The Bipartisan Budget Act Partnership Audit Change: Is It Time to Update Your Operating Agreement?
What the New BBA Procedures Mean:
As a result of the Bipartisan Budget Act (“BBA”) enacted in 2015, beginning this year partnership audits (which means the audits of any entity taxed as a partnership for federal income tax purposes, most typically limited liability companies (“LLCs”) and limited partnerships) will be governed by the IRS's newly centralized audit regime. Considering how many franchisees and franchisors are LLCs and are treated as partnerships for tax purposes, these new rules demand the attention of people involved in franchising, real estate and many other business ventures.
Under the new partnership audit rules, within the context of an IRS audit for tax years beginning after December 31, 2017, the IRS, by default, is allowed to – and in most cases, will – deal exclusively with a single representative of a tax partnership, the Partnership Representative (“PR”). The actions of the PR will bind the entity under audit (and, in certain cases, its owners) for the years under audit, regardless of whether the PR's actions are permitted by the business entity's governing documents. Stated another way, the IRS is not restricted by an entity's partnership agreement or operating agreement, and may rely solely on the actions of the PR as evidence of his or her authority to so act.
Additionally, under the BBA, tax partnerships can be assessed by default at the partnership level, rather than at the level of the partner or member (hereafter, “Member”), which is a significant shift away from their traditional treatment as pass-through entities whose tax burden was passed through to its owners.
Role and Responsibilities of the PR:
Under the BBA, the PR is granted an extensive, and in many cases, exclusive, role within the IRS's audit process. The PR's power includes having exclusive control over: (1) binding the Members to adjustments or settlements offered by the IRS, without being required to consult with the Members, (2) deciding whether to seek judicial review of an IRS determination, and (3) deciding whether to make certain elections that can shift the burden of paying remaining taxes from the partnership or LLC to the Members (a “Push Out Election”).
Further, and perhaps most importantly, under the new regulations, the PR is the designated recipient of IRS communications, but is not required under the BBA to keep the Members informed about IRS communications. Fortunately, there are several paths to manage the role of the PR, as described below.
There are three important elections partnerships and LLCs should consider under the new partnership audit regime.
The first election that can be made is to opt out of the new partnership audit regime, a decision that is made on an annual basis as part of the entity's federal income tax returns. To be eligible for this election, the entity must have 100 or fewer Members, none of which are themselves partnerships, trusts or disregarded entities. Partnerships and LLCs should consider their own circumstances when deciding whether electing out is permitted or desirable.
The second important election for partnerships and LLCs to consider is whether to make a Push Out Election in the event of an audit. This election may have various economic advantages based on available tax benefits and deductions.
The third important election for partnerships and LLCs to consider is whether all of the Members should make an amended return filing, rather than having the imputed underpayment paid at the partnership or LLC level. The opportunity for this election arises when the business entity is assessed an imputed underpayment. If the entire amount of the assessment is reflected on the Members' amended returns, then the partnership would not be liable for the assessment.
How to Address These Concerns:
While the PR may be treated as having common law fiduciary duties to the partnership or the LLC and its Members, the Members should seek more specific legal protection. To most effectively and explicitly obtain such protections, Members should address these issues by amending their existing partnership agreements or operating agreements and other governing documents to address concerns raised by the BBA. Further, Members should discuss the BBA elections described above with their attorney and accountant, and consider (a) whether to demand an annual election to opt out of the BBA rules, and (b) if that is not feasible, who would be the person best suited to act as PR for the entity, and how the PR's actions should be restricted or shaped.
The Members may also want to provide some protection to PRs by including appropriate indemnification provisions in the partnership agreement or operating agreement.
The above issues, and other issues raised by the BBA, should be addressed now to resolve any potential conflicts before they arise. Consequently, if you are an owner of an LLC or partnership, you should discuss with your attorney how their governing documents can be amended to provide protection for your investment in that franchise or other business venture.