Are you a partner in a partnership or member in an LLC?
If able, most partnerships (including LLCs taxed as partnerships) likely will want to “opt out” of the new centralized audit regime enacted under the Bipartisan Budget Act of 2015 (“BBA”) on their upcoming tax return. If unable to opt out (as discussed below), we still recommend certain amendments to your partnership or operating agreements.
If the partnership does not choose to opt out, among other consequences, current partners potentially are liable for former partners’ tax liabilities under the BBA and related IRS regulations. As such, in most circumstances, we believe partnerships should opt out of the new audit rules if eligible. Note that the California Franchise Tax Board (FTB) will respect the opt-out, but not necessarily other decisions allowed under the BBA.
Who can opt out to avoid these concerns?
Notably, if any partner is a partnership or LLC itself (including a disregarded single-member LLC), or a trust (other than for a deceased partner), the partnership is unable to opt out. A partnership is able to opt out only if (1) the partnership has 100 or fewer partners (though S corporation shareholders count in addition to the S corporation itself), and (2) all partners are either individuals, C or S corporations, foreign entities that would be treated as C corporations if they were domestic entities, or estates of deceased partners.
If you have disqualifying partners and your partnership or LLC has a diverse group of partners/members and/or has had or expects to have substantial changes in ownership, we recommend that the partnership consider substituting these partners for qualifying partners before March 15, 2019 in order to qualify for the opt-out. Of course, making changes to be able to opt out does not make sense for many small or family-owned partnerships— the utility of being able to opt out should be balanced with the potential negative impact upon estate (e.g., not holding the partnership interest in a living trust that avoids probate) and asset protection planning.
If our partnership is eligible, how do we opt out?
In order to opt out, the partnership must make the election on each Form 1065 filed each year and notify each partner of doing so within 30 days after filing. The final regulations make clear that the opt-out election must be made by filing the 1065, which is due March 15. However, if your CPA has requested an extension of time to file your 1065, you may delay the time by which you are able to opt out to the extended date.
If I cannot opt out, are we stuck with an audit and liability for past tax years at the partnership level?
Not necessarily. If a partnership is unable to opt out, it still may “push out” the audit adjustments (from the partnership to the individual partners in the applicable audit year) if the partnership elects to do so within 45 days of the date the IRS mails the final partnership adjustment to the partnership. You may wish to amend your partnership agreement to require the partnership representative to make a “push out” election other than in certain specified extraordinary circumstances.
Should we amend our partnership/operating agreements?
Yes, and quickly.
At a minimum, partnerships should:
1. Specify how to choose the new “partnership representative” – such person has sole authority to act on behalf of the partnership in IRS audits and other federal income tax proceedings (the law no longer recognizes a “tax matters partner”). Partners should remember that if their agreement does not identify and specify how to select the “partnership representative,” the IRS can designate anyone it chooses as the partnership representative.
2. If able to opt out, consider making the opt-out mandatory.
3. If unable to opt out, consider provisions that generally require a push-out so that the partners (including former partners), not the partnership, are the ones liable for any past tax liabilities.
An amendment to your partnership agreement or LLC operating agreement to address these matters must be made by March 15, 2019 (no extensions) to apply to the 2018 tax year. This deadline is particularly important for partnerships and LLCs that are unable to opt out of the BBA regime.
***This alert is not intended to provide legal advice, and no legal or business decision should be based on its content. Should you have any questions regarding the contents of this memorandum, please contact one of our business lawyers. If you work primarily with our Fresno or Bakersfield office, please call 559-432-4500. If you work primarily with our Sacramento office, please call 916-791-4500. If you work primarily with our Visalia office, please call 559-739-7200. http://dowlingaaron.com/services/business-transactions-entity-formation/ ***