In 2015, Congress passed the Bipartisan Budget Act of 2015 and amended a portion of it with the Protecting Americans from Tax Hikes Act of 2015 to change the way partnerships and limited liability companies (LLCs) taxed as partnerships are audited. Previously, when partnerships were audited the effect was only felt at the partner or member level. It was a long and cumbersome process for both the Internal Revenue Service (IRS) and the partners or members. In response to these law changes, the IRS has issued proposed regulations, effective when finalized after December 31, 2017, that will allow any additional tax from partnership adjustments, found through the course of an audit, to be paid by the partnership or LLC instead of the partners or members. However, the partnership or LLC can elect under Section 6226 to have the partners or members pay the tax in the partnership tax year to which the adjustment relates. This is also known as the push-through election. The main reason this election is available is because of potential partner or member changes. If partner or member leaves and the partnership or LLC is audited after they have left, the remaining/new partners or members may not want the partnership to pay tax for which they weren’t responsible for.
This leads to who is eligible to make this election on behalf of the partnership or LLC. Historically one might assume it would be the tax matters partner or member, however, under these new rules the tax matters partner or member does not exist anymore. This requires partnerships or LLCs to designate a partnership representative. The partnership representative could be an individual or entity. The individual or entity does not have to be a partner or member in the partnership or LLC. If an entity is chosen, a specific person must be appointed to act on the entity’s behalf. If the partnership does not choose a partnership representative, the IRS can pick any individual or entity to represent the partnership or LLC. Being named the partnership representative is a tremendous responsibility that comes with great power and authority. The partnership representative is the only person who can act on behalf of the partnership when it comes to:
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- making the previously mentioned Section 6226 election,
- agreeing to settlements and the final partnership adjustments with the IRS,
- and agreeing to an extension of the limitation period for making partnership adjustments under Section 6235.
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Because of the power and authority that comes with being the partnership representative, partnerships and LLCs should update their partnership/operating agreements immediately. These first need to be updated to define who the partnership representative is going to be. This is critical because the IRS isn’t going to assume that the previous tax matters partner is the new partnership representative and partnerships/LLCs do not want the IRS to pick who will be the partnership representative. Secondly, the partnership/operating agreement should define the duties of the partnership representative, which should address the aforementioned push-through election. While the duties of the partnership representative can be defined, it should be noted that no partnership or operating agreement, state law, or other document can limit the authority of the partnership representative. However, the partnership representative can be replaced at anytime if the partnership representative resigns. Therefore, it is imperative for the partnership/operating agreement to have procedures in place for choosing, removing, and replacing the partnership representative.
It is possible for the partnership to opt out of these new changes if they meet the following criteria:
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- The partnership or LLC distributes 100 or fewer Schedule K-1s. Included in this 100 number are the shareholders of S corporations when the S corporation is a partner or member.
- And the partners or members are all “eligible partners”. Eligible partners include anyone who is an individual, C corporation, S corporation, estate of a deceased partner, or an eligible foreign entity. Partnerships, trusts, disregarded entities, estates not mentioned previously, and non-eligible foreign entities.
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Opting out means that the IRS will have to audit each partner or member individually and not the partnership or LLC. The election to opt of these changes needs to made annually and the partnership must notify it’s partners within 30 days of making the election. If opting out is the preferred choice of a qualifying partnership or LLC, the partnership/operating agreement could be amended to make the opt out mandatory and to limit partners/member to the eligible partners.
Whether or not a partnership or LLC is eligible or not. It is imperative to update your partnership or operating agreement to address the issues above. Please contact us with any questions.