United States

New partnership audit rules demand attention: A front row perspective

INSIGHT ARTICLE  | 

Tax positions of partnerships, LLCs, and other entities taxed as partnerships, taken with respect to events on or after, Jan. 1, 2018, will be subject to IRS audit and potential readjustment under radically new IRS rules. In particular, the audited entity can bind all of its direct and indirect partners and members, with no right of dissent. Preparing for these new rules requires more than updated boilerplate language in your agreements. The new rules create new business issues and potential conflicts between old and new members, different classes of partners, and partners and managers. Even if the first audits won’t occur until 2020, business issues and potential conflicts will begin arising 2018 and should be addressed sooner rather than later.

Consider this example

ABC, LLC was formed by Partners A, B, and C in 2015. Partner A leaves ABC on April 1, 2018, as the entity is renamed Partnership BC but is otherwise the same partnership for tax purposes. Two years later, the IRS audits BC with respect to A’s share of partnership income for the first three months of 2018, which includes a very substantial gain. The IRS concludes there was an understatement of partnership income by A, and asserts that BC must pay that liability – not A.

Can BC avoid that liability? If not, can BC recover anything from A? Will A want to give BC that right of recovery?

BC may be able to avoid that liability by electing to “push-out” the liability to A, its former partner, by sending a revised K-1. But A cannot challenge the IRS determination on its own.

Many questions remain:

  • Is BC obligated to spend BC resources to challenge the IRS determination, when it doesn’t matter to B or C because it can be shifted to A?
  • If the managers of BC concede too readily to the proposed adjustments to A’s liability, can A sue them for misconduct?
  • Can A take control over the controversy, since it only affects A? Can A require BC to spend its own funds to defend A?
  • If the potential liability affects A, B, and C, can BC require A to contribute funds for its share of the defense?

You can see that the potential for complexity is great. Although the detailed rules are not entirely written, it is not too early to agree upon general guidelines and principles regarding the allocation of tax liabilities and decisional authority with respect to conflicts with the IRS.

Now what?

If you have a partnership or LLC, it is time to walk through the basic tax and business issues that may come to bear with these new audit rules. Get a strong tax perspective so you are prepared to discuss with your attorneys the best way to implement any needed changes to agreements, indemnifications, disclosures, etc. 

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