Business partnerships and similar entities such as LLCs are “pass-through” entities for income tax purposes, meaning the partnership itself is not taxed, but rather income to the partnership passes through to each partner who then pays his or her share of the tax. Likewise, current partnerships are not subject to audit adjustments at the partnership level; instead, adjustments are assessed against individual partners.
This could all change after January 1, 2018. Congress passed a law last November that revamps how the IRS will audit and collect tax from partnerships. The new law replaces a decades-old law called the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), and it allows the IRS to assess and collect taxes associated with audit adjustments at the partnership level, rather than flowing adjustments through to individual partners. In a nutshell, this means the IRS will hold the partnership liable for any past due taxes, penalties, and interest, and the partners must decide how to allocate that liability amongst themselves. Significantly, any adjustment to tax will be applied in the year of the adjustment and not to the previous year that was audited, which could result in new partners being held liable for tax matters that arose before they joined the partnership. For these reasons, the changes to the law will have a substantial effect on partnership formations, planning strategies, and potential tax matters.
Just how far the changes will go are unknown. The Treasury Department will issue regulations regarding how the new law will be implemented by the IRS, but those regulations may not be published until late next year. In the meantime, there are measures partnerships can take to prepare for the changes. One opportunity for small partnerships is to opt out of the new law and elect to be audited under current procedures. This election must be renewed with every tax return filed. Another opportunity is to carefully structure partnership agreements to assign tax liabilities according to basis and income production. The partners can use the agreement to help determine allocation of adjustments. Finally, partnerships must carefully consider who to designate as their representative to the IRS, because if no person is designated the IRS will choose a representative which may leave the partners with diminished controlled over administrative proceedings. If you already have a partnership or LLC and want to know what changes to expect, or are planning on forming a partnership or LLC, please contact us to discuss the new law and its effect on your business.