GlobeSt.com: What are some of the major ways that partnerships and LLCs will be affected?

Ogden: If you think about it conceptually, the new law makes complete economic sense from the federal government's point of view. However, it's all a matter of perspective. On the private side, the application of the general rule may (and likely will) resort in economic distortions. Taken to its logical conclusion, an individual that owned a Partnership a during prior, audited tax year may escape liability for his or her unpaid tax; correspondingly, the new owners of such Partnership (i.e., the owners of the Partnership at the time of the IRS collection process) will bear this economic burden entirely, since the Partnership, not the individual, will be liable for the tax deficiencies at the time of the collection process.

Taken together, the new law is trap for the unwary. A new owner of a Partnership must either: (1) take into account the potential economic burden that could be borne by the Partnership at a later time or (2) confirm that the Partnership will elect-out of the new audit regime, which is possible under certain circumstances. A lack of due diligence as to either issue could leave the new owner “holding the bag,” so to speak.

GlobeSt.com: What should partnerships and LLCs do to prepare?

Ogden: For all of these reasons, we are recommending that our clients review their partnership/operating agreements immediately.

For example, under certain circumstances, Partnerships composed of 100 or fewer owners (and whose owners do not include any Partnerships or certain Trusts) may elect-out of the new audit regime, which election must be filed annually with the IRS. In addition, if certain strict requirements are met, many Partnerships can essentially revert back to the collection process under existing law by imposing liability on those individuals and/or entities that were owners of the Partnership during the audited tax year. To remove the economic uncertainties caused by the new law, the Partnership's governing documents should be crystal clear on which of these avenues the Partnership will be obligated to take.

GlobeSt.com: Are you advising clients, who are eligible, to opt in or out of this new regime?

Ogden: I'm sure that some practitioners will disagree, but I see almost no benefit to subjecting your Partnership to the new audit regime. On the business side, the new audit regime creates substantial economic distortion by shifting tax liability from the true taxpayer (i.e., the owner of the Partnership during the audited tax year) to potentially “innocent” individuals. On the advisor side, I also predict litigation arising from the new audit regime, since some new owners of Partnerships will feel inadequately advised by their counsel, once they are left “holding the bag” after the Partnership is audited. Most (if not all) of these problems can be fixed through proper drafting in the governing documents.

GlobeSt.com: Are there any benefits to this change?

Ogden: It's all a matter of perspective. The law makes sense, from the government's point of view. However, for individuals in the private sector, the new law may create additional economic risk and compliance costs.

GlobeSt.com: Who will be most affected?

Ogden: Essentially all Partnerships will be affected by the new audit regime. Having said that, it will be interesting to see how large funds with thousands of investors navigate the new terrain, since these funds will almost certainly be unable, either legally or as a practical matter, to “elect-out” of the new regime.

A new audit regime, enacted as part of the Bipartisan Budget Act of 2015, will come into effect January 1, and it will affect all LLCs and partnerships. Under the new law, the IRS will be able to collect any unpaid taxes found during an audit at the highest tax rate available for the year under examination. The new law is a shift in former audit procedure, and partnerships should be prepared. To find out more, we sat down with Jamie Ogden, an associate in the Taxation and Trusts & Estates Groups at Jeffer Mangels Butler & Mitchell. Here, he tells us how the rules are changing and how partnerships should prepare.

GlobeSt.com: What is the new partnership audit regime that will be effective in January of 2018?

Jamie Ogden: The new partnership audit regime is true paradigm switch for most, if not all, general partnerships, limited partnerships and multi-member liability companies. The importance of the new law cannot be overstated. Specifically, under existing law, the IRS must generally audit Partnerships for a particular tax year, and to the extent of any tax deficiency, collect the delinquent tax from the persons that owned the Partnership during the examined tax year. However, the IRS found this to be an impracticable procedure, since many Partnerships (think hedge funds) could have thousands of owners—thus, in a single audit, the IRS could be forced to locate and collect tax from thousands of individual owners of the Partnership. For this reason, the current audit rates for Partnerships are relatively low, since the audit/collection process is economically unviable to the federal government. The IRS (and tax practitioners) are acutely aware, however, that Partnerships are generally the entity of choice for aggressive planning (and nefarious tax schemes).

For these reasons, under the new law, the general rule will permit the IRS to collect such unpaid tax from the Partnership itself at the highest tax rate in effect for the year under examination. Thus, under the general rule, the IRS will have a single target - the IRS will audit and then collect the tax from the Partnership itself.

GlobeSt.com: What are some of the major ways that partnerships and LLCs will be affected?

Ogden: If you think about it conceptually, the new law makes complete economic sense from the federal government's point of view. However, it's all a matter of perspective. On the private side, the application of the general rule may (and likely will) resort in economic distortions. Taken to its logical conclusion, an individual that owned a Partnership a during prior, audited tax year may escape liability for his or her unpaid tax; correspondingly, the new owners of such Partnership (i.e., the owners of the Partnership at the time of the IRS collection process) will bear this economic burden entirely, since the Partnership, not the individual, will be liable for the tax deficiencies at the time of the collection process.

Taken together, the new law is trap for the unwary. A new owner of a Partnership must either: (1) take into account the potential economic burden that could be borne by the Partnership at a later time or (2) confirm that the Partnership will elect-out of the new audit regime, which is possible under certain circumstances. A lack of due diligence as to either issue could leave the new owner “holding the bag,” so to speak.

GlobeSt.com: What should partnerships and LLCs do to prepare?

Ogden: For all of these reasons, we are recommending that our clients review their partnership/operating agreements immediately.

For example, under certain circumstances, Partnerships composed of 100 or fewer owners (and whose owners do not include any Partnerships or certain Trusts) may elect-out of the new audit regime, which election must be filed annually with the IRS. In addition, if certain strict requirements are met, many Partnerships can essentially revert back to the collection process under existing law by imposing liability on those individuals and/or entities that were owners of the Partnership during the audited tax year. To remove the economic uncertainties caused by the new law, the Partnership's governing documents should be crystal clear on which of these avenues the Partnership will be obligated to take.

GlobeSt.com: Are you advising clients, who are eligible, to opt in or out of this new regime?

Ogden: I'm sure that some practitioners will disagree, but I see almost no benefit to subjecting your Partnership to the new audit regime. On the business side, the new audit regime creates substantial economic distortion by shifting tax liability from the true taxpayer (i.e., the owner of the Partnership during the audited tax year) to potentially “innocent” individuals. On the advisor side, I also predict litigation arising from the new audit regime, since some new owners of Partnerships will feel inadequately advised by their counsel, once they are left “holding the bag” after the Partnership is audited. Most (if not all) of these problems can be fixed through proper drafting in the governing documents.

GlobeSt.com: Are there any benefits to this change?

Ogden: It's all a matter of perspective. The law makes sense, from the government's point of view. However, for individuals in the private sector, the new law may create additional economic risk and compliance costs.

GlobeSt.com: Who will be most affected?

Ogden: Essentially all Partnerships will be affected by the new audit regime. Having said that, it will be interesting to see how large funds with thousands of investors navigate the new terrain, since these funds will almost certainly be unable, either legally or as a practical matter, to “elect-out” of the new regime.