Effective January 1, 2018, the IRS changed its rule from requiring entities taxed as a partnership to designate a “Tax Matters Partner” to requiring a “Partnership Representative”. The change is more significant than nomenclature. The change is important because it endues significantly more authority to the Partnership Representative to bind the entity than previously endued to the Tax Matters Partner.
In recent times, the limited liability company (“LLC”) has become by far the most popular entity choice for business owners. The LLC provides business owners (owners of LLCs are referred to as members) with the best of both entity worlds, the liability protection offered by corporations and the pass-through taxation of general partnerships. The term “LLC” is not a tax classification recognized by the IRS[1]. Therefore, each LLC must make a choice for how the LLC will be taxed, and the available options vary depending on the number of members in the LLC. For single member LLCs, the default classification for tax purposes is to be a disregarded entity with the default classification for multiple member LLCs to be taxed as a partnership. That means that a significant portion of entities created in recent times are taxed as partnerships.
A large portion of LLCs are taxed as a partnership not only because it is the default option for multiple member LLCs, but also because partnership tax is preferred by many business owners due to the flexibility found in the partnership tax portion of the Internal Revenue Code (“Code”). This is especially true for entities owning real estate and even more true when funds are being borrowed in connection with said real estate. Sophisticated business owners realize that while the partnership portion of the Code offers flexibility, it is also uber complex. Therefore, business owners will usually consult their tax professional before certain business transactions to navigate the complex tax planning.
However, business owners regularly face other issues requiring deliberation or forethought, like a significant change in tax laws. Some tax law changes are accompanied by enough noise, such as the recent Tax Cuts and Jobs Act (“TCJA”), that tax professionals diligently review the impact of such changes with each client. However, some such changes are very significant but subtle and not widely publicized. These types of changes can easily occur outside of the realm of knowledge of the business owner. Unfortunately, with deadlines and pressures surrounding the tax profession, these significant but quiet changes may or may not be discussed by tax professionals with each of their clients.
One such impactful yet mostly quiet change amongst laymen to the laws of partnership tax occurred with the enactment of the Bipartisan Budget Act of 2015 (“BPA”). The BPA went into effect as of December 31, 2017, and it overhauled the way in which the Internal Revenue Service (“IRS”) performs audits on all entities taxed as a partnership. In summary, the IRS’s tax assessment is now assessed at the partnership level unless an alternative procedure election or opt out is made by the partnership. The IRS now collects and assesses tax from partnerships directly from the partnership, rather than the partners, and adjustments are not passed through to partners (for clarity, the term “partner” will here be equated with “member” and the term “partnership” equated with “LLC”). However, the overhaul of the IRS partnership audit regime is not the focus of this article. Instead, the topic of this article is the move away from the previous Tax Matters Partner (“TMP”) under the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”, the old tax law governing the IRS audit of partnerships) to the Partnership Representative (“PR”) under the BPA.
The TMP’s Duties (pre-December 2017)
Under TEFRA the TMP acted as the official representative of the partnership in all IRS matters, and the TMP had to be a partner of the partnership. The TMP’s duties included providing notice of an audit to partners, negotiating settlement agreements, extending the statute of limitations for the partnership and the partners, and determining the forum for judicial review. The TMP was also responsible for conducting the audit in an efficient manner, as well as providing the partners with current information on the proceedings so they can decide whether to participate. Partners were notified and informed about audits and judicial proceedings, had rights to participate, and rights to contest results.
The PR’s Duties (post-December 2017)
The BPA replaced the TMP with the PR, and the requirements and duties of the PR differ greatly from those of the TMP. The requirements of a PR were changed so that now, the PR can be any person or entity and no longer must be a partner of the partnership. The PR simply must have a substantial presence in the U.S. For entities appointed as PR, a designated individual must be appointed. The duties for the PR were also changed. The PR no longer has a duty to keep partners informed. Further, no partner may participate in an administrative proceeding without the permission of the IRS. Most importantly, the PR now has the sole authority to act on behalf of the partnership and its partners and can bind the partnership “for all purposes.” This means that a settlement agreement could be entered into by the PR on behalf of the partnership, a notice of final partnership adjustment (“FPA”) could be issued if it is not contested by the partnership or PR, and a final decision of a court with respect to the partnership if the FPA is contested, would bind all partners. Additionally, the PR can make elections, sign tax returns, and agree to IRS audit adjustments, and the partnership (and its partners) is bound by these decisions.
Limitations on Entity-Governing Instruments
Clearly, the PR has been granted significantly more power than the TMP had been granted. However, there would appear to be a simple solution to this issue. Operating Agreements are the governing instrument for LLCs in the same way bylaws are the governing instrument of corporation. Savvy businesspeople know that almost anything can be addressed in an operating agreement. The partners’ voting rights, the partners’ management powers, transfer restrictions, and buy out provisions may all be allocated and restricted in the operating agreement. For years, the limitations and duties to the LLC of the TMP were addressed in the operating agreement. The simple solution here would appear to be to draft provisions in the operating agreement that limit the authority granted to the PR. However, the Code and Treasury Regulations state that no state law, partnership agreement, or other document or agreement may limit the authority of the PR or the designated individual of an entity appointed as PR. This means that the LLC’s operating agreement cannot limit the powers granted to the PR by the Code and Treasury Regulations.
Examples of a PR’s Authority and Associated Problems
The BPA has clearly granted the appointed PR substantial authority. Consider a situation in which a partnership delegates ultimate settlement authority to its CEO. Perhaps this designation is in the partnership agreement, or the partnership has contracted with its PR that any settlement discussion with the IRS must be approved by the CEO. Nonetheless, the PR executes a closing agreement with the IRS, in contradiction to the contractual agreement with the partnership. From the IRS’s standpoint, there is no issue: The PR, acting as the sole representative of the partnership and its partners, has bound the partnership and its partners. The partnership, on the other hand, may have a legitimate breach-of-contract claim against the PR.
Imagine another scenario where a PR is designated on a 2018 return and in a subsequent year that person has become an adversary (and no longer a partner) to the later partnership group. That expelled partner will have no motivation to elect to push out the audit adjustments for 2018 and thus to himself. The Treasury Regulations do, however, provide for a PR’s resignation and the revocation of the PR’s designation.
Imperfect Solutions
Even though the PR’s authority cannot be limited or varied by operating agreements, certain provisions can be drafted so that partners have some control. Examples of requirements or restrictions that the partnership could place on a PR include: provide notice, within a reasonable time, to the partnership’s leadership or board after each written communication from the IRS; provide written updates upon certain milestones in the exam; obtain permission from the partnership to engage third-party experts, counsel, or accountants; obtain permission from the partnership to extend the statute of limitation, agree to an adjustment, file an Administrative Adjustment Request with the IRS, make any statutory or regulatory elections in Code Sections 6221 through 6241 (the centralized partnership audit regime), or make other binding decisions; consult with certain partners or counsel on the decision to litigate a matter; determine whether an LLC should elect to opt out or push out (elections made under the centralized partnership audit regime); or, in some instances, determine how an LLC will be structured so that it can be eligible for opt-out. Additional provisions can be added to provide adjustment year partners with rights to indemnification from the PR and reviewed year partners. Procedures can also be set forth as to how to locate the former partners from reviewed year, who will pay for what portions of the audit costs and tax liability, and how any such rights can be effectively enforced.
Conclusion
The takeaway point of this article is to ensure that every business owner operating under the partnership tax provisions of the Code is aware of the importance and impact of the changes regarding the appointing of the entity’s PR under the BPA. When business owners are forming such entities, significant thought and consideration should be given amongst partners prior to appointing the PR. For business owners that formed such entities prior to the enactment of the BPA, it is imperative that partners review the entity’s governing instrument (i.e., the operating agreement for most entities) and make certain that the partner named TMP is the individual that the partners desire to be the PR in light of the BPA. Those partners should also consider the importance of updating the language appointing the TMP to language specifically crafted for appointing the PR. Finally, it is vital that corporate and tax attorneys be consulted in each scenario in the amending or drafting such provisions.
(Bobby concentrates his practice in the areas of business law, corporate law, and taxation issues. He assists clients with business formation, choice of entity decisions, contracts, tax planning, and general corporate needs.)
[1] See a previous Van Osdol news article Brief Overview of LLCs and How They are Taxed https://vanosdolkc.com/2019/05/03/brief-overview-of-llcs-and-how-they-are-taxed/ for a brief overview of the taxation of LLCs.