New IRS Partnership Audit Rules Require Changes to Many LLC and Partnership Organizational Documents

August 27, 2018

As mentioned in Sherin and Lodgen LLP’s February 2018 Client Alert, the IRS’s new partnership audit rules require clients utilizing partnerships and/or multi-member LLCs taxed as partnerships to review and likely amend their existing organizational documents.

What Changed?

Prior to December 31, 2017, there was a cumbersome, multi-tiered partnership audit process that was inefficient and required the IRS to seek collection of unpaid taxes at the partner or member level, as opposed to the entity level. Under the new partnership audit rules, effective as of tax year 2018, the IRS now has far greater power to audit partnerships and multi-member LLCs that are taxed as partnerships and will be able to collect taxes directly from the entity, rather than just from its members or partners. Moreover, under the new rules, any liability from an audit is now assessed in the year that the audit is completed, rather than the year in which the item was reported. Thus, a new partner or member of an entity may end up being responsible for an audit assessment relating to years before its admission to the entity. In addition, the concept of a “Tax Matters Partner” has been eliminated, and replaced with a new type of entity tax representative called a “Partnership Representative,” who will have broad authority to deal with the IRS.

What Changes May Need To Be Made To Organizational Documents?

  1. Partnership Representative. Given the new broad legal authority granted to the Partnership Representative, many LLCs and partnerships will want to amend their organizational documents to identify the Partnership Representative and specify how much authority such Partnership Representative should have to make decisions for the entity without prior notice to, consent from and/or consultation with the other partners or members.
  2. Opting Out. The principals will have to decide whether to elect to “opt out” of the new audit rules, which is an option only for “eligible” partnerships and LLCs having fewer than 100 members or partners, where each of the partners or members is an individual, a C corporation, an S corporation, a foreign entity that would be treated like a C corporation if domestic, or an estate of a deceased partner or member. If a partnership or LLC is not eligible to opt out because of an ineligible partner or member, the principals of such entity may want to consider possible restructuring options.
  3. Transfer Provisions. If an entity is eligible to opt out (and would like to retain such status in the future), transfers to ineligible transferees should be restricted. Moreover, consideration should be given, at the time of any interest transfer, to the IRS’s new right to make audit assessments in the future relating to prior tax periods.
  4. Funding Audit Assessments. Since the IRS may now seek to collect audit assessments at the entity level rather than from the entity’s members or partners, the LLC and partnership organizational documents should have a mechanism to fund audit assessment and seek reimbursement from current and, in certain circumstances, past members or partners.

Next Steps

If you or your business utilizes partnerships or multi-member LLCs that are taxed as partnerships, the new partnership audit rules will require you to make many decisions in the coming months. We suggest that you contact your legal and tax advisors as soon as possible in order to discuss your options and arrive at a plan of action that works best for you.

Click here for a copy of our Client Alert, which adds further detail regarding the new partnership audit rules.