Partnership and LLC Agreements Require Amendment Due to Major Changes to Tax Audit Rules for Tax Years Beginning After December 31, 2017

November 19, 2017

SUMMARY: The Bipartisan Budget Act of 2015 (“BBA”) enacted major changes to federal income tax law regarding IRS audits of entities taxable as partnerships and their partners/members. The new rules, including proposed regulations, become mandatory for tax years beginning after December 31, 2017. The new rules will have significant impact on partnerships, LLCs, and their partners/members. Partnerships and LLCs should promptly amend their partnership and LLC agreements to address the new rules and key decisions that must be made by the partnership or LLC.

Under the BBA, Congress repealed the longstanding TEFRA rules relating to partnership audits and adopted a new and very different approach to partnership audits. The new rules were adopted in response to IRS difficulties in auditing partnerships and collecting tax underpayments from their partners. Under the TEFRA rules, the partners in the audited tax year (the “review year”), and not the partnership, are liable for their shares of any tax underpayment, and underpayments are assessed based on the individual review year partner’s tax rate. The TEFRA rules also require every partnership to designate a “tax matters partner” with limited authority and responsibility.

The new rules are significantly different from the existing TEFRA rules. Key changes include:

  1. Unless certain elections are made by the partnership, audits will be conducted, and tax underpayments must be paid, by the partnership instead of by the review year partners, resulting in the current partners bearing the economic cost of underpayments that should have been paid by the review year partners.
  2. Again, unless certain elections are made or other steps taken, underpayments will be calculated at the highest corporate or individual tax rate in the Internal Revenue Code for the year at issue.
  3. The role of “tax matters partner” disappears.
  4. A new, very different and powerful role of “partnership representative” is created, with the sole power and authority to deal with the IRS and to bind the partnership and the partners in matters related to IRS audits, which can result in significant conflicts of interest if a partner is named the “partner representative”.

Eligible partnerships can elect out of the new rules or elect to “push out” an assessed underpayment liability to the review year partners, but those elections may not be available or suitable for all partnerships or taxable years.

Of immediate impact to partnerships, LLCs and other entities taxable as partnerships is the need to amend their partnership and LLC agreements to address the new rules, including key decisions that must be made, in some cases annually or with the filing of the partnership tax return, and to provide direction in connection with naming the “partnership representative” and with decisions the partnership representative will make. The new rules require careful consideration in light of the size and complexity of the partnership or LLC, the nature of its business, and the nature of its partners/members. Decisions made regarding elections under the new rules, and who will be named as the “partnership representative” can have very significant financial impact, for better or worse, on the partnership and its partners/members.

Partnerships, LLCs and other entities taxable as partnerships should move quickly to evaluate the new rules and make appropriate amendments to their partnership and LLC agreements.