Audits of Electing Large LLCs

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

This case study has been adapted from “PPC’s Guide to Limited Liability Companies,” 11th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II and Gregory A. Porcaro, published by Practitioners Publishing Company, Ft. Worth, TX, 2005 ((800) 323-8724; www.ppcthomson.com).

Special audit provisions apply to electing large partnerships or limited liability companies (LLCs). An electing large LLC is one with at least 100 members in any preceding tax year that elects to be subject to the electing large partnership rules. The election applies to the tax year in which made and all subsequent tax years, unless revoked with IRS consent. However, an LLC loses its status as an electing large LLC for any tax year in which it has fewer than 100 members..

Getting Started

Electing large LLCs can treat audit adjustments in one of two ways:

1. Generally, audit adjustments flow through to the members in the year in which the adjustment occurs, not the year to which the adjustments apply. Thus, current-year income, gain, loss or credit will be increased or decreased for any prior-year’s adjustment. If an adjustment spans several years, its net amount will be taken into account in the year the adjustment is made. Prior-years’ returns are adjusted only if there is an audit change to a member’s distributive share.

2. An LLC can elect to forgo a passthrough of the audit adjustment and, instead, make an imputed tax payment; in that case, no member reports any adjustment. The imputed tax paid by the LLC is computed by netting all income and loss adjustments, then applying the highest tax rate (whether corporate or individual) in existence at that time (presently, 35%).

If a large LLC elects to pay the imputed tax, the LLC, not the members, is subject to the interest thereon, as well as any penalties. Interest runs from the due date of the LLC return for the year to which the adjustment applies, to the earlier of the due date for the LLC return for the year in which the adjustment is made or the payment date. Treasury also has the right to set other conditions for making the election, which will generally be designed to ensure the LLC’s payment of the imputed tax. Any payment of such imputed tax, interest or penalty by an electing large LLC is nondeductible.

Example

High-N-Mighty LLC has 110 members. The IRS examines its 2004 return in 2007. As a result of the audit, the IRS proposed an adjustment to increase 2004 income by $100,000. In addition, the IRS determined the LLC had improperly expensed a $25,000 item in 2004 that should have been amortized over five years. The LLC does not elect to pay the imputed tax described in #2 above. The entire $100,000 adjustment to increase income is passed through to the members in 2007. Only the net adjustment of $10,000 ($25,000 − $5,000 of amortization for each of 2004–2006) for the improperly expensed item is reported; the amortization in the intervening years is treated as an offsetting adjustment.

Inconsistent Reporting

A member in an electing large LLC may not report any entity-level item inconsistently with the LLC return, even if the member notifies the Service of the inconsistent treatment. Any such inconsistent reporting is treated as a clerical error, permitting the IRS to immediately assess any tax deficiency against the member.

The Service determines the treatment of all LLC items at the entity level during the audit of an electing large LLC. The IRS is required to give notice only to the LLC, by certified mail. No member is entitled to notice; the members have no individual right to participate in the audit process or to file a Tax Court petition or other claim for readjustment.

SOL

For electing large LLCs, the statute of limitations (SOL) runs for three years from the later of the last day for filing the LLC’s return or the date such return was actually filed. There is no SOL if a fraudulent return was filed. A six-year statute is provided if more than 25% of the LLC’s income is omitted. As with other LLCs, the SOL can be extended with the consent of the entity’s representative.

An electing large LLC must designate a member or other person who has the sole authority to act on behalf of the entity under the electing large LLC audit procedures. The entity and all of its owners are bound by actions taken by the designated representative.

Practice Tip

The LLC operating agreement should contain an indemnification clause to protect the designated member from liability for good-faith decisions. This generally prevents angry members from suing over the decision to settle cases.