New audit rules put into place by the Internal Revenue Service (the “IRS”) at the beginning of this year will have an impact on tax partnerships which may have significant ramifications for some dealers. Historically, many dealers put their dealership and real estate assets into entities that are taxed as “pass through” entities for tax purposes. The S corporation was the preferred form for the dealership entity, and limited partnerships were used for holding real estate. More recently, the limited liability company has come into its own as an entity for holding both real estate and dealership operations. For tax purposes, limited partnerships are taxed as partnerships, and most multiple-member limited liability companies are as well.

Under the prior partnership tax rules, if the Internal Revenue Service audited a tax partnership and found a deficiency, they would have to assess the deficiency against each partner individually for their share. Under the new rules, the IRS may assess and collect any tax obligation owed as a result of an audit at the partnership level, regardless of the relative ownership of the partners. In stark contrast to the previous tax regime, the IRS will no longer have to chase after all of the partners.

For entities that have a single owner, or whose ownership has remained unchanged between the tax year being audited and the date of the audit, this rule does not represent a significant change in any partner’s tax liability. Where an entity undergoes a change in ownership, however, the current owners will end up paying, through the partnership, the tax liability of the former partners. Even where a partner has not left the partnership, where there has been a change in the ownership percentages of the partners, some partners will effectively be paying for tax liabilities that should have been paid by other partners.

For tax partnerships that were formed before the change in the law, the language in their existing governing documents is unlikely to address the new rules. Most tax partnerships are eligible to opt out of this treatment, but the governing documents for the tax partnership need to be clear on how the determination to opt out is made. The election to opt out is an annual election that has to be made as part of filing the tax partnership’s tax return, and the governing documents for the entity will have to be amended to provide for this election to be made. Additionally, the new rules replace the previous concept of “Tax Matters Partner” with a new “Partnership Representative” who will represent the tax partnership in all aspects of an IRS audit.

The new rules give this Partnership Representative broad powers to act unilaterally on behalf of the tax partnership under the audit rules. This broad authority can be modified by the entity’s governing documents, for example, to provide that the Partnership Representative must obtain the consent of a certain percentage of the owners before agreeing to extend the statute of limitations, or agreeing to a settlement with IRS. The governing documents should also address the selection and removal of the Partnership Representative. If a Partnership Representative is not appointed by the tax partnership, the IRS has the authority to appoint someone of its choosing to act in that capacity.

The new audit rules introduced substantial complexity in an attempt to provide flexibility to tax partnerships in dealing with partnership level tax assessments. The Partnership Representative, who is charged in dealing with the IRS throughout the audit process, may need certain information from the owners in order to determine which alternative is best for the partnership and its owners in dealing with an assessment of additional tax. The Partnership Representative will also need the ability to require the owners to take certain actions, such as filing amended returns or paying their portion of the tax assessment directly to the IRS. Where a partner does not comply, the operative documents must also provide for an appropriate remedy for the other partners.

Because the Partnership Representative will have broad authority to act on behalf of the partnership, the question of indemnifying that person becomes important. Where the decisions made by the Partnership Representative affect each owner differently, there is the possibility for disgruntled owners to make a claim against the Partnership Representative. The concern of personal liability of the Partnership Representative should be evaluated on a case by case basis; however, like with Tax Matters Partners under the old rules, indemnification of the Partnership Representative is likely appropriate, so long as they carry out their duties in good faith and within the terms of the governing document.

Additional issues arise when there is a transfer of ownership in the partnership. Where an owner has exited a partnership or there has been change in percentage ownership, the agreement must address the issue of what happens if there is an audit of a pre-sale or pre-transfer tax year. Changes in tax liability for tax years before the transfer may assess additional liability to someone who is no longer an owner. That liability may fall on new owners who did not gain any benefit from those tax years, without some requirement that the prior owner pay his or her share for tax years during which they were partners. Any sale or transfer document of an interest in a tax partnership must now contain provisions addressing this possibility.

Dealers owning their dealership or real estate through an entity taxed as a partnership should review their partnership or limited liability company agreements to make certain that they adequately deal with these new rules.