IRS Gains At The Expense of Partnership Owners
May 9, 2018
The new partnership audit rules went into effect earlier this year. The new rules permit the IRS to assess and collect tax directly from a partnership or an LLC taxed as a partnership (both of these entities are, for simplicity, referred to as an “LLC”). As such, the IRS will no longer have to chase down the owners of LLCs to audit and collect additional tax as a result of audit adjustments. For entities with many owners, this will make the audit process more streamlined for the IRS. However, while these new rules will make life easier for the IRS, they have the potential for adverse consequences to LLC owners.
Pass through Taxation
The new rules break one of the tenets of partnership taxation by assessing tax at the partnership level. Partnerships don’t pay income tax – their income is passed through to their owners who pay the tax individually. That is until now. This major change also opens the possibility that some LLC owners will pay more than their fair share. Here’s how.
Finn Towers, LLC, a tax partnership, was formed in 2016 by three equal members – Bonnie, Michael and Claire. They each own 1/3 of the LLC. In 2019, the LLC purchases Bonnie’s interest in the LLC for $500. In 2020, the IRS audits tax year 2018 and makes an adjustment to the LLC tax return that results in additional income of $100 (which should have been shown on the owners’ Form K-1 in 2018). The IRS then assesses the LLC tax in the amount of $37 ($100 income x 37%). Under the new audit rules, Claire and Michael, as the sole remaining members of the LLC, will need to fund and pay the tax. Bonnie would not shoulder any part of this assessment – unless she has a separate contractual obligation to do so – because Bonnie wasn’t an owner in 2020 when the audit was concluded and the tax was assessed, even though she was a member of the LLC in 2018, the audit year.
It’s hard to see this example as anything other than unfair to Claire and Michael. Fortunately, there are solutions, including certain options to have all three owners share the tax from the audit equally.
Because the rules are new, they would not have been contemplated in the original LLC operating agreement or limited partnership agreement. As such, amendments now to those agreements should be strongly considered. Those amendments should address the following:
- Consider Opting Out. There are some LLCs that will be able to opt out of the new rules, but your operating agreement should be clear on how this determination is made. The election is an annual election and must be made as part of filing the LLC income tax return.
- Who has the Authority to deal with the IRS? The audit rules call for the appointment of a ‘Partnership Representative’ who will represent the LLC in all aspects of the IRS audit. The Partnership Representative, who need not be an owner, is given broad powers to act unilaterally on behalf of the LLC under the audit rules. This was done purposefully, so that the IRS audit would not be slowed down by decisions that need to be made by others. However, this broad authority can be modified. For example, you may want to provide in the operative agreement that the Partnership Representative must obtain the consent of a certain number/percentage of the owners before agreeing to extend the statute of limitations or agreeing to a settlement with the IRS. In addition, the operative agreement should also contemplate the election and removal of the Partnership Representative. Unless one is appointed by the LLC, the IRS has the authority to appoint someone of its choosing to act in that capacity.
- Require Cooperation from all Owners. In the desire to provide flexibility to LLCs in how to deal with partnership-level tax assessments, the new audit rules have become quite complex. The Partnership Representative, who is charged with dealing with the IRS throughout the audit process, may need certain information from the owners in order to determine which alternative is best for the LLC and its owners in dealing with the tax assessment. In addition, the Partnership Representative may need the ability to command the owners to take certain actions, such as filing amended returns for the year under audit, or paying their portion of the tax assessment directly to the IRS. Where an owner doesn’t comply, the operative agreement should also provide an appropriate remedy.
- Is Indemnification Appropriate? The Partnership Representative will have broad authority to act on behalf of the LLC. Because those decisions may affect each owner differently, the LLC may want to indemnify the person acting as the Partnership Representative as long as they carry out their duties in good faith.
- What about Sale Transactions? In addition to the operative governance documents, as the example above illustrates, when an owner of the LLC sells their ownership interest in the LLC, the purchase agreement should address the continuing obligations of the departing owner with respect to any additional tax that may be assessed against the partnership in a future audit.
The new partnership audit rules are quite complex, but navigating the available alternatives will be much easier if the operative agreement contemplates these issues. In sum, it is time to pull out that agreement and make the needed changes.
Timothy Finnerty, co-chairs McNees Wallace & Nurick’s Corporate & Tax Group and is a member of the Estate Planning Group. He can be reached at 717.237.5394 or firstname.lastname@example.org.
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