In 2015, President Obama signed the Bipartisan Budget Act (“BBA”) to extend the national debt limit and spending caps through 2017. The BBA also repealed and replaced the Tax Equality and Fiscal Responsibility Act of 1982 (“TEFRA”) to substantially change how the IRS makes tax audit adjustments to partnerships and LLCs that are treated like partnerships for tax purposes. Although the proposed regulations to implement the new rules were frozen by President Trump early this year, the IRS recently reissued them and the new regulations will likely be finalized after a public hearing on September 18, 2017.
As previously outlined in a blog post on Larry's Tax Law, the new partnership tax audit rules, which will apply to tax returns of partnerships for tax years beginning in 2018, provide that any tax adjustments resulting from IRS audits of partnerships generally will be determined and collected at the
partnership level, even though partnerships are not subject to income taxes and the partners are the relevant taxpayers. These rules are a broad departure from the existing partnership tax audit rules whereby the IRS generally audits the tax return of the partnership but then makes tax adjustments and collects any additional taxes, interest and penalties at the partner level.
Under the new rules, unless a partnership elects to implement a Form K-1 adjustment procedure, the partnership will need to satisfy the cost of a tax adjustment from its own balance sheet or with contributions from its partners. As a result, if the ownership of the partnership changes in the meantime, the cost of a tax adjustment will fall on the individuals and entities that are partners of the partnership when the IRS makes the tax adjustment, rather than the partners for the earlier year that was reviewed in the audit.
The new rules provide for an exception for partnerships with 100 or fewer partners, which are permitted to affirmatively opt out of the new rules. However, this smaller partnership exception does not apply to a partnership in which another partnership is a member, which appears to make the exception inaccessible to any tiered partnership structure regardless of the number of ultimate partners. More concerning is that the exception also does not apply to a partnership in which any partner interests are held in a trust.
Prior to the effectiveness of the new rules, partnerships and LLCs that are treated as partnerships for tax purposes should review their operating agreements to determine whether to implement amendments to enable or require the partnership to elect a Form K-1 adjustment procedure or to allocate the cost of tax adjustments in a different manner. In addition, buyers of partnership and LLC interests should consider the approach of the target interest to the new rules so that the buyer can assess whether they could ultimately bear the cost of an entity level tax adjustment.
We recognize that the new rules may seem confusing or complex. If you would like to discuss the new partnership audit rules and how they may apply to your particular situation, please feel free to contact Rochelle Haller at firstname.lastname@example.org or at 206.816.1416, or Teresa Byers at email@example.com or at 206.816.1386 or any member of GSB's estate planning team.
Foster Garvey’s Family-Owned & Closely Held Business practice group comprises strategic advisors and core practitioners who understand the intersection between law and the unique challenges of running a family business. With more than one hundred years of combined experience, our family-owned and closely held business practice offers clients extensive resources and a knowledgeable team of family wealth advisors across the United States.