On September 1, 2020, the Internal Revenue Service (IRS) added a new section called the BBA Centralized Partnership Audit Regime to its website, IRS.GOV. The step was taken as part of its objective to increase partnership audits in 2021.
Prior to January 1, 2018, when the IRS audited a partnership, tax, interest, or penalties owed could only be collected from individual partners. The IRS had to audit each partner for small partnerships or limited liability companies (LLCs) with ten or fewer members or partners.
For larger partnerships, the IRS could only audit the partnership, but any amounts owed still had to be collected from each partner. As a result, the IRS only audited about 1% of partnerships each year. However, the Bipartisan Budget Act of 2015 (BBA) allowed the IRS to audit partnerships and collect any money owed directly from the partnership, starting with the 2018 tax year, instead of auditing and pursuing payments from each partner.
The IRS had planned to conduct more partnership audits in 2020 for the 2019 tax year. Still, the COVID-19 pandemic caused a delay, and now the IRS is preparing to increase partnership audits in 2022 for prior tax years.
WHY WOULD MY PARTNERSHIP OR LLC ELECT OUT?
A partnership or LLC with 100 or fewer members or partners can choose to elect out of the centralized partnership audit regime if all its partners are “eligible partners.” Eligible partners include individuals, estates of deceased partners, C corporations, foreign C corp equivalents, and S corporations. However, partnerships with other entities as partners, such as trusts, foreign entities that would not be a C Corp in the U.S., disregarded entities, estates of individuals other than deceased partners, and people holding an interest in the partnership on behalf of another person, cannot elect out.
Partnerships that are eligible to elect out can do so by filing an election with the partnership tax return for that tax year and notifying each partner within 30 days. Electing out of the BBA’s centralized partnership audit regime can be beneficial for eligible partnerships as audits can be time-consuming, distracting, and difficult, and expensive for the partners and the partnership.
RECOMMENDED CHANGES TO PARTNERSHIP AND LLC OPERATING AGREEMENTS
Partnership and LLC operating agreements need to be amended to replace the Tax Matters Partner provisions with an updated Partnership Representative provision (the new designation under the BBA) provision. If the Partnership Representative is an entity, a Designated Individual who has a substantial presence in the U.S. should also be named. Several powers and obligations should also be specified on the Partnership Representative (or Designated Individual), such as requiring timely notice to partners and each partner’s agreement to cooperate in any audit, report the partner’s taxes consistent with the partnership’s reporting, amend the partner’s returns if a partnership audit requires it, and pay the partner’s pro-rata share of any tax liability from an audit.
If my Partnership or LLC is Eligible to Elect Out
Partnerships or LLCs that are eligible to elect out should amend their partnership or operating agreement to prohibit any partners or owners who are not eligible partners, without the general partner’s or manager’s consent or the consent of the other partners or members, depending on how the entity is structured. This change will help ensure that the entity does not accidentally lose its eligibility to elect out by admitting an ineligible partner.
If my Partnership or LLC cannot Elect Out
For most partnerships, the agreement should obligate each partner (and former partner) for its share of cost and tax liability for the year being examined or audited. The obligation should be enforced by withholding from distributions, clawing back from prior distributions to departed or reduced partners, or “pushing out” its share of such tax liability to each partner and former partner, their share of that obligation.
Its highly recommended that you consider such practice if your partnership is eligible because its fair to say that this type of election reduces the possibility of audit but of course this is not a guaranteed outcome of such election and also consulting with your legal counsel is important as this information is not intended as legal advice.