How Recent U.S. Tax Laws May Adversely Impact Small Partnerships & LLCs

Regardless of whether you applaud or condemn the passage of the Tax Cuts & Jobs Act of 2017 (“TCJA”), there are changes to partnership audit procedures in the Bipartisan Budget Act of 2015 (“BBA”) that go into effect for tax years beginning after December 31, 2017 and could add additional compliance costs to certain taxpayers.
These changes can have a meaningful economic impact on taxpayers who are members of a partnership or limited liability company (“LLC”).

BBA Requires Special Audit Procedures for Large Partnerships

Under the BBA, partnerships with over 100 partners are required to abide by certain partnership audit procedures, such as:

  • selecting a partnership representative, who can bind the partnership under audit and
  •  taking tax adjustments pursuant to audit at the partnership level

among other things.

“Small” partnerships can elect out of this partnership audit regime, but therein lies the problem: what constitutes a “small partnership” or conversely, what doesn’t constitute a small partnership?

Eligible for the BBA’s Small Partnership Election?

If a partnership (or an LLC which is taxed as a partnership) has one partner that is an LLC or a partnership, such partnership cannot elect out of the BBA’s partnership audit procedures.  For example, if there are only two LLCs that form a partnership (or an LLC), such partnership (or LLC, assuming it elects to be taxed as a partnership) is not eligible to elect out of the BBA’s partnership audit procedures.

Therefore, such partnership, if audited, must assess any tax adjustments at the partnership level.  Imagine a scenario where “Good LLC” and “Bad LLC” form a partnership (or LLC). If the IRS audits the partnership and discovers that Bad LLC under-reported income, this under-reported income would be assessed at the partnership level such that Good LLC would receive less income due to Bad LLC’s under-reporting.  If there are penalties, those penalties will be assessed at the partnership level such that Good LLC would lose pass-through income due to Bad LLC’s conduct.

The bottom line is that legal counsel should be consulted whenever an LLC or Partnership is a prospective partner (or member of an LLC), regardless of the number of existing or prospective partners because adding such prospective partner could have an adverse impact on other partners’ interests.