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Is Your LLC Ready For The New IRS Audit Rules?

Added by Steve M. Frinsko in Articles & Publications, Business Law, Tax Law on February 22, 2016

LLCs are by nature contractual relationships. As a result, the way the members interact with each other is the end result of a series of negotiations. Their operating agreements are drafted to reflect both the members’ agreement and to conform to the current state of the applicable laws.

But, from time to time, new laws come into effect that may change the original relationship and require the terms of the LLC’s operating agreement to be revised to achieve the desired outcome. The Bipartisan Budget Act of 2015 (“BBA”) (discussed in more detail here and here) is one such law. The BBA should cause LLCs that are taxed as partnerships (most of them) to think carefully about how they make tax-related elections. If you haven’t heard about the BBA yet and its potential impact on your taxes, expect to hear about it soon from your accountant. The BBA doesn’t go into full effect until 2018, but it’s not too early to begin thinking about its impacts on your LLC.

The BBA repealed IRS audit rules that had been in place since 1982 and replaced them with a more streamlined process. In connection with the more streamlined process, the BBA eliminates the current “tax matters partner” role and instead requires the LLC to designate a Partnership Representative. The Partnership Representative may be a member, manager, or some outside party like an accountant. One of the significant effects of this change is that under the BBA the IRS is no longer required to notify individual members of audit proceedings. Instead, the Partnership Representative has sole authority to act for the LLC in audit proceedings by the IRS. Any decisions made or actions taken by the Partnership Representative in those audit proceedings will bind the LLC and its members. Accordingly, the Partnership Representative has broad authority to act for the LLC, potentially much broader than what the current tax matters partner may currently have.

And, if the LLC doesn’t designate a Partnership Representative, the IRS may appoint one. So, if the LLC fails to take steps to designate a Partnership Representative it runs the risk of being stuck with one not of its choosing.

With the enactment of the BBA, most LLC operating agreements currently in effect will (at a minimum) need to be amended to designate a Partnership Representative. In connection with a discussion about the proper Partnership Representative, it would also be a good time for the members to discuss what else in the operating agreement might need to be updated.

But, how does the LLC go about picking its Partnership Representative? Well, it depends. It may be left to the manager (in a manager-managed LLC) to choose the Partnership Representative. Or, it may require a vote of the members if that decision is one needing member approval. Neither answer is necessarily right or wrong, but given the potential economic consequences for the members, some thought should be given this decision. Making this an item subject to member vote or approval potentially gives the members more control over their finances if faced with a BBA audit. However, especially in LLCs with a large number of members, it may be administratively difficult to secure the approvals required in a timely manner. If so, it may be more appropriate to allow the manager to select and remove the Partnership Representative.

In either case, the operating agreement should set out the Partnership Representative’s specific powers and responsibilities. Perhaps the members want notice of an audit and the right to participate in the response. They may also want control over the elections the Partnership Representative may make. The default rule under the BBA is that any underreported taxes are the LLC’s—rather than the individual members’—obligation. But, in some cases the BBA allows the individual members—rather than the LLC—to elect to pay any underreported taxes directly to the IRS. This may be especially important to members who were not members during the tax year being audited because they may not want to incur tax liability for those taxing periods. Were the LLC rather than the then-current members to assume the past underpayment liability determined by the audit, those current members would share in that liability. The members may also want to grant an appropriately limited power of attorney to the Partnership Representative to act for the members in tax matters. And even if not, they should include provisions requiring the members to take all actions the Partnership Representative may reasonably request in the face of an audit.

Further, the operating agreement should include a requirement for the members to indemnify the LLC against taxes incurred by the LLC as a result of the member’s status or as a result of the member’s actions. This indemnity and the obligations for the members to take all actions reasonably required must be obligations that survive a member’s dissociation from the LLC. Otherwise, former members could avoid these obligations without liability to the LLC.

It’s possible that your existing operating agreement is drafted broadly enough to address the choice of a Partnership Representative. It may also be broad enough to cover the indemnities and member obligations that the BBA brings into play. For example, Hawley Troxell’s base manager-managed operating agreement form provides the manager with power to make most of the “day-to-day” decisions and reserves voting rights to the members in only limited circumstances. Whether a decision like choosing a Partnership Representative is a “major” decision is up to the members to decide when drafting the operating agreement.

Certainly, these are not choices that should be made lightly and the process of structuring the LLC relationship requires careful thought. But, we regularly help clients work through these issues and, whatever your needs, we are prepared to guide you through the process. So, dust off your operating agreement and call us to discuss. We’re here to help.

For more information, please contact our Business Group or call 208.344.6000.