The New Partnership Centralized Audit Rules Are Coming Soon; Are Your Clients’ Partnership and Operating Agreements Ready? Looking In Particular At the Partnership Audit Provisions

By: Jerald David August

Partnership Centralized Audit Rules Enacted in 2015 Having a General Start Date For Taxable Years Beginning January 1, 2018

The Bipartisan Budget Act of 2015 (the “Budget Act”)  which the President signed into law on November 2, 2015 (as modified by the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”), fundamentally changes how the Service will conduct audits of partnerships. The Budget Act repeals the partnership audit provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) and electing large partnership regimes and replaces them with a new set of rules for partnership audits and judicial review of partnership audit adjustments under a centralized or consolidated partnership audit regime.  While the new rules may have had a specific purpose in mind, i.e., of streamlining partnership audits and raising revenues from incorrect tax positions taken by large partnerships, the statutory language and principles in the new legislation suffer from several structural defects, some of which are fundamentally inconsistent with the long-standing principles of partnership taxation under Subchapter K.  

Proposed Regulations were released on January 19, 2017, but just prior to being released were withdrawn on the following day pursuant to an executive order.   The centralized partnership audit regime regulations were reissued on June 13, 2017. 

The Tax Technical Corrections Act of 2016 (the “TTCA”), H.R. 6439 and S. 3506 (Dec. 6, 2016), propose important “clarifications” to the BBA, but has not yet been enacted into law.  Noteworthy provisions in the TTCA include:  (i) the expansion of the term “partnership-related item,” as defined in section 6241(a)(2)(B)(i); (ii) limits on the scope of the BBA to taxes contained in chapter 1 (income taxes); (iii) provision for modification of adjustments not resulting in an imputed underpayment; and (iv) rules permitting tiered partnerships to be subject to the push-out election. The Treasury is deciding whether principles contained in the TTCA require enactment or could instead be adopted as part of the final regulations.

This post summarizes the TEFRA rules and the run up so to speak to the enactment of the BBA. The focus of this post and several to follow will be the need to revise outstanding partnership agreements, that will continue to have to address the TEFRA audit rules and the role of the tax matters partner, and in drafting new partnership agreements that will be subject to the BBA (for taxable years beginning after 2017),  defining the role of the partnership representative as well as highlight other key provisions of the partnership agreement which need to be addressed in light of the BBA.

This first post will first address TEFRA and the Tax Matters Partner drafting points. The next several posts will cover the general rules of the BBA and focus on the Partnership Representative drafting points. A lead-in will be provided in this post on why Congress decided to sunset the TEFRA audit rules and introduce the consolidated audit regime under the BBA.

Repeal of the Partnership Audit Rules Under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)

Prior to enactment of the entity-level audit rules in TEFRA, audits involving partnership items were conducted by the IRS examination division at the partner level, in recognition of the fact that partnerships under Subchapter K were not subject to income tax. Thus, for example, if a partnership had eight partners, the IRS would have to audit each of the eight individual partners separately to collect the aggregate deficiency in income tax. Of course it did not legally have to audit all eight.

Where one of the partners, for example, was a pass-through entity, then the audit would ultimately have to focus on the individual partners or partner-taxpayers directly subject to the reporting and payment of federal income tax. Where the partners resided in different geographical areas and therefore resided in different venues in determining governing precedent, inconsistent treatment of the same item was always more than simply a theoretical possibility.

As a matter of effective tax administration, the individual audit approach handicapped the Service from effectively auditing partnerships.  The tax administration difficulties were compounded by an awareness on the part of the Service that the hybrid tax system under Subchapter K was being exploited by tax shelter promoters who produced and marketed tax shelter partnerships  designed to generate tax savings for investors at a multiple over invested cash or cash at-risk. Right offs at 10 to 1 or more in non-credit deals and 5 or one or more in tax credit deals were commonly being “pushed” to high-end individuals currently realizing large gains or having high levels of taxable income. The promotions of these abusive tax shelters through partnerships to individuals reached their peak during the 1970s and early 1980s.  Since this activity occurred prior to the adoption of the TEFRA entity level audit rules in 1982, the IRS was forced to search out each partner and make timely tax assessments (or proposed assessments) on an individual basis. In many cases the Service may have been unable to timely issue notices of deficiency.

Moreover, where audits were concurrently conducted in different jurisdictions or IRS districts, there was always the chance that the audit results, settlements, and litigation outcomes would not be consistent among the partners. The potential for inconsistent outcomes increased substantially where the tax shelter promotion involved many individual investors, or was warehoused in large investment partnerships, making the audit under pre-TEFRA rules a challenging, uphill climb for the government. In fact, since many partners challenged the proposed assessments that were timely issued, abusive tax shelter partnership litigation clogged the dockets of the Tax Court and posed numerous burdens and challenges for the Service and its lawyers. The IRS Chief Counsel's Office would invariably attempt to pick a “lead” case, e.g., the earliest filed case, and require other investors filing a petition with the Tax Court to agree to be bound by its outcome.

The TEFRA partnership entity level audit rules were designed to alleviate the costs associated with multiple audits involving a single partnership or tiered partnerships and to achieve uniformity of outcome for partnership level items through a single unified procedure. As set forth in Sections 6221 through 6234, the TEFRA entity level audit rules provided a separate framework for conducting the audit, administrative appeal, and tax litigation of a TEFRA partnership, including claims for refund and refund suits. The entities subject to the TEFRA audit rules include: (1) any partnership, including a foreign partnership, as defined in Section 761(a), and which is required to file a partnership return under Section 6031;  and (2) all other entities which file a partnership tax return and meet the definition of a partnership in Section 6231(a)(1)(A). It is therefore important to identify whether the relationship between the parties to an economic undertaking is a “partnership” so, the TEFRA audit rules will generally apply.

Eligible Small Partnerships Not Subject to TEFRA Entity Level Audits

Under the TEFRA rules, Section 6231(a)(1)(B) provides that a partnership having ten or fewer partners, each of whom is an individual (other than a nonresident alien), a C corporation, or an estate of a deceased partner is not subject to the entity level audit rules  No election was required to be filed to qualify under the "small partnership" exception. Alternatively, a decision may be made to “opt-in” or otherwise meet the definition of a partnership subject to TEFRA under Section 6231(a). No pass-through entity may qualify to be a partner under this election out. Qualification under this rule is determined on an annual basis and it is possible for a partnership to be covered by the entity level rules in one year and then not be covered in another year.

A partnership qualifying for the small partnership exception can still elect-in to become subject to the TEFRA audit rules. This is made by filing an election statement (or Form 8893) with the partnership return signed by all persons who are partners during the partnership tax year. Once this opt-in election is made, it is permanent unless revoked with the consent of the IRS.

The small partnership exception is not available where at least one of the ten partners is a juridical body such as a limited liability company or corporation. Thus, having a single member LLC owning a partnership interest would eliminate the partnership from qualifying for the small partnership (election out) exception.   The same result applies where a qualified Subchapter S subsidiary owns a partnership interest, or a partner which is organized as a grantor trust. Such outcomes pose a danger for the partner who is not aware that the TMP will have substantial control and authority of income tax audits of the partnership under TEFRA. Where a small partnership is not “eligible” it again will be subject to the entity level audit rules and the governing agreement should make provision for the appointment, duties, limitations, etc. on the TMP.

Electing Large Partnerships Under TEFRA

Large partnerships having 100 or more partners in the preceding year may elect to be treated for tax procedure purposes as “electing large partnerships” and are outside of the entity level audit rules under TEFRA. Once the election is filed, it applies for all subsequent years unless a revocation of election is consented to by the Service. An electing large partnership under TEFRA is subject to a separate set of procedural rules pertaining to the audit and litigation of partnership items relating to such entity. A modified entity form of reporting is required with fewer partnership items passing through to the partners and a separate set of rules for audit and litigation. Partners in an electing large partnership are required to report all items consistent with the partnership's return. Under the large (electing) partnership rules, the current-year partners' share of current-year partnership items of income, gains, losses, deductions, or credits are adjusted to reflect partnership adjustments relating to a prior year audit that take effect in the current year. The adjustments generally do not affect the prior year returns of any partners (except in the case of changes to any partner's distributive share).

Under the current electing large partnership rules, the Service is not required to provide notice to individual partners that it has initiated a partnership level audit or it has made a final adjustment or FPAA. Section 6223(a) provides that a copy of the FPAA must be mailed to each partner. The Service is only required to give notice to the partnership of a partnership adjustment to the partnership's last known address, even if the partnership has terminated. The  procedural rules are contained in Sections 6240 thru 6255. Within 90 days of the mailing of the FPAA to the tax matters partner, only the tax matters partner may file a petition for readjustment of the partnership items. Where the TMP does not file within the prescribed 90-day period, any “notice” partner may file a petition within the next 60 days under Section 6226(b).

Summary of TEFRA Audit Rules

The basic characteristics of the TEFRA entity-level audit rules (other than the small partnership and electing large partnership exceptions) may be summarized as follows:

(1) Partners are required to report on their tax returns in a manner which is consistent with positions taken and reported on Form K-1unless the partners provide notice of any inconsistent treatment;.

(2) Partnership items or issues are addressed at the partnership level in a unified partnership level proceeding for audit, appeal, and administrative purposes, as well as in instituting judicial proceedings;.

(3) The “tax matters partner” designated by the entity taxed as a partnership, i.e., a general partner of the partnership, generally represents the partnership and its partners;

(4) The Service makes its proposed audit adjustments in a final notice (FPAA) which starts the time period for the partnership to file for judicial review of one or more contested items, including an affirmative defense such as the running of the statute of limitations;

(5) Each “notice partner” is required to receive notice of important actions to be taken by the IRS such as the commencement of an audit or the issuance of a FPAA;

(6) In general, a “notice partner” has the right to participate in the audit, administrative appeal or judicial proceeding involving a TEFRA partnership audit;

(7) Each partner has the right to a settlement consistent with any settlement agreement the Service enters into with another partner;

(8) On completion of the audit and administrative proceedings, each partner has the right to contest the recommended adjustments made by the IRS before a court of applicable jurisdiction, i.e., the Tax Court, federal district court in which venue lies, or the Court of Federal Claims;

(9) After a final partnership-level determination (on one or more partnership items) has been made, either through final court decision or settlement, the Service makes its computational adjustments and issues assessments. At such time a partner can challenge the assessment only with respect to the computation itself and not as to the merits of any partnership level adjustment; and

(10) The statute of limitations for all partners' partnership items generally (but not exclusively) is determined based on the filing date of the partnership return. The TMP may extend the statute of limitations with respect to partnership items and certain “affected items” by executing a partnership-level extension agreement, which is effective for all partners even if the partners do not individually agree to an extension for their individual tax return year(s).  See Section 6229(b)(1)(B). Still, the partners have their separate statute of limitations for assessment purposes as well. The TMP may also select the forum for litigation of partnership items. Section 6226. 

In a follow-up post, these ten essential characteristics of TEFRA partnership audits have been replaced by the centralized audit rules. One remarkable difference is that the partnership may be subject to pay federal income tax, penalties and interest on partner level taxes attributable to adjustments to taxable income or loss from a prior year. Another major change is that only the partnership representative, who replaces the tax matters partner, has sole and exclusive authority to settle tax issues on behalf of the partnership with the IRS. There is no notice partner idea and no right of a partner to intervene. That is why it will be critically important for partnership agreements to “reign in” to the extent possible, the powers and authority of the partnership representative.

Calls for Reforms or Repeal of the TEFRA Rules

As previously discussed, the TEFRA entity level audit  rules were originally adopted in response to the increasing number of tax shelter syndicators who were marketing tax shelter transactions, which in many cases were abusive, which were offered or presented to high-income individuals in an effort to eliminate and/or defer an anticipate tax gain or one that was already realized earlier in the same taxable year.  “The inherent characteristics of such shelters were low cash payments in relation to tax savings generated from leveraged transactions. Many of the deals did not have economic substance without taking tax savings into account and promoters also used inflated values from which taxpayer-investors to claim cost recovery expensing and tax credit amounts. The Service wanted to audit such tax shelters in a single proceeding that would have the opportunity to bind all affected partners.

Over thirty years have passed since the TEFRA entity level audit rules were enacted, it has been reported that a large segment of the tax shelter industry directed toward eliminating and/or deferring large taxable gains or income of individuals has “retired”. Still, the corporate tax shelter phenomenon got into full swing with the use of “basis plays” and “foreign tax credit splitting techniques” and other tax avoidance transactions from the mid-1990s for a 10 or more year period. Most of the promotions involved the use of partnerships such as in “Son of Boss” promotions which strategies would necessarily involve the application of the partnership audit rules.  This is attributable to the flexibility afforded partnerships for federal income taxation as a blend of entity and aggregate level rules.

Presently, as acknowledged in the recent GAO report mentioned above, the Service audits few large partnerships. Even when audited, there were small, if any, adjustments made. Although internal control standards call for information about effective resource use, the IRS has not defined what constitutes a large partnership and does not have codes to track audit results. According to IRS auditors, the audit results may be due to challenges such as finding the sources of income within multiple tiers, while meeting the administrative tasks required by TEFRA within specified time frames. For example, IRS auditors have said that it can sometimes take months to identify the partner that represents the partnership in the audit, reducing time available to conduct the audit. TEFRA does not require large partnerships to identify this partner on tax returns.

Also under TEFRA, unless the partnership elects to be taxed at the entity level (which few do), the IRS must pass audit adjustments through to the ultimate partners. IRS officials stated that the process of determining each partner's share of the adjustment is paper and labor intensive. When hundreds of partners' returns have to be adjusted, such as for investors in hedge funds or private equity funds, i.e., so-called “large partnerships,” the costs involved limit the number of audits that the IRS can conduct. Adjusting the partnership return instead of the partners' returns would reduce these costs (but, without legislative action, IRS's ability to do so was limited). The noble goal of a single-entity audit and proceeding was compromised by increasing awareness that the rules were overly complex, at times counterintuitive, led to unfair results, and could hardly be said to have resulted in administrative efficiencies.

Over the years the Service has become increasingly frustrated in auditing partnerships subject to the TEFRA rules. This was relected in a GAO Study that was issued in September 2014. 

Thus many in Congress were increasingly concerned that “large partnerships” may not be subject to the proper level of audit review, fueled in some part by the complex entity level audit provisions, and that reform in this area was needed. Over the past several years various commentators, including professional groups and organizations, have called for major reforms if not the outright repeal of the ELA rules as well as the “electing large partnership provisions.”

Continued Applicability of the TEFRA Entity Level Audit Rules

In general, the BBA centralized audit regime does not start in earnest until taxable years beginning after 2017. Partnership audits, therefore, will continue to be governed by the TEFRA entity level audit rules for all taxable years that are still within the applicable period of limitations, be it the general 3 year period, 6 year period for items that constitute greater that 25% omissions or unlimited in the event no return is filed for a pre BBA year or there are items of fraud on a return filed at any time prior to 2018. 

Under current law (TEFRA), there are three regimes for auditing partnerships. For partnerships with 10 or fewer eligible partners, the IRS generally applies the audit procedures for individual taxpayers, auditing the partnership and each partner separately. For most large partnerships with more than 10 partners, or small partnership that are not “eligible small partnerships”,  the Service and the partnership engage in a single administrative proceeding to resolve audit issues regarding partnership items that are more appropriately determined at the partnership level than at the partner level. Once the audit is completed and the resulting adjustments are determined, the IRS must recalculate the tax liability of each partner in the partnership for the particular audit year.

Provisions to Consider for Partnership and LLC Operating Agreements For TEFRA Partnerships: It Still Matters

In instances where the partnership will be subject to entity level audit procedures under TEFRA, which will apply to existing partnerships through the expiration of the statute of limitations on assessment of income tax with respect to audits of partnerships for taxable years commencing on or before December 31, 2017, it is important for the draftsperson of the partnership agreement give a fair amount of thought and consideration to what provisions needed to be reflected in the agreement pertaining to the tax matters partner and the TEFRA provisions in general. While the BBA is receiving by far the most attention by tax commentators, the Treasury and the Service, it should not be overlooked that TEFRA is still the “game” for a few more years.

As will be noted in the next post, many of the provisions that are part of a comprehensive set of rules governing the tax matters partner can be incorporated within a set of rules applicable to the partnership representative. Since the partnership representative is the exclusive agent for representing the partnership before the IRS and can bind all partners to a settlement or set of adjustments at audit, the set of provisions governing the partnership representative under the BBA are critically important and are not well served by the adoption of a short form paragraph or two to reduce document costs.

The Tax Matters Partner Provision. The tax matters partner (TMP) has direct responsibility for representing the partnership in a TEFRA proceeding and notifying and informing the partners of the status of the audit, appeal or litigation. The Service considers of course that the TMP is the quarterback for the partnership and will send out TEFRA notices and information of proceedings. The title, jobs and duties of the TMP needs to be identified in the partnership agreement.

Responsibility of the Tax Matters Partner. The responsibilities of the TMP are described in broad brush under Proc. Reg. §301.6223(g)-1. The first area of responsibility is to provide notice of the commencement of the audit to each non-notice partner within 75 days after the Service mails the notice of audit to the TMP and notice partners per section 6223(a)(1). Similarly, the TMP is required to forward, within 60 days after receiving a notice of a final partnership administrative adjustment (FPAA) set forth in section 6223(a)(2), file a notice to each non-notice partner. The regulations provide exceptions to the notice requirement rule. Proc. Reg. §301.6223(g)-1(a)(3).

  1. The TMP must inform each partner of a closing conference with the examining agent. Proc. Reg. §301.6223(g)-1(b)(i).
  2. The TMP must provide all partners with information about proposed adjustments, rights of appeal, the requirements for filing an administrative appeal with the IRS and the time and place for the appeals conference.
  3. The TMP must notify the partners of an acceptance on behalf of the partners of a settlement offer made by the Service. Proc. Regs. §§ 301.6223(g)-1(b)(ii)–301.6223(g)-1(b)(iv).
  4. The TMP may bind partners who are not notice partners to a settlement with the IRS unless such partners file statements with the Service revoking this authority. Section 6224(c)(3).
  5. The TMP may waive the period of limitations to all partners. Section 6229(b)(1)(B).
  6. The TMP may file an administrative adjustment request on behalf of the partnership under Section 6227(c)
  7. The TMP is required to provide the Service with information concerning the address and identify of the partners if requested. Section 6230(e).

Selection of the Tax Matters Partner. It is axiomatic that in a carefully drafted partnership or organization agreement for a limited liability company or limited liability partnership (collectively referred to herein as the “partnership”) the partners or members may negotiate the selection of the TMP to be the product of negotiation which takes into account, inter alia,  who is best suited to represent the partnership before the IRS and other taxing authority. In some instances, it will be a majority partner or majority group that will do the selecting.  As a threshold consideration, shouldn’t the TMP be the general partner in a limited partnership or a member of the corporate general partner’s board of directors? The answer is “yes” since the TMP is required to be a general partner. Section 6231(a)(7). If there is no general partner designated as the TMP, then the general partner having the largest profits interest in the partnership at the close of the taxable year involved is generally required to serve as TMP. If the partnership is a limited liability company, then shouldn’t the TMP be the manager of the LLC? What if there is more than one general partner or LLC manager, how is the selection made? On the basis of which partner has the largest capital or profits interest as general partner? Or the largest overall capital and profits interests as both general partner/manager and limited partner/member? With respect to an LLC, the preferred view appears to be that a manager-member must be selected as TMP as compared with a manager who is not a member. 26 CFR § 301.6231(a)(7)-2(a) ( “only a member-manager of an LLC is treated as a general partner”)

Term of the Tax Matters Partner. The term of the TMP should be set out in the partnership agreement. Since a new partnership may not be audited for several years or more, the initially selected TMP, absent resignation, death, disability or the fact that such individual is no longer a partner at a later date, should initially serve a term of office for an extended term of years, e.g.,, 5 taxable years. The period can be shorter of course. On the other hand,  an extended or indefinite period of time for the TMP’s term of service may prove to be undesirable and concentrate too much authority in one individual on tax matters than may be intolerable to the other partners.  

Compensation of the Tax Matters Partner. Since the obligations and duties of the TMP are substantial, the TMP’s services should be paid out of the cash flow of the partnership as Section 707(a) payment and not as a part of the TMP’s distributive share of partnership profits. The compensation should be based with an awareness of the amount of time necessary for the TMP to do his or her tasks carefully and properly and with due regard to the business operations of the partnership, the nature of its assets, and the relative complexity of its tax reporting and compliance profiles. While it is conceivable that a majority owner may “forfeit” or decline to serve for compensation, in my experience as tax counsel who have in representing numerous TEFRA partnerships in difficult audits, appeals or in tax litigation matters, the TMP is not a bystander to the process and must be directly involved in the tax audit, etc., and in making judgment calls and keeping the partners notified of what is going on.

Replacement of the Tax Matters Partner. The operating agreement should set forth a procedure for voting out the TMP or replacing the TMP who resigns or is unable to serve due to illness or some other factor. The election process should correspond to the selection process. The TMP should be removed, of course, for acts of malfeasance, recklessness or fraud. Of course the replacement TMP must be eligible under Section 6231(a)(7).

Conflicts of Interest. The question that surfaces here is whether the TMP serves as a fiduciary to the partnership and its partners. The assumption must be that he or she is a fiduciary to the other partners. What if the fiduciary, however, has competing interests with respect to what he or she wants the IRS to do with respect to one or more items to benefit his tax position that unfortunately results in a tax detriment to one or more other partners? In such instance is there a voting procedure to resolve the conflict? Are there other adversely affected partners “notice partners” who can participate in the process? What if the conflict of interest involves both notice and non-notice partners? How does the TMP protect himself from lawsuit? Many TMPs will want a waiver of conflict of interest contractual protection and legal counsel representing the partnership should be reluctant to agree to this type waiver unless he or she can get unanimous or close to unanimous consent from the other partners. Granted this problem is more severe under the new BBA regime since the partnership representative is the sole authority who speaks for the partnership and its partners, but the issue is still present. Ultimately, it should be expected that the TMP will be called to speak on behalf of the majority in interest of the partners.

Indemnification of Tax Matters Partner. Even in a non-conflict of interest situation, the TMP will want to be held harmless and indemnified by the partnership for any claim made by a current or former partner for damages alleged to have been caused by his acting on behalf of the partnership in a tax audit, administrative appeal or judicial proceeding, including in a situation that a conflict of interest could be asserted. There may be a need to get a policy or general business liability coverage for the TMP as there would be for a managing member or general partner of a partnership.

Exceptions to Indemnification. Of course, where the offensive conduct is reckless, careless, grossly negligent or fraudulent, the indemnification provision should be tailored to not hold the TMP harmless in such instances.

Indemnification of Successor Tax Matters Partner. This situation may be just as critical to address as the subject of the indemnification of the TMP. That is because a successor TMP may inherit a “bad” or “critical” situation where important decisions are immediately front and center yet the successor TMP may lack sufficient history in the matter or even the expertise to make these decisions. Another consideration is whether the successor TMP want to bring in a new set of tax advisors? If so, will the partnership bear the cost of the replacement team?  It should be anticipated that the Successor TMP will want to be held harmless and indemnified with respect to all pending and prior tax matters affecting the partnership as well as the prior years’ returns reporting of partnership items. Again, there should be exceptions from such indemnification for gross negligence or fraud.

Confirmation of Fiduciary Duty. While this issue is more problematic under the BBA where the partnership representative is not a partner in the partnership, generally the TMP will be under a fiduciary duty to perform his services under the applicable state law standard pertinent to fiduciaries of business entities. This includes a duty of loyalty, good faith disclosure, etc. See, e.g., Feely, AK-Feel, LLC and Oculus Capital Group, LLC, v. NHAOCG, LLC, 62 A.3d 649 (Court of Chancery of Delaware 2012). [1]

Contractual Authority of the Tax Matters Partner. The partnership agreement should address the authority of the TMP to hire and discharge accountants, lawyers, experts, etc. in connection with the partnership returns, audits, appeals and litigation involving tax matters. Consider whether such authority should be limited to a specific dollar amount for the calendar year or other period. For additional charges a majority in interest of the partners may be required to approve. Perhaps the TMP should have a budget for such expenditures approved in advance as part of an annual business plan. The duties and responsibilities of the TMP should be set out in a separate provision of the partnership agreement and should not be included as part of the duties and responsibilities of the general partners or managers.

Should the TMP Be the Tax Return Preparer or Tax Advisor for the Partnership? There may be various views on this subject. Some may feel that someone most knowledgeable of the tax return filings and reporting positions of the partnership, i.e., the CPA who signed the partnership return aspreparer,  is most able to represent the partnership and should serve as the TMP. Others may disagree including on grounds 

of potential conflict of interest. Perhaps a stronger case for a problem in this area may be connected with a situation in which the tax return preparer’s representation of one or more of the partners may cloud his perspective in favor of his clients who are partners. Other partners may feel there may be an appearance of bias. Note again, that if a non-member is selected, the LLC must be a manager and hopefully the government will respect such status. Otherwise if a limited partnership only a general partner, which can be an entity as well as an individual, must be selected.  Then there are technical issues such as attorney-client privilege to consider especially in a delicate audit or where litigation is anticipated. Overall, the more conservative route may be to have a committee of the partnership oversee of the acts and decisions of the TMP and to exercise authority the TMP where prior approvals are needed in order for the TMP to take decisive action on an issue, a settlement, an appeal, a waiver of the statute of limitations, on the conduct of litigation, and on settling out Tax Court or refund suit case.

Therefore, in general, it will be difficult for a CPA who is not a member of an LLC or general partner in a partnership to serve as the TMP.

Selection of Judicial Forum To Challenge Partnership Adjustments In many instances the partnership may prefer to challenge a proposed set of deficiencies in tax against the partners (for the reviewed years of course since this is pre-BBA) in the United States Tax Court since full payment of the amount in dispute is not required. The benefit to filing a tax refund suit may be the selection of a more favorable forum because of the desirability of a jury to hear the case in federal district court where venue lies, but the Court of Federal Claim may be even more attractive perhaps due to the fact that neither side may ask for a jury and the court is not overwhelmed by a docket full of tax cases as is the Tax Court. There may be more favorable precedent in the Federal Circuit Court of Appeals which would tend to favor a refund suit be filed in the Court of Federal Claims.

There is also the issue of precedent in the appeals court to which an appeal from the trial court would lie. The problem with refund litigation is the Flora rule requiring full payment of the amount in issue as a jurisdictional requirement. Does the partnership have a reserve in place for such purpose? If not, should the TMP unilaterally decide to have the partners pay up to the full payment requirement? What if some partners refuse? Since refund litigation may be difficult, should the partnership agreement require the TMP to take any federal tax dispute up to the United States Tax Court unless there is a supermajority of partners who, after receiving analysis from partnership’s tax counsel, decide to embark on refund litigation. 

Prior Approval For the TMP’s Taking Affirmative Actions

It is obviously protective of the partners in the partnership to require prior notice and even approval before the TMP takes certain acts. A breach of such prior approval provision could result in the loss of contractual protection as well as a reduction in compensation to the TMP. So careful consideration should be given to drafting specific provisions in the partnership agreement requiring prior approvals. Here is a list of points to consider:

  1.  The TMP may not enter into a settlement with the IRS on a tax audit, based on a schedule of adjustments, without first notifying all partners of the proposed adjustments and receiving the consent of a majority (or super-majority) of the partners, based on percentage ownership interest, to agree to the settlement.
  2. As part of considering #1, the agreement could restrict any partner other than the TMP from entering into a settlement with respect to partnership items. This provision could be made expressly subject to #1 which requires prior approval or, alternatively, the agreement may provide the TMP with the express authority to enter into settlement agreements. See Section 6224(c)(3)(B).
  3. The TMP will notify all partners within the required number of days of:
       a. Receipt of a NOPA from the IRS for the commencement of an audit of the partnership;
       b. Receipt of a FPAA from the IRS in accordance with Section 6223;
       c. The partnership’s filing of a petition for judicial review of any FPAA;
       d. Any and all information required under Section 6223(g); and
       e. All other information required to be delivered to the partners in accordance with the terms of the partnership agreement.
  4. The TMP may not (or may), unless he first receives the necessary prior approval by appropriate written resolution of the partners in accordance with  the agreed terms of the partnership agreement:
       a. Enter into a settlement with the IRS on any tax audit, appeal, or judicial proceeding;
       b. File a petition for judicial review of an FPAA pursuant to Section 6226;
       c. Intervene in any action brought by any other partner for judicial review of a final administrative adjustment;
       d. File a request for an administrative adjustment with the IRS or file a petition for judicial review with respect to the request;
       e. Enter into an agreement to extent the statute of limitation of assessment of tax under Section 6229; and
       f.  Take any other action on behalf of the partners or partnerships pertaining to any administrative or judicial proceeding to the extent allowed by the Internal Revenue Code or regulations.

This is the first 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”

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


[1] As noted by the Court of Chancery of Delaware in Feeley, supra, the Delaware Limited Liability Company Act (the “LLC Act”) contemplates that equitable fiduciary duties will apply by default to a manager or managing member of a Delaware LLC. Section 18–1104 states that “[i]n any case not provided for in this chapter, the rules of law and equity ... shall govern.” 6 Del. C. § 18–1104. Like the Delaware General Corporation Law, the LLC Act does not explicitly provide for fiduciary duties of loyalty or care; consequently, the traditional rules of law and equity govern. See Auriga, 40 A.3d at 849–56. “A fiduciary relationship is a situation where one person reposes special trust in and reliance on the judgment of another or where a special duty exists on the part of one person to protect the interests of another.” Metro Ambulance, Inc. v. E. Med. Billing, Inc., 1995 WL 409015, at *2 (Del.Ch. July 5, 1995) (quoting Cheese Shop Int'l, Inc. v. Steele, 303 A.2d 689, 690 (Del.Ch.1973), rev'd on other grounds 311 A.2d 870 (Del.1973)). The managing member of an LLC “is vested with discretionary power to manage the business of the LLC” and “easily fits the definition of a fiduciary.” Auriga, 40 A.3d at 850–51. 

A plain reading of Section 18–1101(c) of the LLC Act is consistent with Section 18–1104 and confirms that default fiduciary duties apply. Section 18–1101(c) states:

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....”

See Hecker, Jr., “Fiduciary Duties in Business Entities Revisited”, 61 U. Kan. L. Rev. 923 (2013). 


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