New Federal Tax Audit Rules for Partnerships and LLCs May Require Amending Your Operating Agreements because of Potentially Serious Financial Implications

Partnerships and LLCs are “flow through” or “pass through” entities, meaning that the income tax associated with the entity’s taxable income is paid by the partners and members (the owners).  Current audit rules require the IRS to collect back taxes from the owners due to any increase in the entity’s taxable income.  Effective for tax years beginning after 2017 (although earlier application can be elected), the Bipartisan Budget Act of 2015 changes the rules regarding IRS audits of partnership and LLC tax returns.  The purpose of the new law is to make life easier for the IRS by permitting the IRS to collect back taxes from the entity instead of from the individual owners.  As such, the owners of the entity in the tax year the tax audit adjustments become final are the ones who bear the economic cost of any additional taxes associated with a prior year!  The highest tax rate will be used to calculate the back tax.  Regulations may permit owners in lower tax brackets to prove a lower rate to the IRS.  In that case, the operating agreement should address how to compensate the owner who lowered the entity’s back tax amount.  In addition, the new law has serious implications for the owners with respect to who has the authority to enter into binding audit agreements with the IRS. 

Since this new law affects the legal and economic relationships of the owners, you should consider working with your legal team to make any necessary changes to the operating agreement, such as requiring a withdrawing partner to indemnify the entity for back taxes and selecting the partnership audit representative.  Typically, the owners would want any tax burden associated with audit adjustments to be borne by the owners in proportion to their ownership interests in the tax year that was audited.  In addition, those now acquiring ownership interests should pay special attention to this change because the entity can elect earlier application of the new audit rules, and new members can be exposed to past tax problems if not otherwise dealt with in the operating agreement. 

There is an election out of the new audit rules for entities with 100 or fewer owners.  But to ensure that the election remains available, no LLC or partnership or trust should be permitted to become an owner of the entity, although C and S corporations and estate owners are permitted.  The number of S corporation shareholders are counted in whether the 100 owner test is met.  The election out must be made annually on a timely filed tax return.  This election should be addressed in the operating agreement. 

There is an exception to the entity paying the additional tax.  Within 45 days of the IRS’ notice of final adjustment, the entity may elect not to pay the tax and instead require the individual owners to pay the tax.  The entity apparently has to do the work in getting the owners to calculate their additional individual tax.  The owners would also be responsible for their share of any penalty and interest.  This election should also be addressed in the operating agreement.

Pres. Obama’s 2016-2017 Federal Budget Rehashes Many Old Tax Proposals but Also Makes Important New Proposals

On February 9^th Pres. Obama released his final budget proposal.  The budget has a very long list of proposed tax changes, generally proposed to take effect after 2016, which increase taxes by $2.8 trillion over 10 years!  While the chance of enacting the tax proposals is currently slim, proposals have a way of making a reappearance in future tax legislation.  Below is a selection from the many proposals.

Individual Tax Increases

·       The current top income tax rate on qualified dividends and long-term capital gains is 20% for taxpayers with income above $415,050 (single) or $466,950 (joint).  In addition, a 3.8% net investment income tax (NIIT) created under the Affordable Care Act applies.  The President proposes to increase the top tax rate on qualified dividends and long-term capital gains to 24.2% reaching 28.0% when the 3.8% NIIT is included.

·       Eliminate the specific identification method and require the average cost method for identifying the cost basis of “covered” stocks purchased after 2010.  This will prevent the “cherry picking” of high basis stocks for loss harvesting and of low basis stock for charitable giving.

·       Make Pell Grants excludible from income and from the American Opportunity Tax Credit thereby eliminating the planning that can create refundable tax credits.

·       Reduce the tax rate benefit of itemized deductions to 28% (which impacts taxpayers paying tax at the higher 33%, 35%, and 39.6% rates).

·       Implement the so-called “Buffett Rule” to require millionaires to pay no less than a flat 30% tax on income after the deduction of charitable contributions.

Business Tax Increases

·       Limit the amount of real estate like-kind exchange gain that can be deferred to $1 million per taxpayer per year (as indexed for inflation).

·       Tax “carried interests” (partnership or LLC profits interests) as ordinary income instead of long-term capital gain.

·       Require professional service business profits to be subject to Social Security and Medicare taxes regardless of whether the business is conducted through an S corporation, an LLC, or a limited partnership.

·       Repeal the LIFO method of inventory cost accounting.

·       Repeal the lower-of-cost or market and subnormal goods methods of inventory cost accounting. 

Estate and Gift Tax Increases

·       Increase the estate, gift, and generation skipping tax (GST) rate from 40% to 45%.

·       Lower the estate tax and GST exemptions from $5.45 million to $3.5 million.

·       Lower the gift tax exemption from $5.45 million to $1.0 million.

·       Require grantor-retained annuity trusts (GRATs) to have a minimum 10-year term and to have a remainder value for gift tax purposes equal to the greater of 25% of the value of the property transferred to the GRAT or $500,000.  These requirements eliminate the short-term, zeroed-out GRAT and also increase the size of the GRAT to at least $2 million to avoid a disproportionate size of gift.

·       Eliminate the benefits of a sale to an “intentionally defective grantor trust” by requiring the value of property sold to the trust to remain in the gross estate of the grantor, thereby preventing the shift of appreciation out of the estate.  In addition, the gift tax would apply to the transfer if the trust terminates and distributions are made to a third party.

·       Limit the duration of the exemption from the generation skipping tax to 90 years for “dynasty” trusts created after the date of enactment.

·       Eliminate the unlimited number of permitted annual gift tax exclusions for gifts of $14,000 per donee in favor of a flat $50,000 exclusion per donor for all gifts.

·       Under current law, most assets receive a new basis at death equal to the date of death value.  For gifts, the donee generally takes a carryover basis, meaning the donee pays the capital gain tax when the asset is sold.  Neither an inheritance nor a gift requires recognition of capital gain.

o   The proposal treats bequests and gifts other than to charitable organizations as a sale with the gain being included in the decedent’s final income tax return.  The capital gains tax paid at death may be deducted for estate tax purposes.  The combined estate, capital gain, and Utah taxes on appreciated property would amount to as much as 60%.

o   A spouse could inherit from a deceased spouse without immediate tax, but with carryover basis.  The tax would not be due until the death of the surviving spouse.

o   There would be an exemption from capital gains tax at death of up to $100,000 per individual ($200,000 per couple).  Note that these figures are “gains” and not the fair market value of the asset.  Any unused exemption of one spouse would “port” to the surviving spouse.  In addition, capital gains of up to $250,000 per individual ($500,000 per couple) for a personal residence would be exempt.  This additional exemption would also be portable between spouses.

o   Tangible personal property other than expensive art and similar collectibles would be exempt.

Limiting Retirement Plan Contributions

·       Under a new proposal, backdoor Roth IRA contributions would be eliminated by restricting conversions from traditional IRAs to only the pre-tax portion of the IRA.  Thus nondeductible IRA contributions would no longer be able to be converted to a Roth.  This concept is also extended to after-tax dollars in a 401(k) or profit sharing plan.  Essentially all after-tax dollars would be prevented from being converted to a Roth IRA.

·       The minimum required distribution rules would be extended to Roth IRAs so that distributions would be required once the account owner attained age 70 ½.  As a by-product, this change would also prevent further contributions to Roth IRAs after age 70 ½.

·       Non-spouse beneficiaries of IRAs and qualified plans and annuities would no longer be able to stretch-out distributions over their life expectancies as the account balances must be fully distributed by the end of the fifth year after the year of death.  For a minor child beneficiary, the distributions would commence after reaching the age of majority.

·       The President proposes to prohibit contributions to and accrual of additional benefits to IRAs, 401(k)s, and pension plans when balances are sufficient to produce an annual distribution of $210,000 in retirement.  Under current assumptions, the permitted balance would be about $3.4 million.

·       The special “net unrealized appreciation” (NUA) rules for employer securities received in a lump-sum distribution from a qualified retirement plan would be eliminated.  The NUA rule permits the gain on the sale of the stock to be long-term capital gain instead of ordinary income.  The repeal only applies to those who are younger than age 50 in 2016.

A Few Tax Cuts and Other Proposals

·       Increase the Section 179 expensing amount from $500,000 to $1,000,000.

·       Index the $25,000 limit on the cost of a sport utility vehicle that can be expensed under Section 179.

·       Expand simplified accounting methods for small businesses averaging $25 million (as indexed) of gross receipts over three years.

·       Increase the up-front expensing of start-up and organizational costs from $5,000 to $20,000.

·       Simplify and expand the research tax credit.

·       Permanently extend certain energy tax credits, such as the 30% solar panel credit.

·       Allow non-spouse inherited IRAs and retirement accounts to be rolled over within 60 days.  Rollovers are currently restricted to spouse beneficiaries.

·       Eliminate required minimum distribution rules for IRAs with account balances of $100,000 or less.

·       Require employees working at least 500 hours per year for three years be admitted into the employer’s qualified retirement plan.  Currently there can be a 1,000-hour requirement.

·       Impose the liability for unpaid corporate income taxes on shareholders.