On January 1, 2018, the new partnership audit rules took effect on all business entities taxed as partnerships. For purposes of this update, partnerships and partners include limited liability companies (LLCs) taxed as partnerships for federal tax purposes and their members treated as partners for federal income tax purposes. The new partnership audit rules make substantial changes to the TEFRA regime, and will effect virtually every partnership agreement in place prior to January 1, 2018. The most significant change brought by the new audit rules is the designated partnership representative. The new audit rules require every partnership to designate a partnership representative on its federal income tax return for each tax year beginning after December 31, 2017.
Under the new audit rules, the designated partnership representative will receive all notices and communications involving federal income tax audits and most importantly, the partners will have no right to participate in the audit. Since the new audit rules vest exclusive authority for partnership audits and partnership tax litigation communications, actions, representation, and elections in the partnership representative, partnership agreements should be revised to address and consider this new reality.
First, and foremost, at a minimum, the partnership agreement should include who will serve as designated partnership representative, as well as, provide internal partnership procedures and rules for resignations and removals of the partnership representative. Generally, once the partnership representative is designated, the designation remains in effect until: (1) a valid resignation, (2) a valid revocation; or (3) an IRS determination of no valid appointment. It is important to note that there doesn’t appear to be any requirement in the Code or the proposed regulations that the partnership representative consent to, or even be informed of, the appointment, although the IRS might determine it is not a valid determination under those facts.
To be eligible to serve as the designated partnership representative, the representative must have a substantial presence in the United States and the capacity to serve. For purposes of the new audit rules, substantial presence in the United States means a U.S. street address, a telephone number, availability during normal business hours, and a U.S. taxpayer identification number. The new rules provide that capacity to act can terminate upon death of the representative, a court order determining the representative’s incapacity to act and serve, a court order enjoining the person from acting, incarceration, liquidation or dissolution of the entity, or an IRS determination of incapacity to act.
One of the most important reasons every partnership should revisit their agreements and operating documents is to plan for the anomaly of a partnership representative who has resigned or been removed under the terms of the partnership agreement but has not resigned or been removed for purposes of the new audit rules effective resignation. If a partnership agreement is silent on the terms and responsibilities for the partnership representative, the IRS has the authority to designate one for the partnership. If a designated partnership representative is ever removed by the terms of the partnership agreement, one should provide duties for such representative to file the necessary documentation for the IRS to recognize such a change.
Also, partnership agreements should provide and consider the authority, restrictions, obligations, duties, and standard of care owed by the partnership representative to the partnership and to the partners. Since the partnership representative role was created by the changes to the audit rules, there is a high chance that the agreement is silent on the role and duties of such representative. The partnership stands susceptible to miscommunication and potential derivative lawsuits emanating from such miscommunication without a clear understanding of the partnership representative’s duties to the other partners in the agreement. As a matter of precaution, partnership agreements should at a minimum address the partnership representative’s role and standard of care owed to the partnership.
If the agreement is going to consider the authority, obligations, and responsibility of the designated partnership representative to the partners, the agreement should also provide for the obligations and responsibilities owed to the partnership representative, because the decisions that will be made by the partnership representative will have a lasting effect on the partnership and all of the partners. In the event of an audit, the partnership representative will require the full cooperation of the individual partners in meeting the compliance demands and requests from the IRS. Any potential problems with the cooperation of one partner and the partnership representative with an audit taking place will likely result in higher costs and fees to all partners. It is important for the partnership agreement to be clear that the other partners not serving as partnership representative have a duty to assist and comply with partnership representative’s requests during the audit process.
Finally, partnership agreements should also consider the partnership representative’s authority to incur audit and litigation costs and fees on behalf of the partnership. Partnership agreements should consider the compensation that the partnership representative will receive for the services rendered during an audit and potentially litigation with the IRS. If a partnership agreement is silent on these issues, partnerships will have to resort to a facts and circumstances analysis as to what constitutes reasonable compensation, litigation costs, and other expenses that could have been addressed in an agreement.
The role of the designated partnership representative in the new partnership audit rules has created a clear and present need for the reevaluation of all partnership agreements that do not effectively address such changes. To avoid any miscommunication or disputes among the partners regarding future audits or litigation, partners in the partnership should reevaluate their agreements to address the new perceived problems that could occur and miscommunications that could potentially threaten the business of the partnership. Accordingly, without delineated rules or a concise plan of action for such events in the partnership agreement, the partnership will be left vulnerable to unnecessary uncertainties that could affect the relationships between the partners and the partnerships overall business dealings.