What to Know About Changing LLC Auditing Rules

SAN DIEGO—Last month, President Obama signed HR 1314, the Bipartisan Budget Act of 2015, a comprehensive bill which—among other things—significantly alters the way partnerships and limited liability companies are audited and taxed by the IRS. The new "streamlined" rules allow the IRS to audit and assess taxes and penalties against large partnerships more easily and retool a 33-year-old law that sets the rules for audits, Phil Jelsma, a partner and chair of the tax practice team at the San Diego-based commercial real estate law firm Crosbie Gliner Schiffman Southard & Swanson LLP, tells GlobeSt.com.

According to the Congressional Budget Office, the new partnership auditing procedures are expected to increase Treasury revenues by up to $11.2 billion over the next decade. Jelsma, co-author of the book, The Limited Liability Company, says commercial real estate professionals should be aware of the changes in the legislation—especially since existing partnership and operating agreements will need to be revised to incorporate the new rules. He tells GlobeSt.com exclusively what the industry should know about these new rules and how they differ from the current law.

GlobeSt.com: Please describe the current law.

Jelsma: The new "streamlined" rules allow the IRS to more easily audit and assess taxes and penalties against large partnerships and retools a 33-year-old law that sets the rules for audits.  Under current law, partnership and LLCs composed of more than 10 partners or members are subject to audits under rules established the Tax Equity and Fiscal Responsibility Act of 1982, which establishes certain categories of partnership items determined at the partnership level. Every partnership and LLC designates a tax matter partner to act on behalf of the partnership or LLC in IRS audits. Partnerships and LLCs composed of 10 or fewer partners or members—if each partner or member is an individual, C-Corp or an estate—are exempt from the TEFRA rules, unless they elect TEFRA's provisions. Partnerships and LLCs consisting of at least 100 partners or members are subject to a simplified TEFRA audit process that affords partners or members fewer participation rights. 

GlobeSt.com: Can you discuss the new rules?

Jelsma: Under the Act, all audits and resulting adjustment would be made at the partnership or LLC level—if there is a deficiency, it won't be imposed upon the partners or members. Instead, the tax will be imposed on the partnership or LLC at the highest individual or corporate tax rates in effect for the year under examination. The IRS will develop rules that allow the partnership or LLC to establish that certain partners or members may be taxed at a lower rate or may be tax exempt.

The partnership or LLC can elect instead to furnish adjusted K-1s to each partner or member in the reviewed year reflecting the adjustment and must elect this alternative within 45 days after the notice of a final partnership adjustment. The partnership or LLC may self-report adjustments for prior tax years and may request from the IRS an administrative adjustment with respect to the prior year.

The Act also eliminates the tax matters partner and replaces that person with a representative who may not be a partner or member but must have a substantial presence in the US. If the partnership or LLC fails to designate a representative, the IRS may select one for it. Any decision made by the representative is binding on the partnership or LLC and its partners or members. 

The partnership or LLC must report to the IRS the name, taxpayer identification number of each partner or member—including any shareholder of an S corporation as a partner or member. Each S-corp shareholder is counted towards the 100-partner or -member limit. The price of this election is that the underpayment interest rate will accrue at a rate that is 2 percentage points higher than the normal underpayment rate.

A partnership or LLC with 100 or fewer partners or members and whose partners or members do not include any partnerships or trusts may elect out of the new rules.

GlobeSt.com: What specifically do partnerships/LLCs need to consider now?

Jelsma: These new rules suggest that existing and new partnership agreements should be carefully reviewed and potentially revised to incorporate the new rules. Under existing law, new partners or members generally have no risk with respect to prior-year partnership adjustments, but under the new rules, the historical liabilities could be transferred to current partners or members. Drafters may want to consider the following:

1. If the partnership or LLC qualifies to elect out, deciding who makes that election, whether it is the general partner or manager or partners or members and, if so, how approval is determined.

2. Limiting the number of partners or members to less than 100 if the partnership or LLC desires to elect out of the new rules. This may require excluding partnerships or trusts as partners or members.

3. If the partnership or LLC cannot elect out, who will be both tax-matters partner and the new representative.

4. The partnership or LLC representative will probably want some form of indemnification.

5. If the partnership or LLC representative is negotiating with the IRS which partners or members may also participate in that process.

6. If you have a client who is joining an existing partnership or LLC, what representations, warranties and indemnities should be drafted for prior year's tax liabilities.

GlobeSt.com: What are the next steps?

Jelsma:Ultimately, the new rules make it easier for the IRS to audit larger partnerships/LLCs—and also provide a streamlined way to contest as well as audit and divide the taxes among the partners. Going forward, existing partnership and operating agreements will need to be carefully examined and revised to incorporate the new rules, especially because under the new legislation, past liabilities could be transferred to current partners.