Navigating the New IRS Partnership (LLC) Audit Rules
New laws governing IRS partnership audits (the “New Audit Rules”) were enacted during 2015 and are effective for all partnership tax returns filed for partnership tax years beginning January 1, 2018.
The New Audit Rules apply to LLCs taxed as partnerships. The current partnership audit rules under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) will not apply for tax years subject to the New Audit Rules. Tax and business lawyers at Frost Brown Todd have been preparing for the implementation of these new rules since 2015 and have extensive knowledge of the rules and considerable experience working with owners of LLCs and partnerships to address the impact of the rules, as well as preparing for their impact on transactions involving the purchase or sale of LLC or partnership interests.The New Audit Rules will apply to all entities taxed as partnerships, including LLCs. A partnership may elect out for a tax year if (i) each of its partners is an individual, a domestic C corporation, a foreign entity taxable as a C corporation, an estate of a deceased partner, or an S corporation; and (ii) it has issued 100 or fewer Schedule K-1s. LLCs or partnerships with complex trusts or other partnerships as partners must operate in accordance with the New Audit Rules, which will complicate estate planning involving gifts to complex trusts and investment partnerships, including private equity funds. Partnerships, trusts and disregarded entities are not "eligible partners" for purposes of qualifying to elect out of the New Audit Rules.
An opt-out election must be made with respect to specific annual return and only applies with respect to that return. The election must be made on an annual return-by-return basis. All partners must be provided notice annually of the election opt-out and the partnership must provide the names and tax identification numbers (SSNs) of the partners to the IRS.
For partnerships that do opt out, the IRS will be forced to audit partnership items and collect deficiencies at the individual partner level. In the future, we expect that many eligible small tax partnerships will elect to opt out in order to avoid some of the harsh aspects of the New Audit Rules. If the experience of operating under TEFRA is any guide, there is a perception that the IRS will be less likely to audit in situations where it is forced to audit the returns of each partner rather than just the partnership.
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Mark F. Sommer is FBT’s Tax, Benefits and Estates Practice Group leader, focusing on state, local and federal tax, incentives, tax controversy and litigation. He has successfully handled thousands of audits, protests, appeals, and transactional matters.