Limited liability company (“LLC”) operating agreements commonly contain a clause on “Tax Matters Partner” (“TMP”). A TMP represents a partnership before the Internal Revenue Service (“IRS”) in all tax matters under the former Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). The TEFRA audit rules apply to LLCs that are treated as partnerships for federal income tax purposes. LLCs with 10 or fewer members are exempt from these rules.
Now the TEFRA rules have been repealed and replaced by a new centralized partnership audit regime (“CPAR”), enacted by section 1101 of the Bipartisan Budget Act (“BBA”) of 2015. The new CPAR rules took effect for tax years beginning after December 31, 2017.
New Duties and Opportunities
Importantly, under the new CPAR, the IRS intends to increase the number of partnership audits, as stated in the preamble of the proposed regulations (REG-136118-15). This will affect a large number of LLCs, as LLC has become a popular choice of entity for business formation, and LLCs commonly file taxes as partnerships.
Therefore, the new CPAR represents additional duties as well as opportunities for counsel to assist LLC clients in updating the outdated and inapplicable TMP clauses in the operating agreements, and in adding new provisions to minimize unwanted tax consequences and costs.
Why Would It Hurt
Under the old rules, the IRS made adjustments to individual members’ tax returns, and generally collected underpayment from the individual member.
Now under the new rules, the IRS assesses and collects at the LLC level. The LLC will have to pay the IRS any imputed underpayment in tax from the year audited (“Reviewed Year”) at the highest marginal income tax rate applicable in the year the audit is completed (“Adjustment Year”), plus interest and penalties.
This also means that the members in the Adjustment Year will have to bear the liability caused by the previous members’ underpayment in the Reviewed Year, even if they were not members in the Reviewed Year.
The key person under the new CPAR is the Partnership Representative, which replaces the TMP under the old TEFRA rules. A Partnership Representative (required to have a substantial U.S. presence) must be appointed every year in a timely filed tax return. This is the only person allowed to deal with the IRS on behalf of the LLC in an audit and all related matters, such as making settlements and extending the statute of limitations.
Unlike the previous TMP, the Partnership Representative:
- Has much broader powers. The Partnership Representative’s actions are valid and binding regardless of any other provisions of state law, LLC operating agreements, and any other agreements. Individual members no longer have the rights to receive notice and to participate in the process.
- Does not have to be a member of the LLC. The LLC’s attorney, CPA, or other advisors can be appointed as the Partnership Representative.
- Can be an entity (including the LLC itself), if an individual is named to represent the entity.
Exceptions and Choices
- Opt-out: an LLC can elect out of the CPAR, if:
- It has 100 or fewer members (i.e. issue 100 or fewer K-1s; note that the number of K-1s issued by a member is included in determining eligibility for opt-out), and
- All of its members are “eligible partners”: individuals, C corporations, S corporations, foreign entities treated as C corporations, or estates of deceased members.
- Push-out – An LLC can also elect to have the members of the Reviewed Year pay the imputed underpayment. Additional rules and costs apply under this option.
Control What You Can
Counsel can help their clients minimize unwanted tax and non-tax consequences under the new audit rules by amending the LLC operating agreements.
This is also a good opportunity for attorneys to have a conversation about the importance of operating agreements with those LLCs that are not represented by counsel. A vast number of LLCs out there use boilerplate operating agreements or do not have an operating agreement. Clients need to be informed of the danger of operating a business without an applicable and updated operating agreement.
Even though the Partnership Representative’s authority cannot be limited or varied by operating agreements, certain provisions can be drafted so that members have some control in:
- How the LLC will select and remove the Partnership Representative;
- What qualifications the Partnership Representative must possess in addition to the minimum statutory requirements;
- How the Partnership Representative will keep the members informed;
- How the Partnership Representative will make decisions; or
- Whether an LLC should elect to opt out or push out, and, in some instances, how an LLC will be structured so that it can be eligible for opt-out.
Additional provisions can also be added to provide Adjustment Year members with rights to indemnification from the Partnership Representative and Reviewed Year members. Procedures can be set forth as to how to locate the former members from Reviewed Year, who will pay for what portions of the audit costs and tax liability, and how any such rights can be effectively enforced.
The new IRS partnership audit rules represent new duties, opportunities, and risks for LLC members, managers, and their attorneys and tax advisors. With the IRS’ intention to increase partnership audits and the new rules that make the LLC pay, counsel can help LLC clients act early to take control of what they can, while they can, by reviewing and amending their operating agreements.
This eBulletin was prepared by Monica Lin at CEO Law, Inc. (lin@CEOFirm.com)