Tax treatment is one of the key factors a business owner must consider when choosing a business form. Business partnerships can exist in several multiple forms, differing mainly in the extent of liability protection offered to the owners. As a general rule, partnerships are not directly subject to federal income tax. Individual partners are instead liable for tax on a pro rata share of partnership income, commonly known as “pass-through taxation.” 26 U.S.C. § 701. Congress passed the Bipartisan Budget Act (BBA) of 2015, Pub. L. 114-74 (Nov. 2, 2015), 129 Stat. 584, which amends the rules for partnership tax audits and could make partnerships themselves subject to income tax. The new rules do not go into effect until 2018.
A general partnership consists of any two or more people engaged in business together. It does not offer its owners, known as partners, any protection against personal liability for business debts. State laws allow the formation of partnerships that offer liability protection, including limited liability partnerships and limited partnerships. See, e.g. N.J. Rev. Stat. §§ 42:1A-47, 42:2A-1 et seq. The business form known as the limited liability company, see N.J. Rev. Stat. § 42:2C-1 et seq., is normally subject to pass-through taxation like a partnership, but it gives owners the option to elect taxation as a corporation. 26 C.F.R. § 301.7701-3(a).
The current rules regarding partnership tax audits originated with the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982, Pub. L. 97-248 (Sep. 3, 1982), 96 Stat. 324. TEFRA created a process for partnership-level audits, instead of audits of each individual partner. Partnerships that are subject to these audit rules are known as TEFRA partnerships. A “small partnership exception” applies to many partnerships with 10 or fewer partners. 26 U.S.C. § 6231(a)(1)(B). Partnerships with 100 or more partners may make a “large partnership election,” which allows for different procedures. 26 U.S.C. §§ 771 et seq., 6240 et seq.
The BBA eliminates many of the provisions established by TEFRA, including the entire subchapter regarding partnership audits, currently codified as Subchapter C of Chapter 63, 26 U.S.C. § 6221 et seq. This includes the sections that define the “small partnership exception” and “large partnership election” discussed above.
Instead of a three-tiered system for small, regular, and large partnerships, one general system will apply. A partnership with 100 or fewer partners may opt out of the new rules by indicating their intent to do so on their annual tax return. They may also opt out of partnership-level taxation by electing, within 45 days of a final audit adjustment, to have the tax liability fall on whomever was a partner at the time the tax was incurred, rather than at the time of the audit.
Under the new audit rules, partnerships must designate a “partnership representative,” who does not need to be a partner, to represent the partnership in audit proceedings. This representative must be a person—which may include a business entity—”with a substantial presence in the United States.” 26 U.S.C. § 6223, as amended by Pub. L. 114-74 § 1101(c)(1), 129 Stat. 627.
Samuel C. Berger, a New York and New Jersey tax law attorney, represents businesses, business owners, and entrepreneurs in the greater New York City area. We offer fixed-fee packages of legal services covering a wide range of client needs. Contact us online, at (201) 587-1500, or at (212) 380-8117 today to schedule a confidential consultation with a knowledgeable and skilled business advocate.
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How New York and New Jersey Startups and Small Businesses Could Benefit from Section 83(b) Elections, New York & New Jersey Business Lawyer Blog, March 17, 2016
New Tax Law Improves Conditions for C Corporations that Convert to S Corporations, New York & New Jersey Business Lawyer Blog, February 18, 2016
New Federal Budget Law Includes Major Changes in Partnership Taxation, New York & New Jersey Business Lawyer Blog, December 3, 2015