Drafting Partnership Agreement Provisions With Respect To Partnership Audits Both Under TEFRA And The New Bipartisan Budget Act Of 2015

Focusing On The Controversial New Partnership Representative Rule

By: Jerald David August

Partner, Kostelanetz & Fink, LLP [1]

This is the second part of a series of posts pertaining to drafting and revising partnership, limited liability and limited liability partnership (“partnership”) agreements  into account the new consolidated audit rules. The first part of the series appeared on this website, “Business and International Tax Developments” on Friday, June 14, 2014. .

The new partnership audit rules are quite important not only for tax lawyers but for business lawyers and estate planners who undertake to advise clients on partnership agreements and further undertake the responsibility for negotiating and drafting such agreements. Let’s not forget to mention that the clients must have a general understanding of the new rules.

 The new partnership audit rules generally go into effect in January 2018, [2] however, currently drafted partnership agreements and LLC operating agreements should take the new partnership audit rules into account. Current audit rules (the “TEFRA audit rules”) will remain in effect until the effective date of the new partnership audit rules. [3] The first part of this series focused on the partnership provisions relating to the tax matters partner. This installment will turn to the drafting considerations with respect to the new “partnership representative”, which individual or entity will have sole authority to meet with, argue and resolve partnership items with the Internal Revenue Service or before a court of applicable jurisdiction, without intervention or the participation of any other partner or member. A lead in will explain the authority and power of the partnership representative both under the statute and under the proposed regulations. That’s quite a change from the rules set forth which apply to the TMP as well as the “notice” and ‘indirect” partners under TEFRA.

Summary of the Bipartisan Budget Act’s New Partnership Consolidated Audit Rules

The Budget Act's [4] partnership audit rules continue to incorporate the rule that started with TEFRA that the Service conducts its tax audit at the partnership level. A core principle of the flow-thru treatment of a partnership for federal income tax purposes is that it is not a taxable entity in comparison with a regular or C corporation. Instead, federal income tax with respect to partnership taxable income (and the allowance of a net operating or capital loss, subject to applicable limitations) is the liability of each partner determined in accordance with each partner's distributive share of partnership taxable income. Therefore, under TEFRA, as has always been true under the Code, the assessment and collection of federal income tax occurred at the partner level.

The centralized audit rules continue to impose a consistency requirement. Each partner on its return must treat each item of income, gain, loss, deduction, or credit attributable to a partnership consistently with how such item is treated on the partnership return. [5] A resulting underpayment in tax from the failure of a partner to conform with the partnership's reporting of tax items is treated as a mathematical error and cannot be abated under Section 6213(b)(2). Nevertheless, a partner is permitted to file a statement identifying the inconsistent position taken on its return from that of the partnership. [6] A final decision in an administrative or judicial proceeding with respect to a partnership under the centralized system is binding on the partnership and all partners of the partnership. [7] In contrast, a final determination in an administrative or judicial proceeding with respect to a partner's identified inconsistent position is not binding on the partnership if the partnership is not a party to the proceeding. [8]

The most profound change in the Budget Act is that contained in Section 6225 which now provides a default rule that in the event of audit the Service makes net positive adjustments increasing the partnership’s taxable income or reducing the amount of a previously reported loss with respect to a reviewed year, the partnership will be responsible to make payment of any resulting imputed underpayment. The imputed underpayment, including additions to tax in the form of penalties which are to be determined at the partnership level, and interest, will be assessed against the partnership. [9] The assessment against the partnership is for the final amount, as modified and/or adjusted, of the “imputed underpayment” amount.

Implicit in the rules set out in the preceding paragraph is that under the new centralized partnership audit regime, the IRS is no longer required to determine each partner's share of the adjustments made to partnership items followed by a separate computational adjustment for each partner to assess the correct tax due as a result of the partnership audit. Instead, under the default rules of Section 6225, the partnership is liable for an imputed underpayment based on the adjustments made at the partnership level. [10] The imputed underpayment calculation may, for some partnerships, overstate the amount of tax due had the partnership and partners reported the partnership adjustments properly. To correct potential overstatements, the Budget Act contains modification procedures and provides additional discretionary authority for the IRS to further modify imputed underpayments to avoid excessive taxation and achieve a result that attempts to approach the aggregate amount of tax due if the partnership and the partners had correctly reported and paid the tax on the originally filed returns. The proposed regulations go in great detail to explain the computation of the imputed underpayment amount as well as the modifications contained in Section 6225(c).

The Imputed Underpayment Amount

Under Section 6225(b) the “imputed underpayment” is calculated with respect to any “reviewed year,” i.e., the year under audit, and is required to be determined “(A) by netting all adjustments of items of income, gain, loss, or deduction and multiplying such net amount by the highest rate of tax in effect for the reviewed year [the year under audit] under Section 1 or Section 11 (B) by treating any net increase or decrease in loss under subparagraph (A) as a decrease or increase, respectively, in income, and (C) by taking into account any adjustments to items of credit as an increase or decrease, as the case may be, in the amount determined under subparagraph (A) [the imputed underpayment].”

The proposed regulations provides rules for the issuance of multiple imputed underpayments instead of a residual or general imputed underpayment amount. [11] In general, each administrative proceeding that ends with the determination by the IRS of an imputed underpayment will result in a general imputed underpayment. The IRS may determine, in its discretion, a specific imputed underpayment on the basis of certain adjustments allocated to one partner or a group of partners based on the items or adjustments having the same or similar characteristics, based on the group of partners sharing similar characteristics, or based on the partners having participated in the same or similar transactions. Therefore there may be multiple specific imputed underpayments depending on the adjustments such as reallocation groupings for reallocation of income or deductions among certain partners.

The partnership is required to produce information for generating the reduction in the imputed underpayment within a prescribed time, i.e., 270 days after the notice of proposed audit adjustments is received by the partnership representative, unless extended by consent.

Under a set of modifications set forth in Section 6225(c), an imputed underpayment amount can be reduced: (i) based on a reduction in the applicable tax rate at the partner (“reviewed year”) level of items of income; (ii) based on the allocation of net taxable income to a tax-exempt partner provided such income would not constitute unrelated trade or business income or debt-financed income; or (iii) where one or more partners for the reviewed year file amended returns taking into account their increase in federal income tax from the adjustments for the reviewed year plus make payment of the tax with the amended return. Reduction in the imputed underpayment amount may also result with respect to a foreign partner’s reduced income tax rate for certain species of U.S. source income or as provided under pertinent income tax convention.  

Generally, the partnership is liable for any penalty, addition to tax, or additional amount. Additions to tax are determined at the partnership level as if the partnership were an individual who was subject to federal income tax for the reviewed year, and the imputed underpayment were an actual underpayment or understatement for the reviewed year. Therefore partner level defenses to imputed underpayments are not taken into account.

The Partnership “Push-Out” Election

In accordance with Section 6626(a) where the partnership is subject to the assessment of an imputed underpayment for one or more reviewed years, it may elect out of having to make the tax payment if no later than 45 days after the final partnership administrative adjustment (FPAA) is issued to the partnership, and at such time and in such manner as provided by guidance issued by the Service, it furnishes to each partner of the partnership and to the Service a statement of the partner's share of any adjustment to income, gain, loss, deduction, or credit (as determined in the FPAA) for the reviewed year(s). The partnership may make the push-out election within the 45-day period from the FPAA, and, within 90 days of the FPAA, also may file a petition for readjustment with the Tax Court, federal district court (having venue), or the Court of Federal Claims. This ability to push-out and challenge can not go overlooked.  Upon the final court decision, dismissal of the case, or settlement, the partnership is to implement the election by furnishing statements (at the time and in the manner prescribed by the Secretary) to the reviewed-year partners showing each partner's share of the adjustments as finally determined.

The Joint Committee on Taxation's General Explanation of Tax Legislation Enacted in 2015 (“Blue Book”) [12] provides that with respect to tiered partnerships, a partnership that receives a statement (push-out election statement) from the audited partnership is treated as an “individual” and must take into account the aggregate of the adjustment amounts determined for the partner's tax year, including the end of the review year, plus the adjustments to tax attributes in the succeeding tax years of the recipient partnership. It is unclear at this time whether a second-tier partnership that is the subject to a push-out election, can itself make a push-out election and move the lower-tier partnership's aggregate adjustment amount to its partners. Some commentators want the push-out election to be permitted to go up as many tiers as are necessary in order to reach the ultimate tax paying individuals or entities up the entire chain. Alternatively, such commentators want each upper tier to be able to elect whether or not to push-out.

Election Out of the New Partnership Audit Rules

In escaping the imputed underpayment rules under Section 6225 as well as the alternative push-out election provision in Section 6226, Section 6221(b) provides that a partnership having 100 or fewer partners may elect out of the new audit rules for any tax year, provided all partners are individuals, C corporations, foreign entities which would be treated as a C corporations were they domestic entities under the check-the-box regulations, S corporations having certain types of shareholders, or estates of deceased partners.  Under the statute and proposed regulations, a partnership has 100 or fewer partners when it is required to furnish 100 or fewer statements under section 6031(b), currently Schedule K-1 The proposed regulations did not expand upon this list of eligible partners.

Second, a partnership must only have eligible partners. Under the statute, eligible partners are individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic, S corporations, and estates of deceased partners. Section 6221(b)(1)(C). Under section 6221(b)(1)(D)(i), a partnership may elect out of the centralized partnership audit regime only on a timely filed return for a taxable year (including extensions).The election out cannot be made with respect to any tax year of the partnership where any partner is a partnership, trust, or even a single member LLC or defective entity, such as a single member LLC which does not file a reverse default election or a grantor trust, unless the categories of eligible partners are expanded by future regulations..

Meet the Partnership Representative; Not the Same as the Tax Matters Partner? Its Not the Same Boss; Its Bigger!”

Under new Section 6223(a) the new term, “partnership representative”, replaces the TEFRA term, “tax matters partner,” to represent the partnership and therefore serve as the interface

between the partners and the Internal Revenue Service under the centralized audit rules. In a profound and significant departure, the partnership representative does not have to be a partner, but must be a person having a “substantial presence” in the United States. The partnership representative is granted, by statute, the sole and presumably exclusive authority to act on behalf of the partnership. Where a designation is not in effect by the entity taxable as a partnership, the Service may select any person as the partnership representative. Under Section 6223(b), a partnership and all partners are bound by any actions taken by the partnership (through the partnership's representative) and by any final decision in a proceeding brought under the new rules. [13]

The Partnership Representative.

Each partnership designates a partner (or other person) as the partnership representative. The partnership representative serves a similar function as the tax matters partner but the differences in their rolls in representing the partnership before the IRS are profoundly different. Each partnership is required by the partnership audit rules to designate a partnership representative. The partnership representative has the sole authority to act on behalf of the partnership in an audit examination. [14] While not required by the Code, the partnership representative should be designated by the partnership in writing (a convenient place is the partnership agreement or if the partnership is a non-partner, under a separate service agreement). The draftsman of a partnership or LLC agreement must consider what duties, functions, and obligations the partnership representative will have. The draftsman also should consider how he can limit the discretion of the partnership representative.

Eligibility Requirements. As far as eligibility to serve as the partnership representative, the proposed regulations per proposed §301.6223-1(b)(1) provide that a partnership may designate any person as defined in Section 7701(a)(1), including an entity, that meets the requirements of proposed § 301.6223-1(b)(2), (b)(3), and (b)(4), to be the partnership representative. The partnership representative must have a substantial presence in the United States and must have the capacity to act. If an entity is designated as the partnership representative, the partnership must identify and appoint an individual to act on the entity's behalf. The appointed entity partnership appointed individual must also have a substantial presence in the United States and the capacity to act. Accordingly, provided the person is otherwise eligible, the partnership may appoint a partner or a non-partner, including the partnership's management company, as the partnership representative. Again, a partnership representative need not be an individual.

Proposed §301.6223-1(b)(2)(i) instructs that a person has a substantial presence in the United States for the purposes of Section 6223 if three criteria are met. First, the person must be able to meet in person with the IRS in the United States at a reasonable time and place as is necessary and appropriate as determined by the IRS. Second, the partnership representative must have a street address in the United States and a telephone number with a United States area code where the partnership representative can be reached by United States mail and telephone during normal business hours in the United States. Third, the partnership representative must have a U.S. TIN.

Designation of the Partnership Representative. A partnership must designate the partnership representative on the partnership's return filed for the partnership taxable year. Proposed §301.6223-1(c). A partnership must designate a partnership representative separately for each taxable year. In other words, a designation for one taxable year is not effective for any other taxable year. A designation of the partnership representative for a partnership taxable year remains in effect until the designation is terminated under proposed § 301.6223-1(d) (resignation), proposed § 301.6223-1(e) (revocation), or proposed § 301.6223-1(f) (determination that the designation is not in effect).

Under the TEFRA partnership procedures, a TMP may be designated, including through a resignation or revocation, at any time after the filing of the initial partnership return by submitting a new designation to the IRS. The IRS processes each of these subsequent designations regardless of whether the partnership is examined, creating unnecessary work for the IRS because very often the TMP is not required to take any action on behalf of the partnership or the partners.

In a break from the TMP rules,  the proposed regulations provide that a partnership representative designation may not be changed (either by resignation or revocation) until the IRS issues a notice of administrative proceeding (NOPPA) to the partnership, except when the partnership files a valid administrative adjustment request (AAR) in accordance with section 6227 and proposed § 301.6227-1.

As to the removal of the partnership representative, proposed § 301.6223-1(e) sets forth rules which allow the partnership to revoke the partnership representative designation and designate a successor. This revocation provision is an exception to the general rule that the partnership representative has the sole authority to act on behalf of the partnership. In general, a change in the partnership representative or designated individual should only occur when the partnership representative resigns and appoints a successor under proposed § 301.6223-1(d). Still there may be instances where the partnership would like to change the designation, and the partnership representative or designated individual is not willing to step aside and tender a resignation to the IRS (and the partnership). Proposed § 301.6223-1(e) provides flexibility to the partnership in these circumstances, allowing the partnership, through its partners, to revoke a prior designation. [15]

In the case of a revocation (removal), the partnership must notify the IRS in writing and must also notify the partnership representative whose designation is being revoked of the revocation. Note that the partnership may not revoke the partnership representative designation prior to the issuance of a notice of an administrative proceeding except in conjunction with the filing of a valid AAR. This is important. See proposed § 301.6223-1(e)(1). Upon the receipt of a valid revocation, the IRS will notify the partnership and any partnership representative whose designation is being revoked of the acceptance of the revocation.

Designation Not in Effect. Proposed § 301.6223-1(f) sets forth rules which allow to IRS to designate a partnership representative where a designation is not in effect. When the IRS makes such a determination, it is required to notify the partnership and the last partnership representative, if there was one, of the IRS's determination. The prior designation is terminated as of the day the IRS notifies the partnership that no designation is in effect. Proposed § 301.6223-1(f)(4) provides that except in cases where the partnership designation is not in effect because there were multiple revocations, the partnership will have 30 days to designate a successor partnership representative before the IRS will designate a new partnership representative. If the IRS has already received multiple revocations from different partners and determined it is unable to ascertain which partnership representative the partnership wants to designate, proposed § 301.6223-1(f)(4) provides that the IRS will notify the partnership that the designation is not in effect and designate a new partnership representative pursuant to proposed § 301.6223-1(f)(5) without providing the partnership with an opportunity to designate a partnership representative.

Designation of the Partnership Representative by the Service. Proposed § 301.6223-1(f)(1) explains where no designation of a partnership representative in effect, the IRS will notify the partnership and last partnership representative.

Designation Not in Effect. Proposed § 301.6223-1(f) sets forth rules which allow to IRS to designate a partnership representative where a designation is not in effect. When the IRS makes such a determination, it is required to notify the partnership and the last partnership representative, if there was one, of the IRS's determination. The designation is terminated as of the day the IRS notifies the partnership that no designation is in effect. Proposed § 301.6223-1(f)(4) provides that except in cases where the partnership designation is not in effect because there were multiple revocations, the partnership will have 30 days to designate a successor partnership representative before the IRS will designate a new partnership representative. If the IRS has already received multiple revocations from different partners and determined it is unable to ascertain which partnership representative the partnership wants to designate, proposed § 301.6223-1(f)(4) provides that the IRS will notify the partnership that the designation is not in effect and designate a new partnership representative pursuant to proposed § 301.6223-1(f)(5) without providing the partnership with an opportunity to designate a partnership representative.

Specific Powers of the Partnership Representative

The partnership representative has the power to: (i) meet with representatives of the IRS in any audit or investigation involving the federal income tax liability of the partners based on the audit of the partnership; [16] (ii) settle the audit with the IRS; (iii) extend the partnership’s statute of limitations (and therefore partners’ statute of limitations with respect to partnership items); (iii) to bind all partners to a settlement agreement which it enters into with the IRS, Chief Counsel or the Department of Justice, Civil Tax Division; (iv) decline to challenge or contest all or part of an FPA that it receives from the IRS by filing for a judicial proceeding; (v) elect out of partnership treatment if it meets the requirements of an eligible partnership and timely files the election required under Section 6221;  (vi) make any and all other decisions related to the payment methods set forth under Sections 6225 (partnership assessment) or Section 6226(b) (push-out election); (vii) enter into a closing agreement with the IRS on one more partnership items; and (viii) decide to litigate one or more proposed adjustments to tax with respect to an imputed underpayment for a reviewed year and select the choice of forum for such litigation to take place.  Despite comments it received to the contrary in response, the proposed regulations do not include any notice requirements with respect to providing notice to all partners of significant developments in an administrative proceeding and, as mentioned, no other partner has the right to participate.

Additional Powers of the Partnership Representative. In addition to the main or primary powers of the partnership representative, there may be additional stated or implied powers held by the partnership representative such as the power: (i) to hire accountants and lawyers in connection with a tax audit, appeal or legal proceeding; (ii) to direct how the accountants and lawyers will work and what issues it wishes to challenge; (iii) to hire expert witness; (iv) to bind the partnership to invoices for services rendered by professionals and experts on behalf of the partnership; (v) to have unfettered access to the partnership books, records, tax filings, files from prior audits; and (vi) to charge out the value of his services to the partnership.

Limitations on the Powers of the Partnership Representative

The partnership agreement must set forth limitations on the power of the partnership representative as well as include provisions for the selection, removal and appointment of a successor partnership representative. Limitations on powers contained in a partnership agreement are warned to have no effect on the IRS even if it were on notice of such limitations.  Still, the partnership agreement, and any amendments, will be part of the audit documentation and will further be introduced into evidence in court. What impact, if any, a set of limitations on the powers of the partnership representative by being introduced into evidence will have on the court in review is unknown. Perhaps it could be used by plaintiff’s counsel in a subsequent suit filed by one or more partners against the partnership representative for breach of contract, negligence, conflict of interest, breach of fiduciary duty or even fraud.  

Subject Matters for Drafting Provisions With Respect to the Partnership Representative.

Limitations on Powers. Where the partnership representative is not a partner, then the partnership representative and the partnership should enter into a written services agreement which sets forth the term, compensation, bonus, duties, rights, etc. of the partnership representative entity or individual. The partnership representative must always warrant and prove up that it will maintain a substantial presence in the United States at all times.  In many instances the partnership representative will be a general partner or manager of the partnership or limited liability company in which case the partnership or operating agreement should set forth the conditions and limitations that the partnership wants the partnership representative to be subject to. Such conditions can be set out in the written services agreement as well. Reference to the services agreement should be referred to in the partnership agreement and attached as an Exhibit.

Notification of Partners Provisions. The partnership agreement should contain direct and unequivocal instructions for the obligation of the partnership representative to provide each partner with every communication issued by the IRS with respect to any partnership return, filing, audit, appeal, litigation, appeal from litigation, brief filed, notices of discovery, etc. [17] Presumably there will be some lawyers drafting such provisions who will differ on the amount of detail that should be set out in a notification provision. In partnerships that are comprised of non-related parties, erring on the side of greater disclosure may prove to be quite prudent. Even in family partnerships, younger generational members may want to be kept informed about tax matters that could easily affect their tax returns for reviewed years as well as for adjustment years.  Of course, notification would extend to decisions related to whether the partnership will make a push-out election with respect to one or more multiple imputed underpayments.

Restrictions on Partnership Representative's Powers. The partnership agreement may place restrictions on the powers of partnership representative, at least from a contractual (and accountability) standpoint including:

  1. Engagement of attorneys and accountants without the prior approval of the management of the partnership or by vote of the partnership based on ownership percentages or majority of number of partners.  

  2. Engagement of experts or other personnel without prior approval as set forth in the partnership agreement.  

  3. The partnership representative must provide the partnership and all partners with copies of all notices from the Internal Revenue Service within a specified number of days of receipt.

  4. The partnership representative must receive the prior approval of the partnership management or a majority in interest of the partnership prior to filing all protests, court filings, settlements, etc., and other written communications with the  Internal Revenue Service.

  5. The partnership representative must receive the prior approval before proposing or otherwise entering into any and all material agreements with the Internal Revenue Service or the United States (including waivers of statutes of limitations and settlement agreements).

  6. The partnership representative is required to inform the partnership management in advance of all meetings with the Internal Revenue Service.

  7. Partnership management must approve all material items or transactions involving the partnership audit and potential settlement and partnership management must be present and given prior notice of meetings with counsel and accountants representing the partnership and/or the partnership representative.

  8. The partnership representative must consult regularly with the partnership management concerning its audit and litigation strategy.

  9. The partnership representative must regularly to update the partnership of the progress of the audit and any court proceeding.

  10. The partnership representative must submit periodic written reports with partnership management concerning the status of the partnership audit.

  11. The partnership representative must obtain prior approval by the partnership management or possibly by vote of a majority in interest of the partners of any agreement with the IRS to extend statutes of limitations.

  12. The partnership representative must obtain approval by the partnership management of any settlement with the Internal Revenue Service.

  13. The partnership representative must receive prior approval from partnership management approval in advance of incurring any expense in excess of a specific dollar amount in connection with the audit, appeal and litigation through all appeals.

  14. The partnership agreement will require the partnership representative to state that it or he has not conflict of interest that would violate his fiduciary duties of the partnership representative. [18] 

  15. The partnership representative should be subject to a rather definitive confidentiality requirement.

  16. The partnership representative may be required to use best efforts, or alternatively something less than best efforts, in connection with representing the partnership in the audit.

  17. The partnership representative must obtain the prior approval of partnership management or as otherwise provided in the partnership agreement for vote of the partners in the adjustment year, before electing to make a push-out election with respect to an imputed underpayment in accordance with section 6226(b).

  18. The partnership representative must obtain the prior approval of partnership management or as otherwise provided in the partnership agreement for the filing of an administrative adjustment request in accordance with section 6227.

  19. The partnership representative must obtain prior approval in the manner set forth in the partnership or services agreement before filing a judicial action in response to a notice of final partnership adjustments for a particular taxable year as well as setting forth the justification for the selection of the particular forum for the case.

  20. Liquidated damages provision for violation of one of the restrictions or limitations may serve as a good “control” over the partnership representative from entering into settlements or taking other actions in the audit or under the payment method rules that does not have the requisite approval. In some instances, such as negligence or fraud, the damage claims may not be difficult to estimate. So there could be alternative remedies for breach of contract or fiduciary duty set forth in the personal service contract or under the partnership agreement with respect to the partnership representative.

  21. Other Provisions. As set forth with respect to partnership agreement provisions affecting the relationship of the TMP to the partnership and the partners, we covered various topics including: (i) Selection of Tax Matters Partner (Partnership Representative); (ii) Term of the TMP (partnership representative); (iii) Compensation of the TMP (partnership representative): (iv) Replacement of the TMP (partnership representative): (v) Conflicts of interest; (vi) Indemnification Provisions (and exceptions); (vi) Indemnification of Successor TMP (Partnership Representative); (vii) Confirmation of Fiduciary Duty; (ix) Contractual Authority; (x) Should the TMP (partnership representative Be the Tax Return Preparer or Tax Advisor for the Partnership?; (x) Selection of Judicial Forum To Challenge Partnership Adjustments; and (xi) Prior Approval for the TMP’s (Partnership Representative’s ) Taking Affirmative Actions. [19]

  22. Provisions Imposed by Third Parties. Various third parties who are not partners may want to see actual provisions inserted into the partnership agreement, an amendment to the partnership agreement or by certified resolution, of rights that such third parties have to notice of audit, notice of the issues involved in the audit, indications on what a favorable settlement may look like, etc. In some instances, such as a commercial lender, it may insist that the audited partnership always make a push-out election so that an application of funds borrowed from a bank or other financial institution are not used to pay off prior years’ taxes. Lenders may also want to undertake a thorough review of the contingent tax liabilities of the partnership. The same sort of contractual due diligence and assurances may be invoked by the purchaser of a partnership interest. Also representations and warranties will be required to be made in may instances by partnerships where partnership interests are being purchased from another partner or partners or as part of a partnership subscription. Of course the same process will be involved in a merger or even a division of partnerships.

Conclusion. With January 1, 2018 right around the corner it is at this time that legal counsel and tax advisors to partnerships must advise their clients who are partnerships or entities taxed as partnerships for federal income tax purposes as well as clients who are partners or members of a partnership or entity taxed as a partnership to address and revise their partnership or operating agreements to anticipate the new, complex and perhaps unfair new model that Congress has devised for auditing partnerships. Without the TEFRA notice and right to participate provisions, the “czar” of the partnership, the partnership representative, yields what some may view as excess power by delegation of federal law, not the partners to the partnership. The terms of a thorough and comprehensive set of provisions reigning in the powers and identifying the responsibilities and duties of the partnership representative can not be overemphacized as to their importance.


[1] This is the second of a series of blog posts on the subject of “Drafting Partnership Agreement Provisions With Respect to Partnership Audits Both Under TEFRA and the New Bipartisan Budget Act of 2015; Focusing on the New Partnership Representative and the Outgoing Tax Maters Partner”

This series of posts will appear in article format in the September issue (Part 1 (of a 2 Part article)) of the Journal of Corporate Taxation.   

Jerald David August,  © all rights reserved

[2] In August, 2016, the Service issued temporary regulations pertaining to elections to have the newly enacted audit procedures apply with respect to certain tax years beginning before January 1, 2018. See T.D. 9780. The rules permit the election to be made before January 1, 2018 by partnerships that have received notices of selection for examination of the partnership for that year. Such partnerships must make the election to have the new consolidated audit rules apply within 30 days of the date of notification. Where a partnership files an “early, elect-in” election in accordance with the temporary regulations, it is not permitted to elect out under the small partnership exception under §6221(b) for that return. Temp. Reg. §301.9100-22T(a) further provides that an election made not in accordance with these temporary regulations is not valid, and an election, once made, may be revoked only with the consent of the Service. In some instances, the elect-in now election will be treated as invalid where it frustrates the purposes of the Budget Act. The election may be revoked only with the IRS’s consent, and a taxpayer cannot request an extension of time for making the election under Treas. Reg. §301.9100-3. An election will not be valid if it frustrates the purposes of Section 1101 of the BBA (Temp. Reg. §301.9100-22T(a)).

[3] Partnerships with 10 or fewer partners often are not subject to the TEFRA audit rules. I.R.C. § 6321(a)(1)(B) (exception for small partnerships).

[4] The Bipartisan Budget Act of 2015, P.L. 114-74, Act §1101 was signed into law by President Obama on November 2, 2015 and was modified by the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”), P.L. 114-113. On August 5, 2016, the Treasury and IRS published temporary regulations (TD 9780) pertaining to the early election-in permitted for any partnership return filed for a partnership taxable year beginning after November 2, 2015 and before Januar 1, 2018. See Temp. Reg. §301.9100-22T(a). Proposed Regulations were issued by the Treasury and the IRS [REG-136118-15] and were withdrawn following the issuance of a White House memorandum on January 20, 2017 ordering a freeze on all new and pending regulations. The proposed regulations were recently re-issued on June 13, 2017.

See, in general, August and Cuff, “The TEFRA Partnership Audit Rules Repeal: Partnership and Partner Impacts,” ALI-CLE Video Webcast (July 17, 2016); August, “The Good the Bad, and Possibly the Ugly in the New Audit Rules: Congress Rescues the IRS from Its Inability to Audit Large Partnerships,” 18 Business Entities 4 (May/June 2016); August, “Entity-Level Audit Rules Continue to Pose Challenges for Partners,” Parts 1 and 2, 16 Business Entities 4 (Nov./Dec. 2014), 17 Business Entities 4 (July/Aug. 2015). Budget Act section 1101 repeals the current rules governing partnership audits with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level. On the new audit provisions generally, see NYS Bar Ass'n, Tax Section, “Report on the Partnership Audit Rules of the Bipartisan Budget Act of 2015,” Report No. 1347 (May 25, 2016).

[5] Section 6222(a).

[6] Section 6222(c). 

[7] Section 6223(b).

[8] Section 6222(d).

[9] Section 6225(a)(1).

[10] The proposed regulations take an expansive view of the scope of the centralized partnership audit regime to extend to all items and information related to or derived from the partnership. Accordingly, under proposed § 301.6221(a)-1 all items required to be shown or reflected on the partnership's return and information in the partnership's books and records related to a determination of such items, as well as factors that affect the determination of items of income, gain, loss, deduction, or credit, are subject to determination and adjustment at the partnership level under the centralized partnership audit regime.

[11] Proposed §301.6225-1(e). Examples are set forth in the regulations. See proposed §301.6225-1(f).

[12] Staff of Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 2015, JCS-1-16, March 2016 (“Blue Book”).

[13] The Blue Book (“General Explanation of Tax Legislation Enacted in 2015 (JCS-1-16 March 2016) discusses the new “boss”.

“Partners bound by actions of partnership; designation of partnership representative

For purposes of the centralized system, the partnership acts through its partnership representative. The partnership representative has the sole authority to act on behalf of the partnership under the centralized system. Under the centralized system, the partnership and all partners of the partnership are bound by actions taken by the partnership. Thus, for example, partners may not participate in or contest results of an examination of a partnership by the Secretary. A partnership and all partners of the partnership are also bound by any final decision in a proceeding with respect to the partnership brought under the centralized system of subchapter C. Thus, for example, a settlement agreement entered into by the partnership, a notice of final partnership adjustment with respect to the partnership that is not contested, or the final decision of the court with respect to the partnership if the notice of final partnership adjustment is contested, bind the partnership and all partners of the partnership.

Each partnership is required to designate a partner (or other person) with a substantial presence in the United States as the partnership representative. A substantial presence in the United States enables the partnership representative to meet with the Secretary in the United States as is necessary or appropriate, and facilitates communication during the audit process and during any other proceedings in which the partnership is involved. In any case in which such a designation by the partnership is not in effect, the Secretary may select any person as the partnership representative.”

[14] I.R.C. § 6223 (“Sec. 6223. Partners bound by actions of partnership. (a) Designation of partnership representative. – Each partnership shall designate (in the manner prescribed by the Secretary) a partner (or other person) with a substantial presence in the United States as the partnership representative who shall have the sole authority to act on behalf of the partnership under this subchapter. In any case in which such a designation is not in effect, the Secretary may select any person as the partnership representative. (b) Binding effect. – A partnership and all partners of such partnership shall be bound – (1) by actions taken under this subchapter by the partnership, and (2) by any final decision in a proceeding brought under this subchapter with respect to the partnership”).

[15] See proposed §301.6223-1(d)(3)(designated individual may resign and appoint a successor).

[16] The Blue Book states that the partners may not participate in or contest the results of an examination of the partnership by the IRS.

[17] As to notices, under the Budget Act the partnership representative and the partnership are entitled to receive notice of any administrative proceeding initiated at the partnership level with respect to an adjustment of any item of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year, or any partner’s distributive share thereof, notice of any proposed partnership adjustment resulting from the proceeding, and notice of any final partnership adjustment resulting from the proceeding.

[18] Where the partnership representative is itself a partner or manager of an LLC, i.e., an entity partnership representative, it is clear that there is a fiduciary duty on the part of the entity partnership representative which is owed to the partners/members.  See, e.g., Feely v. NHAOCG, LLC 62 A.3d 649 (Del. 2012).  See 4 A.L.R. 4th 1122, “Partner’s Breach of Fiduciary Duty on Sale of Partnership Interest to Another Partner”; Haynes, “Partners Owe to One Another A duty of the Finest Loyalty…or Do They?”, 37 Tex. Tech. L. Rev. 433 (Winter, 2005); Marks, “Piercing the Fiduciary Veil”, 19 Lewis & Clark L. Rev. 73 (2015). See Del. Cod Ann. Tit. 6, §18-1101(c) (“To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member's or manager's or other person's duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.”).

Some argue that a non-partner partnership representative is under no such obligation to act as a fiduciary with respect to the partnership or its partners for state law purposes. In many instances a partnership representative will want to protected not only by an errors and omissions policy procured by the partnership for its or his benefit, but beheld harmless and indemnified from any and all claims filed by the partners, former partners or successor partners. See Ribstein, “Fiduciary Duties and Limited Partnership Agreements:, 37 Suffolk U.L. Rev. 927 (2004); Guttenberg, “Waiving Farewell Without Saying Goodbye: The Waiver of Fiduciary Duties in Limited Liability Companies in Delaware, And The Call For Mandatory Disclosure”, 86 S. Cal. L. Rev. 869 (May, 2013). 

[19] Obviously, some of the same topics have been discussed with respect to Partnership Representatives. Moreover, there may be countless other provisions that learned counsel will want to ensure be placed in the documents.


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