By Phil Jelsma
The IRS recently re-released its proposed regulations on the implementation of its new centralized partnership audit regime – rules that impact every partnership and limited liability company (“LLC”). Our previous article addressed the implications of the new regulations – which are effective next year – whereby IRS adjustments to income, gain, a loss, deduction or credit are made at the partnership or LLC level and not at the partner or member level.
Generally, these rules require the partnership or LLC pay any tax deficiency, penalty and interest. Clearly to the extent partnerships and LLCs can elect or opt out of these rules, many will choose to do so. By electing out, the adjustments will be made at the partnership or LLC level, consistent with existing law.
This week we will discuss who can elect out and how to make that election.
Who Can Elect Out?
The IRS’s proposed regulations only permit an “eligible” partnership to elect out of the centralized partnership audit regime. An “eligible” partnership is one with 100 or fewer partners during the year and at all times during that year, all partners were “eligible” partners. Generally, the number of partners is determined by counting the number of Schedules K-1, partner’s share of income, deductions, credits, etc., issued during the taxable year. Are a husband and wife, however, treated as a single partner or member?
Under the predecessor law, the Tax Equity and Fiscal Responsibility Act (“TEFRA”), there was a provision that specifically stated husband and wife were considered a single partner. The new provisions contain no similar language; therefore, husband and wife would appear to be two partners for purposes of the 100 partner rule.
There is a special rule for partnerships or LLCs that have S corporation partners or members. For purposes of the 100 partner rule, the S corporation’s shareholders are counted as partners. For example, if an S corporation has 20 shareholders and the S corporation is a partner and in a partnership, there are deemed to be 20 Schedules K-1 issued for purposes of the 100 partner rule. The most difficult aspect of this rule is who is an “eligible” partner, which the proposed regulations define as an individual, S corporation, C corporation, eligible foreign entity or estate of a deceased partner. A C corporation includes a real estate investment trust (“REIT”) or an entity exempt under Section 501(a) such as a public charity or private foundation. An eligible foreign entity is a foreign entity classified as a corporation. Importantly, eligible partners do not include partnerships, LLCs, trusts, foreign entities that aren’t classified as corporations, disregarded entities such as single member LLCs, nominees and other persons who hold an interest on behalf of another person and any estate that is not an estate of a deceased partner. A simple living or revocable trust designed to avoid probate, therefore, would not be an eligible partner.
Whether some of these entities can be restructured to create eligible partners remains to be seen. For example, a trust could issue an economic or transferable interest to an individual beneficiary who is an eligible partner – yet the trust maintains the LLC membership interest.
How to Elect Out
The election out of the centralized partnership audit regime must be made on a timely filed partnership return, including extensions, i.e., a Form 1065, for the partnership year to which the election is effective. Thus, a partnership cannot make an election on a return filed after the due date for a tax year. An election may only be revoked with the IRS’s consent.
The form of election requires the partnership or LLC to disclose to the IRS the names, correct taxpayer identification numbers and tax classifications of the partners of the partnership or members of the LLC. If there is an S corporation partner, it must describe the names, correct taxpayer identification numbers and federal tax classifications of all persons to whom the S corporation partner is required to furnish Schedules K-1 during the year.
A partnership or LLC that elects out of the centralized partnership audit regime must notify each partner or member that the partnership or LLC has made the election within 30 days after making the election. The notice can be in writing, electronic means, such as email, or another form chosen by the partnership or the LLC.
In general, the IRS may rely on the election for all purposes unless it determines that the election is invalid. Even if the election is done improperly, it can still be relied on by the partnership or LLC unless challenged by the IRS, and the IRS may also rely on the election in determining whether the partnership or LLC is subject to the centralized partnership rules.
What to do?
Because of the burdens placed on most partnerships and LLCs by the new centralized partnership audit rules, if an entity can elect out of the new centralized partnership audit rules, it should do so. For most, the cost of annually electing out is much less than the cost of doing nothing and being subject to these often expensive and complicated new requirements.
Phil Jelsma is a partner and chair of the tax practice team at Crosbie Gliner Schiffman Southard & Swanson LLC (CGS3). Jelsma is recognized as a leading joint venture and tax attorney, with a 30-year background in real estate exchange transactions, syndications, nonprofit corporations and international tax planning.