United States: New Audit Rules Require Changes To Partnership and LLC Operating Agreements

William B. Sherman is a Partner and Daniel L. Janovitz is an Associate in our Ft Lauderdale office.


  • The Bipartisan Budget Act of 2015 includes a complete overhaul of the procedures that apply to IRS audits of partnerships, including limited liability companies (LLCs) taxed as partnerships and their partners.
  • Many issues will remain unresolved until the issuance of regulations by the U.S. Treasury Department; however, the Act will have a significant impact on entities operating in partnership or LLC form. These entities should anticipate potential issues and proactively address these issues in their partnership and LLC operating agreements.
  • Although the new rules generally apply to IRS audits of partnership returns for 2018 and subsequent taxable years, partnerships may affirmatively elect to have the new regime apply for the 2015 through 2017 taxable years. 

The Bipartisan Budget Act of 2015 (P.L. 114-74) includes a complete overhaul of the procedures that apply to Internal Revenue Service (IRS) audits of partnerships, including limited liability companies (LLCs) taxed as partnerships and their partners. The Act also repeals the Tax Equity and Fiscal Responsibility Act (TEFRA) audit rules that have been in place since 1982 and the reporting and audit procedures for electing large partnerships in effect since 1998. Unfortunately, while there is substantial uncertainty about how the new procedures will be implemented, it is clear that the Act will have a significant impact on entities operating in partnership or LLC form. These entities are therefore advised to anticipate issues and address them proactively for transactions currently being negotiated. In addition, amendments to existing transaction documents and governing instruments will be necessary in many instances.

The Act, signed into law on Nov. 2, 2015, makes the following major changes to the partnership audit process:

  • The "tax matters partner" (TMP) is replaced with the "partnership representative."
  • Liability is imposed at the partnership level rather than at the partner level for partnership audit adjustments.
  • Liability is imposed in the year of an adjustment rather than the tax year to which an adjustment relates.

The Act gives the IRS broad authority to issue regulations to implement the new law. Thus, many questions raised by the Act will have no clear answers until these regulations are issued. This alert addresses some of the initial questions raised by the Act and makes recommendations for amending existing partnership agreements and LLC operating agreements.

New Partnership Audit Rules

Partner Representative Replaces TMP. The TMP has been eliminated and replaced with the new concept of a partnership representative. Unlike the TMP under current law, the partnership representative need not be a partner, but must have a substantial presence in the United States. The partnership representative will have sole authority to act on behalf of the partnership in connection with an audit. If the partnership fails to name a representative, the IRS may designate one. Under prior law, any partner generally had the right to participate in a partnership audit; under the new regime, it appears that only the single partnership representative will be permitted to participate. The partnership and all of its partners will be bound by actions taken by the partnership representative in the audit process. As a result, partners will want to consider carefully who will retain the right to designate the partnership representative.

Partnership-Level Taxation. Under the Act, the partnership will be liable for any additional tax imposed as a result of a partnership audit adjustment. The entity-level taxation of partnerships represents a significant divergence from established tax principles. The partnership-level tax on the audit adjustment (termed the "imputed underpayment amount" under the Act) is determined without the benefit of partner-level tax attributes that otherwise could reduce the tax due on any adjustments. For example, it appears that the net operating losses of a partner cannot be used to offset any additional partnership income. Likewise, income that would be allocated under a partnership or LLC operating agreement to a tax-exempt partner may now be subject to taxation at the partnership-level. The adjustment generally is calculated assuming the highest rate of tax in effect for the reviewed year. Additionally, no deduction is allowed for the tax, interest or penalties paid by the partnership. The IRS is directed by the Act to promulgate regulations to establish procedures under which the imputed underpayment amount may be adjusted to reflect the realities of the partners' tax positions, such as excluding the amount allocable to a tax-exempt partner or using a reduced tax rate for capital gains or qualified dividends allocable to an individual partner.

Adjustment Year. Under the new rules, the partnership takes into account audit adjustments in the taxable year in which the audit (or any judicial review) is completed—referred to as the "adjustment year." All partnership and partner adjustments related to the audit are made in the adjustment year (with an enhanced interest rate applied). This represents a significant departure from the treatment of adjustments under the current TEFRA regime. As a result, the new rules could shift the cost of an assessment of tax due to persons that are partners in the adjustment year, rather than a simple flow-through of adjustments to the partners who benefitted from the underpayment in earlier years. For partners seeking to exit a partnership, this may provide added comfort because subsequent audits would not impact the investor. For parties joining an existing partnership, this may require consideration of additional indemnification provisions for new partners.

Opt-Out for Small Partnerships. The new rules include an "opt-out" election for partnerships with 100 or fewer partners (small partnerships) to elect not to apply the new partnership audit rules. In determining whether a partnership meets the 100 or fewer shareholders requirement, each shareholder of an S corporation that is a partner in the partnership is treated as a separate partner. More importantly, an opt-out election is not available to partnerships if another partnership is a partner (tiered partnerships), unless the IRS issues future guidance extending the election under such circumstances (a possibility that is expressly contemplated in the Act). It appears at least reasonably likely that future IRS regulations will allow a small partnership that has a partner that is itself a small partnership to opt out. However, as the law stands now, in a typical tiered partnership fund structure, the election to opt out is not available for lower-tier partnerships. Where a decision to opt out is available, the partnership must make an affirmative election annually on a timely filed return and include appropriate information to help the IRS identify the partners, including each partner's name and Taxpayer Identification Number. Thus, currently negotiated transaction documents should include provisions that require or allow the annual election to be made if it is available. With the repeal of the TEFRA audit rules starting in 2018, if a partnership opts-out of the new regime, the partners will be audited under the pre-TEFRA rules. In other words, there would be no unified partnership proceedings and all adjustments and litigation would occur at the partner level.

Deciding Whether to Opt-Out. While the decision on whether or not a partnership should opt-out will depend heavily on future IRS regulations, there are some potential benefits to the new regime. For example, under the new rules, if the IRS makes an audit adjustment, the partnership itself generally will be liable for the tax due. The Act is silent as to whether the partners are liable for an audit adjustment if the partnership still exists, but is unable to meet its obligation (due to the partnership's bankruptcy or insolvency). A legislative summary of the Act appears to indicate that partners would not be liable if the partnership is unable to make the payment. While this should be carefully monitored, it is difficult to imagine that this result was intended or will survive IRS clarifying regulations. Similarly, the new rules appear to provide that the statute of limitations for assessment by the IRS generally is three years from the later of the following: (1) the due date of the return without regard to extensions, (2) the filing of the partnership's tax return and (3) the filing of an administrative adjustment request. Under prior law, the IRS applied the statute of limitations based on the last to expire of the partnership's or each partner's statute of limitations. For many partners, the new regime would be a welcome change in this regard, as tolling agreements result in a considerably longer statute of limitations period.

Electing Out of Partnership-Level Taxation. The Act provides for two ways in which the partnership can elect to push down the audit adjustments to prior year partners. These exceptions differ from the opt-out available for small partnerships discussed above. First, the partnership may elect to push down the items of adjustment to all prior year partners. The election must be made within 45 days of the final notice of adjustment, and the partnership must furnish to each prior year partner and to the IRS a statement of each partner's distributive share of each item of adjustment. The prior year partners are then responsible for paying tax on their share of the adjustment, plus interest at a slightly enhanced rate. The ability to compel or forbid this election is likely to be a focus for many partners, although the importance of this issue will be driven by the regulations to be promulgated. Second, if a partnership cannot meet the requirements or does not wish to elect out under the rule mentioned above, the partnership may reduce its liability for an adjustment if it complies with certain adjusted information return procedures, which the Act directs the U.S. Treasury Department to establish through regulations. More specifically, if within 270 days of the partnership's receipt of the notice of proposed adjustment, (1) the partnership issues new Form K-1s to its partners, (2) the partners file amended tax returns to take into account the adjusted Form K-1s and (3) the partners pay the tax liability, the partnership may compute the amount of tax it owes without regard to the income taken into account by the partners. If an adjustment occurs as a result of a reallocation of the partners' distributive share of income, all partners affected by the adjustment must file amended returns in order for the partnership to reduce its liability. The partnership still will be liable for the tax on any adjustment that is not pushed down to the prior year partners.

Effective Date. The new rules generally apply to IRS audits of partnership returns for 2018 and subsequent taxable years. However, partnerships may affirmatively elect to have the new regime apply for the 2015 through 2017 taxable years. For existing partnerships, it is advisable to review whether the current TMP is required to seek consent prior to making such an election. It also is noteworthy that the TMP provisions in the Code were repealed by the Act. Existing partnership or LLC operating agreements will need to be amended to reflect the elimination of the TMP concept. Additional restrictions on general partner or manager authority related to the new regime also may be addressed via amendments to existing partnership and LLC operating agreements. For deals closing in the near future, we advise that these issues be addressed in some reasonable fashion, taking into consideration the absence of IRS regulations.

Issues that Partnerships Need to Address

There are a number of key issues to monitor, consider and discuss with your partners/members. In addition to those noted above, consider the following key issues:

1. Existing partnership and LLC operating agreements should be reviewed, and amendments will need to be drafted to address aspects of the new rules, including:

  • designating the partnership representative in place of the TMP
  • determining the partner(s) that will control the decision to opt out of the new regime
  • preventing assignments of partner interests to persons that would preclude the ability to opt-out
  • addressing the payment of entity-level tax
  • committing to making certain elections in the event of an audit adjustment
  • addressing circumstances where partners agree to "adjusted information returns" in lieu of entity-level tax

2. Negotiations will be necessary to determine the appropriate partnership representative and the contractual limitations on the authority of such representative.

3. In secondary market transactions, parties acquiring partnership interests will need to consider their potential share of the partnership's liability with respect to prior tax years if the partnership has not elected out of the new regime. Parties may want to include certain protection provisions to address this issue in the entity's governing documents or in agreements governing the transfer.

4. Many technical tax issues arise from subjecting partnerships to tax that will need to be considered. For example, provisions governing the allocation of the tax paid by the partnership will be necessary where the tax profiles of the partners differ. Many partnership agreements and LLC operating agreements allocate items based on the partners' percentage interest in the partnership; however, some partners, such as tax-exempt entities, may not find this allocation scheme appropriate. In such a situation, the partners would likely prefer to allocate the tax expense based on the relative amounts for which the partners would be liable if assessment was made at the partner level rather than at the partnership level. However, this will significantly increase administrative and bookkeeping costs, and the partners will have to balance the added burden of this allocation scheme against the benefits from the more economically accurate allocation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
Ostrow Reisin Berk & Abrams
Ropes & Gray LLP
Dickinson Wright PLLC
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Ostrow Reisin Berk & Abrams
Ropes & Gray LLP
Dickinson Wright PLLC
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions