Few of us still remember the acronym “TEFRA.” It stands for the Tax Equity and Fiscal Responsibility Act of 1982. TEFRA focused on standardizing audit procedures and closing tax loopholes. It is back in the news. The Bipartisan Budget Act of 2015 (the “Act”), which was signed into law last November, repeals the TEFRA audit rules and changes the procedures for partnership audits. As a result of the Act, important changes will need to be made to partnership agreements and limited liability company operating agreements. The necessary changes as well as issues to consider include the following:
- The partnership itself, rather than just the partners, will be responsible for audit adjustments. This has the effect of shifting financial responsibility for tax assessments from the partners to the partnership. This may be problematic since the tax rate of the partnership may be significantly higher than the aggregate tax rate of the individual partners.
- The role of “Tax Matters Partner” will be replaced by the “Partnership Representative.” This, effectively, makes prior agreement provisions about the tax matters partner obsolete. Under TEFRA, other partners could participate in the audit process. Under the Act, the Partnership Representative has exclusive authority to represent the partnership/LLC in an IRS audit. The Partnership Representative will no longer need to be a partner so long as he/she has a substantial presence in the US. From a drafting perspective, consideration should be given in amending agreements to clarify whether the Partnership Representative must also be a partner, whether he/she must obtain approval of the partners/members before making decisions that impact the partnership/LLC and whether to include any fiduciary duties.
- Tax audit liability will be based upon the year of adjustment rather than the tax year to which the adjustment relates. For example, if a partnership/LLC is audited in 2019 for a 2015 return and the audit is completed in 2020, the tax adjustment will be made in 2020 and impact the partnership’s 2020 taxes notwithstanding that the error occurred back in 2015. This is critical since it has the potential to shift the liability from former partners existing in 2015 to new partners in 2020. To address this issue, partnership and operating agreements may need to be amended to include language requiring former partners to file amended returns and pay taxes within 270 days of notice of the adjustment. It will also be necessary to include provisions affirming that these new provisions will survive the termination of a partner or member’s interest in the partnership/LLC. An alternative is for the partnership/LLC to issue a statement to the former partners/members and the IRS listing the share of adjustment to income, gain, loss, deduction or credit. The statement must be issued within 45 days from final notice of adjustment. The partnership/operating agreement can either compel or preclude this adjustment, but it should be clear whether such assessments may be tagged to former partners.
- The Act changes the statute of limitations for such assessments to three years from the later of the due date of the tax return, the date the return was filed or the date that an administrative adjustment request is filed.
- The Act does allow some small partnerships/LLC’s to opt out and to continue to be subject to partner-level audits.
Since most multi-member limited liability companies are taxed as partnerships, the rule changes will likely affect most small businesses operating as LLC’s. In most instances, it will be necessary to revise existing partnership and operating agreements. The Act becomes effective as of January 1, 2018, although an election can be made to apply to any tax year beginning after November 2, 2015.
For more information about TEFRA and potential changes to your partnership and/or LLC operating agreements, contact me by e-mail or phone at (301) 251-1180, ext. 306.