The Bipartisan Budget Act of 2015 substantially changed audit-related rules impacting entities taxed as partnerships, including both state-law partnerships and many limited liability companies (LLCs). The most significant change is that any additional tax or penalties resulting from an audit of an entity taxed as a partnership generally will be assessed and collected at the entity level (as opposed to at the partner or member level). These new rules are effective for taxable years beginning on or after January 1, 2018. Proposed regulations addressing, among other things, some of the problem areas of these new rules were released in January 2017, but were almost immediately withdrawn as part of the Trump administration’s regulatory freeze. Updated proposed regulations were re-released mid-June 2017.
Now is the time for entities taxed as partnerships (i.e., partnerships and many LLCs) to evaluate the new rules and amend their governance documents to address the changes. Hospitals commonly utilize LLCs for affiliations and ancillary joint ventures and should consider their options under the new rules. The changes also impact many physician entities, including physician practice groups, real estate holding companies, and ambulatory surgical centers taxed as partnerships.
The following items, among others, should be considered in amending governance documents under these new rules:
Certain entities with 100 or fewer eligible partners/members may elect to opt out of the new partnership audit rules. An electing entity will be subject to the former rules under which the IRS conducts examinations at the entity level but applies pass-through treatment to calculate and assess liability at the partner/member level. This election, if available, must be made annually on the entity’s timely filed federal income tax return.
Payment of Tax Deficiencies
The amount of any tax deficiency, or the “imputed underpayment” plus interest and penalties, is computed under the new rules based on the highest tax rate applicable to individuals or corporations in the audit year (instead of the partners’/members’ actual marginal income tax rates). It is possible for the underpayment amount to be reduced, if there is a tax-exempt partner/member, among other situations. The payment of any additional amounts due generally is the responsibility of the entity unless the adjustment amount is “pushed out” to the entity’s partners/members. If the entity pays the additional tax due, it is recommended that governance documents provide for the adjusted year’s partners/members to bear their allocable share of such adjustment. This is so the partners/members of the entity at the time the payment is made do not have to bear the economic consequence of any adjustment amount because ownership of an entity may change from year to year.
Designating a Partnership Representative
Each entity subject to the new rules must designate a “partnership representative” with a substantial U.S. presence or the IRS will appoint one on its behalf. Unlike the “tax matters partner” under the former rules, the partnership representative does not need to be a partner/member of the entity taxed as a partnership, and can unilaterally bind current and former partners/members in a federal tax matter. The proposed regulations place additional restrictions on an entity’s ability to change the designation of its partnership representative. Accordingly, entities should consider clarification in their governance documents to address elements of these rules, such as fiduciary duties, specific grants of authority (or limitations thereon), and the rights of the entity to require the resignation of the partnership representative and to designate a successor.
Finally, while there has been progress at the federal level on the parameters of these new partnership audit rules, everyone should be mindful that most states have yet to determine how they will handle audits of entities taxed as partnerships given the new federal rules.