by Ryan Jones
If your business entity is taxed as a partnership (including many multi-member LLCs), the IRS can now collect a business partner’s tax deficiency from the entire business. In other words, your company could be liable for your business partner’s tax deficiency. This article briefly compares the old rules with the new rules and provides four critical action steps in response to the new rules.
What are the new rules?
The old rules. Historically, the IRS calculated taxes at the partnership level (i.e. the whole business), but collected taxes at the individual partner level. If the IRS discovered a tax deficiency for the entire business, the IRS could only collect from the individual partner who caused the deficiency.
The new rules. The new partnership tax audit rules are a part of the Bipartisan Budget Act of 2015 (the BBA), effective January 1, 2018. Beginning with the tax year 2018, the IRS can collect a tax deficiency from the business itself. This means that the entire business could suffer due to a tax deficiency caused by one of the owners.
5 action steps in response to the new rules:
1. Determine whether the new rules apply to you.
If your business is taxed as a partnership, the new rules apply to you. Keep in mind that your business may be taxed as a partnership under federal law even if it is not considered a partnership under state law. For example, LLCs are not considered partnerships under state law. However, a partnership tax structure is the default classification for multi-member LLCs. It follows that many Oklahoma LLCs with more than one owner are taxed as partnerships.
2. Determine whether you qualify to opt out of the new rules.
Thankfully, small businesses are generally allowed to opt out of the new rules. Here are the requirements you must satisfy to opt out:
i. Number of Owners. Your business must have less than 100 owners. (For LLCs: less than 100 members. For partnerships: less than 100 partners.)
ii. Ownership Structure. Your business must not be owned by any other pass-through entity, other than an S-corporation. For example, if your LLC is owned 25% by another LLC taxed as a partnership or disregarded entity, you do not qualify. If your business is owned exclusively by individuals, corporations, or S-corporations, you satisfy the requirement.
3. Elect out of the new rules each year with your annual tax return.
Even if you qualify to opt out, the election is not automatic. You must actively make the election each year with your annual tax return. Presumably, the IRS will issue additional guidance on exactly how to make the election. The new rules do not take effect until January 1, 2018, so you do not need to make an election until you file your taxes for the tax year of 2018. By that time, there should be additional guidance issued by the IRS on how to make the election, and your tax advisor should be familiar with the proper election method.
4. Modify your partnership agreement or operating agreement.
In addition to electing out of the new rules (if you qualify), you should also add certain provisions to your partnership agreement or operating agreement. These provisions will provide some protection against the new rules even if you fail to elect out properly (or if you don’t qualify). Here are the two provisions you should add to your governing document:
i. Ultimate Liability Provision. As described above, the biggest problem created by the new rules relates to liability for tax deficiencies. The entire business could end up paying for the tax deficiency of an individual partner. To protect against this unfair result, your partnership agreement or operating agreement should contain a provision that makes each owner ultimately liable for any tax deficiency caused by him or her. This way, even if the IRS collects a deficiency from the entire business, the business owners can then collect the deficiency from the owner who caused it. In other words, the owner who causes a deficiency bears ultimate liability for any tax deficiency caused by him or her (even if the IRS collects from the entire business).
ii. Partnership Representative Provision. Aside from the major issues discussed above, the new rules also contain another, minor change that should be reflected in your partnership agreement or operating agreement. Previously, entities taxed as partnerships were required to name a “tax matters partner” in their government documents. The new rules require a “partnership representative” instead. The duties and authority of the new “partnership representative” differ slightly from the historical “tax matters partner.” Therefore, to be fully compliant with the new rules, you should replace the old “tax matters partner” language in your agreement with updated “partnership representative” language.
5. Contact us for assistance.
If you have questions about the new rules, or if you would like assistance in updating your operating agreement to account for these tax law changes, please contact us. We are available to assist you in complying with the new rules and taking steps to protect against tax liabilities caused by your business partners.
 See 26 U.S.C. § 6221 to 6234.