New IRS Audit Rules: Impact On Trusts that Hold LLC and Partnership Interests

Take-Away: Effective the first of this calendar year, the IRS  imposed new audit rules on partnerships and multimember LLCs. These new rules may leave a trustee vulnerable for claims for tax liabilities of others, or for a breach of trust with regard to an interest in a partnership or LLC owned by the trust.

Background: The new Audit Rules impose a new ‘default rule’ for partnerships and multimember LLCs. This is a change from prior audit principles. Now, under the Audit Rules,  audits will be conducted and ‘imputed underpayments’ of tax, interest and penalties will be collected at the partnership level (or LLC level) rather than at the partner or LLC member level.

• Opt-Out Rule: Fortunately many partnerships and LLCs will be able to opt out of these Audit Rules. Generally, those partnerships and LLCs which issue fewer than 100 Schedule K-1’s in a year are able to ‘opt out’ but only if the partnership or LLC does not have an ‘ineligible partner’. The exercise of the ‘opt out’ election is made on each timely filed partnership tax return (Form 1065) for each tax year. [26 U.S. C. Sections 6221(a) and 6225(a).]
• Ineligible Partner: An ineligible partner is any partner (or member) that is one of the following: (i) another partnership; (ii) a trust, including a revocable trust or a grantor trust; (iii) a foreign entity that would not be taxed as a C corporation, or an estate of an individual, other than a deceased partner. Consequently, if a trust holds a partnership or LLC membership interest, that partnership or LLC cannot ‘opt-out’ of the Audit Rules.
• S-Corporation Stock: Accordingly, if a trust is a member of any multi-member LLC taxed as a partnership, or the trust is a partner in any partnership, such entity will be subject to the Audit Rules. But an S corporation that has a trust as a shareholder will not by virtue of that fact alone cause the partnership of which the S corporation is a partner to be ineligible to opt out of the Audit Rules.
• Tax Rates: Any tax that is to be paid by the partnership (or LLC), in the absence of liability by the partners from the audit tax year, will be assessed at the highest applicable income tax rate for the year under audit.
• Change in Assessment Default Rule: Prior to this new Audit Rule regime, an audit of a partnership or LLC was carried out at the partner/member level, and the partners/members themselves were liable for the amounts due for the tax year under audit. Under the Audit Rules, the default rule is that the IRS will conduct a partnership/LLC  audit at the partnership/LLC level and will collect any imputed underpayment of tax, interest and penalties arising from one or more partnership/LLC adjustments determined by the IRS directly from the partnership/LLC during the year in which such partnership/LLC adjustments become final, rather than from the individual partners (or LLC members) from the year under audit. The effect is to place the burden of underpayment on the partners/members in the year in which the audit becomes final, rather than the partners/members in the year under audit, even if the partners/members in the year the audit becomes final were not partners or members during the year under audit and otherwise would have no liability for such taxes. In short, if a trust acquires a partnership interest or LLC membership interest in a year after the tax year for which the audit takes place, the trust’s partnership (or LLC) will have to pay the additional  tax, penalties, and interest, even though the trust did  not own the partner/membership interest when the misreporting occurred.
• Change in Terminology – Partnership Representative: The Audit Rules introduce a new concept called the partnership representative. This role player replaces the old roles of tax matter partner or tax matters member. Note, too, that the partnership representative does not need to be a partner in the partnership or a member of the LLC. A partnership representative is the one and only person who may participate in the tax audit, or may act on behalf of the partnership/LLC and is the only one entitled to receive notice from the IRS under the Audit Rules. The acts of the partnership representative are binding on the partnership/LLC and all partners/members, including the timely filing of a push-out election (see below.) Finally, if no partnership representative  is appointed by the partnership/LLC, the IRS will select one for the partnership/LLC. [26 U.S.C. 6223(a).]
• Risk to Trust: In sum if a trust is a direct partner in a partnership or a member in an LLC, there is no ability for the partnership/LLC to opt out of these new Audit Rules.  The default rule then is that any partnership/LLC in which a trust is a partner/member will be liable for imputed underpayments in the case of an audit of the partnership/LLC, thus making the current partners of the partnership/LLC (i.e. the trust) indirectly liable for such a tax, penalties and interest. Example: A trust becomes an assignee of a partnership interest in a partnership after the calendar (tax) year under audit. The trust could thus bear an income tax burden that could have been the liability of the former partner who assigned his/her interest to the trust. It could also lead to an income tax imposed at a higher rate rather than would otherwise have been assessed to the trust.

Push-Out Election: While any audit under the Audit Rules has to be conducted at the partnership/LLC level, the Audit Rules payment default rule may be altered by the partnership/LLC by making what is called a valid push-out election. Following this election, the partners/members during the tax year under audit must account for and pay their share of the partnership/LLC adjustments related to the imputed underpayment of tax. This election effectively pushes the tax liability out from the partnership/LLC and to the partners/members in the year of the audit becomes final to the partners/members during the tax year under audit. By effecting a push out election a partnership/LLC can avoid liability for the income tax during the year an audit becomes final if all partners/members during the year under audit agree to file amended returns to reflect the underpayment of income tax from the audit and pay such amount with the amended filing. Example: If there is no timely push-out election,  a trustee of a trust that holds the partnership interest or LLC membership interest might be subject to breach of trust claims from trust beneficiaries who would presumably argue that their interests in the trust suffer from a higher income tax burden had the trustee not demanded a push-out election made by the partnership/LLC.

Practical Steps: If a trust holds a partnership or LLC membership interest, it should pursue the following steps to comply with these new Audit Rules:

1. Amend the partnership agreement or LLC operating agreement to: (i) appoint a sophisticated partnership representative; (ii) assure that there is a mechanism to appoint a replacement, or name as successor partnership representative;
2. Require specific actions to be taken by the partnership representative, including making a timely push out election  and the need to promptly pursue available remedies in the event of an unsatisfactory IRS audit, or to contest the audit;
3. Require a voting procedure of the partners (or members) prior to any discretionary steps taken by the partnership representative; and
4. Require that the partnership representative provide timely notices and updates to the partners (or members) as received on a regular basis with regard to the pending IRS audit.

Conclusion: The Audit Rule change is designed to relieve the IRS of conducting multiple audits among several partners or members of the same LLC- just one audit, just one collection of underpayment of income taxes, penalties or interest. But the timing of the audit could expose a trust owner of a partnership or LLC interest, to tax liability incurred at a time the trust did not even own the interest that caused the underpayment. As such, before a trust acquires a partnership interest, or an LLC membership interest a fair amount of due diligence of prior tax returns will be required, not to mention following the practical steps outlined above.