For many New Hampshire business entities taxable as partnerships, including multi-member limited liability companies and general and limited partnerships (all of which I’ll refer to here as “partnerships”), the possibility of an adverse IRS audit is a continuing nightmare.
You never know when the IRS will show up at your partnership’s doorstep or what it will decide when it looks at your partnership’s return.
On Nov. 2, 2015, Congress enacted a new law entitled the Bipartisan Budget Act of 2015 (the BBA). The BBA contains partnership audit rules that will become effective for all partnerships in 2018, but partnerships can elect into BBA coverage at any time before 2018.
In 2018, the BBA rules will completely replace the partnership audit rules that have applied since 1982 under the Tax Equity and Fiscal Responsibility Act (called the “TEFRA” rules by tax professionals). As explained below, for many New Hampshire partnerships and their partners, the BBA rules will create grave IRS audit risks that don’t exist under TEFRA.
Under TEFRA, the IRS is allowed to audit partnerships at the partnership level, and these audits will bind the partners. However, in a TEFRA audit, partners can fully participate, and if the audit results in additional federal taxes, only the partners, not the partnership, will be liable. Furthermore, any such partner-level taxes will be payable at the partners’ marginal tax rates and will be reduced by partner tax deductions, losses and credits.
The BBA has changed all this. Under the BBA, the IRS is authorized not only to audit partnerships but also, with one major exception, to impose federal income taxes on partnerships, not on partners; these taxes will be nondeductible; and the IRS may assess them at a draconian 39.6 percent rate.
In other words, under the BBA, in a radical departure from traditional federal tax law, a partnership can be taxed just like a C corporation — except, in some ways, far more harshly.
The major exception, which applies both under TEFRA and under the BBA, is for “small partnerships.”
Under TEFRA, small partnerships mean any partnerships that have 10 or fewer partners and whose partners consist exclusively of individuals, estates and C corporations. Thus, TEFRA partnerships whose partners include, for example, revocable trusts, single-member LLCs, multi-member LLCs or partnerships can’t qualify as TEFRA small partnerships.
However, if a partnership is a TEFRA small partnership, it is automatically exempted from partnership-level audits; it need not file any annual or other small partnership election with the IRS.
Under the BBA, small partnerships mean any partnerships that have 100 or fewer partners and all of whose partners are individuals, estates, C corporations or S corporations. Thus, it is generally easier for partnerships to qualify as small partnerships under the BBA than under TEFRA. However, in order to qualify as a BBA small partnership, a partnership must make a new small partnership election in its tax return every year. If it doesn’t, it won’t be a BBA small partnership for that year and thus will be exposed to the full brunt of an IRS partnership audit.
What does the enactment of the BBA mean for New Hampshire multi-member LLCs and for other New Hampshire business entities taxable as partnerships? In my view, it means at least the following:
The partners of all existing New Hampshire partnerships that qualify as TEFRA small partnerships need not worry about the BBA until 2018. However, if their partnership agreements don’t already contain provisions protecting them from losing their TEFRA small partnership status, they should include these provisions in these agreements. Furthermore, they should consider including BBA partnership audit provisions in their partnerships even now so they won’t have to worry about them in 2018.
The partnerships of existing partnerships that do not qualify as TEFRA partnerships should consider whether to restructure their ownership structure order to qualify — for example, by persuading partners that are revocable trusts to transfer their partnership interests to individual trustees or beneficiaries.
Partnerships that are TEFRA small partnerships can lose their small partnership status without knowing it. To address this risk, their partners should consider adding to their partnership agreements “tax matters partner” provisions and other specialized TEFRA partnership audit provisions to handle TEFRA partnership-level audits.
The partners of existing partnerships that can’t qualify as TEFRA small partnerships but can qualify as BBA small partnerships should consider whether to opt in even now to the BBA and to file BBA small partnership elections in all future returns.
In short, there are many things New Hampshire partnerships can do to deal effectively with the BBA. The thing they shouldn’t do is to ignore it.