On Jan. 1, 2018, drastic changes to long-standing federal partnership audit laws will go into effect, primarily in an attempt by the IRS and Congress to streamline the audit process for complex partnership structures. Lest this sound like an obscure issue for tax wonks, these changes are actually of pressing relevance to a large proportion of pass-through business entities — e.g., general and limited partnerships as well as most limited liability companies (LLCs) — that are taxed under Subchapter K of the Internal Revenue Code.
The finer points of the law, and the long-term business strategies to adopt in light of these changes, are beyond an article of this length. Further discussion with your legal counsel and tax professionals is encouraged. At a minimum, partnerships (and LLCs taxed as partnerships; hereinafter, collectively, "partnerships") should be aware of the following. First, tax deficiencies assessed upon audit will now be assessed and collected by the IRS in full at the partnership level. Second, the role of the "tax matters partner," and provisions in an entity's governing documents pertaining to the same, are soon to be rendered moot. Third, such governing documents will need amendment to adhere to the new laws.
These changes come from the 2015 Bipartisan Budget Act ("BBA"), which replaces the partnership audit rules enacted by the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"). Prior to TEFRA, all partnerships were audited, and deficiencies assessed, at the individual partner level, causing potential inconsistencies in partner treatment. To address these inconsistencies, TEFRA generally resulted in partnership audits being conducted at the partnership level. The audit results were then passed through proportionally to all partners to be assessed and collected individually after adjustments were made to the partners' distributive shares. Under TEFRA, a partnership generally selected a "tax matters partner" ("TMP") whose role was to represent the entire partnership, and the individual partners' interests, during the audit process.
Since the passage of TEFRA, LLCs have proliferated as a go-to entity structure that offers the limited liability of the corporate form, allows the pass-through tax flexibility of the partnership form, and avoids the ownership limitations imposed upon Small Business Corporations ("S Corps"). The more recent emergence of complex, multi-tiered partnership and LLC structures for asset protection have made audit and collection significantly more difficult for the IRS. The BBA seeks to streamline the audit process even further than TEFRA had, in order to crack these numerous and complex structures and increase tax revenue.
The focus on large, tiered partnerships notwithstanding, the BBA generally applies to partnerships of any size. Under the BBA, the role of the TMP is replaced by a "Partnership Representative" ("PR") who need not be a partner, but who must be appointed by the entity in advance of audit, or else the IRS will select one. Like the TMP, the PR may bind all partners to its actions. However, the IRS may now deal solely with the PR, leaving partners entirely out of the audit process.
Deficiencies, including penalties and interest, will now be assessed and collected as a non-deductible expense of the partnership in the year of assessment (regardless of the audited tax year in question) and at the highest applicable rate. The deficiency will no longer be passed through to partners for collection.
Finally, a qualifying partnership of 100 or fewer partners, none of whom may be another partnership or LLC, may opt out of the BBA audit rules by an annual election made on its tax return. Given the BBAs repeal of TEFRA, however, such audits will be conducted under pre-TEFRA, partner-by-partner rules, potentially giving rise to the inconsistencies between partners that TEFRA sought to remedy.
Don't be blindsided by these changes. Partnerships and LLCs of any size will be affected in some way by the BBA. If nothing else, entities are highly encouraged to select their PR before the end of the year, and amend their governing agreements accordingly.