Partnerships and LLCs Need to Revise Their Agreements to Address New Audit Procedures

In August 2018, the U.S. Department of the Treasury issued final Regulations concerning the qualifications, designation, authority, and resignation of the required Partnership Representative under the new Centralized Partnership Audit Regime.[1] The rules are effective for tax years beginning after December 31, 2017 and apply to all partnerships and LLCs taxed as partnerships, although certain partnerships and LLCs may elect out of the regime to continue to be audited under the former rules. The option to elect out of the regime is limited to partnerships having 100 or fewer partners with individuals or corporate partners only (any partnership or LLC with a trust or a disregarded entity as a partner/member cannot elect out). Partnerships and LLC’s taxed as partnerships both will be referred to in this letter as “partnerships.”

Under the new partnership audit regime, the IRS can make an audit change to a partnership’s tax return and assess the tax against the partnership instead of the partners. This could result in the partnership paying additional tax for a prior year adjustment even though there are different partners or different ownership interests in the current year than in the year that was audited. As discussed, partnerships need to amend their agreements to address this and other partnership audit issues.

In addition, the new regime replaces the former “Tax Matters Partner” with a “Partnership Representative” (“PR”), but provides much greater authority for the role of the PR. Importantly, the PR has the sole and binding authority over all matters of the partnership before the IRS in audits under the Bipartisan Budget Act of 2015 (BBA). The partnership must designate the PR each year on its filed tax return for all tax years beginning after 2017. For a calendar year Partnership/LLC this would be its 2018 tax return, so this issue needs prompt attention.

Authority of the Partnership Representative in Centralized Partnership Audit Regime

The PR has the “sole authority to act on behalf of” the partnership. Other than the PR or designated individual for a PR that is an entity, no partner or other person may participate in administrative proceedings without permission by the IRS.[2] However, the rules are not intended to prohibit partnerships from using state law to limit the authority of the PR. Therefore, partnerships and LLCs should review and amend agreements carefully to tailor the duties and authority of the PR.

Designation and Eligibility of the Partnership Representative

Every partnership must designate a PR for each separate taxable year. There may only be one designated PR for a partnership taxable year at any time, and the designation will remain in effect for that year until terminated by resignation, revocation, or a determination by the IRS that a designation is not in effect. If a partnership fails to designate a PR, then the IRS will designate one for the partnership.[3] When designating a PR for the partnership, the IRS may designate anyone except an IRS employee, unless the IRS employee is a partner in the partnership or was a partner in the partnership for the year under audit.[4]

The PR need not be a partner or member of the entity. Any person or entity who meets the requirements in the Regulations may serve as the PR, even the partnership itself. If an individual is designated as PR, the person must have a “substantial presence” in the United States, which exists if (1) the person makes itself available to meet in person with the IRS, and (2) the person has a United States taxpayer identification number, a street address located in the United States, and a telephone number with a United States area code. If an entity is designated as the PR, there must be a “designated individual” appointed to act for the partnership at the time of designation, and the individual must meet the substantial presence requirements for an individual PR.[5]

Resignation, Revocation, or Determination by the IRS that a Designation is Not in Effect

Resignation. A PR or designated individual of an entity PR may resign by notifying the partnership and the IRS in writing of the resignation, but may not appoint a successor PR or designated individual.

Revocation. The partnership may revoke a PR designation for a tax year for any reason by notifying the PR and the IRS in accordance with applicable forms and instructions, but the partnership must designate a successor PR. However, the flexibility for revoking a PR designation is limited where the PR has been designated by the IRS.

IRS Determination that a Designation is Not in Effect.  The has the authority to determine that a PR designation is not in effect in situations including: the IRS becoming aware that the PR or designated individual does not have a substantial presence in the U.S., the partnership failing to appoint a designated individual of an entity PR, the partnership failing to make a valid designation of a PR, and the PR or designated individual resigning. Until a termination, resignation, or revocation is in effect, the PR’s authority to bind the partnership remains unaffected.[6] Therefore, a partnership will want be sure that the particular requirements for a valid resignation are followed.

Push-Out Elections

Partnerships and LLCs may make a “push-out” election to transfer the liability for underpayments from the partnership itself to those who were partners during the year being audited. The economic effect of this election may be material in situations where the ownership of the partnership may change from year to year.

Amendments to Consider in Partnership and LLC Agreements

Partnerships and LLCs taxed as partnerships should consider amending agreements to account for how the new rules might affect the liability of partners in the audit year and the prior year, and due to the amount of power vested in the PR, should specifically address the obligations and limitations on the PR’s authority. Amendments to agreements will vary, but items that should be considered include:

  • The conditions for making the opt-out election (the election to opt out of the new regime) and push-out election (the election to cause audit adjustments to be allocated to those who were partners in the year under audit), and maintaining eligibility for making these elections;
  • Indemnification by former partners if partners become liable for any tax, penalties, or interest that effectively pertain to a former partner with respect to a prior year;
  • The manner and method of appointing and removing the PR;
  • The PR’s fiduciary duties to the other partners, if any;
  • The PR’s duties to notify and keep informed the partnership and the partners of any matters relating to its authority under the new rules;
  • Extending the PR’s duties beyond the year of designation until the statute of limitations for such year has run; and
  • Limiting the PR’s authority, such as by requiring cooperation with the partners prior to any settlement with the IRS.

This is not an exhaustive list, and new amendments will vary based on the needs of each partnership or LLC. Partnerships and LLCs should carefully review and amend their agreements to address the new audit procedures.

For more information, contact Coblentz Tax Partner Jeff Bernstein at jbernstein@coblentzlaw.com.

 

[1] See Treas. Reg. §§ 301.6223-1 and 301.6332-2.

[2] Treas. Reg. § 301.6223-2(d).

[3] Treas. Reg. § 301.6223-1(c) and (f).

[4] Treas. Reg. § 301.6223-1(f)(5).

[5] Treas. Reg. § 301.6223-1(b).

[6] Treas. Reg. § 301.6223-1(d) – (f).