the election, the partnership is no longer obligated for the payment, but each partner will be liable for their share of tax, interest and penalty. The interest charge on any underpayment of tax will be two percentage points higher if the election is made.

Partnerships may elect out of these new rules if two conditions are met: first, if the partnership has 100 or fewer qualifying partners requiring a Schedule K-1 for Form 1065; and second, all partners must be “eligible” partners. “Eligible” partners include individuals, C Corporations, S Corporations, and estates of deceased partners.

The proposed IRS regulations state that if a partner is 1) a trust, including a grantor trust, 2) another partnership, or 3) a disregarded entity such as a single member LLC the partnership is not eligible to elect out of the new rules.

DESIGNATING A “PARTNERSHIP REPRESENTATIVE”
The partnership is required to designate a “partnership representative,” replacing the formerly known “tax matters partner.” The partnership representative, who is not required to be a partner of the partnership, will have exclusive authority to take actions on behalf of the partnership, without regard to any contrary position in the partnership agreement, or any other formal agreement between the partners.

The partnership representative is designated on the entity’s timely filed tax return, and the designation by law, is made annually. If the partnership does not name a partnership representative, the IRS may select any person of its choosing. The proposed rules explain how the IRS’s selection will work, and prohibits the partnership from making a change to the IRS appointed representative without its consent.

There is no requirement that the IRS communicate with anyone except the partnership representative. Therefore, it will be the partnership’s responsibility to inform the partners of the examination and any other IRS proceedings.

UNDERPAYMENT OF TAX UNDER NEW RULES
The new rules state that the underpayment of tax will be calculated at the highest rate of federal income tax in effect for the year under audit. Under current tax rates, the rate would be 39.6 percent. The statute of limitations for making adjustments for any partnership tax year is generally three years, but this period may be extended under certain conditions.

Partnership agreements must consider the problems that may be created by partners that have withdrawn, and partnerships that have dissolved between the tax year under audit and the year the deficiency in tax is resolved. Collection of prior-year taxes due from more difficult without specific remedies under a binding partnership agreement. This is a major consideration in the amendment to any agreement currently in place, or a reason to formalize a verbal agreement.

In summary, the new rules make it easier for the IRS to audit partnerships and collect tax. The fact that there is no notice or participation rights to individual partners allows partnerships to be under audit without notification to the partners. By collecting the tax from the partnership, the payment moves from the partner to the partnership, Congress estimates that partnership audits under the new rules will generate approximately $10 billion in tax revenue

CONSIDER THE FOLLOWING FOR IMMEDIATE ACTION:

  • Amend partnership and LLC operating agreements to implement the new rules by December 31, 2017
  • Designate a Partnership Representative and provide requirements for representation
  • Restrict transfers of interests to entities that are eligible partners or members
  • Coordinate with partners or members who sell or transfer their interest after the year under audit
  • Determine partner consent, if any, for making elections or settlements by the partnership representative

This is a brief discussion of a complicated tax topic, and is not meant to provide a complete explanation of the new centralized partnership audit rules. It is meant to inform you of a major change in the way the IRS will audit partnerships and limited liability companies. These rules are effective in 2018. If you are a partner in a partnership, or a member of a limited liability company, you are affected, and need to take action.

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