As we approach the end of 2017, many uncertainties prevail in the United States tax system. Late last week, Congressional leaders proposed extensive tax reform legislation that has sparked sharp debates about rates, deductions, eliminating some taxes, and frankly, whether any of it can be actually passed into law. There is, however, prior legislation that goes into effect in just 8 weeks that may require the prompt attention of certain businesses and individuals. Effective January 1, 2018, key changes will apply to all entities that are taxed as partnerships (including limited liability companies); therefore, it is imperative that all impacted entities evaluate partnership and operating agreements to determine whether amendments may be required to address the changes.
The Bipartisan Budget Act of 2015 significantly changes the landscape for the way the Internal Revenue Service (IRS) audits partnerships. These changes are not just administrative details, but rather they (i) potentially change how economic risk is shared between partners in the context of a tax audit, and (ii) imbue a single partnership representative with absolute power to effect those changes. In addition, all partnerships continue to be subject to prior audit rules for tax years prior to 2018. Available elections may be different, the powers of those representing the partnerships may be different, and the rights of partners to participate in, and affect the outcome of, audits may be different, depending on which audit regime applies. For example, audits of small partnerships (less than 100 partners) have historically resulted in adjustments at the individual partner level. But after January 1, all adjustments are at the partnership level unless the partnership is eligible to make, and in fact makes, an election every year to be exempted.
The IRS is increasing audit activity and the changed partnership audit rules are part of the IRS strategy to improve its ability to examine more entities in less time. In the past, the tax matters partner had to notify partners of key audit developments and partners had the right to participate in any phase of administrative proceedings. Now, because a partnership representative has no statutory duty to keep partners informed, and partners have no statutory right to participate in the audit, partners and partnerships that do not address these important rights and responsibilities in partnership organizational documents may experience unwelcome economic results with little or no warning. In addition, partnerships must now be prepared to operate under two sets of audit rules, depending on which years are under audit. The law is designed to increase IRS efficiency, but can negatively impact the interests of individual partners. This means that a partner’s most important protection against an unexpected audit result is a well-drafted partnership or operating agreement that addresses any required changes to a partnership’s ownership structure, how audit-related decisions will be made, what role individual partners will have in decision-making, and how economic consequences of audits will be shared among current and historic partners.
We have significant experience in assisting our clients with such partnership issues. In order to be ready for the coming partnership audits that could encompass past as well as future years, we suggest that partnership and operating agreements be evaluated and updated in the near future. Appropriate changes to organizational documents should be accomplished long before the IRS issues the first audit notices. Although we expect partnerships to begin to receive audit notices under the new rules after the 2018 tax year, it is appropriate to begin the discussions now because some of the changes to governing documents may affect critical partnership governance ownership, and economic issues that will require more than perfunctory attention from the partners. We are available to discuss and review your existing partnership or operating agreements and provide guidance on the best way to address this new regulatory environment.