LLCs Taxed as Partnerships Must Adopt a Tax Audit Agreement

LLCs Taxed as Partnerships Must Adopt a Tax Audit Agreement 2017-12-06T07:55:14+00:00

by Richard Keyt, LLC & partnership tax law attorney

This article about the new partnership tax audit rules created by the Bipartisan Budget Act of 2015 (the “BBA”) applies only to LLCs taxed as partnerships (and partnerships taxed as partnerships).  If your LLC is taxed as a sole proprietorship, a disregarded entity, a C corporation or an S corporation, the new partnership tax audit rules do not apply to that LLC and you can stop reading.  However, if you are a member of an LLC taxed as a partnership your failure to read this article and to cause your LLC to adopt an agreement that contains appropriate new partnership tax audit language could cost you and  the other members of your LLC a lot of money.

The BBA and the IRS regulations promulgated thereunder (see the proposed regulations) apply to all LLCs and partnerships taxed as partnerships beginning January 1, 2018.  This article explains why all LLCs taxed as a partnership must adopt an agreement that contains appropriate BBA language.

I have a masters degree in federal income tax law, an LL.M., from New York University School of Law.  NYU is the “Harvard” of federal income tax law.  I remember the first day of my partnership tax course when the professor told the class that all the tax classes offered in the NYU graduate tax law program were difficult, but the hardest class was partnership tax.  He was right.

I know from experience that few lawyers and document preparers who draft LLC Operating Agreements have ever taken a class on partnership tax or have much, if any, knowledge of this very important subject.  Nevertheless that does not stop partnership tax ignorant people from drafting Operating Agreements for LLCs taxed as partnerships.  You should not get partnership tax law advice from a person who is not a partnership tax expert.

I have been practicing tax law and forming corporations, limited partnerships  since 1980.  I formed my first LLC the day Arizona’s LLC law became effective in 1992.  I have drafted 5,800+ LLC Operating Agreements.  I am writing this article as a federal income tax lawyer with significant partnership tax law knowledge and experience.  I’ve studied the BBA and the proposed regulations and reached the following conclusion:

All LLCs taxed as partnerships must adopt an agreement as soon as possible that contains language that addresses the new partnership tax audit rules created by the Bipartisan Budget Act of 2015 effective January 1, 2018, and the IRS regulations promulgated thereunder.

In my opinion EVERY LLC must adopt an agreement that contains BBA provisions.  The failure to do so could result in major economic harm to one or more members if the LLC is audited by the IRS.

Tax Professionals Who Say LLCs Taxed as Partnerships Need an Agreement that Addresses the New Tax Audit Rules

I am not the only federal income tax professional who recommends that all LLCs taxed as partnerships adopt an agreement that adds language that addresses the BBA.  Read what 34 other tax professionals say about LLCs taxed as partnerships and the need for an agreement that includes new partnership tax audit language.

34. November 27, 2017.  King, Krebs & Jurgens: “All tax partnerships need to be prepared to make certain amendments to their governance agreements, preferably prior to December 31, 2017.

33. November 20, 2017.  Bradley Arant Boult Cummings LLP: “Every partnership agreement must be reviewed–soon . . . . There are a number of items related to the new partnership audit rules that need to be addressed in any new or amended partnership agreement. . . . When should these amendments be made? Now.

32. November 2, 2017.  Darlene Pulliam, PhD, CPA and Sharon K. Burnett, PhD, CPA, CISA:  “All partnerships and entities treated as a partnership should review and, if necessary, modify their partnership agreement.”

31. October 30, 2017.  Lou Vlahos: “no llc[ taxed as a] partnership can assume that the new audit rules will not apply to it and, so, every [LLC taxed as a] partnership has to ensure that its partnership/operating agreement addresses the new rules.”

30. September 18, 2017. Jeffer Mangels Butler & Mitchell LLP: “As a result of the new partnership audit regime: (1) individuals and/or entities that were formerly owners of . . . multi-member Limited Liability Companies (together “Partnerships”) during prior, audited tax years may escape liability for unpaid tax, and correspondingly (2) the existing owners of such Partnership (i.e., the owners of the Partnership at the time of the IRS collection process) will bear the economic burden entirely. Thus, in the absence of properly drafted Partnership and Operating Agreements, any existing owner of a Partnership may be economically liable for the unpaid tax of former partners/members of the Partnership. It is therefore critical that Partnerships and their owners review and modify their existing partnership and operating agreements immediately.”

29. August 31, 2017. JD Supra[members] ought to look to the amendment of partnership [and operating] agreements now in order to, at the very least, name a partnership representative and set forth the parameters of the authority of such person between the [members].

28. August 16, 2017. DLA Piper, LLP:  “The changes made to the partnership audit regime under the BBA Rules are significant. Entities that are taxed as partnerships should consider whether to make changes to their partnership or operating agreements to address these changes (and newly formed entities should consider adopting similar provisions at the outset), including:

  • Establishing how, whether, and under what circumstances to make the opt-out election or push-out election, and where such an election is not made, providing for indemnification from historic partners for tax, interest, or penalties that may arise in a reviewed year. . . .
  • If a partnership decides to make the opt-out election or wants to maintain its eligibility for that election in the future, the partnership agreement should consider restrictions on transfers of partnership interests to non-qualifying partners . . . .
  • As noted above, imputed underpayments are collected in adjustment years, but relate to adjustments arising in reviewed years, which means that the tax burden relating to an audit could be imposed on partners who were not partners during the reviewed year. Partnership agreements should consider providing recourse against former partners for tax assessed for a year during which they were a partner.
  • Given the wide authority of the partnership representative, the partnership agreement should set out how the partnership representative is elected and removed, and should consider limitations on the partnership representative, for example, (i) requiring the partnership representative to give notice of audits and assessments, or (ii) limiting the partnership representative’s discretion in settling an audit or extending the statute of limitations, potentially by requiring that a certain percentage of the partners agree to those actions before they are taken.”

27. August 16, 2017. von Briesen:  LLCs taxed as partnerships ” will need to consider changes to partnership agreements, operating agreements

26. August 8, 2017. JD Supra:  Operating “agreements should be reviewed and amended as necessary to deal with some or all of the following provisions, among others, to accommodate the new rules:

  • whom to appoint as the partnership representative and procedures for his, her or its replacement;
  • indemnification provisions for the partnership representative;
  • contractual limitations of power on the partnership representative and/or notice requirements to partners with respect to all IRS (and state income tax) communications;
  • if it is eligible, whether the partnership should make an election to opt-out of the new regime; and
  • the ability of the partnership to request certain information from its partners necessary for the partnership to modify its tax liability.

Given the complexity and broad scope of the rules, each partnership agreement should be reviewed and amended”

25. August 3, 2017. NewsMax Finance:  This article titled “New Tax Rules Require Partnership Agreement Revision” states, “The fact that it was a bipartisan Congressional act was a bright red flag that something bad for taxpayers was on the way. . . . life for taxpayers treated as partners for federal tax purposes just got more complicated—and expensive. . . . The action step to take now is to start the process of reviewing and modifying your partnership agreement to conform to the new IRS partnership audit regime.”

24. July 25, 2017. Accounting Today:  The title of this article aimed at CPAs is “Partnership agreements need to reflect the new audit regime, now.”  The article concludes with: “Partnership agreements should be amended sooner than later to set out partner liabilities for the initial year, as well as to designate partnership representatives who will control the audit conversation with the IRS. While amendments to those agreements can always be made to reflect further guidance, as a practical matter it may be difficult for existing partners to agree on tax allocations in the first place, so that the sooner the process is begun, the less likely problems will arise when a future audit occurs.”

23. July 22, 2017. Cole Schotz: “The new rules upend the status quo, affect countless existing partnership agreements, and create additional liability for purchasers of partnership interests. At the same time, the new rules potentially create additional leverage for controlling partners. All these considerations need to be reviewed on a case-by-case basis to amend existing agreements and draft robust new ones for the future under the new regime.”

22. July 19, 2017. McDonald Hopkins:  In an article called “All [LLCs taxed as] Partnerships Should Amend their [Operating] Agreements for the New IRS Audit Rules” stated, “every [operating] agreement must be reviewed and revised to account for the law changes. . . . Through the [operating] agreement, the [LLC] may designate the partnership representative, place limits on the partnership representative’s authority, and plan for important taxpayer elections, among other things. [LLCs] should also consider fiduciary responsibility for the powerful partnership representative. Keep in mind that conflicts of interest among partners and the partnership representative could lead to litigation.”

21. July 12, 2017. Partridge Snow & Hahn LLP: “Although the New Rules create challenges for LLCs, taxpayers can avoid the harshest outcomes through some basic planning. This article discusses the key developments under the New Rules and the steps every LLC should take to protect itself. . . . LLCs and their members can protect themselves from the worst outcomes under the New Rules by taking preventative action now. At the very least, adequate planning in this case should include revisions to existing operating agreements . . . . If your LLC already has an operating agreement, or if it has yet to implement one, you should consult an experienced business attorney to advise you in advance of the New Rules becoming effective in 2018.”

20. July 7, 2017. Bradley Arant Boult Cummings, LLP: “All entities classified as partnerships for federal income tax purposes should amend their partnership or LLC operating agreements to account for the new rules by the end of this year . . . . Among the items that should be addressed are the following:

  • the designation and removal of the partnership representative
  • the designation and removal of the individual that must be appointed if the partnership representative is an entity

  • the requirements for the partnership representative and partners to obtain and provide information that may reduce the partnership’s liability for the imputed underpayment

  • partner consent required, if any, for the making of elections or settlements by the partnership representative, including the election out and the push-out election
  • the potential for filing amended returns by those who were partners in the reviewed year(s)
  • terms and conditions for amending the partnership or LLC operating agreement to deal with changes or updates to the new rules
  • restrictions on transfers of partnership interests to entities that are ineligible partners

  • partners’ notice and participation rights in connection with IRS or state audits
  • appropriate indemnifications for the partnership representative
  • how to ensure that the appropriate partners and former partners bear the actual costs of imputed underpayments, including cooperation requirements for former partners”

19. July 7, 2017. Blank Rome, LLP: “as a result of the new rules, careful consideration will have to be given in drafting the operative provisions of the governing documents, including but not limited to the expansion of the role and powers of the partnership representative, and the manner in which the various elections available to the entity will be dealt with . . . . the new rules present new challenges for [LLCs taxed as] partnerships. [LLCs taxed as] Partnerships should review their partnership agreements before the end of the year, and consider amending their agreements in anticipation of the new rules taking effect in 2018.”

18. June 22 2017. Winston & Strawn LLP: LLCs taxed as partnerships “should be considering appropriate amendments to their [operating] agreements to address a number of the issues discussed above, including

(i) the designation and removal of the partnership representative,
(ii) partners’ notice and participation rights in connection with audits,
(iii) appropriate indemnification protection for the partnership representative, and
(iv) how to ensure that imputed underpayments are economically borne by the appropriate partners (or former partners).”

17. June 21, 2017. JD Supra: “What Partnerships and LLCs need to do: Every partnership and LLC [taxed as a partnership] should consider revising their agreements to adapt to these new rules.

16. June 20, 2017. JD Supra: “The new rules, embodied in proposed regulations re-issued last week, require changes in partnership agreements and LLC operating agreements.”

15. June 16, 2017. Bloomberg BNA: “Many partnerships (and limited liability companies taxed as partnerships) will find it necessary or desirable to amend the partnership (or operating) agreement in response to the new audit rules”

14. April 21, 2016. Bradley Arant Boult Cummings, LLP: “A final warning: Anyone that is either (1) contemplating a new . . . business that will be classified as a partnership for federal tax purposes (including an LLC or joint venture) or (2) needing to amend an existing agreement should strongly consider incorporating these changes into the new or revised agreement immediately

13. March 28, 2016. Paul Hastings LLP:  The article states one of the most important reason that operating agreement of all LLCs taxed as partnerships must be amended to deal with the new audit rules:

Partnership and LLC agreements should generally be revised to provide for who will act as the ‘partnership representative’ because in the absence of an appointed person, the IRS has the discretion to pick a ‘partnership representative.”

12. February 8, 2016. Taft Stettinius & Hollister LLP: “Although these rules have not yet taken effect, they should be taken into account when drafting new operating agreements or engaging in acquisitive transactions involving partnerships”

11. January 26, 2016. Cozen O’Connor: “These new rules will lead to new provisions in partnership and LLC agreements and amendments of existing agreements to, among other things, designate a method for selecting a partnership representative and its rights and obligations of the partners, address whether certain tax elections will be made, and provide for indemnification and other contractual provisions (e.g., in the case of a withdrawing partner).”

10. December 22, 2015. Kilpatrick Townsend & Stockton LLP: “Almost all partnership (and LLC operating) agreements will need to be amended

9. December 21, 2015. Holland & Knight LLP: “Existing partnership and LLC operating agreements should be reviewed, and amendments will need to be drafted to address aspects of the new rules, including:

  • designating the partnership representative in place of the TMP
  • determining the partner(s) that will control the decision to opt out of the new regime
  • preventing assignments of partner interests to persons that would preclude the ability to opt-out
  • addressing the payment of entity-level tax
  • committing to making certain elections in the event of an audit adjustment
  • addressing circumstances where partners agree to “adjusted information returns” in lieu of entity-level tax”

8. December 18, 2015. Dykema Gossett PLLC: “The sweeping changes in the realm of partnership tax audits will likely require revisions to most partnership agreements and new considerations when entering or leaving a partnership.”

7. December 17, 2015. Venable LLP: “existing partnership agreements should be reviewed to account for these new audit procedures

6. December 4, 2015. Akerman LLP: “These new rules will also lead to many new provisions in LLC agreements and amendments of existing agreements to, among other things, designate a method for selecting a partnership representative; seeking indemnification from withdrawing partners; spelling out whether certain tax elections will be made; how payment of the tax by the partnership impacts the partners’ capital accounts; whether compensation will be paid to partners whose tax attributes reduce the partnership’s tax liability to the benefit of other partners; whether capital contributions will be required to pay tax liability; requiring partners to cooperate and disclose tax information including that of the partners of a partnership that is a partner of an audited partnership; and possibly prohibiting trusts and partnerships from becoming partners in the partnership so the partnership can elect not to have the new rules apply.”

5. November 30, 2015. Drinker Biddle & Reath LLP:  “partnerships and their advisors need to plan now for these eventual changes. Anyone entering into a new partnership agreement or acquiring an interest in an existing partnership should focus on what tax audit rights, and what tax representations and covenants, to seek.

4. November 20, 2015. Kaye Scholer LLP: “All partnerships will need to consider appropriate revisions to existing partnership agreements—preferably, long in advance of the Effective Date.”

3. November 9, 2015. Ropes & Gray LLP:  The authors said the partners of a partnership and the members of an LLC taxed as a partnership should revise “partnership agreement provisions addressing the sharing among the partners of any partnership-level tax and related items.”

2. November 9, 2015. Shearman & Sterling LLP: “Existing partnerships should review operating agreements before new rules take effect.

1. November 5, 2015. Sutherland Asbill & Brennan LLP: “existing partnerships and their partners will also need to consider the extent to which the new rules will necessitate amendments to their partnership agreements to preserve their existing arrangements.

Hire Me to Prepare a Tax Audit Agreement

Your LLC taxed as a partnership needs to hire me to prepare a Tax Audit Agreement if:

  • The LLC has an existing Operating Agreement, or
  • The LLC does not have an Operating Agreement.

My Tax Audit Agreement is not an LLC Operating Agreement.  It is a separate stand-alone agreement among all the members of an LLC.  My Tax Audit Agreement is appropriate for partnerships and an LLC formed in any state in the United States.  The text in the Tax Audit Agreement concerns only partnership tax audit issues.  The Tax Audit Agreement does not alter an existing Operating Agreement or affect any LLC matters other than partnership tax audit matters.

It is very easy to hire me to prepare a Tax Audit Agreement. The first step is to go to our Buy an Operating Agreement or a Tax Audit Agreement page.

If you have questions about a Tax Audit Agreement, call LLC attorney Richard Keyt at 480-664-7478 or send an email to Richard at rickkeyt@keytlaw.com.  You may also call Richard’s son LLC attorney and former CPA Richard C. Keyt at 480-664-7472 or email him at rck@keytlaw.com.