Your partnership, limited liability company (“LLC”) or s-corporation (“S-Corp”) could be subject to tax at the entity level after an IRS audit, even if your entity is not considered a c-corporation, beginning in 2018. That’s right, your partnership, LLC, or X-Corp could be taxed much more similarly to a c-corporation than a partnership if the IRS finds an underpayment in taxes after an audit. The simplest way to prevent your partnership, LLC or S-Corp from being liable for tax underpayments found after an IRS audit is if you can elect to be treated as a small partnership on your tax return. Keep in mind that this is something you need to elect when filing your tax return and not after an audit has already taken place or is in progress. Also note that there are specific requirements to being able to qualify for this election, including some that prevents many entities from being able to qualify for the small partnership election.
General Requirements and Process
Generally, a partnership, LLC or S-Corp can qualify for the small partnership election if it (1) makes the election in the taxable year on its tax return, (2) has 100 or fewer partners, members or shareholders and (3) only has partners, members or shareholders that are individuals, c-corporations, foreign entities that would be c-corporations if they were domestic, S-Corps, or estates of deceased partners, members or shareholders. Even if a partnership, LLC or S-Corp is eligible for the election, this election does not extend to the entities in which they own an ownership interest. Those entities will need to separately meet the same eligibility requirements to also exercise the election. All partners, members and shareholders will be bound by the election unless the IRS determines that the election was invalid. The IRS will notify the partnership, LLC or S-Corp in writing if the election is invalid.
The small partnership election must be made on a timely filed return for the taxable year. The election must be accompanied by a disclosure of information about each partner, member or shareholder of the partnership, LLC, or S-Corp, including the shareholders of any S-Corp that is a partner, member or shareholder itself. These disclosures include the name, taxpayer identification number and tax classification of each partner, member or shareholder and an affirmative statement that each respective partner, member or shareholder is an eligible partner (i.e. an individual, a c-corporation, a foreign entity that would be a c-corporation if it was domestic, an S-Corp or an estate of a deceased partner, member or shareholder), along with any other information required by the IRS. Finally, the partnership, LLC or S-Corp must also notify each partner, member or shareholder of the election within 30 days of making the election.
For purposes of calculating the 100 or fewer partners, members or shareholders, the IRS generally considers the number of statements that are required under Section 6031(b) of the Internal Revenue Code. In other words, the number is generally based on the number of partners, members or shareholders in the partnership, LLC, or S-Corp. Therefore, even if a partner, member or shareholder were to be issued 1 K-1 for their general interest and another K-1 for their limited interest, then only 1 K-1 would be deemed to have been issued for the purpose of meeting this requirement. Persons and entities who have limited authority to act on behalf of the partnership, LLC, or S-Corp are also counted, but these nominees are typically only involved in the initial formation of the entity before a responsible party (i.e. general partner, manager, principal officer or director) has been identified.
Some bad news is that if any partner, member or shareholder is an S-Corp, it’s not just the S-Corp that will be counted in determining the 100 partner/member/shareholder limit. First the S-Corp is counted. Then, the shareholders of that S-Corp are also counted. So, if a partnership, LLC, or S-Corp is required to issue a K-1 to an S-Corp, the S-Corp itself would count, and if the S-Corp is required to furnish 50 K-1s to its 50 shareholders, then these 50 count as well. Therefore, instead of the S-Corp counting as 1 partner, member or shareholder, it’s counted as if it were 51 partners, members or shareholders.
Also, husbands and wives will no longer be considered 1 partner, shareholder or member. Instead, for purposes of calculating the 100 partner/member/shareholder threshold, husbands and wives will generally be considered to be separate partners, members or shareholders. Fortunately, the 100 partner/member/shareholder threshold will not be negatively affected by states like Texas which are community property states. An ownership interest acquired by 1 spouse in a community property state does not require the furnishing of a K-1 under Section 6031(b) of the Internal Revenue Code to the other spouse by virtue of the community property interest in the partnership, LLC, or S-Corp, and therefore only the spouse who is actually a partner, member or shareholder would be counted for determining the 100 partner/member/shareholder threshold.
Finally, if a partner, member or shareholder dies during the taxable year or sells its ownership interest during the taxable year, then multiple partners, members or shareholder will be counted towards the 100 partner/member/shareholder limit. The partner, member or shareholder who died will be counted as 1 while the decedent’s estate will be counted as another because multiple K-1s will need to be furnished. Beneficiaries of a deceased partner’s estate need not be counted toward the 100 partner/member/shareholder threshold. Upon the sale of an ownership interest, the seller and the buyer of a partnership/LLC/S-Corp ownership interest are each allocated a K-1, meaning that they will be individually counted as 2 partners, members or shareholders.
The small partnership election is a great means of avoiding assessments and collections made at the entity level for partnerships, LLCs and S-Corps. However, it is not available to everyone and does not apply to many entities, such as entities with IRAs, LLCs and Trusts as partners, members and shareholders. Adequate legal guidance in this new regulatory landscape is crucial, and the professionals at Dodson Legal Group are happy to help. You can contact our office at 844-4DODSON for a consultation.