by Phil Karter, tax controversy lawyer and shareholder at Chamberlain Hrdlicka (Philadelphia)
There are many considerations that go into the choice of business entity in which a startup chooses to operate, but for most new businesses, operating as a limited liability company (LLC) is the preferred entity of choice. In fact, these are the fastest-growing types of entities, increasing at an average rate of four percent over the past decade.
While LLCs are not necessarily favored by companies seeking to raise capital after initial funding, incentivize employees with equity compensation arrangements or those looking to go public or be acquired, they do offer attractive benefits for owners, including protection from liability, low cost of organization, flexibility in constructing business arrangements and profits allocations, and the avoidance of double taxation. Moreover, because many startups take time before realizing profits, these pass-through entities provide a mechanism for losses to be utilized to offset other income.
One dramatic change in tax law that has received a lot less attention than deserved – perhaps because of the back-and-forth in Washington over tax reform – is that on Jan. 1, 2018, partnerships and LLCs will become subject to an entirely new and unfamiliar set of partnership audit rules enacted into law by the Bipartisan Budget Act of 2015. Yes, that’s right, this law was passed more than two years ago but until Jan. 1, 2018, it has been voluntary.
So ready or not, all partnerships and LLCs – even the simplest ones – will have to deal with these new rules to varying degrees of complexity.
All partnerships and LLCs (other than single-member LLCs) must file partnership tax returns (IRS Form 1065). For pass-through entities classified as small partnerships (those with 10 or fewer owners), any IRS audit adjustments are determined at the individual partner level. Larger partnerships are subject to what is known as the TEFRA partnership rules (an acronym for the 1982 Tax Equity and Fiscal Responsibility Act), which are audited at the partnership level.
In either instance, any partnership tax adjustments flow through to individual partners and any tax deficiencies must be collected directly from such partners. In stark contrast, under the BBA the partnership, not its partners, will generally be responsible for any tax underpayment.
Further, if there has been a change in ownership of the entity, the partners affected by the adjustment are those who are partners in the year the adjustment is made, not the year giving rise to the adjustment.
Finally, the rate at which the partnership is taxed for any deficiency is the highest tax rate in effect for the adjustment year.
For example, if a partner is in the 25 percent tax bracket but the highest taxable rate at the time is 39.6 percent (today’s top tax rate), the adjustment will be taxed at the higher rate, indirectly diminishing the value of the partner’s equity interest significantly more than the additional tax liability the partner would incur under present law.
Avoiding the Quagmire.
The new law applies to all partnership type entities, including those with 10 owners or less. However, the BBA allows such entities to “opt out” of its application (if there 100 or fewer partners) by making an annual election to do so on the partnership tax return.
With hundreds of pages of new IRS regulations to navigate and an untested new audit regime, few, if any, professionals would recommend that entities eligible to opt out do not elect to do so.
How? First, all partnerships and LLCs, down to a two-person company, will be required to identify a “Partnership Representative” on the tax return each year. As reflected by the fact that the Partnership Representative is the only party that can cause the entity to opt out of the BBA, the Partnership Representative is the only authority permitted to act on behalf of the entity in any tax-related matter. If the entity doesn’t select one, the IRS will select it on their behalf, which is never a desirable alternative.
But opting out of the BBA is not as simple as just making an election. Only entities with certain types of partners or LLC members qualify for this opportunity. These include C or S corporation partners/members but exclude lower-tier partnerships and trusts.
Any new business considering a partnership or LLC as its preferred choice of entity must take into account who its owners will be or risk plunging blindly into the abyss of the new audit rules. This means that new agreements must account for the BBA and existing agreements must be amended – and soon! New businesses already face many challenges on the path to success. Opting out of the BBA is a prudent way to remove or ameliorate at least one of those challenges.
Phil Karter is a tax controversy lawyer and shareholder at Chamberlain Hrdlicka (Philadelphia) where he counsels clients ranging from Fortune 500 companies to small businesses, joint ventures, startups and individuals in tax-related matters.