Pursuant to the Bipartisan Budget Act of 2015, effective January 1, 2018, new rules will govern IRS audits of partnerships, including LLCs treated as partnerships for income tax purposes. Generally, any taxes due as a result of a partnership audit are currently imposed at the partner level, meaning that the partners during the audited tax year are responsible for any unpaid tax. Under this new regime, any taxes due as a result of a partnership audit will be imposed at the partnership level, meaning that the partnership will bear the cost of a past year’s tax liability (and indirectly, the partners of the partnership as of the current tax year, and not the partners as of the audited tax year, bear such cost). The purpose of these new partnership audit rules is to make it easier for the IRS to audit partnerships. State tax authorities are also currently considering adopting similar rules and regulations with respect to partnership audits. We are alerting you to this major change because it has significant consequences for partnerships and their partners, as briefly described below.
Tax Deficiency Liability: Since any taxes due as a result of a partnership audit are currently imposed at the partner level, when a past tax year is audited, the partners of the partnership during that past tax year appropriately bear the cost of any tax deficiency. Unfortunately, under the new partnership audit rules, the default rule is that the partnership itself will be obligated to pay for any tax due and owing, even if partners have joined and left the partnership since the audited tax year. This effectively means that current partners may bear the cost of tax for a tax year when they were not partners in the partnership.
Cash Considerations: Under the new audit rules, the IRS will soon be able to audit partnerships and collect any tax deficiency from the partnership itself. This could have a significant effect on cash reserves, as well as distributable cash, and may lead to additional penalties and interest if the partnership does not have sufficient funds to pay the tax liability.
Fortunately, the Bipartisan Budget Act of 2015 provides certain elections and may allow for other methods to mitigate or avoid the potential dire consequences of the new partnership audit rules. For instance, certain partnerships may qualify for an election that allows the partnership to elect to opt out of the new partnership audit rules and continue to require the IRS to impose any taxes due from a partnership audit at the partner level. Other elections or solutions may be available to resolve the issues above if the partnership does not qualify for such an election. Any such election or method intended to mitigate the effects of the new partnership audit regime should be designated in the partnership’s partnership agreement (or LLC’s operating agreement); otherwise the new partnership audit rules generally will apply. We have studied this new partnership audit regime since its introduction as part of the Bipartisan Budget Act in 2015, and, with our extensive knowledge of these new rules, we can evaluate your partnership (or LLC) to determine the best course for the partnership/LLC and appropriately address these rules with state-of-the-art tax and indemnity provisions. In order to protect yourself from the problems potentially arising from the new partnership audit regime, the partnership/LLC and its partners/members should review and amend their partnership agreement (or operating agreement) as soon as possible. As always, we are ready to address these concerns and provide solutions to the adverse effects caused by this development in the law.