Your LLC tax classification affects how the IRS can audit and collect penalties
A new audit regime was introduced in the Bipartisan Budget Act (BBA) of 2015 relating to partnerships. Historically, partnerships or LLCs taxed as partnerships were audited by auditing the partnerships individually. Under the BBA, the IRS only audits the partnership itself and assesses penalties, interests, or adjustments to the partners within the year the audit was conducted.
However, a mechanism was included that allows for certain partnerships (or LLCs taxed as partnerships) to opt out of the new regime.
To Elect Out of the Audit Regime, the Partnership Must Meet the Following Elements:
Have 100 or less partners during the year; and
All partners must be “eligible partners” at all times during the tax year with “eligible partner” including any person who is an:
Eligible foreign entity
S Corporation, or
An estate of a deceased partner.
You must elect out on a timely filed partnership return for the tax year the election relates to. The entity must also notify each of its partners within 30 days of making the election and include:
Correct US taxpayer ID number, and
Federal tax classification of each partner and shareholder of partner that’s an S Corp.
Who Cannot Elect Out?
Disregarded entities (single member LLCs or grantor trusts) as well as partnerships with partnership as a partner cannot elect out. If you cannot elect out of the new regime, you must designate a partnership representative to assist in the audit process.
It is important to consult with your tax or financial advisor and legal counsel to determine the steps you should take in your individual circumstances. You should also take this into consideration when forming an LLC and electing its tax classification and whether you should have a disregarded entity. It depends on your unique circumstances.