The new partnership audit rules apply to tax years beginning in 2018.1 While the new rules eliminate the need for a tax matters partner, that role is replaced with a new role called the partnership representative (PR). If the PR is an entity, a designated individual (DI) will act on behalf of the PR. When partnerships (including LLCs taxed as partnerships) begin filing their 2018 returns in 2019, they will need to include the names of their PRs and the DIs, if applicable, on their tax returns.
Broad Authority of the PR
Under the new audit rules, adjustments to partnership items will be made and enforced at the partnership level (rather than at the partner level).2 Once appointed, the PR has the sole authority to act on behalf of the partnership for the audit. The partnership and all partners are bound by the decisions made by the PR during the audit and final decisions made during any audit-related proceedings.
There is no requirement in the Code for the PR to inform the partners of proceedings and no requirement that partners be allowed to participate in proceedings. In addition, the PR’s authority may not be limited under federal law. This essentially gives the PR unfettered authority to bind the partnership in an audit. However, the partnership’s governing documents may place limitations on the PR’s authority and require the PR to provide notice of an audit to the partners. These restrictions are not binding on the IRS, but may provide the partners with a claim under state law should an issue arise.
Appointment by the IRS
If a partnership does not select a PR or the designation is not effective, the IRS may appoint a PR for the partnership. The regulations provide that the IRS may not designate an IRS employee, agent or contractor as the PR, unless that individual is a partner. In addition, the regulations provide that the IRS will look to multiple factors in determining who should be the PR, such as (1) the views of the partners who have a majority interest in the partnership, (2) the general knowledge of the person in tax matters and administration of the partnership, (3) the person’s access to the books and records of the partnership, (4) whether the person is a U.S. person, and (5) the profits interest of the partner. There is no guidance as to how the IRS will weigh these factors. A partnership could end up with someone who is not a partner as the PR. In light of this, it is best practice for the partnership to select its own PR.
Requirements of a PR or DI
A PR may be an entity, including a disregarded entity or even the partnership itself, provided it meets the PR qualifications. If the PR is an entity, the partnership must also appoint a DI to act on behalf of the PR. Both the PR and the DI must meet the substantial presence test.
Under the regulations, a person has substantial presence in the United States if (1) the person makes themselves available to meet in person with the IRS in the United States at a reasonable time and place as determined by the IRS, and (2) the person has a U.S. taxpayer identification number, U.S. street address and U.S. telephone number. Notably, neither the PR nor the DI needs to be a U.S. citizen or resident. In fact, the regulations include an example where a PR works in a foreign country and spends the majority of her time there. That example PR, however, meets the substantial presence requirements described above and thus is an eligible PR.3
Resignation or Revocation of a PR or DI
A PR or DI may only resign from its role after the IRS issues a notice of administrative proceeding. A resigning PR or DI may not appoint its successor.
A partnership may revoke a designation of a PR or DI after the IRS issues a notice of administrative proceeding or after the partnership files an administrative adjustment request. The partnership must include the name of the replacement. If there are two revocations within 90 days, the IRS may determine that the revocation is not effective.
In both a resignation and revocation, the IRS will provide a confirmation of the change to the partnership and the PR or DI, as applicable, within 30 days of receipt of written notice.
With 2018 tax returns due soon, it is important to update governing documents to address these new audit rules as quickly as possible. It is always better to agree to matters upfront and before there is any issue with the IRS. In updating governing documents to address the new audit rules, it is important to consider who will be appointed the PR/DI, whether and when the PR/DI must inform the partnership of its resignation, who makes the decisions regarding revocations, and whether the PR/DI should be entitled to indemnification by the partnership. Partners may also want to require that they be given notice of any proceedings.
1 See sections 6221-23, 6225-27 of the Internal Revenue Code of 1986, as amended, along with the corresponding Treasury Regulations.
2 This assumes that a push-out or pull-in election is not made. While these concepts are beyond the scope of this article, they should be considered if there is an adjustment to a partnership item that results in an imputed underpayment.
3 Treasury Regulations section 301.6223-1(b)(4), Example 3.