CHANGING IRS AUDIT RULES FOR PARTNERSHIPS

In an effort to make IRS examinations of partnership returns (Form 1065) more cost effective for the
government, Congress included new partnership audit rules in the Bipartisan Budget Act of 2015. These
new rules are scheduled to be effective for partnership tax years beginning after 2017. The rules apply
to partnerships and LLCs treated as partnerships. The Treasury Department has issued Proposed
Regulations addressing some of the specifics, but there are many unanswered questions and some
genuine concerns about how to handle certain issues. The purpose of this correspondence is to make
you aware of these new rules and proposed regulations and provide some suggestions of steps that
should be considered in the coming months. As further guidance is issued, we will provide updates with
additional recommendations.

Under the new rules, the partnership will generally be liable for payment of tax, penalties, and interest
resulting from IRS audit adjustments. This is in stark contrast to the old rules that pushed audit
adjustments out to each partner, who was then responsible for paying any tax resulting from the IRS
adjustment to the partnership. There are several elections available to the partnership to either opt out
of these new rules or pass through the IRS adjustments to the partners. These elections are made at
different times and none of them have to be made immediately. This means we still have time to receive
further guidance from IRS before you need to make any elections.

Only certain partnerships are eligible to elect out of the new rules. The election is made on a timely-filed
partnership return. The partnership must have 100 or fewer partners and all the partners must be an
individual, a C corporation, a foreign entity that would be treated as a C corporation were it domestic,
an S corporation, or an estate of a deceased partner. If any of the partners are trusts, partnerships, or
disregarded entities, the partnership cannot elect out of the new rules even if it has fewer than 100
partners.

Currently, partnerships with more than 10 partners designate one of the partners as the Tax Matters
Partner (TMP). The TMP is responsible for signing tax returns and dealing with IRS audits. The new rules
create a different position called the Partnership Representative (PR), replacing the TMP. All
partnerships subject to the new rules are required to designate a PR. If no PR is named, the IRS will
select one. The PR will have the sole responsibility to act on behalf of the partnership for purposes of
the partnership audit rules. The designation of the PR must be made separately each tax year on the
partnership return and the designation is only effective for that tax year. The PR should be selected
carefully because the partnership and all its partners will be bound by the actions of the PR. The PR does
not have to be a partner in the partnership.

Partnership Agreements and LLC Operating Agreements (Agreements) will need to be amended to
address these new rules. Since there is still some time before the new rules become effective, it might
be prudent to wait for answers to some of the open questions before amending your Agreement. You
should contact your attorney who drafted your original Agreement for assistance. Some of the issues to
be addressed include:

  1. Agreements should include an indemnity in favor of the partnership from each partner and former
    partner for payments by the partnership attributable to the share of the adjustments of that partner
    or affected former partner.
  2. If the election out of the new rules is available, a partnership should probably make it on each tax
    return filed.
  3. The Agreement should address the selection, control, indemnification, and removal of the
    Partnership Representative.
  4. If the new rules apply (more than 100 partners or any of the partners are a trust, partnership, or
    disregarded entity), please contact us for additional items to be considered, including:

    • Requiring the PR provide correspondence and notices to all affected current or
      former partners.
    • If the partners and their respective partnership interests in the adjustment
      (current) year are not materially different from those in the reviewed year, it
      may be acceptable to handle the adjustments under the basic rule of the new
      regime.
    • Otherwise, the partnership should consider making a serious effort to
      induce/coerce the reviewed-year partners to file amended tax returns and pay
      the tax due.
    • Even while the partnership is working on achieving an optimal result under the
      amended return mechanism, it should be considering actively the effects of
      making a pass-through election. The deadline for making such an election is only
      45 days after the date of the notice of final partnership adjustment.
  5. As you can see from the above discussion, these new rules are complicated and have many potential
    unintended consequences. The decisions made by the Partnership Representative will affect all
    partners, some possibly adversely. It is important for all partnerships and LLCs taxed as partnerships to
    understand these new rules and make appropriate changes to their management documents to provide
    protection to their owners. Stanfield + O’Dell is ready to assist you in working through these new rules
    and reviewing documents with your legal counsel. Stay tuned for updates with additional
    recommendations once further guidelines and final regulations are issued.