Time to Update Partnership and Operating Agreements
The Internal Revenue Service Intends To Begin Partnership and Limited Liability Company Income Tax Audits Under 2019 Finalized Rules
The IRS intends to start auditing partnerships’ and limited liability companies’ income tax returns following brand-new Internal Revenue Code procedures, effective January 1, 2018, but delayed because the IRS needed to issue procedural regulations. To avoid being repetitive, we use the term “partnerships” to refer to both kinds of entities. The focus of the new procedures begins with the partnership as a tax-paying entity for all additional taxes found due upon audit. This focus is quite a departure from long-in-place procedures when the focus was auditing partnerships’ income tax returns, but not assessing additional taxes against partnerships, proceeding to audit partners’ tax returns mainly by grafting the partnership audit adjustments into those returns for the same audit years, and assessing additional taxes from each partner. After all, partnerships do not pay income taxes, their partners do. This is not being changed, except for additional taxes.
How? In a nutshell: assuming that an IRS revenue agent finds that a partnership’s Form 1065 understates gross income or overstates deductions and credits or both, the result is increased taxable income as an audit adjustment. For each of 2018 and 2019, the revenue agent applies a 37% rate to the increase to get the tax amount and adds on to this amount at least one non-compliance penalty, if any, and interest on both amounts. These three amounts will be reflected in a proposed notice of partnership adjustment.
The procedures grant sole and binding authority vis-?-vis the IRS and the partnership to a “partnership representative”. The person’s binding authority with the IRS extends to such important matters as being sole decision maker about the partnership’s prompt payment of the amounts in the notice, or invoking new procedures for “modifying” the notice amounts, or choosing instead to have the partners take the audit adjustments into account by each putting his share of adjustments on his own income tax return and paying the resulting tax due, if any. Except in rare and unusual cases, however, the sum of the taxes due by the group is not going to equal the 37% tax imputed to the partnership by the notice. Partnership representatives also control proceeding to the IRS Office of Appeals or Federal courts in order to contest any partnership adjustments that arguably do not follow the applicable tax law.
There are going to be plenty of legitimate controversies among a partnership’s treatment of a partnership tax item, the IRS revenue agent’s treatment and the consequences to partners as a group or individually. A given partnership representative might be in a conflicted position in making important decisions. Consequently, and for other reasons such as notice and opportunity to be heard, now is the time to update partnership agreements with tax and governance provisions taking into account both the new procedures and partnership representative’s preeminent position as far as the IRS is concerned. For example, a partnership agreement should address to what extent the partnership representative has unfettered powers over the decisions summarized here as compared to having to get prior approval from a consenting committee.
The tax and business law attorneys at Herold Law, P.A., have studied the new procedures in such depth so as to gain the necessary understanding of their workings to listen, discuss and implement changes to agreements’ tax and governance provisions to better ensure, among other things, that no partners or partnership representatives are going to have mutual misunderstandings and quarrels about making the key decisions, negotiating with the revenue agent and settling or proceeding to administrative or court appeals. If we can be of service to you, please don’t hesitate to contact Robert S. Schwartz, Esq., at 908-647-1022 or contact him at [email protected].