The IRS recently released new guidance to IRS examiners detailing procedures on how to handle early opt-in requests from partnerships and LLCs. This early opt-in election allows partnerships and LLCs to apply the new centralized audit rules ahead of the official effective date, extending the applicable tax periods from Nov. 2, 2015 to the official start date of Jan. 1, 2018.
To recap, the new centralized partnership audit rules are a fundamental change in taxing partnerships and LLCs. Generally, partnerships and LLCs are not taxed at the entity level; rather they are taxed as pass-through entities, meaning the owners of the interest are responsible for paying the income they receive from the partnership/LLC, and not the entity itself. Thus, in order for the IRS to collect any disputed payments from the partnership or LLC, it had to seek out each individual member to assess and collect payments.
As you can imagine, for a cash-strapped organization like the IRS, this was not a very efficient or effective way of auditing partnerships or LLCs, especially for entities with more than 100 partners and in tiered structures. So in November 2015, Congress decided to change the rules. By enacting the Bipartisan Budget Act of 2015 (BBA), Congress completely revamped the way the IRS could assess and audit partnerships. The BBA changed IRS audit procedure for partnerships and LLCs in two distinct ways:
- Congress rewrote the Internal Revenue Code to allow the IRS, during audit proceedings to levy and collect taxes on partnerships and LLCs, as an entity, unless the entity makes an election to opt out.
- Congress got rid of the “tax matters partner” and replaced it with the “partnership representative,” which has the sole authority to bind the owners of a partnership or LLC in its dealings with the IRS.
For some businesses, there is a way out. Small (comprising 100 or fewer K-1s), single-tier (having no partnerships, LLCs, or trusts as members) partnerships or LLCs may be able to opt out of the new rules and go back to the old system where the IRS conducts separate proceedings and assessments for each member. The opt-out election only lasts for one year, so it must be renewed each year on a timely filed partnership tax return.
Why would someone want to opt in early to new audit rules?
Why would someone want to opt in early to these new audit rules that were supposedly designed to help make it easier for the IRS to audit and collect taxes from partnerships and LLCs?
For some partnerships, opting out is simply out of the question. And if you are currently under audit, you may want to elect to have uniform IRS procedures between past years and the future years that have yet to be audited.
You might also look at the new audit rules as a way to ensure that everyone in the partnership gets equal treatment from the IRS. Under the old rules, the IRS would conduct separate proceedings against each partner or member, which could lead to inconsistent results depending on the IRS revenue agent in charge or the presentation by the legal advisor. Under the new rules, the entire partnership or LLC is represented by one person, the partnership representative, so all partners or members are tied to a single proceeding. It might be an easier administratively for the partnership or LLC to handle one proceeding for 30 different partners, than to coordinate 30 separate proceedings to account for each member. The results may not be as favorable tax-wise, but it could cut down on the expenses of managing such an arduous process.
2 ways to opt in early to new partnership audit rules
If you choose to opt-in early under the new rules, the new guidance provides that there are two different ways to do so.
- Opting in before Jan. 1, 2018: The early election may only be made within 30 days of the date the IRS first notifies a partnership in writing that its return has been selected for examination. In other words, you generally cannot opt in early unless you have been informed that you are under audit and that you make the election no later than a month into the proceeding.
- Opting in after Jan. 1, 2018: Partnerships and LLCs can choose to make the early opt-in election by filing an Administrative Adjustment Request (AAR) under Section 6227 as amended by the BBA for tax periods beginning after Nov. 2, 2015 and before Jan. 1, 2018.
Again, this early opt-in election is generally intended to help resolve the issue of having two different audit procedures apply midway through a multi-year audit.