If your business files a Partnership Form 1065 return or you have an interest in a partnership, you need to be aware of changes in the IRS audit rules which will have a significant impact on partnerships. These changes also affect LLCs filing partnership returns.
Some small partnerships/LLCs may be able to elect out of the new rules. The election requires the partnership/LLC to have no more than 100 partners/members. The owners must generally be: Individuals, C or S corporations, or the Estate of a deceased partner/member. It is unclear whether a Single-Member LLC is a qualified owner. An annual election is required for this option in addition to other disclosure requirements.
Affected businesses will want to modify their operating agreements in addition to taking other actions to minimize the potential adverse effects of the new rules. Due to the nature of these actions, your attorney should be involved to assure proper implementation.
The primary changes to the audit rules are:
• IRS adjustments are assessed against the partnership in the year the examination is completed even though an earlier year was audited.
• The additional tax is assessed at the highest marginal tax rate (currently 37%).
• The partnership representative can also agree to IRS adjustments without approval from the partners/members.
The new audit rules may affect the value of a partnership/LLC interest since new partners/members would assume potential tax liabilities from years before they were owners. Actions also need to be taken to address concerns on the representative’s responsibilities if an audit is started.
To address these changes and minimize the adverse effects, the following actions should be considered:
• The partners/members can agree to have IRS adjustments assessed at their level. This prevents adjustments from being taxed to and paid by the partnership/LLC at the maximum tax rate.
• Partners/members who leave the business can agree to indemnify the remaining owners for tax liabilities related to the years they were owners. The former owners can also agree to have adjustments assessed at their level as discussed above.
• The partnership/LLC and its representative should agree on what actions the representative can take with or without approval from the partners/members. An understanding should also be in place on how approval should be requested, granted, and what to do if the partners/members do not agree.
The new rules are effective for tax years beginning after 2017. Therefore, it is important to update these agreements to be effective January 1, 2018.
If you would like to discuss the new partnership audit rules and the actions which may need to be taken, please feel free to contact us at 402-391-1065.
Ray Thomas joined Hancock & Dana in 2014. He specializes in representing individual and business clients with IRS issues including Audits, Notices, Collection, Employment Tax, Appeals, and Offer-In-Compromise. Ray joined Hancock & Dana after a 26-year career with the IRS as a Revenue Agent and manager. This background provides a unique understanding of how to resolve and prevent issues with the IRS.