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.