The IRS has instituted new audit rules which require most LLC Operating Agreements and LP Limited Partnership Agreements to be amended. While we have never experienced such a dramatic requirement, it is important to make document amendments before Dec. 31, 2017.
Why the big change? In the past, when the IRS audited an LLC or LP taxed as a partnership, they eventually had to interact with all of the LLC members or LP partners. (From here on we will just use the word “partner.”)
Identifying and monitoring all the partners was a difficult task, especially in very complex, multitiered partnership structures (think oil and gas and real estate syndications.) Partners could intervene in the proceedings, complicate the audits and even litigate over them.
As well, the IRS usually needed the agreement of every partner to settle the audit. You can imagine how difficult this would be in a sophisticated LP with 3,000 partners in four separate tiers of rights. As well, even if the aggregate post audit tax obligation amount was large, the costs of collecting small amounts from (or getting refunds to) many partners was forbidding.
The new rules allow the IRS to deal directly with the LLC or LP. It is called the Centralized Partnership Audit Regime. Unlike the past, individual partners have no rights to receive notice, engage in the proceedings or disagree with the result. A single Partnership Representative (who need not be a LP partner or LLC member) interacts with the IRS.
In the eyes of the IRS, the Partnership Representative has absolute authority to bind the partnership. Typically, an LLC Manager/Member or LP General Partner is listed, with the ability to later appoint a CPA or tax lawyer, if you desire, if an audit comes your way. If a Partnership Representative is not appointed in your operating document, the IRS may select anyone they want to serve in this key role.
This is why you want to promptly amend your documents to appoint yourself or someone else who is on your side as the Partnership Representative. You don’t want the IRS making this decision for you.
Partnerships with fewer than 100 eligible partners may elect out of the new rules and stay with the old ones. Eligible partners include individuals, C corporations and S corporations (but each S corporation shareholder counts toward the 99 partner limit).
Importantly, disregarded entities (i.e., single member LLCs) and living – or revocable – trusts aren’t eligible partners. Virtually all of our clients use a mix of single member LLCs and living trusts for their combined asset protection and estate planning goals.
Under the new rules, opting out is not allowed. Even if you opt out, you must affirmatively opt out every year with the IRS and provide the names and tax identification numbers of all partners. The burden of such annual reporting is greater, in our opinion, than just complying with the new rules.
If you opt out and a partner changes their ownership to a Wyoming LLC or your CPA doesn’t make the annual election, you are automatically back into the new rules. However, because you didn’t opt in, amend your agreement and appoint a Partnership Representative, the IRS gets to appoint one for you. This is not a good position to be in.
There are a number of new technical rules that will only be necessary for you and your CPA to know if you are ever audited. The other requirement to know is that if money is owed after an audit, the IRS will collect from the partnership, or, if the 6226 election is made, from the existing partners. You could have a situation where partners who owed the tax in an Adjustment Year (i.e., 3 years ago) are no longer partners of the entity today.
We have added language in our amended agreements that allows the Manager or General Partner, in their discretion, to collect monies owed from previous partners. We have also included provisions in the transfer of ownership sections where the responsibility for any tax audit obligation is assigned.
It is helpful to know why the IRS (as authorized by Congress) made this change. As mentioned, the large and complicated master LP structures made it nearly impossible for the IRS to collect from individual partners. Audits of large partnerships were few. The new rules allow the IRS to deal with these entities. Large and complex partnerships are the target here – not smaller LLC and LP asset holding entities.
Be sure to speak with your attorney and/or CPA about how these new rules affect your LLCs and LPs. Handling any amendments before the end of the year is recommended.
Garrett Sutton is a Reno-based attorney and author, owns Sutton Law Center. www.CorporateDirect.com or call 775-824-0300.