A few weeks ago I traveled down to Washington, D.C., where I did what everyone does when they visit our Nation’s Capital…attend a national tax conference for 16 hours over two days.
The highlight of my trip was not the legislative tax updates, the best practices on how to achieve capital gain treatment on asset sales, or the discussions regarding the potential savings that new federal opportunity zones provide. No, nothing was as exciting as the discussion regarding the recent changes to how the Internal Revenue Service (“IRS”) will begin auditing partnerships for tax year 2018. Generally, although the days of entrepreneurs forming general partnerships have been replaced by the flexibility and liability protection that limited liability companies (“LLC(s)”) offer, in the eyes of the IRS nothing has changed. Unless an LLC makes a specific election to be classified as a corporation, the IRS does not view an LLC as a separate tax entity and by default, classifies an LLC as either a partnership or a disregarded entity.
One of the speakers at the tax conference was a noteworthy employee of the IRS. Similar to the repeated warnings throughout Game of Thrones that “Winter Is Coming”; all of us tax professionals were also placed on high alert by this IRS employee that “Partnership/LLC Audits Are Coming”. The representative informed us that the IRS is currently in the process of training its staff to audit partnerships and individual partners under its new audit rules. The new rules generally provide broad authority to a newly established and mandatory representative of the partnership, titled the “Partnership Representative”.
This Partnership Representative should be selected by the partnership and officially recorded on the partnership’s annual federal income tax return. In addition, the Partnership Representative, who interestingly, is not required to be a partner of the partnership, will be granted the authority to legally bind the partnership, and indirectly its partners, on several issues that may arise with the IRS, including whether or not the partnership elects to be audited at the partnership level or on the individual partner’s allocation of income. Further, in order to ease the administrative burden of auditing potentially thousands of individual partners, the IRS granted the Partnership Representative significant decision-making authority. Theoretically, the decisions made by the Partnership Representative could reallocate assessed tax, penalties and interest stemming from previous tax years to partners who have since left the partnership. As you can imagine, these individuals would be unpleasantly surprised to see a tax bill regarding a partnership in which they no longer participate in. Granted the wide range of authority, the decision on who will be the Partnership Representative should be given significant consideration by the partners in coordination with their accountant.
In October 2019, all 2018 partnership tax returns will have been required to be filed with the IRS. Therefore, now is the time for partners to act before “winter arrives”, literally and figuratively. Partners should consider consulting with their attorney to update their partnership or operating agreements to clarify exactly what authority the Partnership Representative is given. Some examples of possible limitations that can be placed on the Partnership Representative’s authority are:
- How the Partnership Representative is selected and removed;
- Notice and reporting requirements of the Partnership Representative;
- Eliminating the Partnership Representative’s ability to make tax elections, including whether to opt in or out of the new partnership audit regime;
- Extending the statute of limitations for an audit;
- Determining how tax assessments will be paid;
- Determining how litigation and settlements will be handled; and
- Everyone’s favorite, determining how disputes will be handled between the Partnership Representative and one or more of the partners.
You have been officially warned, partnership/LLC audits are coming, so be prepared.
For assistance with updating your partnership and operating agreements, please contact a member of the FL&B team.