Does Your LLC Agreement Address the New Partnership Audit Rules? If Not, the Time to Amend Is Now
The federal Bipartisan Budget Act of 2018 overhauled the former rules for partnership audits, repealing and replacing the Tax Equity and Fiscal Responsibility Act (TEFRA) partnership rules. The Act affects returns for the 2018 tax year and forward, and the IRS has indicated that audits will be starting in summer, 2019. Some LLCs that have already filed their returns have undoubtedly learned that, instead of a tax matters partner, a partnership must now designate a partnership representative. Other LLCs that filed for extension may only just be learning that a partnership representative must be designated. In either case, LLCs and their members should carefully consider who will serve as the partnership representative, and look to amend their LLC agreements in light of new changes in the law with respect to partnership audits.
Aside from the terminology change from tax matters partner to partnership representative, the new audit regime has significantly changed the way partners are notified of an audit, the authority of the partnership representative, and the default rules for assessing changes resulting from audit (and who pays any resulting tax). Accordingly, it is important for members/partners to familiarize themselves with some of these changes and ensure that protections and plans are built into the LLC agreements so there are no unexpected surprises down the line.
Choosing Your Partnership Representative
The most pressing decision for partnerships/LLCs is to determine who will serve as the partnership representative and designate that individual as the partnership representative. The partnership representative need not be a member of the partnership, but it must be a person with substantial U.S. presence. Selection of the partnership representative is very important because the partnership representative has the exclusive authority to act for the partnership with the IRS for audit purposes, and both the partnership and the individual partners are bound by the partnership representative’s actions in the audit. Furthermore, the IRS is no longer required to notify individual partners and instead all communications flow through the partnership representative, so it is important to select a reliable partnership representative. Finally, selection of the partnership representative by the LLC/partnership is essential because if the partnership does not designate a partnership representative, the IRS can choose any person.
Once the partnership representative has been selected, LLCs should look to amend their LLC agreements to address some of the unique features of the new partnership audit rules. For instance, given that the partners do not receive any notices from the IRS regarding audit, LLC members may want to ensure (via the LLC agreement) that a partnership representative notify members of significant decisions or issues, or allow voting on significant decisions, or that the partnership representative must act in good faith with reasonable cause and prudence. A partnership representative may want liability or indemnification provisions.
New Default Rule for Tax Payment
With respect to the manner in which the tax is actually assessed and paid, the new audit rules shifted the default rule such that the partnership pays any understatement of tax, rather than the previous rule, whereby any adjustment flowed through to individual partners who were obligated to pay (and could separately challenge the adjustment). But taking the adjustment at the partnership level may create inequities if there were different members/partners in the year under audit than in the current year of the audit or the year when the tax adjustment is made. There are alternative methods a partnership may use (not discussed in detail here), but the partnership must decide whether and how the partnership representative will be required to utilize these various methods of paying the tax, along with any obligations the partnership wants to impose on its members to facilitate payment of the tax by the various methods. The LLC agreement can include the specifics on these issues as well.
Finally, it may be possible in some instances to opt out of this new regime altogether, depending on who the partners/members of the LLC are, and the members should decide whether they want to delegate authority to decide whether to opt out to the partnership representative (if opting out is an option), or whether the members want to specify how the partnership representative is to proceed, i.e. requiring that the partnership representative make the opt-out election if possible.
All of the foregoing issues can and should be addressed in amendments to LLC agreements, and there is still time to do so before the IRS begins audits under the new regime in earnest. If you have specific questions on how these changes impact your business, contact Claire Taylor or a member of the Stokes Lawrence Business practice.