Next year, the IRS will begin using a new centralized audit regime to audit partnership, LLP and LLC tax returns. Investors have been bombarded with more information than they can absorb about this change, but most of the details are only interesting to the lawyers and accountants who must work directly with the IRS. Here is what you ought to know about this new IRS procedure if you are an investor in a partnership, LLP or LLC—or if you are thinking about becoming one.
These changes are being made for the benefit of the IRS, not the investors. Investors will lose some of their statutory rights to (A) be informed of dealings with the IRS and (B) appeal settlements with the IRS.
For many years, the IRS has struggled with partnership audits because of its duty to give each partner appropriate notice of proposed adjustments and its duty to preserve each partner’s separate appeal rights. A 2015 law changed this to accommodate the IRS. The rules become mandatory for all partnerships (and other entities taxed as partnerships) in January 2018, with limited rights to elect out, as described below.
The IRS will now find it easier to do partnership, LLP and LLC audits, but partners have lost many of their due process rights. Your notice and appeal rights are no longer protected by law. These rights must now be spelled out in your partnership agreement or LLP/LLC operating agreement. Most existing partnership agreements and operating agreements will have to be amended effective on January 1, 2018.
Under prior law, most partnership agreements provided for a Tax Matters Partner (TMP) that handled audit matters with the IRS, pursuant to the “TEFRA” rules (the Tax Equity and Fiscal Responsibility Act of 1982). However, beginning with the 2018 tax year, any audits will be managed at the partnership level by a Partnership Representative (PR). We currently see that many partnership agreements have simply added a provision that substitutes the term PR for the term TMP and the agreement has otherwise left the current TMP rules in place. Unfortunately, the actions and powers of a TMP under the former TEFRA rules were far more limited than the sweeping powers given to a PR under the new law. From now on, unless your partnership is eligible to elect out, and does elect out, the IRS will only deal with the PR, and the partners have no rights to separately appeal a tax assessment. The PR also has the power to take other binding actions with the IRS that you cannot appeal. These include:
- Waiving the Statute of Limitations or other defenses;
- Communicating with the IRS and agreeing to settle the total tax liability of all the partners;
- Once the total tax assessment is agreed, the PR is able to elect to either:
- allocate that total amount among the partners, so the IRS can collect a specific amount from each partner or
- pay the tax on each partner’s behalf at the partnership level.
Moreover, the new rules eliminate the concept of notice partners who are entitled to hear directly from the IRS. So, an audit could commence and run its course, and unless the PR keeps the partners informed, they might never know about it until they get a bill that is no longer appealable.
Some partnerships will be able to elect out of this new centralized audit regime. To be eligible, the partnership must have 100 or fewer partners, all of whom are individuals or C corporations. The new rules are mandatory for everyone else. And the election must be made by the entity. The partners themselves have no ability to elect out. If your partnership can elect out, you and your partners should seriously consider doing so. If you can’t—or if you’re unsure—here are some important questions the investors and the managing partners should answer in the form of amendments to the partnership agreement.
Your partnership agreement needs a new set of rules directing the PR in its dealings with the IRS.
The rules need to address questions like the following:
- Does a decision to extend the statute of limitations or a decision to settle the case require a simple majority vote of the partners, a majority of each class or a unanimous vote?
- How should the PR settle the case if there is no agreement among the partners?
- How and when should the PR notify the partners of correspondence and other communications with the IRS?
- How should the partnership’s tax liability be allocated among the partners and the classes of partners?
- Should any additional tax simply be paid by the partnership and charged against each partner’s account as a distribution? Or should the tax-payment responsibility be “pushed-out” to each partner so the IRS handles the collection? This election must be made within a very short 45-day window.
- The new law presumes that all partners are taxed at the highest possible bracket, unless the PR proves otherwise within 270 days of making a settlement. How and when should the partners supply information to the PR that will enable him to protect their right to use the lower tax brackets?
The IRS will be allowed to rely on the actions of the PR and you may not prevent that reliance. Neither the new law nor the regulations provide any remedy for a dissatisfied partner. So, the amendments to your partnership agreement should include a dispute-resolution mechanism (such as mediation or arbitration) to deal with the concerns of a partner who doesn’t agree with the PR’s settlement of the IRS case. And it should include a collection mechanism in the event the partnership pays a tax assessment at the entity level and one or more partners are unwilling or unable to pay their share of the assessment. Some partnerships may decide to require the dilution of a defaulting partner’s interest, just as partnerships often do when a partner defaults in making a required capital contribution.
The amendments to the partnership agreement should also provide for what happens in the event the PR makes a good-faith mistake in deciding what is best for each partner. They should include notice provisions to reduce the risk of mistakes due to poor communication between the PR and the partners.
Even with adding these rules, the partnership must decide whether to buy an errors-and-omissions insurance policy to recover the unnecessary taxes, penalties and interest that would result from a PR’s unintentional failure to follow the rules for taking directions or breaking tie votes among the partners.
While many partnerships may continue reimbursement policies that are similar to the ones that apply to their TMP, it should be expected that many others will turn to professional PRs who will charge fees for representing the partnership in an IRS audit.
Pay serious attention to who is being named as the PR. You will be empowering this person to represent you if there is a dispute with the IRS. The investors, the general partner and the PR should be clear on each other’s expectations.
General partners and investors should communicate to determine how the partnership will deal with these changes.
If the partnership is not eligible to elect out of the new centralized audit regime, then it is important to add provisions applying these new rules to the partnership agreement or LLC/LLP operating agreement. There are many points to address, but in particular, the partners should determine who will serve as the PR, and they should consider requiring the PR to give all partners timely notice of all IRS communications. Other provisions partnerships should consider include obligating the PR to use its best efforts to give you enough time to respond and comment on any interactions with the IRS, and the option for you to have your personal tax attorney or accountant participate in the partnership audit from the beginning, since you will no longer have the right to appeal separately. Obviously, there are pros and cons to most of these new rules.
Finally, it may make sense to completely depart from the TMP provisions in your current agreement. It was pretty common and reasonably safe under the old TEFRA rules to permit the managing partner or the dominant partner to be the TMP. But starting in 2018, the managing partner may not want that responsibility, or all the partners might be better served by having an independent PR.
It also makes sense to have a thorough discussion of these points with your tax advisor. Indeed, an outside tax advisor might be a good choice as an independent PR. He or she will have no duties unless there is correspondence from the IRS, and you would probably be consulting with him or her at that time anyway.