The centralized partnership audit procedures under the Bipartisan Budget Act of 2015 (BBA), P.L. 114-74, became effective for partnerships with tax years beginning after Dec. 31, 2017. As a result, calendar-year partnerships must consider the impact of the BBA when filing their 2018 returns.
Under the BBA, the IRS will conduct an examination at the partnership level to determine the accuracy of the partnership's tax return. If the examination results in an underpayment of tax, the partnership may pay the underpayment on behalf of the partners or "push out" the underpayment, as well as the responsibility for payment, to the individual partners.
Decisions on behalf of the partnership vis-à-vis the IRS examination are made by a single individual: the partnership representative (PR), or, if the PR is an entity, the designated individual (DI). The power of the PR and DI cannot be overstated. Under the BBA, the PR and DI have the sole authority to act on behalf of the partnership and its partners, and the PR's actions are binding on them. This is a marked change from the role of the tax matters partner (TMP) under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97-248, which generally governed partnerships' examinations before the enactment of the BBA.
This item discusses issues partnerships and their advisers should consider when designating a PR or DI, accounting for the potential for conflicts of interest, whether and to what extent limitations can be placed on the PR or DI, and how these roles differ dramatically from that of the TMP.
Who may serve as the PR?
Under Sec. 6223 and the recently issued final regulations (T.D. 9839), the partnership may designate any person (as defined in Sec. 7701(a)(1)), including an entity, to be the PR (Regs. Sec. 301.6223-1(b)(1)). If the partnership designates an entity as the PR, the partnership must also identify a DI. Essentially, the IRS wants to be able to communicate with a human being, whether it is the PR or the DI.
Under TEFRA, the IRS often found it difficult to even make contact with the TMP. Identifying a qualified TMP was a significant challenge in examining large partnerships, often taking months, with many IRS agents viewing partnerships as purposefully designating unqualified or difficult-to-reach TMPs (see U.S. Government Accountability Office, Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency (GAO-14-732), p. 27 (September 2014)).
By requiring PRs to be identified upfront by partnerships and endowing them with enormous authority, the government aims to ensure that the IRS does not waste time simply looking for the right contact person. Additionally, the law gives the IRS tremendous power to designate a PR on the partnership's behalf where necessary. The IRS may designate a PR if it determines that a designation is not in effect under Regs. Sec. 301.6223-1(f)(2).
The PR or DI must have a substantial presence in the United States, which, under the regulations, requires that the PR or DI be available to meet with the IRS in person, has a U.S. street address and a phone number with a U.S. area code, and has a U.S. taxpayer identification number (Regs. Sec. 301.6223-1(b)(2)). This will be especially relevant for hedge funds and private-equity funds, which often use foreign partnerships with foreign managers. Those entities will need to consider who will serve as their PR or DI. The considerations of whom to designate as the PR or appoint as the DI are just as important for funds that have a manager that sits in the Cayman Islands or one that sits in Connecticut.
Under the proposed regulations (REG-136118-15), the PR or DI also must have had the capacity to act. Those regulations were intended to correspond to situations where the person would not have been able to represent the partnership in an administrative proceeding. However, the final regulations removed this requirement. The preamble to the final regulations (T.D. 9839) states that "partnerships are in the best position to make the decision as to who can best represent them before the IRS." This is consistent with the general theme of the BBA, where burdens are shifted away from the IRS and onto the partnership and the partners.
The partnership, according to the IRS and Treasury in the final regulations' preamble, "can adequately protect itself if the concept of capacity is removed since it can revoke the partnership representative." Nevertheless, if the IRS determines that the designation of a PR or DI is not in effect, then the IRS may designate a PR of its choosing. Even then, the IRS is under no obligation to determine that a designation is not in effect. Nor is the IRS required to act if it is aware of any circumstances in which the PR or DI designation is not in effect (Regs. Sec. 301.6223-1(f)(2)).
Again, the PR and DI designation requirements are intended to ensure that the partnership has a ready and available individual to discuss examination-related issues with the IRS. Partnerships should consider who should serve as a PR or DI and to what extent this individual has access to the partnership's books and records or other relevant financial data. This is especially relevant given the nature of the PR's role, discussed below.
Importantly, and unlike under TEFRA's tax matters partner rules, the PR or DI does not have to be a partner of the partnership. The DI is also not required to be an employee of the PR, if the PR is an entity, based on the final regulations. Also of note is that under the final regulations, the decision on designating a DI still rests with the partnership itself — not the PR.
The buck stops with the PR
Regs. Sec. 301.6223-2(a) governs the binding nature of the PR's actions. A PR may bind "all partners of the partnership," including passthrough partners, as well as "any other person whose tax liability is determined in whole or in part by taking into account directly or indirectly adjustments determined under [the centralized partnership audit regime]." For example, a settlement agreement entered into by the PR on behalf of the partnership, or a notice of final partnership adjustment (FPA) that is not contested by the partnership or PR, or the final decision of a court with respect to the partnership if the FPA is contested, binds all of those persons described above.
Very plainly, the regulations state that the PR "has the sole authority to act on behalf of the partnership" under the BBA, and that "[e]xcept for a partner that is the partnership representative or the designated individual, no partner, or any other person, may participate in an administrative proceeding without the permission of the IRS" (Regs. Sec. 301.6223-2(d)). This is a change from the proceedings under TEFRA.
Designating the PR
The partnership must designate a PR separately for each tax year, and the designation is effective only for the tax year for which it is made (Regs. Sec. 301.6223-1(c)(1)).
Example: A partnership designates X as the PR for the tax year ended Dec. 31, 2018, but then, after a falling out with X, the partnership designates Y as the PR for the tax year ended Dec. 31, 2019. In 2021, the IRS examines the partnership's 2018 tax return. X is the PR for the 2018 tax year, notwithstanding the fact that the partnership designated Y in 2019.
This example raises the question of when exactly a partnership may designate a new PR and how a partnership may revoke a designation, especially if the partnership has some reason to want a specific individual to represent it in a year in which the partnership designated someone else as the PR.
The final regulations state that, generally, the designation of the PR must be made on the partnership's Form 1065, U.S. Return of Partnership Income, for the year to which the designation relates, and that the designation is effective when that return is filed (Regs. Sec. 301.6223-1(c)(2)). The final regulations do contain noticeable differences from the proposed regulations on how a partnership may change its PR or DI.
Under the final regulations, a PR may be changed only in the context of the filing of an administrative adjustment request (AAR), or in conjunction with a notice of administrative proceeding (NAP) for the tax year. The final regulations do recognize, however, that the rules may be revisited through subsequent guidance after the IRS gains experience with the BBA.
Resignation by the PR: Under the final regulations, a PR or DI may resign for any reason by notifying the IRS in writing, only after the IRS issues a NAP. A PR or DI may not, unlike under the proposed regulations, pick his or her successor. The final regulations also require the IRS to provide written notice of the resignation to the partnership. Nevertheless, the IRS's failure to notify the partnership within 30 days of the PR's or DI's resignation does not affect the resignation, so long as the PR or DI resigned in accordance with the regulations and other guidance.
Revocation of the PR's designation: The partnership may revoke the designation of a PR or DI by notifying the IRS in writing (Regs. Sec. 301.6223-1(e)). The manner in which the notification is submitted to the IRS is subject to applicable forms and instructions the IRS prescribes but will require the partnership to simultaneously designate a successor PR or DI for the tax year of the revocation. Under the proposed regulations, the revocation and new designation would have become effective 30 days from the date on which the IRS received a written notification. That led some commentators to call the 30-day period a "dead man walking" situation, in which a PR whose designation has not yet been revoked could cause havoc for a partnership (see Yauch, "IRS to Review Powers of Audit Representative Amid Concerns," 159 Tax Notes 1513 (June 4, 2018)). The final regulations address this concern and state in Regs. Sec. 301.6223-1(e)(3) that the revocation is "immediately effective upon the IRS's receipt of the written notification." Unlike under the resignation rules, where the PR or DI could only resign after the issuance of a NAP, the partnership may revoke the PR's or DI's designation before that point, when the IRS issues a notice of selection for examination. The partnership may also revoke the designations by filing an AAR, but the AAR may not be filed solely to revoke the designation, similar to the rule in the proposed regulations (Regs. Sec. 301.6223-1(e)(2)(ii)).
Designation by the IRS: If the IRS determines that a designation of a PR is not in effect, it has broad authority to designate a PR or DI for the partnership. The IRS will consider the following factors when making its determination: the views of the majority partners; the knowledge of the person about the partnership's tax or administrative matters; the person's access to the partnership's books and records; whether the person is a U.S. person, as defined in Sec. 7701(a)(30); and the profits interest of the partner, in the case of a partner as the PR (Regs. Sec. 301.6223-1(f)(5)). The final regulations clarify that the IRS should not designate an IRS employee, agent, or contractor who has no affiliation with the partnership as a PR or DI.
What restrictions can a partnership place on the PR?
Partnerships should consider what kinds of restrictions can be placed on the PR — whether that PR is a partner or not. The law clearly comprehends that the actions of the PR are binding and that "[n]o state law, partnership agreement, or other document or agreement may limit the authority of the partnership representative or the designated individual as described in section 6223 and this section" (Regs. Sec. 301.6223-2(c)(1)).
Partnerships are in a bit of a bind in this regard and should nevertheless consider what kinds of arrangements must be made to ensure that their rights and the rights of their partners are adequately protected if a PR or DI, acting on behalf of the partnership and partners, takes actions contrary to his or her actual authority. While this discussion does not explore the nuance of the law of agency as it relates to a potential civil tort claim, the issue nonetheless exists and should be explored with the help of competent counsel.
Consider a situation in which a partnership delegates ultimate settlement authority to its CEO. Perhaps this designation is in the partnership agreement, or the partnership has contracted with its PR that any settlement discussion with the IRS must be approved by the CEO. Nonetheless, the PR executes a closing agreement with the IRS, in contradiction to the contractual agreement with the partnership. From the IRS's standpoint, there is no issue: The PR, acting as the sole representative of the partnership and its partners, has bound the partnership and its partners. The partnership, on the other hand, may have a legitimate breach-of-contract claim against the PR.
Putting aside a worst-case scenario, and assuming that the PR will abide by the restrictions placed on him or her by the partnership, there are practical considerations. The PR will, of course, be the primary face of the partnership before the IRS. If the PR is not equipped to adequately represent the partnership in a controversy before the IRS, then the partnership obviously should engage competent representation to handle the day-to-day interactions with the exam team, including timely and adequately responding to information document requests; navigating the contours of the examination with the IRS; and making the business decisions of which adjustments the partnership should challenge, and to what degree.
Here are some examples of requirements or restrictions that the partnership could place on a PR:
- Provide notice, within a reasonable time, to the partnership's leadership or board after each written communication from the IRS;
- Provide written updates upon certain milestones in the exam;
- Obtain permission from the partnership to engage third-party experts, counsel, or accountants;
- Obtain permission from the partnership to extend the statute of limitation, agree to an adjustment, file an AAR, make any statutory or regulatory elections in Secs. 6221 through 6241 (the centralized partnership audit regime), or make other binding decisions; or
- Consult with certain partners or counsel on the decision to litigate a matter.
A well-drafted partnership agreement or a contract between the partnership and the PR may dictate these terms as well as some of the major decisions a partnership will encounter, including whether to "push out" an adjustment under Sec. 6226.
There may even be practical or nontax business considerations for the PR to consider. For example, if the partnership were to designate an entity as the PR, and then appoint an employee of the PR as the DI, such an arrangement may create new employment or conflict considerations for the DI and the PR, potentially interfering with the employer-employee relationship. A partnership may also need to consider how a PR or DI is compensated, if at all.
Should a partnership designate a third-party nonpartner as the PR?
Unlike TEFRA, where the TMP had to be a partner of the partnership, under the BBA a nonpartner can act as the PR. Partnerships must account for the potential for conflicts of interest to arise in the designation of a partner as the PR.
At the heart of the BBA is the decision of whether to pay an imputed underpayment by the partnership on behalf of the partners under Sec. 6225 or to elect to push out the adjustments to the partners under Sec. 6226. This decision can have a significant impact on differently situated partners of the partnership.
Arguably, Sec. 6225 is administratively convenient for a partnership: The partnership simply pays the amount due after accounting for modifications to the imputed underpayment under Prop. Regs. Sec. 301.6225-2(a) and, potentially, "pulling in" the adjustments under Sec. 6225(c)(2). The push-out procedures generally relieve the partnership of the obligation to pay the imputed underpayment on behalf of certain adjustment-year partners, but they do require some administrative burden in issuing "statements" to the reviewed-year partners, not to mention an increased rate of underpayment interest.
But in either situation, certain partners may benefit more than others. A tax-exempt partner may have different considerations than a corporate partner, an individual partner, or a foreign partner. The relative size of the partner's investment in the partnership may affect that partner's willingness to pay under the default method of Sec. 6225 or to push out under Sec. 6226. Moreover, newer partners, who may not be reviewed-year partners, may have significantly different interests than older partners, who may be reviewed-year partners. All of this is to say that an inherent conflict of interest may exist for a partner to serve as a PR.
The BBA has, on the other hand, given rise to a cottage industry of off-the-shelf PRs. Professional services firms or law firms may balk at the risks and potential conflicts associated with being a PR, but registered agents and independent directors have been providing similar services for a long time. It may be worth considering engaging such services, to the extent the partnership has difficulty in determining who should be the PR (see Yauch, "Audit Rules Could Lead to Partner Infighting," 159 Tax Notes 1041 (May 14, 2018)). Third-party PRs must be prepared to incur significant time and resources to become educated about the partnership, its partners, and its activities. Moreover, PRs should be aware of not just risks related to conflicts of interest but also the strong possibility of being subject to suit by partners of the partnership.
Partnerships need to make these decisions soon
The BBA is in effect for tax years beginning after Dec. 31, 2017. For a calendar-year partnership, the designation of the first PR will likely be on the partnership's 2018 Form 1065, U.S. Return of Partnership Income. For some partnerships with short tax years, that return may already have been filed or will be due soon. For others, the time for making these decisions is winding to a close.
Partnerships and their investors should carefully consider the impact of the BBA and, in particular, take notice of the PR's extraordinary authority. These considerations will likely have an impact on the way a partnership is structured, a partner's decision to invest in a partnership, and exactly who will represent the partnership in an IRS examination.
The author wishes to thank Elizabeth Askey, Grace Kim, and Tom Connolly for their helpful comments. Any errors in this article are the author's.
Valrie Chambers is an associate professor of accounting at Stetson University in Celebration, Fla. Shamik Trivedi, J.D., LL.M., is a senior manager in the National Tax Office of Grant Thornton LLP in Washington. Mr. Trivedi is a member of the AICPA Tax Practice & Procedures Committee. For more information about this column, contact firstname.lastname@example.org.