Know the rules to protect yourself and your partnership.
By Elizabeth M. Reeder
With a new year comes new tax rules that have significant impacts on your operating agreements and LLCs. If you haven’t updated your operating agreement for some time or if you are entering or exiting an LLC, the Bipartisan Budget Act of 2015 (the “BBA”) has significant impact for the former “tax matter partner” provisions. These BBA provisions took effect January 1, 2018 and repeal the TEFRA and ELP procedures and apply to all partnerships that file a Form 1065 return. In implementing these rules, it is anticipated that the IRS will increase audit activity and make it easier to assess deficiencies for unpaid taxes to your partnerships. It is critical to understand the new rules in order to better protect yourself and your partnership in future audit.
In particular, under the BBA, you need to consider:
- Partnership Representative. The BBA requires the partnership to designate a partnership representative (“PR”), which has far greater authority than the old “tax matters partner.” Unlike a tax matters partner, the PR does not have to be a partner in the partnership. The PR can be an entity. You should designate a PR in your operating agreement and you will also have to designate the PR on your tax return. Because exams and any corresponding adjustments are conducted at the entity-level, the PR has a significant role and clients should be careful in selecting PRs. If a PR is not designated or the designation is withdrawn, the IRS will select the PR.
- Partners’ (Lack of) Participation. Under the BBA, you as a partner have no right to participate in or even have notice of audit administrative or judicial proceedings. The PR is not required to send any notices to you and neither is the IRS. More concerning, the PR can bind you as a partner and LLC in a proceeding without notice to you. Partners in LLCs should add language to their operating agreement requiring the PR to give notice to any members and an ability to participate.
- Imputed Underpayments; Push-Out Election. If the IRS assesses a deficiency, they will issue a notice of proposed partnership adjustment with the imputed underpayment. The payment, interest, and penalties are to be paid by the partnership itself unless it elects to “push out” the payment of the underpayment to the partners by issuing K-1s for the deficiency. The partners for the push-out are those in the partnership in the year in which the adjustment is made. And the push-out adjustments are taken into account during the year when the partners receive their K-1s for the adjustments. An additional 2% underpayment interest rate is charged if the push-out election is made. Because these underpayments are paid in the year the final adjustment is made, these provisions are important for members entering and exiting LLCs. Clients entering already operating LLCs will want to conduct careful due diligence. They could be responsible for tax for a year that they weren’t even a partner in the LLC and may want to request an indemnity to the extent tax is assessed for a year when the client/member wasn’t even part of the LLC. Likewise, you may want to require an indemnity from exiting members to the LLC until the statute of limitation runs on prior tax years.
- Electing Out. The BBA rules are designed to increase tax revenue without raising tax rates by streamlining the audit and assessment procedure. Because of that, most partnerships will want to elect out of the BBA rules and you should draft provisions in your operating agreement to provide for that. To be eligible to opt out, the partnership must have 100 or fewer “partners.” “Partners” is determined by the number of K-1s sent–not by the number of Members identified in an operating agreement. Additionally those partners must be eligible partners for the entire tax year. Ineligible partners include partnerships, trusts, disregarded entities, a person that holds an interest on behalf of another person, or certain estates. Special rules apply to partners who are s-corps. The opt out election must be made each tax year.
Please consult with your attorney for additional guidance regarding these new rules.