The Bipartisan Budget Act of 2015 and the Protection of Americans for Tax Hikes Act of 2015 created new audit rules, which will in 2018 (unless for some generally ill-advised reason you want to opt in early) replace the current TEFRA regime. The new default rule is that if a partnership (or an LLC, LP, etc. taxed as a partnership) is audited, there will be a partnership level determination, assessment and collection. The problem with this default regime is what happens if you currently have different partners than who you had during the year being audited?
Also problematic is if certain allocations are challenged, the IRS will still assess the tax difference against the partnership (rather than simply undoing the allocations), which can create distortions. Notice comes solely to the partnership, and a partner individually cannot appeal. The partnership only has 90 days from the date of final adjustment to appeal. According to the new law, “imputed underpayments” will be determined “by netting all adjustments of items of income, gain, loss, or deduction and multiplying such net amount by the highest rate of tax in effect for the reviewed year.” (Emphasis added).
Opt Out, If You Can
What to do about the new audit regime? Opt out! If you can. If you elect out then the IRS has to pursue each separate partner. However, you must have less than 100 K-1s (and if you have an S Corp member each shareholder is counted separately for purposes of this limit). You also must have individuals, corporations, or estates of deceased partners as members. A partnership that has a partnership (or an LLC taxed as a partnership) as a member (i.e. an upper tier partnership) cannot opt out. It is unclear as to how trustees will be treated, although informally it has been suggested at a recent ABA tax conference that the IRS might deal with this issue through regulations.
We will also have to say goodbye to the tax matters partner. There is now a Partnership Representative. Unlike the tax matters partner, this person can be a non-partner and nonresident (but must have substantial US presence). Interestingly enough, this flexibility might not actually be a good thing. If a Partnership Representative has not been appointed, then the IRS can appoint one. It is an open question as to whether the IRS would use this flexibility to appoint a non-partner who is favorable to the IRS.
So, in light of all of this, should current operating agreements be amended? At this point, in many cases it might be better to wait for a bit more guidance. However, for current deals, it would seem quite prudent to incorporate very flexible language that can take into account these new rules, especially since these rules can alter the economics of a deal, particularly between current and former partners. Moreover, extra thought should be given as to which types of partners may join the partnership.
-Michael Goode is with Stites & Harbison in Nashville, TN.