IRS partnership audits: why the LLC pays for the partners' tax

Here's a scenario we see often. Three people own an Oklahoma company through a multi-member LLC taxed as a partnership. One of them sold out two years ago. Then an IRS letter arrives addressed not to any of them, but to the company. Under the current partnership audit rules, that letter can end with the LLC itself writing the check for tax on income the partners already reported, computed at the highest rate in the Code, and paid by whoever owns the company now.

That outcome surprises owners and CPAs alike. So let's walk through the question the way it usually reaches us.

What if the IRS audits our multi-member LLC?

Start with what changed. For partnership tax years beginning in January 2018 and later, the IRS examines partnerships under what it calls the centralized partnership audit regime, often shortened to BBA after the Bipartisan Budget Act that created it. It replaced the older TEFRA procedures that most practitioners grew up with.

The core rule is short. Any adjustment to a partnership-related item is determined at the partnership level. Any tax attributable to that adjustment is assessed and collected at the partnership level. Penalties are determined there too.

In plain terms: the IRS no longer chases each partner for their share of an audit adjustment. It computes one number, called the imputed underpayment, and the partnership owes it. The IRS describes it exactly that way: it generally assesses and collects any understatement of tax at the partnership level.

For an Oklahoma closely held company, this matters more than it sounds. Most of the operating businesses, real estate ventures, and professional groups we work with are multi-member LLCs that file a partnership return. Every one of them is inside this regime unless it affirmatively elects out.

Who speaks for the company during a partnership audit?

Each year on its return, the partnership designates a partnership representative. This is the person, or entity, the IRS deals with during the examination. The old regime had a tax matters partner and gave individual partners a right to participate in the examination. The new one doesn't.

The IRS's own comparison puts it bluntly. Under TEFRA, partners could participate in the examination and challenge partnership adjustments. Under BBA, partners have no participation right to challenge a partnership adjustment.

In practice the representative receives the notices, requests or declines Appeals, decides whether to seek modification, and makes the push-out election we'll get to below. Those elections bind the partnership. Members who never see the notice are bound just the same.

The practitioner's edge on this one

Federal law gives partners no notice rights. None. If you want to be told that your LLC is under examination, to be consulted before a settlement, or to have a say in whether the company pays or pushes out, the only place you get those rights is the operating agreement. Federal tax law won't supply them, and the IRS has no obligation to copy you.

That's why we treat the partnership representative clause as governance, not boilerplate. A well-drafted operating agreement addresses who serves as representative and how they're removed, a duty to inform the members when an examination begins, member consent before the representative settles or makes an election, how audit costs and any imputed underpayment are allocated between current and former owners, and an indemnity from departed members for their share of a reviewed year. We've written before about why the operating agreement carries more weight than the articles, and this is one of the clearest examples.

How is the number computed?

This is where the regime bites. The IRS sorts the adjustments into groupings. Reallocation adjustments move a partnership-related item from one partner to another. Residual adjustments are everything that doesn't fit the other categories. Credit and creditable-expenditure adjustments get their own treatment.

Within those groupings, positive and negative adjustments are netted only inside the same subgrouping. A negative adjustment in one bucket doesn't offset a positive adjustment in another. The net positive adjustments are then multiplied by the highest tax rate in effect under Section 1 or Section 11 for the reviewed year. The IRS example on its own page uses the top individual rate for 2023, but the point is the mechanism, not the figure: it's the top rate, regardless of what bracket any actual partner was in.

Think of it as the IRS charging retail to everyone in the room. A partner who sat in a low bracket or had losses to absorb the income gets no credit for it in the default computation.

Adjustments that don't produce an imputed underpayment aren't ignored. They're pushed out to the partners regardless of what the partnership elects.

The honest government-side view

Consider why Congress built it this way. Under the old rules, collecting an adjustment meant pursuing the partners individually, and for large or tiered partnerships that was widely understood to be hard to administer. Collecting one number from one entity is administrable. The top-rate default isn't a penalty; it's a ceiling the partnership can lower by doing the work to show what the partners would have paid. The burden of proving the lower number sits with the partnership, which is where the information lives.

The IRS isn't the adversary here; it's a process-driven counterparty following a statute. The company's job is to know the process as well as the examiner does.

What does the audit actually look like?

On its partnership audit process page the IRS lays out the sequence, and the letters matter because the clocks run from them.

1. Letter 2205-D. The examination notice, mailed to the partnership. The partnership is asked to call the listed contact by a stated date to schedule the initial appointment.
2. Notice of Administrative Proceeding (NAP). Letters 5893 and 5893-A, issued roughly 30 days after the 2205-D, to the partnership and the representative. Once the NAP issues, the partnership may no longer file an administrative adjustment request for that year. If there's a known error you'd rather fix yourself, the window to do so closes here.
3. Summary report. Issued to the representative once the examination is developed, with preliminary results and the imputed underpayment computation.
4. Appeals. The representative may request an Appeals conference if at least 18 months remain on the assessment period under Section 6235. If less time remains, the IRS may ask for an extension. We've described how the Appeals protest works for a smaller business; the partnership version runs on the same office with different paperwork.
5. Notice of Proposed Partnership Adjustment (NOPPA). Letters 5892 and 5892-A. This starts a 270-day window to request modification of the imputed underpayment on Form 8980. The window cannot be extended, and a representative who lets it pass forfeits the right to modify.
6. Final Partnership Adjustment (FPA). Letters 5933 and 5933-A. The date of the FPA starts two clocks at once: 45 days to make the push-out election, and 90 days to petition a court.

Modification: lowering the number the company owes

Modification is the partnership's opportunity to replace the top-rate default with something closer to reality. The request goes in on Form 8980 within the 270 days after the NOPPA.

The idea is consistent: the partnership shows the IRS facts about its partners that justify a lower imputed underpayment. Done late, it can't be done at all. And modification still leaves the partnership paying, which is why the second tool exists.

Push-out: sending the adjustment back to the people who earned the income

Section 6226 lets the partnership elect, not later than 45 days after the date of the FPA, to push the adjustments out to the partners who held interests in the reviewed year. The partnership furnishes each of those partners a statement of their share of the adjustments. Once that's properly done, the entity-level payment rule in Section 6225 doesn't apply, and no assessment, levy, or collection proceeding for the underpayment may be brought against the partnership.

The reviewed-year partners then account for their share on their own returns, in the year the statement is furnished. Penalties are determined at the partner level. So is interest, and here's the trade-off: interest under a push-out runs at the underpayment rate with five percentage points substituted for the usual three. In other words, two points higher than ordinary underpayment interest.

After the election, the IRS process page describes the follow-through. Within 60 days of the adjustments becoming final, the partnership furnishes Form 8986 to each reviewed-year partner and files Form 8985 with the IRS. Individual and corporate partners report the result on Form 8978. A partner that is itself a pass-through entity carries it further down the chain on its own Forms 8985 and 8986. That 60-day period, like the 45-day election, cannot be extended.

Why the 45 days is the one we watch

Of all the deadlines in this process, the push-out clock is the shortest, it can't be extended, and it runs from the date on the FPA, not from the day someone at the company opens the envelope. A representative who's traveling, or who has left the company, or who simply doesn't understand what the letter means, can cost the current owners the ability to shift the liability back to the people who earned the income. Partners who were bought out years ago have every incentive to hope nobody notices.

Who really pays: the year-of-audit problem

This is the part that makes the issue bigger than it looks. When the partnership pays the imputed underpayment, the cash comes out of the company in the year the audit concludes. The people bearing that cost are the partners in that year. The income being taxed belonged to the partners in the reviewed year. When ownership has changed in between, those are different people.

A buyer of an LLC interest, in other words, inherits the seller's audit unless the company pushes out or the purchase documents deal with it. Someone who joined last year can end up funding tax on income distributed to a departed member years earlier.

Push-out solves the mismatch by design. Modification doesn't. An operating agreement that's silent on the question leaves the representative free to choose whichever option is easiest for the representative, which may or may not be the option that's fair to the members. We've seen agreements that handle buy-outs carefully and say nothing at all about who bears a later audit, and the two subjects are inseparable.

Can we just elect out?

Sometimes. Section 6221(b) lets a partnership opt out of the regime for a year if it meets every condition. It must furnish 100 or fewer Schedule K-1 statements for the year. Every partner must be an individual, a C corporation, a foreign entity that would be treated as a C corporation if it were domestic, an S corporation, or the estate of a deceased partner. The election is made with a timely filed return for that year, discloses each partner's name and taxpayer identification number, and the partnership must notify each partner that it has elected out.

On the form, this means answering yes to the election-out question on Schedule B of Form 1065 and attaching Schedule B-2 listing each eligible partner's name, TIN, and type. If an S corporation is a partner, the partnership also lists that S corporation's shareholders, and those shareholders count toward the 100-statement limit.

The disqualifiers are where most Oklahoma companies stumble. A partnership cannot elect out if it must issue a K-1 to another partnership, a trust, a foreign entity not taxed as a C corporation, a disregarded entity, an estate of anyone other than a deceased partner, or a nominee holding for someone else. One member who owns through a single-member LLC, one interest held in a revocable trust for estate-planning reasons, one holding-company structure, and the election is off the table for that year.

Two further points. An election is annual, so it's a filing-season discipline rather than a one-time fix. And the IRS treats all elections out as valid unless it determines otherwise, in which case it notifies the partnership in writing. That's helpful, but it also means a defective election may not be discovered until the audit that the election was supposed to avoid.

Electing out isn't automatically the right answer either. It returns the partnership to partner-by-partner examination. For a company with a few active members it's often the better posture; for one with many passive investors it may not be, and the trust and disregarded-entity rules frequently decide the question before anyone gets to weigh it.

What about Oklahoma?

Everything above is federal. A federal partnership adjustment can also carry state reporting consequences, and the way a state expects partnerships and partners to report federal changes varies and can change. We're deliberately not summarizing Oklahoma's specifics here; the safe statement is that state follow-up obligations may exist after a federal partnership audit closes, and that's a question to put to counsel or your CPA at the time rather than assume away.

Where Oklahoma matters most is on the front end. The multi-member LLC is the default vehicle for closely held companies in this state, and a large share of them were formed on operating agreements that predate 2018 or were never updated for it. In our experience, many still name a tax matters partner, a role that no longer exists in this regime. Some name a representative but give the members no information rights and no consent rights. A surprising number say nothing about who bears an audit cost when ownership has changed.

Fixing that is a drafting exercise, and a modest one, when it's done before a Letter 2205-D exists. It's a negotiation among people with opposing interests after.

Where the operating agreement earns its keep

Our rough rule: when a partnership notice arrives, or when an interest changes hands in a company that files a partnership return. In either case, the cost of getting the representative clause and the election calendar right is small next to the cost of an imputed underpayment landing on the wrong owners at the top rate.

If your Oklahoma LLC has received an examination notice, or you're revisiting an operating agreement and the partnership-audit provisions are thin, we're glad to talk it through. You can reach our Oklahoma City office through the contact page on this site. A conversation before the clocks start is almost always cheaper than one after.

This article is general information about Oklahoma, Texas, and federal law, not legal advice, and it does not create an attorney-client relationship. Facts matter; talk to a lawyer about yours.