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October 24th, 2017 by Garrett Sutton
The IRS has instituted new audit rules which require every LLC Operating Agreement and Limited Partnership (LP) Agreement to be amended. While we have never experienced such a dramatic requirement, it is important to make document amendments before December 31, 2017. The IRS likes to penalize non-compliance.
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, multi-tiered 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 10,000 partners in seven 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.
So you can kind of understand why the IRS would want to change the whole process. You would too in their shoes.
Immediate Actions Required For LLCs and LPs
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.
When the audit is finished, the IRS calculates an ‘inputed underpayment’ that the partnership owes the IRS. This will equal the understatement of income multiplied by the highest tax rate assessed during the year in question. By collecting directly from the partnership the IRS doesn’t have to track down and collect from individual partners through layers and layers of partnerships and entities.
It is the Partnership Representative who deals directly and exclusively with the IRS. An entity may be appointed to serve in this role, but an individual with a substantial presence in the United States also must be identified. 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.
There are other new technical rules in place which will only be necessary to know if you are ever audited. The only other general rule of import is that some small partnerships may opt out of the new rules.
For reasons we shall discuss, opting out is not your best choice.
Who Can Opt Out Of The New Rules?
Partnerships with less 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 towards the 99 partner limit.)
Single Member LLCs and Trusts Can’t Opt Out
Importantly, disregarded entities (i.e. single member LLC’s) 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 for such clients. 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.
It gets worse. 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.
The IRS has made it clear what they think about opting out. From their website:
Again, these rules are aimed at large partnerships. In most cases, it doesn’t really make a difference whether an audit is done at the entity level or the partner level. In closely held entities they are really one and the same. There is no great burden to following the new rules. Indeed, they involve less ongoing IRS surveillance.
There are a number of new technical rules, which will only be necessary for you and your CPA to know if you are ever audited. The only 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 the amended agreements which 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.
By amending your LLC Operating Agreement and/or LP Partnership Agreement, by designating a Partnership Representative, and by providing the IRS with accurate returns as you have always done, you will be fine.
– Garrett Sutton (Rich Dad Advisor)
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