Is your LLC or Partnership Ready for its (Possibly) Impending Audit?

January 22, 2021
cameras watching with title, by Brad Hamilton

2021 may be the year the IRS dramatically increases partnership tax audits.

By Brad H. Hamilton.

On September 1, 2020, as a first step in its stated intention to increase Partnership audits in 2021, the Internal Revenue Service added a new section, BBA Centralized Partnership Audit Regime, on its website at IRS.GOV.

BACKGROUND

Before January 1, 2018, when the IRS audited a partnership (including any entity taxed as a partnership, like the typical limited liability company), and tax, interest or penalties were owed, the IRS could only collect from the individual partners. For small partnerships or LLC’s (ten or fewer partners or members), the IRS had to audit each partner or member, too. For larger partnerships, the IRS could audit only the partnership, and not each partner, but it still had to collect any amounts due directly from each partner.  Consequently, the IRS typically audited only about 1% of partnerships each year.

When the Bipartisan Budget Act (“BBA”) became law in 2015, beginning with the 2018 tax year it gave the IRS the ability to audit partnerships and collect any money owed directly from the partnership, instead of having to audit and pursue payment from each partner.

The IRS planned to implement the procedures and resources for more partnership audits in 2020 for the 2019 tax year. But then 2020 happened.

Now the IRS is preparing to increase partnership audits in 2021, for prior tax years.

SOME PARTNERSHIPS CAN ELECT OUT OF THE NEW PROCEDURES

A partnership or LLC with 100 or fewer partners or members can elect out of the centralized partnership audit regime if all its partners are “eligible partners,” defined as follows:

  • Individuals
  • Estates of deceased partners
  • C corporations
  • Foreign C corp equivalents
  • S corporations

A partnership with any of the following as partners can NOT elect out:

  • Partnership (e.g., an LLC with multiple owners)
  • Trusts
  • Foreign entities that would not be a C corp in the U.S.
  • Disregarded entities (e.g. an LLC with a single owner, or a grantor trust)
  • Estates of individuals other than deceased partners
  • People who hold an interest in the partnership on behalf of another person

If your partnership or LLC is eligible to elect out, and wants to do so, the election must be filed every year with the partnership tax return for that tax year and you must notify each partner within 30 days.

WHY WOULD MY PARTNERSHIP OR LLC ELECT OUT?

Audits can be time consuming, distracting, and difficult, and that is just for the IRS auditor! For the partners and the partnership, they can be time consuming, distracting, difficult, and expensive. Because of the many difficulties, rules, and traps ingrained in the IRS partnership audit rules, and the difficulty of auditing and collecting from individual partners, the IRS did not often audit partnerships under the old rules. There is a very good explanation of the historical development and application of the partnership audit rules by Kreig Mitchell explaining the daunting obstacles each partnership auditor must address under the old rules here: Electing Out of the Partnership Audit Regime.

Suffice it to say that an eligible partnership or LLC that elects out of the BBA’s centralized partnership audit regime is less likely to be audited.

RECOMMENDED CHANGES TO PARTNERSHIP AND LLC OPERATING AGREEMENTS

Older partnership and operating agreements need to be amended to replace the Tax Matters Partner provisions with an updated Partnership Representative (the new designation under the BBA) provision (and, if the Partnership Representative is an entity, to also name a Designated Individual that has a substantial presence in the U.S.), as well as specify several powers and obligations on the Partnership Representative (or Designated Individual, if applicable), such as requiring timely notice to partners, and state each partner’s agreement to

  • cooperate in any audit,
  • report the partner’s taxes consistent with reporting by the partnership,
  • amend the partner’s returns if a partnership audit requires it, and
  • pay the partner’s pro rata share of any tax liability from an audit.

If my Partnership or LLC is Eligible to Elect Out

Consider amending your partnership or operating agreement to prohibit any partners or owners who are not “eligible partners,” without the general partner’s or manager’s consent, or the consent of the other partners or members, depending upon how the entity is structured. This change will help ensure that the entity does not accidentally lose its eligibility to elect out by admitting an ineligible partner. For example, a growing company formed as an LLC may decide to accept investment from a venture capital or other investment fund, which is probably a partnership or LLC. Accepting that investment will disqualify your entity from electing out of the centralized audit regime in future years, and if your agreement prohibits that investor from becoming a partner or member without consent, the disqualification will be intentional rather than accidental.

If my Partnership or LLC cannot Elect Out

For most partnerships, the agreement should obligate each partner (and former partner) for its share of cost and tax liability for the year being examined or audited, rather than the year the audit or examination concludes, and to enforce that obligation the partnership must have the right to withhold from distributions, claw back from prior distributions to departed or reduced partners, “push out” (via an election under the BBA rules) its share of such tax liability to each partner and former partner, their share of that obligation. Otherwise, that obligation will fall on the partners still with the company, who will have to pay on behalf of those who left or reduced their interest after the tax year being examined or audited (which is often quite important in negotiations with respect to redemptions and sales of partnership interests).

WHAT NEXT?

On November 24, 2020 the IRS published proposed regulations to assist its impending focus on auditing large partnerships, as authorized by the Tax Technical Corrections Act of 2018. These regulations address (1) partnerships that have an S corporation partner, (2) how to treat partnerships that have been dissolved, and (3) IRS authority to make certain partnership related adjustments without opening a full audit of the partnership (for example, when auditing a single partner), among other things.

This information is not intended as legal advice. Readers should seek specific legal advice before acting with regard to the matters addressed above.