There are changes coming to any business operation that is currently taxed as a partnership in the United States. The concept of the “tax matters partner” is being done away with in favor of what is called a “partnership representative.”
Multi-member LLCs (which do not elect to be taxed as a corporation) are taxed as partnerships for tax purposes, and the entity itself is not responsible for payment of the income tax. It files an information return (Form 1065) and issues a K-1 to each of its partners. Historically (prior to 1982) all individuals partners could be audited in their own right.
As of 1982, that changed and under what’s referred to as TEFRA, all partnership items are determined at the partnership level and the partnership must designate a “tax matters partner” who would represent the partnership in front of the IRS. The tax matters partner can file for refunds, settle with the IRS, extend statutes of limitations and be the lead contact with the IRS on an audit. Other partners got notice of the events but were not allowed to participate. The partners did, however, get to determine if they would agree to be bound by any settlement agreement.
The Bipartisan Budget Act of 2015, which was signed by President Obama on November 2, 2015, changes TEFRA and sets out new partnership audit rules. The rules go into effect beginning in tax year 2018 (the IRS and the Treasury Department are working on the regulations). They allow the IRS to deal with a single representative of the partnership, and the representative can agree on an result which binds the partnership and partners. The other partners do not have any right to get notice or any vote on the acts taken by the representative including litigation or settling claims with the IRS. Interestingly, the partnership representative does not need to be a partner.
Under the new rules, if a partnership got audited for a previous tax year and was found to have underpaid federal tax, the partnership would have to pay the amount of the underpayment (calculated at the highest rate not the actual rate of the partners), in the year of the audit. Interest and penalties may also be involved.
Importantly, the new rules do not allow netting of benefits and costs to partners. For example if the partnership overallocated an amount to partner 1 instead of (and at the expense) of partner 2, the overallocated amount given to partner 1 would be deemed to have caused an underpayment and there would be no offset for the amount underallocated to partner 2.
If there is an underpayment for any year, and the partnership still exists, the partnership itself is liable for the underpayment (if the partnership is dissolved at the time of audit, the partners are liable for the underpayment).
The new rules set a somewhat firm statute of limitations at 3 years after the partnership’s filing of the information return, and does not allow the IRS to audit the partnership three years after any of the partners files a return (which is what the current rules apply).
Elections under New Rules
Each tax year, the partnership can make an election to opt out of these new rules, provided that there are less than 100 partners and no partners are themselves tax partnerships or trusts. If the partnership elects to opt out, then each partner can be audited individually but the partnership itself cannot.
Also, if a partnership does not opt out (or cannot opt out) and gets audited, within 45 days of receipt of a final partnership adjustment, it can avoid paying adjustments by instead issuing revised K-1’s to the partners (which would require the partners to amend their individual returns for the year).
So existing LLC operating agreements and partnership agreements which contain the old “tax matters partner” language and procedures under the TEFRA will need to be updated and the partners should meet with their tax advisors to discuss whether elections discussed above should be made.
Attorneys are working on provisions requiring consent from the LLC members for certain actions of the partnership representative, including those related to litigation and especially resolving audits and signing settlement agreements. Also the ability for the LLC or partnership to be able to make any of the elections for any tax year or during an audit are being worked on as well.