Is Your Partnership's Operating Agreement Out of Date?

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Earlier this year, LMC Special Tax Alert 2/17/19 explained new changes to the way the IRS audits partnership tax returns. Although effective in 2018, these rules were not part of the Tax Cuts and Jobs Act. They were enacted in 2015 but delayed until last year.

 

Audit adjustments are now taxed to the partnership, not passed through to the returns of the owners. Changes are assessed to the partnership at the highest individual tax rate (currently 37%) regardless of the actual brackets partners pay. The burden effectively falls on partners who own the entity when the audit is completed, regardless of ownership changes since the year under audit.

 

Our Alert discussed the creation of a new position, the Partnership Representative (PR), to replace the prior Tax Matters Partner. The PR, who need not even be a partner, has powerful authority over the partnership and its partners. We mentioned how partnerships with 100 or fewer K-1s, none of whom are themselves partnerships or LLCs, can opt out of the new audit regime.

 

In this Alert, we discuss additions and amendments that partnerships should consider making to their operating agreement (OA) to address these many changes. Some (but certainly not all) amendments to consider are discussed below. Partnerships should consult their attorneys to draft any changes.

 

The Partnership Representative

Absent any restricting language in the OA, the PR is a virtual "czar" over tax matters. The PR does not have to notify the partners about an audit, can unilaterally make any of the many elective (and time-sensitive) actions the audit may entail, and can agree to any settlement. Partnerships may restrict some of this authority by adding language to the operating agreement.

 

The OA should designate who the PR is and what vote of the partners is needed to appoint and remove that person. It should address the need for the PR to notify the partners during the proceedings. It can require that partners must approve any elections, settlements, or other action (and by what vote). The OA can also describe the rights of the PR as to indemnification, release of liability for acts and omissions, and restrictions to that release in the event of gross negligence, willful misconduct, or fraud.

 

The Partners

If ownership changed since the year under audit, the OA should identify which group of partners may vote in audit-related matters or are responsible for indemnifying the PR. The OA should clarify whether former partners must reimburse the partnership for any federal or state taxes, interest, and penalties assessed for years when they were owners. It should specify whether former partners are still subject to their responsibilities under the OA with regard to audits of years when they were still owners.

 

The OA should clarify whether (and which) partners may participate in audit proceedings, attend meetings, or receive notice of actions. It should clarify if partners must receive periodic updates about the audit. It should spell out if a partner may transfer his or her interest when doing so invalidates the partnership's opt-out election (such as an individual transferring ownership to a single-member LLC).

 

Contact your LM Cohen professional for information about the new IRS audit regime, or your attorney to update your operating agreement. All our prior Alerts are available on the Updates page of our website.

 

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