by Richard Keyt (LL.M. income tax) Tax Attorney

The Bipartisan Budget Act of 2015 changed the way the IRS audits LLCs taxed as partnerships and the way partnerships are audited.  The new audit rules became effective January 1, 2018.  Because the new audit rules can cause substantial economic harm to members of LLCs taxed as partnerships and partners of partnerships all of entities taxed as partnerships should adopt a Tax Audit Agreement that solves the problems caused by the new partnership audit rules.

Note:  When I use the words “LLC” and “Operating Agreement” below those terms include “partnership” and “Partnership Agreement,” respectively.  Also, the information in this article applies only to entities that are taxed as partnerships.

To hire us to prepare a custom Tax Audit Agreement for your LLC or partnership for $497 complete and submit our Tax Audit Agreement questionnaire.    For an additional $97 we can send the agreement to all the members for them to sign digitally using DocuSign.

Why Your LLC Must Have a Tax Audit Agreement

I am a tax lawyer who has a masters degree in federal income tax law, an LL.M., from New York University School of Law.  I’ve formed 10,000+ limited liability companies and many partnerships in my 46 years of practicing law.  The hardest class I had at NYU was partnership tax.  It is a subject that most people who form LLCs don’t understand.  As a very experienced tax lawyer who has invested a lot of time studying the new partnership audit rules my opinion is that ALL LLCs taxed as partnerships must do one of the following:

• amend their Operating Agreement to include tax audit provisions, or
• adopt a Tax Audit Agreement.

If you don’t believe me then read my article called “LLCs Taxed as Partnerships Must Adopt a Tax Audit Agreement” in which I have quotes from 36 tax lawyers with links to their articles in which they all say that entities taxed as partnerships must amend their Operating Agreements to add language that deals with the new partnership audit rules.  I could have added many more tax lawyers to my list of the 36 tax lawyers who recommend amending the LLC’s Operating Agreement, but I stopped adding them on April 18, 2018, because everybody gets the message that all partnership tax lawyers recommend that ALL entities taxed as a partnership adopt contractual provisions that deal with the new audit rules.

Because the new partnership tax audit rules do not have anything to do with governing the LLC, which is the purpose of an Operating Agreement, I recommend that LLCs adopt a separate agreement, a Tax Audit Agreement, that contains provisions dealing with the new partnership audit rules rather than amending the LLC’s Operating Agreement to add that language.

Major Problems for LLCs that Do Not Have a Tax Audit Agreement & Why You Should Never Be an LLC’s Partnership Representative Unless It Has a Tax Audit Agreement that Protects You

Congratulations!!  You are named as your LLC’s partnership representative.  For the reasons I list below, you should never accept the job of partnership representative unless the members of the LLC have signed a Tax Audit Agreement that contains provisions that reduce or eliminate your liabilities that arise from being the partnership representative.

If you are your LLC’s partnership representative you may asking for trouble.  As the partnership representative you may agree with the IRS that the LLC must pay additional taxes, penalties and interest and then get sued by one or more members who believe that if you had done your job of representing the LLC properly you would have convinced the IRS that some or all of the additional taxes are not actually owed.  For example, if, as a result of you agreeing with the IRS that the LLC owes back taxes of $40,000, which causes Homer Simpson a 50% member to become obligated to pay $20,000, Homer could sue you for negligence in defending the LLC.  If Homer can prove in court that the LLC actually did not owe the taxes you would be liable to Homer for the damage your negligence caused.

The Tax Audit Agreement should require the partnership representative to call a meeting of all members to discuss any prospective agreements with the IRS and give the members the right to vote to approve or disapprove the proposed agreements.  When the partnership representative later obligates the LLC to pay additional taxes, penalties and interest the partnership representative will not be liable to any member as a result of the partnership representative taking the action approved by the members.

If the partnership representative agrees with the IRS that the LLC owes additional taxes, penalties and interest without the approval of the members, one or more members may object and sue the partnership representative.  If the LLC has not agreed in writing to indemnify the partnership representative if he/she/it gets sued, the partnership representative will have to use his/her/its funds to defend the lawsuit and pay any damages if the partnership representative loses the lawsuit.

Bottom line:  Never, ever agree to be an LLC’s partnership representative unless you first enter into a contract with the LLC that obligates the LLC to indemnify you for any loss or expense you pay or incur as a result of being the partnership representative.  Note also:  If the LLC does not have the resources to indemnify you then do not agree to be its partnership representative.

As the partnership representative you may incur expenses in hiring a tax professional to defend an audit.  You do not want to be personally liable to pay these types of expenses.  If the LLC is audited the partnership representative may be required to invest a lot of time dealing with the IRS and the LLC’s tax professional.  Should the partnership representative be compensated for the time he or she spends dealing with an audit?  I think so. 

The Tax Audit Agreement should also require the LLC to pay the partnership representative’s expenses and pay the partnership representative for the time spend on an audit.  I recommend the agreement state an hourly rate payable to the partnership representative for the time spent on an audit.

ABC, LLC, was audited for tax year 2018 during which it had two members, Homer Simpson (90%) and Ned Flanders (10%).  The LLC did not elect out of the new partnership audit rules.  Ned acquires Homer’s 90% in 2019.  In 2022 the IRS audits the LLC for its 2018 tax year.  The audit  resulted in the LLC owing an additional $10,000 in federal income taxes.  Because Homer is not a member of the LLC in 2022 the entire $10,000 comes out of Ned’s pocket.

Ned and Homer should have adopted a Tax Audit Agreement that provided that if a member of the LLC ceases to be a member and the LLC is audited for a tax year during which the former member was a member, the former member will pay his/her/its prorata share of the additional taxes, penalties and interest.  If Ned and Homer had signed my Tax Audit Agreement Homer would be liable for $9,000 and Ned would be liable for $1,000.

Bottom line:  Your LLC needs a Tax Audit Agreement to prevent the inequity that could arise if the LLC is audited for a tax year and one or more members of the LLC during that tax year are not members when the IRS conducts the audit.

If your LLC is taxed as a partnership it must name a partnership representative on its federal income tax return, IRS form 1065, EVERY tax year.  The partnership representative does not have to be the same person every year.  The partnership representative can be a member of the LLC, but does not have to be a member, but he or she must have a substantial presence in the U.S.  The partnership representative is the only person who can deal with and interact with the IRS if it audits a tax year.

Who the LLC names as its partnership representative is a very important decision that should not be left to the whim of one member or nobody.  The partnership representative is the only person who can interact with the IRS if the LLC is audited.  The partnership representative has the power to agree with the IRS that the LLC owes additional taxes, penalties and interest.  Because the partnership representative is such an important position all of the members should agree on who the LLC’s partnership representative should be each tax year.

Because the partnership representative does not have to be a member or manager of the LLC the members may want to nominate the LLC’s tax preparer or attorney.

Bottom line:  The members should carefully consider who the LLC’s partnership representative should be and then vote on whether to nominate that person.

If your LLC fails to name a partnership representative on a tax return for a tax year the IRS can name the LLC’s partnership representative who can be a person who has nothing to do with the LLC.  Trust me!  You do not want the IRS to name a person who can cause the LLC to become liable for additional federal income taxes arising from an IRS audit.

What do you think will happen if the IRS audits your LLC’s tax return and claims the LLC owes an additional $40,000 i income taxes for a year the IRS named the LLC’s partnership representative?  Will the person the IRS named as the LLC’s partnership representative fight the assessment or agree that the money is owed and obligate the LLC to pay the $40,000 plus any penalties and interest?

To avoid the IRS naming your LLC’s partnership representative your LLC must do two things:

1. Nominate a willing person to be the LLC’s partnership representative, and
2. Name that person as the LLC’s partnership representative on the LLC’s tax return, IRS form 1965, every tax year.

An LLC may elect out of the new partnership audit rules if the LLC does not have an ineligible member.  The significance of electing out of the new partnership audit rules is that instead of a single audit of the LLC’s tax return the IRS will audit each member.  As a tax lawyer, I do not recommend that an LLC elect out of the new partnership audit rules because a single audit is better for the members than multiple individual audits.

Electing Out Hypothetical:  ABC, LLC, has four members.  It elects out of the new partnership audit rules for 2018.  The IRS audits each of the four members who hire a tax professional to defend them.  Each member pays their tax professional $10,000 over the life of the audit.  Total professional fees of the four members is $40,000.  Two professionals convince the IRS that no back taxes are owed for 2018.  The other two audits result in the members paying additional taxes for 2018 of $20,000 each.

Not Electing Out Hypothetical:  XYX, LLC, has four members.  It does not elect out of the new partnership audit rules for 2018.  The IRS audits the LLC’s tax return.  The LLC hires a tax professional to defend the LLC and pays the tax professional $10,000.  The cost to each member for the audit is $2,500 rather than $10,000.  The results of the tax audit will apply indirectly to all the members because if money is owed, the LLC will be liable to pay the additional taxes, penalties and interest unless it “pushes the payment out” to the members.

Bottom Line:  By not electing out the member’s save a substantial amount on the cost to defend the audit and there is one result rather than the possibility of some members owning more money and others owing less money or no money.

To elect out of the new partnership audit rules for a tax year the LLC must satisfy all of the following requirements during all of the tax year to which the election out applies:

• The LLC must have less than 100 members.
• All of the members must be eligible members.

An eligible member is an individual, an entity taxed as a C corporation, an “eligible foreign entity,” an entity taxed as an S corporation, or an estate of a deceased member.  An entity taxed as an S corporation is an eligible member if it has a shareholder or member who holds an interest directly and would not be an eligible member himself or herself.  An eligible foreign entity is a foreign entity that is a per se corporation under Regulation Section 301.7701-2 or an association taxable as a corporation (either by default or due to an election under Regulation Section 301.7701-3).

When the LLC May Not Elect Out of the New Partnership Audit Rules

If any member is one of the following at any time during a tax year the LLC is not eligible to elect out of the new audit rules for that tax year:

• an entity taxed as a partnership,
• a trust,
• a disregarded entity such as a disregarded limited liability company taxed as a sole proprietorship,
• a nominee or other similar person that holds an interest on behalf of another person,
• a foreign entity that is not an eligible foreign entity, and
• an estate that is not the estate of a deceased member.

Electing out or not electing out!  That is the question.  Unless you have language in your Operating Agreement or in a separate Tax Audit Agreement that specifies who has the authority to elect out or not elect out the members of your LLC are asking for trouble.  Here are the options as to who can make the decision to elect out or not elect out of the new partnership audit rules EVERY tax year:

• nobody because there is nothing in writing that states who can make the decision.
• any member because there is nothing in writing that states who can make the decision.
• any manager because there is nothing in writing that states who can make the decision.
• a majority of the members because there is nothing in writing that states who can make the decision.
• all of the members because there is nothing in writing that states who can make the decision.
• a majority of the managers if the LLC has more than one manager because there is nothing in writing that states who can make the decision.
• all of the managers if the LLC has more than one manager because there is nothing in writing that states who can make the decision.
• the LLC’s tax preparer because there is nothing in writing that states who can make the decision.

Given that electing out or not electing out is a decision that can have monetary implications to the LLC and all of its members I recommend that the members of all LLCs state in their Tax Audit Agreement which way the LLC will go each year.  My Tax Audit Agreement states the Company will never elect out or always elect out with respect to years during which the LLC is eligible to elect out.  The members also have the ability each year to change their minds for a specific year or all future years.

ABC, LLC, was audited for tax year 2018 during which it had two members, Homer Simpson (90%) and Ned Flanders (10%).  The LLC did not elect out of the new partnership audit rules.  The audit resulted in the LLC owing an additional $10,000 in federal income taxes.  Unless the LLC takes appropriate action to “push out” the tax liability to the two members, the LLC must pay the $10,000.  If the additional tax is not pushed out to the members the following problems may arise:

• The LLC may not have the funds to pay all of the additional taxes.
• If the LLC does not have the funds neither member is obligated to pay his percentage of the total tax to the LLC so it can pay the taxes.
• The IRS may garnish the LLC’s bank account.

This is another example of why all LLCs need a Tax Audit Agreement.  The members should have agreed in their Tax Audit Agreement in advance of filing the tax return for the audited year to one of the following:

• If additional taxes are owed the LLC will pay, but if it does not have sufficient funds each member will pay to the LLC the member’s share of the amount needed to pay the tax.  The additional taxes paid by the LLC will allocated 90% to Homer and 10% to Ned rather than 50% to Homer and 50% to Ned.  The result is that each member bears the member’s proportionate share of the additional tax liability.
• If additional taxes are owed the liability will be pushed out to the members which would cause Homer to pay 90% of the taxes and Ned to pay 10% of the taxes.  Again, the result is that each member bears the member’s proportionate share of the additional tax liability.

Questions?

If you have any questions call me, Richard Keyt, at my direct phone number 480-664-7478.