For more than 30 years, the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) has guided taxpayers on unified partnership audit and litigation procedures. However, beginning Jan. 1, 2018, the recently passed Bipartisan Budget Act of 2015 (BBA) provided a marked departure from the previous rules as to whom the unified rules could apply and expanded the issues the Internal Revenue Service could resolve at the partnership level. The one additional statutory change that the authors feel may be ignored until it is too late is that under the BBA, partnerships no longer have a tax matters partner (TMP) to handle tax filings and deal with the IRS, but now have a partnership representative (PR). Under the BBA, the PR can have little to no ownership in the partnership and yet make many significant unilateral decisions affecting the audit and litigation of a partnership matter. The decision of whom to select as the TMP was generally obvious and rarely controversial under TEFRA. Those days are gone. The following article discusses the PR rules as found in the BBA and IRS regulations as well as raises further questions that are currently left unanswered.
OUT WITH THE OLD
The original rules found in TEFRA were meant to create unified audit and litigation procedures for partnerships. According to the Joint Committee on Taxation, TEFRA’s original goal was to streamline the IRS’s partnership audit process while simultaneously ensuring the rights of all partners. (Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and Fiscal Responsibility Act of 1982, JCS-38-82 (Dec. 31, 1982).) Prior to TEFRA, the IRS generally was forced to conduct an audit of each partner in order to review and ultimately adjust any tax item reported on a partnership return (Form 1065). In the pre-TEFRA era, each partner could control all decisions impacting his or her liability from the proposed IRS adjustments—from statutory extensions to negotiations of the partnership tax items in dispute. While TEFRA removed many of the procedural safeguards partners had prior to TEFRA, the BBA partnership rules took it one giant step further and essentially eliminated most of the rights partners had prior to TEFRA, which could ultimately impact collection cases.
In the eyes of the IRS, TEFRA made the examination of large partnerships “a complex and time-consuming process.” (REG-136118-15, 82 Fed. Reg. 27,334 (June 14, 2017), “Background,” 2.A.) According to the IRS, during the more than 30 years since the TEFRA partnership audit rules were enacted, there was “a shift in how business entities [were] structured—toward partnerships and away from C corporations.” (Id.) Between 2002 and 2011 alone, the number of partnerships increased 47 percent to 3.3 million while the number of C corporations decreased 22 percent to 1.6 million. (GAO, Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency, GAO-14-732 (Sept. 18, 2014).) The Government Accountability Office (GAO) asserted that the structure of these partnerships grew more and more complex with the number of large partnerships (those with 100 or more direct and indirect partners), tripling to more than 10,000. (Id.) Yet, as the number of large partnerships increased, the number of partnership audits did not keep pace. The GAO report said that the rapid increase in the number and complexity of these partnerships meant that the IRS could audit less than 1 percent of large partnerships annually. (Id.) This is especially striking, considering that the annual audit rate for 2012 of C corporations was roughly 27 percent.) That trend continued as in calendar year 2016, over 3.9 million partnership returns were filed, yet only just over 15,000 were examined, resulting in a .4 percent audit rate, one of the lowest rates for all forms of returns filed. (IRS Data Book, 2017, p. 23.) Of those approximately 15,000 partnership returns examined, just over 9,000 were actual field examinations with the remaining 6,000 audited solely by correspondence. (Id.)
The IRS claims examiners had trouble efficiently conducting partnership audits in large part due to the procedural issues and treatment of partnership audits under TEFRA, as well as the difficulties that arose with TMPs. For example, under TEFRA rules, the IRS claims a challenge is passing the audit adjustments to partnership items on to the ultimate partners. In the view of the IRS, it was onerous to “link potentially thousands of partner returns, including through tiers of partners that are themselves partnerships, to determine the proper share of the adjustments for each ultimate partner flowing from adjustments to partnership items.” (REG-136118-15, “Background,” 2.A.) Moreover, the IRS stated “the requirements placed on the designation of the TMP under TEFRA [made] it difficult in many cases to identify a qualified TMP,” thus delaying the audit procedures while the period of limitations for the IRS to assess tax with respect to each partner continued to run. (Id.) Clearly, the IRS attributed the rules (or lack thereof) governing TMPs as a factor that prevented the IRS from efficiently conducting audits of a partnership.
In 2015, Congress enacted the BBA to implement changes to the partnership audit process, creating an even more centralized audit and litigation procedure. While beyond the scope of this article, it is important to note that the BBA intensifies the responsibilities of the representative of the partnership by increasing the authority of the IRS to make adjustments at the partnership level and allowing the IRS to collect the ultimate tax liability from the partnership.
The increased responsibility comes from the fact that the BBA permits the IRS to resolve more tax items at the partnership level while demanding one dedicated point of contact: the PR. As part of the new BBA rules, for tax years beginning after 2017, each partnership must designate a PR for each partnership taxable year. (Internal Revenue Code “Section” 6223(a).) Thus, the partnership could have a different PR serving each year, which could be advantageous for those tax years in which significant business transactions occur. Any individual, including non-partners, can serve as a PR (subject to the eligibility requirements discussed below). (Prop. Treas. Reg. 301.6223–1(b).) In June 2017, the IRS issued proposed regulations regarding the new partnership procedures, including regulations involving the PR. (REG-136118-15.) As of the date of this article, these regulations have yet to be finalized.
Courts have found that proposed regulations are not entitled to judicial deference and “carry no more weight than a position advanced in a brief by the [IRS].” (Scott v. Commissioner; F.W. Woolworth Co. v. Commissioner.) Nonetheless, taxpayers should be able to rely on proposed regulations such as those governing PRs as long as the regulations do not contradict the unambiguous language of the statute. (CWT Farms, Inc. v. Commissioner.)
TMP 2.0—THE ROLE AND POWERS OF THE PR
Under the old rules, the IRS conducted an audit of a partnership by dealing directly with the “tax matters partner” (TMP). Selecting a TMP was relatively easy because a TMP had to be a general partner, or for an LLC, a member-manager. (Treas. Reg. 301.6231(a)(7)-1.) Thus, the partnership would usually select one of the partners who had the most to lose from adjustments imposed by the IRS. However, while the TMP had the authority to bind the partnership in connection with the audit and litigation, it could not bind the individual partners in the partnership with regards to partner-level items such as penalty defenses, individual statutes of limitations, and other partner-specific items that would impact the due process rights of the individual-taxpayer/partner. Moreover, each individual partner had certain notification rights and rights to participate and intervene in the audit proceedings. Thus, a non-TMP partner could intervene in an audit or the IRS appeals process and attend meetings as well as intervene in a Tax Court proceeding. (Sections 6226(c) and 6224 (prior to amendment by the BBA).)
The PR has significantly more power than its previous TMP counterpart. According to the newly enacted sections, any action taken by the PR during an audit proceeding is binding on the partnership and all partners. This includes any final decisions entered into or agreed upon by the partnership representative. (Section 6223(b).) Theoretically, a PR—who may or may not even be a partner in the partnership—could enter into an agreement with the IRS without consultation from the partners, and bind the entire partnership and individual partners to certain agreements.
Not even a partnership agreement, written agreement, or state law can limit a PR’s power to bind the partnership for purposes of a centralized partnership audit proceedings. (Prop. Treas. Reg. 301.6223-2(c)(1).) This means that if a designated PR acts in violation of a partnership agreement, or even state law, under the proposed regulations its actions would be deemed binding on the individual partners. The proposed regulations state that by virtue of being designated a PR, the PR has the requisite authority to bind the partnership for all purposes related to audit procedure. (Prop. Treas. Reg. 301.6223-2(c)(2).) Consider the following shortened example from the proposed regulations:
Example 2. Partnership designates a partnership representative, PR, on its partnership return for 2020. PR is not a partner in Partnership. During an administrative proceeding with respect to Partnership’s 2020 taxable year, PR agrees to certain IRS adjustments and within 45 days after the issuance of the notice of final partnership adjustment (FPA), elects the alternative to payment of the imputed underpayment. Certain partners challenge actions taken by PR alleging that PR was never authorized to act on behalf of Partnership under state law or the partnership agreement. Because PR was designated by Partnership as the partnership representative, PR was authorized to act on behalf of Partnership and the IRS may rely on that designation as conclusive evidence of PR’s authority to act on behalf of Partnership. (Prop. Treas. Reg. 301.6223-2(d) Ex. 2 (modified/shortened).)
As noted, a PR has the ability to choose whether to incur the cost from an audit adjustment liability by the partnership or by the partners in the reviewed year. (Prop. Treas. Reg. 301.6226-1.) Once the total tax assessment is determined, the PR may elect to either allocate that total amount among the partners—so the IRS can collect a specific amount from each partner—or pay the tax on each partner’s behalf at the partnership level. This could mean that a PR could settle a liability for an audit for a past year with partnership funds even if the partnership consists of entirely new partners from the past audited years.
Furthermore, unlike the old TEFRA rules where an individual partner had certain rights to intervene, under the BBA rules, only the PR would be permitted to raise defenses to penalties, additions to tax, or additional amounts, including the partnership’s defenses and defenses that relate to any partner. Other partners no longer have per se statutory notification rights or rights to participate in the audit proceedings. Instead, the regulations provide that non-PR partners may participate in the audit only with “the permission of the IRS.” (Prop. Treas. Reg. 301.6223-2(c)(1).) The stakes are especially high considering that the regulations state that any defense not raised by the partnership before a final determination is likely waived, even if that defense relies on facts and circumstances relating to one or more partners or any other person. (REG-136118-15, “Explanation of Provisions,” 1.) Moreover, a PR, without the consultation of the individual partners, may extend the partners’ statute of limitations with respect to partnership items as well. (Prop. Treas. Reg. 301.6223-2(b).) The greater responsibilities of the PR means that partnerships should be especially careful in designating a PR and be sure to clearly enumerate any directions or limitations they seek to impose on the PR.
Eligibility to Become a Partnership Representative
Under the old rules, the partnership’s TMP was usually the general partner of the partnership. (Treas. Reg. 301.6231(a)(7)-1.) With the BBA, any individual is eligible to be designated as a PR so long as they have a “substantial presence” in the United States. (Prop. Treas. Reg. 301.6223-1(b)(2).) It should be noted that this “substantial presence” test is a separate and distinguishable assessment from the substantial presence test described in Section 7701 (relating to determination of whether an alien individual should be treated as a resident alien for U.S. tax purposes). According to the proposed regulation explanations, the “substantial presence” test found in Prop. Treas. Reg. 301.6223 is intended to ensure that the person selected to represent the partnership will be available to the IRS in the United States when the IRS seeks to communicate or meet with the representative. (REG-136118-15, “Explanation of Provisions,” 4.A.)
The proposed regulations state 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 U.S. area code where the partnership representative can be reached by U.S. mail and telephone during normal business hours in the United States. Third, the partnership representative must have a U.S. taxpayer identification number. (Prop. Treas. Reg. 301.6223-1(b)(2).)
If the partnership designates an entity instead of an individual to be the partnership representative (known as an “entity partnership representative” or EPR), the proposed regulations require the partnership to appoint an individual (a “designated individual” or DI) as the sole individual to act on behalf of the EPR. (Prop. Treas. Reg. 301.6223-1(b)(3).) Like the partnership representative itself, the designated individual must meet the substantial presence test detailed above. (Prop. Treas. Reg. 301.6223-1(b)(3)(ii).) If the partnership does not appoint a designated individual, the IRS may determine the partnership representative designation is not in effect. (Prop. Treas. Reg. 301.6223-1(f).) According to the proposed regulation explanations, communication between the IRS and the PR is “fundamental to an efficient administrative proceeding,” and therefore it seems that an emphasis has been placed on ensuring direct communication with an individual who has the power to bind the entire partnership. (REG-136118-15, “Explanation of Provisions,” 4.A.) While the proposed regulations on silent on such point, the PR should be able to be engage a representative holding a power of attorney to represent the PR before the IRS, just like other taxpayers. (Section 7521(c).)
In addition to the “substantial presence” test, the proposed regulations state that to be eligible as a PR or DI, a person must have the requisite capacity to act as the partnership representative. A person does not have the capacity to act, and is therefore ineligible to serve as a PR or DI, in the event of:
(ii) A court order adjudicating that the person does not have the capacity to manage his or her person or estate;
(iii) A court order enjoining the person from acting on behalf of the partnership or the entity partnership representative;
(v) Liquidation or dissolution under state law in the case of an entity partnership representative; or
(vi) Any similar situation where the IRS reasonably determines the person may no longer have the capacity to act. (Prop. Treas. Reg. 301.6223-1(b)(4).)
Notice here that while the IRS can make a “reasonable determination” that a PR does not possess the requisite capacity, a partner or non-member cannot unilaterally conclude that a PR has lost capacity without a supporting court order.
Clearly the appointment of a PR and how the partners can control the PR’s decision-making ability will be (or should be) a hotly negotiated item. For example, when and if the PR can elect out of the partnership provisions should clearly be discussed in the agreement. Finally, the PR provisions of a partnership or operating agreement should be reviewed by a tax litigator to ensure that the rights and responsibilities of a PR are consistent with the duties the PR will have during any examination, IRS appeal, and/or litigation.
Thinking Outside the Triangle—Considerations for Selecting a Non-Partner PR
While a partnership has the ability to select a non-partner PR, should it? For purposes of this article, the authors assume the primary consideration for the partnership is whether to select an outside firm that is holding itself out as qualified to serve as a PR (versus the brother-in-law or neighbor of the managing member, who could serve). All indications are that the IRS would invite the selection of a non-partner PR for a variety of reasons, including the fact that the non-partner PR may be more responsive on a timely basis than the IRS witnessed with the TMP.
The partnership would have to decide whether it was in the best interests of current and future partners to have a PR that owed a fiduciary responsibility to the partnership similar to the independent trustee of a trust or to a board of directors. A few advantages of designating an independent non-partner PR would be: (1) to permit the partners to focus on the partnership business and their other business dealings, (2) to resolve any conflicts of interest among the partners, (3) continuity as the firm should be around for years and decreased risk of withdrawing from partnership, and (4) experience with dispute resolution, including litigation. The disadvantages could include: (1) cost, (2) partner perception/distrust because the PR “has no skin in the game,” and (3) lack of control by the partners.
Resignation of PR
Given the time commitment as well as the enhanced responsibility of the PR, it may come as no surprise that the proposed regulations lay out in great detail the PR resignation procedures. According to the proposed regulations, a PR may resign by notifying the partnership and the IRS in writing and in accordance with applicable forms and instructions prescribed by the IRS. The notification to the IRS may include a designation of a successor PR for the partnership taxable year for which designation of the resigning partnership representative was in effect. This resignation and subsequent designation is effective 30 days from when the IRS receives the written notification. Failure to satisfy the requirements of the procedures outlined in the proposed regulations could result in a determination that no resignation has occurred. (Prop. Treas. Reg. 301.6223-1(d)(1).)
While the resignation process by a PR may be relatively straightforward, a PR is only allowed to initiate that process at certain times. The proposed regulations provide that a PR designation may not be changed (either by resignation or revocation) until the IRS issues a notice of administrative proceeding to the partnership, except when the partnership files a valid administrative adjustment request (AAR) in accordance with Section 6227. (REG-136118-15, “Explanation of Provisions,” 4.B.) This effectively means that the PR may not resign prior to the issuance of a notice of administrative proceeding (except in conjunction with the filing of an AAR), but the PR may resign at any time after the issuance of the notice of an administrative proceeding. (Prop. Treas. Reg. 301.6223-1(d)(2).). Seemingly, the drafters recognize “there may be other circumstances that warrant allowing a partnership or partnership representative to change the partnership representative designation” but that it will rely on provided comments to address such circumstances. (REG-136118-15, “Explanation of Provisions,” 4.B.)
The proposed regulations also describe the rules that allow the partnership to revoke the partnership representative designation and designate a successor. (Prop. Treas. Reg. 301.6223-1(e).) This revocation provision is an exception to the general rule that the PR has the sole authority to act on behalf of the partnership. In general, a change in the PR or designated individual (or DI) should only occur when the PR resigns and appoints a successor. However, there may be circumstances where the partnership would like to change the designation, and the PR or DI will not resign. Prop. Treas. Reg. 301.6223-1(e) provides flexibility to the partnership in these circumstances, allowing the partnership, through its partners, to revoke a prior designation. (REG-136118-15, “Explanation of Provisions,” 4.B.)
Generally, for revocations of PR by a partnership, a general partner (as shown on the partnership return at the close of the taxable year for which the partnership representative was designated) must sign the revocation. If no general partner has the capacity to act on behalf of the partnership, any reviewed year partner in the partnership may sign the revocation. For purposes of determining which partners may sign a revocation, member-managers are treated as general partners, and other members are treated as a partner other than a general partner. (Prop. Treas. Reg. 301.6223-1(e)(3)(i).) If there is no member-manager, each member is treated as a member-manager. (REG-136118-15, “Explanation of Provisions,” 4.B.) Based on the importance of the responsibilities of the PR, the revocation of that position should be addressed early in the partnership or operating agreement.
Expansion of the Small Partnership Exception
Not all partnerships are subjected to the mandatory designating of a PR. Certain partnerships can elect out of the centralized partnership audit regime. (Section 6221(b).) Of course, the PR could be in control or at least participate in the decision to elect out, which as noted, would need to be addressed in the agreement. These small partnerships are subject to the pre-TEFRA audit procedures under which the IRS must separately assess tax with respect to each partner. There are two conditions that must be met for a partnership to be eligible to elect out of the centralized partnership audit regime.
First, a partnership must have 100 or fewer partners. Under the proposed regulations, a partnership has 100 or fewer partners when it is required to furnish 100 or fewer Schedules K-1. (Prop. Treas. Reg. 301.6221(b)-1(b)(2).) Each S corporation shareholder of an S corporation partner, each U.S. shareholder of a controlled foreign corporation, and each shareholder making a qualified electing fund election for a passive foreign investment company is also counted for purposes of the 100 or fewer Schedule K-1 limitation. (REG-136118-15, “Explanation of Provisions,” 2.B.)
Second, a partnership must only have eligible partners. (Prop. Treas. Reg. 301.6221(b)-1(b); REG-136118-15, “Explanation of Provisions,” 2.B.) 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).) A partnership must include a disclosure of the name and taxpayer identification number of each partner of the partnership. (Section 6221(b)(1)(D)(ii).) In the case of an election out by a partnership with an S corporation partner, the election also must include a disclosure of the name and taxpayer identification number of each person to whom an S corporation partner is required to furnish a statement for the taxable year of the S corporation ending with or within the partnership taxable year that is subject to the election. (Prop. Treas. Reg. 301.6221(b)-1(b)(2)(ii).)
These rules provide for a noticeable expansion of the small partnership exception from the previous regime. Under TEFRA, only partnerships with more than 10 partners (and partnerships with at least one partner that is not a U.S. individual, a C corporation, or an estate of a deceased partner) were automatically covered. (Section 6231(a)(1)(B) (prior to amendment by the BBA).) Under the BBA, a partnership can qualify for the exception if it has less than 100 partners. It should be noted that under the BBA, to qualify for this small partnership exception, the proposed regulations explanations state that a partnership must take an affirmative action to elect out of the regime; simply having less than the 100-partner requirement is not enough to qualify. Once a partnership has successfully opted out of the centralized partnership audit regime, they are subject to pre-TEFRA audit procedures where the IRS separately assesses tax against each partner. (Prop. Treas. Reg. 301.6221(b)-1; REG-136118-15, “Explanation of Provisions,” 2.B.) Thus, considerations should be given before opting out of the centralized audit procedures of the BBA to pre-TEFRA audit procedures, pre-TEFRA guidance, and pre-TEFRA case law.
The new BBA rules make choosing the PR an extremely important decision for a partnership. Unlike under TEFRA, the PR does not have to be a general partner, managing member, or even a partner at all. The PR is solely empowered with the authority to bind the partnership and all partners in a dispute with the IRS without any participation by any partners. To that end, partnership or operating agreement should address this new set of rules that can guide and direct the appointed PR from appointment to revocation of the position. The partnership or operating agreement should address each possible decision the PR may be forced to make in order for the partnership to take a unified position on how the decision should be handled as well as what steps should be taken should the PR make a decision contrary to the agreement terms.
Chuck Hodges, M.S. (Economics), J.D., LL.M. is a partner in the Tax Practice of Jones Day, where he focuses his practice on federal tax controversies and litigation and assists U.S. taxpayers facing tax disputes around the world. He has been involved in more than 125 litigation cases against the IRS. By combining his tax law background with his master’s degree in economics, Chuck also advises clients on transfer pricing issues and the global taxation of intellectual property.
Aditya Shrivastava, J.D. is an associate in the Jones Day Tax Practice where he focuses on domestic and international intellectual property tax issues and tax controversy matters. Aditya has experience in all administrative and judicial stages of a tax dispute, including audits, appeals, summons enforcement actions, privilege issues, and complex discovery disputes.
The comments, considerations, and strategies discussed below are for general thought-provoking and discussion purposes to assist readers based on input from a variety of sources and do not necessarily reflect the opinions of the authors.