The Bipartisan Budget Act of 2015 is making major changes to the examination and collection processes the IRS uses in its administration of the tax regime that governs businesses that are taxed as partnerships, such as limited liability companies that don’t affirmatively elect to be taxed as a corporation (this is most LLC’s). The new rules go into effect for tax years beginning January 1, 2018, so 2017 will be the last tax year the IRS will conduct partnership audits by default under the old rules for calendar year entities. If you have an interest in an entity taxed as a partnership, you should be aware how these changes may impact you.
The old rules made use of a “tax matters partner” to be the representative the IRS corresponded with during an examination. Partners had a number of rights to participate throughout the audit on their own behalf, and some were entitled to certain notices throughout the process. The new rules are more restrictive. They designate that a partnership representative (who need not be partner) will be the sole representative the IRS corresponds with and the representative will have the authority to bind the partnership in all matters concerning the examination.
The old rules mandated that the IRS deal with each of the individual partners in collecting audit adjustments, the partnership itself was not treated as a tax-paying entity. The default scheme under the new rules is to have the partnership pay any additional tax that results from an adjustment. Under this default scheme, the partnership will pay the tax at the highest individual rate, currently 39.6%. The partnership will not “go back” to the year the audit applies to and the individuals (or entities) that were partners at that time, the tax will be assessed as of the current year on the partnership entity. This means that new partners who have come into the partnership in years after the year the audit applies to may suffer financial losses for years that they weren’t even a part of the entity and hence didn’t benefit from a reduced tax bill.
Two Elections to Decrease the Impact of These Changes
There are two elections that can be made by partnerships that can eliminate or lessen the impact of these new rules. For short-hand, the elections are called by the section of the Tax Code they are contained in: the Section 6221 election and the Section 6226 election. Finally, absent making either of these elections, there are some provisions that can lessen the bite of the IRS using the highest individual rate when computing the additional tax attributable to the audit adjustment.
The Section 6221 Election
This election allows the partnership to completely opt-out of the new examination and collection rules. The partnership must have 100 or less partners and partners may only be individuals, S corporations, C corporations, or some estates. It is not entirely clear at this point whether single member LLC’s generally treated as disregarded entities will be treated as individuals for this purpose. However, it seems very likely that they will not as proposed regulations have been issued that would not allow such treatment (so any entity with an LLC owner would not be eligible for this election). This election must be made on the timely filed return for the year the audit applies to, it cannot be made after that point.
The Section 6226 Election
This election allows the partnership to opt-out of the new collection rules, the new examination rules will apply. The election is not restricted to smaller partnerships like the Section 6221 election. The election can be made up to 45 days after the final notice of adjustment is made by the IRS after an examination. Rather than collect the additional tax at the partnership level, this election allows the partnership to issue the IRS adjustment applicable to each partner to that partner. That partner then incorporates the adjustment into their current year individual income tax return. Making this election allows partners who were not partners during the audit year not to be penalized and reduces the tax due in terms of those partners not in the highest individual income tax bracket.
If Neither Election is Made
If neither election is made, partnerships may reduce the amount of entity-level tax by having partners (or former partners) file amended returns for the audited year consistent with the adjustment applicable to them. Partnerships may also reduce the entity-level tax by demonstrating to the IRS that there are partners that have certain tax characteristics, such as having a tax-exempt partner. There isn’t much guidance on how these provisions will be carried out at this point; partnerships should first consider their options under the two elections available.
Entities taxed as partnerships should review their operating agreements and update them accordingly before the implementation of these new rules. For instance, the partnership representative in the event of an examination should be agreed upon and language concerning the use of the Section 6221 and possibly the Section 6226 election should be incorporated into the agreement. Additionally, some entities may want to add language concerning potential tax reserves, partner indemnifications, requirements for former partners to file amended returns in certain circumstances, and/or holdback/claw-back provisions. Make sure that you consult with your tax advisor before implementation of these news rules to better understand their potential impact on you and to have your operating agreement amended where needed.
Written by: Brian Spencer