LLC members: beware 2018
New, tougher rules for IRS audits take effect Jan. 1
Last year, I wrote an article in this journal (“IRS troubles for partnerships?” Sept. 2-13 NH Business Review) and others introducing the draconian new congressional rules for IRS audits of multi-member LLCs taxable as partnerships. There are roughly 15,000 such LLCs in New Hampshire. All of them face a significant risk of IRS audit. The rules, passed as part of the Bipartisan Budget Act (BBA) of 2015, will become effective on Jan. 1, 2018. That day is fast approaching.
If you’re a member of any of these LLCs or if you’re a lawyer or accountant for any of them, here are seven key points you should know about the new rules. Some of these points are in my 2016 article, but most are new:
1. With one big exception and two little ones (discussed below), the new rules provide that if the IRS audits a multi-member LLC taxable as a partnership and asserts that it owes a tax, the tax will apply at a draconian 39.6 percent rate, and the LLC itself, not the members pro rata, must pay the tax.
2. The big exception is for multi-member LLCs that are “small partnerships.” An LLC is a “small partnership” if it has 100 or fewer members and if all of its members are either individuals, the estates of deceased individuals, C corporations or S corporations.
3. Many New Hampshire multi-member LLCs qualify as small partnerships. However, for probate avoidance, many of them have members that are revocable trusts; in order to obtain extra liability protection, the members of some of them hold their memberships through single-member LLCs; and some of them have multi-member LLCs as members. These LLCs cannot qualify as small partnerships, and thus will be subject to the new partnership audit rules, unless:
• If one or more individuals hold their LLC memberships through trusts, these individuals transfer their memberships from their trusts to themselves as individuals
• If one or more individuals hold their LLC membership through single-member LLCs, their single-member LLCs transfer their memberships to themselves as individuals
• If one or more multi-member LLCs hold LLC memberships, these LLCs transfer their memberships pro rata to their partners
4. The first of the two “little” exceptions to the BBA rules provides that if individual LLC members want to voluntarily pay their shares of a tax the IRS assesses against their LLC, they can do so at their individual federal tax rates (which might be much less than 39 percent). The second provides that the LLC can “push out” an IRS tax assessment to its members and make them pay the tax as individuals. In this case, too, the members’ individual tax rates will apply, and this rate, as noted, may be much less than 39 percent.
5. However, deciding whether to exploit the two “little” exceptions can be complicated, and the decision will vary greatly from one LLC to another.
6. Whether your LLC is or isn’t a small partnership, its operating agreement needs to contain BBA partnership audit provisions tailored to its needs. Drafting these provisions can be tricky.
7. Finally, and most importantly: The best way to avoid a BBA audit is to be conservative in your LLC’s federal tax return. In fact, the main reason Congress enacted the BBA rules was to encourage this conservatism.
Attorney John Cunningham, of counsel to the law firm of McLane Middleton, can be reached at 603-856-7172 or firstname.lastname@example.org.