As of January 1, 2018, new tax rules took effect for partnerships and limited liability companies.  These entities are widely used by businesses and professionals because the entities themselves do not pay income tax.  Until now, only the entity owners (partners and LLC members) have paid tax on the income that is passed through from the entity to the owners.  

Under the new tax rules, however, the entity itself will be liable for income tax if its income is incorrectly reported or incorrectly allocated among the owners. 

The new tax rules set out a series of requirements for partnerships and limited liability companies and a road map for escaping entity-level taxation.

First, each entity must appoint a “partnership representative” who will have the sole authority to act on behalf of the entity in dealing with the Internal Revenue Service, including agreeing to tax adjustments and making elections to avoid entity-level taxation.

Second, eligible partnerships and limited liability companies can elect out of the new tax rules (a so-called “opt-out election”).  This will eliminate the risk of entity-level taxation.  In order to qualify for this election, an entity must issue 100 or fewer Schedules K-1 to its owners, and all of the owners must be individuals, C or S Corporations, estates, and foreign entities that would be C Corporations under U.S. tax laws.  The opt-out election is not available if any owner is a partnership or LLC, trust, disregarded entity (such as a single-member LLC), or estate that is not the estate of a deceased owner.

Third, if the IRS proposes a tax adjustment that is payable by the partnership or LLC under the new rules, the entity may elect to push out the adjustment (a so-called “push-out election”) to the partners or LLC members who were the owners for the year under review, even if one or more of them is no longer an owner when the adjustment is determined.

The new rules will make it advisable for partnerships and LLCs to review their partnership agreements and operating agreements and consider several important points:

• How should the partnership representative be chosen, and how can the partnership representative be removed and replaced?
• Should the opt-out election be mandatory or discretionary?
• Should the push-out election be mandatory or discretionary?
• What obligations should partners and LLC members have to provide information to the partnership representative in connection with an IRS audit of the entity?
• What is the partnership representative’s liability to the entity and its owners, and to what extent should the entity and its owners indemnify the partnership representative?

Partnerships and limited liability companies should seek guidance on the application of these new tax rules.  For more information, please contact Robert L. Teicher (rteicher@brodywilk.com).