By John Love
On January 1, 2018, the Internal Revenue Service began implementing new rules under the Bipartisan Budget Act of 2015 (“BBA”) designed to streamline the audit of tax returns for entities taxed as partnerships for federal income tax purposes, including general partnerships, limited partnerships, and LLCs. Chief among the changes are (i) the replacement of the former “tax matters partner” capacity with a new “partnership representative” designee with a higher level of authority to act on behalf of the partnership; and (ii) tax assessment and collection now occurs at the partnership level, rather than being passed on to the individual partners.
Tax Matters Partner versus Partnership Representative
Before 2018, newly formed partnerships were required to designate a partner (or member in the case of an LLC) as the “tax matters partner” to serve as the point person to interface with the IRS on behalf of the entity in the event of any IRS inquiries and audits. This arrangement was often viewed as problematic for certain partners – particularly those residing outside of the US – primarily due to a lack of understanding as to what the title involved. On a general level, the tax matters partner was essentially responsible for the preparation of the entity’s returns, mainly through supplying information to the company’s tax preparers.
The involvement of the tax matters partner was somewhat of an inefficient process for both the taxpayers and the IRS since the tax matters partner would interface with the IRS during audits, yet each partner had separate notice and appeal rights the IRS was required to observe. As such, the creation of the partnership representative title is an IRS-friendly initiative intended to simplify the agency’s notification efforts and limit rights of appeal.
How does this affect your partnership or LLC? Prior to 2018, the tax matters partner designated in the partnership agreement (or operating agreement in the context of an LLC) would serve as little more than the partnership’s liaison to the IRS. Under the IRS’s new audit rules for partnerships, however, the partnership representative has significantly broader authority to bind the partnership and each partner to IRS action at any stage during the audit process. Consequently, it is advisable to carefully choose your partnership representative and ensure such individual understands all of the rights, duties and obligations associated with the position. It may also be prudent to include a provision in the partnership or operating agreement requiring the partnership representative to give notice to each partner prior to entering into any agreement or other binding action with the IRS.
Partnership Tax Assessment and Collection
In another change to the partnership audit rules having a potentially greater impact, the IRS may now assess and collect taxes resulting from audit at the partnership level. This is in contrast to the procedure under prior rules which required the IRS to collect from the individual partners. Under the new rules, the IRS can collect the tax from the partnership in the adjustment year, while the tax itself was assessed during the reviewed year (the year of the audit). The obvious problem that could arise is that new partners could be held liable for tax liabilities incurred by now-dissociated partners. To address this issue, or to simply pass the tax liability from the partnership to the partners, the partnership can elect to send amended Schedule K-1s to the partners of the partnership in the year of audit.
The new partnership audit rules are likely to affect the designees of the partnership representative title, as the IRS now requires the partnership representative to have a substantial presence in the US. A substantial presence includes, among other things, being available to meet with the IRS at a reasonable time and place, having a US street address and phone number where the partnership representative can reasonably be reached during business hours, and a US taxpayer ID number. The partnership representative can be virtually any person, even an outsider to the business, as long as they meet the substantial presence rules.
Entities taxed as partnerships have the ability to elect-out of the new BBA audit rules if they have 100 or fewer partners and do not have a partnership as a partner. Each partner must be one of the following: an individual, a deceased partner’s estate, a C-corporation, a foreign entity that would be required to be treated as a C-corporation if it were a domestic entity, or an S-corporation.
Partners should give consideration whether to revise existing operating agreements to provide for the appointment of a partnership representative for dealing with IRS matters. This is especially true when none of the partners are based in the US. We also advise that any partnership or operating agreement revision include any preferred restrictions on the partnership representative’s powers to take certain actions without consent of the partnership or notice to the partners.
If eligible, you should also give consideration to electing out of the new rules (while still compliantly appointing a partnership representative) due to the potentially thorny issues of current partners dealing with the liabilities created by a previous partnership regime.
As an attorney and CPA, I focus my practice at the Forrest Firm at the intersection of the financial and legal ramifications of tax compliance. Contact me at the firm if you have questions regarding the IRS’s new partnership audit rules.