A major change is on the horizon to how partnerships and LLCs are taxed and the relationships they have with their current and former partners. When the new audit regulations of the Bipartisan Budget Act of 2015 (the BBA rules) take effect Jan. 1, 2018, it will be the first time ever in the history of audits that a tax could apply to a partnership or LLC.
Our firm has found that very few partnerships have been audited in the last 10-15 years because TEFRA rules made it virtually impossible for the IRS to efficiently administer their examination. Partnerships can expect more IRS audits to begin in summer 2019, with a majority beginning in 2020.
Are you prepared for the new regulations to take effect? Ask yourself the following questions:
- Did our partnership go through a change in ownership in recent years?
- Does our partnership or LLC operating agreement allow us to legally pursue and collect a tax assessment from former partners?
- Our partnership is looking to form a new partnership. Do we have the appropriate legal provisions in the agreement that will protect each individual partner and the partnership for these new imputed tax assessments?
- Do we need to accrue a tax for this potential exposure to the partnership?
If you answered YES to any of these questions, your partnership is exposed to costing new partners money for former partners' economic tax liability. When these rules take effect next year, partnerships have the following three options:
Option 1: Partnerships may elect out of the new regulations if they qualify. The proposed regulations, however, make it clear that the IRS intends to enact strict limitations on those partnerships seeking to elect out. So, who qualifies? Generally, smaller partnerships with individuals as partners.
Option 2: Partnerships pay on any IRS assessment. The IRS may choose to audit back years (reviewed years) and find that current year partnerships may owe tax. If an examination results in an adjustment to a partnership's income that creates an 'imputed underpayment,' the new regulations require the partnership to pay the imputed underpayment for the reviewed years in the current year. If the ownership of the partnership changed in the intervening years, how do the current partners collect this tax from the appropriate reviewed year's (former) partners? If your governing documents do not cover this reimbursement, then the new partners may be subject to a formers partner's tax liability.
Option 3: Partnerships may elect to "push out" for assessment. This is an alternative to the partnership paying the imputed underpayment mentioned earlier. The push-out election normally permits a partnership to force the reviewed year partners to take the proper amount of income into account. Instead of the partnership paying, the partners have to pay the tax in the current year. Again, governance documents should be updated to make it clear and legally binding that the former partners will agree to pay this imputed underpayment assessed by the IRS.
In order to avoid any surprises, the single most important step you should take is to look at your operating agreement and consult with your advisors. Does your operating agreement compensate for any of the aforementioned options? Contact your local UHY LLP professional.