We’ve all been there. You recently formed your new company and now it’s time to start dishing out cool titles to all the founders. Of course, you designate yourself as President & Chief Executive Officer (I mean who wouldn’t). You give your buddy the title of Chief Operating Officer and everyone else gets to make up their own title (Chief Experience Officer, Chief People Officer, Vice President of Resource Management, etc.). However, in your rush to add titles to your team, you’ve neglected to name your “tax-matters” partner; now known as the partnership representative.
There used to be a fairly antiquated process, once a partnership was formed. The partnership usually named a random partner to “act” as the “tax-matters” partner. This individual did not necessarily have to be knowledgeable about tax law or the affairs of the partnership. It was really just a check-the-box for the partnership without necessarily understand the full implications of such a designation. However, after the passage of the Bi-Partisan Budget Act of 2015 (“BBA”), effective for 2018 and beyond, partnerships, including limited liability companies taxed as partnerships, should rethink about their designation of a partnership representative.
According to the Internal Revenue Service (“IRS”) Data Book, in the fiscal year 2018, 4.2 million partnership (Form 1065) and 5.1 million S-Corporation (Form 1120-S) returns were filed with the IRS. Of those returns, 0.4% were selected for audit, with 99% of those audited, resulting in a change to the tax return. It’s important to note that Form 1065 and Form 1120-S are information returns and therefore these statistics do not reflect audits that may have been done on the individual partners/shareholder. While a .4% audit rate may appear rather small and insignificant, it’s important to understand the implications of these updates to the partnership audit rules, so that you can take appropriate steps to protect your business.
Under previous rules, which were enacted almost 40 years ago, there was an attempt to put more responsibility on the partnership to resolve issues related to the audit of the partnership. By requiring a “tax-matters” partner, Congress attempted to create a single point of contact for working through a partnership audit. However, under the previous rule, each partner had an opportunity to participate in the examination process and any subsequent conferences with the IRS, therefore not necessarily resolving the problem. The BBA was enacted to help facilitate the streamlining of the partnership audit examination process in order to reduce the time spent working through a partnership audit.
CHANGES TO PARTNERSHIP AUDIT RULES
Under the BBA, the IRS will continue to focus on auditing partnership returns for accuracy. However, the BBA and subsequent regulatory guidance have made a few significant changes in how the IRS intends to interact with partnerships going forward. Some of the significant changes that the BBA implemented included:
- Allowing a partnership to pay any underpayment directly or by “pushing down” the liability to the individual partners;
- Allocating authority to bind the partnership to the partnership representative;
- Allocating to the partnership representative sole authority to act on behalf of and bind the partnership; and
- Striping the ability of a partner, other than the partnership representative or the designated individual, from participating in any administrative proceeding unless expressly agreed by the IRS.
While a designation of a partnership representative or designated individual becomes effective upon the filing of Form 1065, on a yearly basis, a partnership, partnership representative or the designated individual may revoke the designation. It’s important to note that a partnership representative or designated individual designation cannot be revoked without the partnership naming an alternative. If a partnership has not named an alternative, the IRS may name a new partnership representative.
THINGS TO CONSIDER FOR YOUR PARTNERSHIP
Most importantly, it is important to understand who might be subject to the provisions of the BBA and who might be eligible to elect-out of certain provisions. Under the BBA, all partnerships, including limited liability companies (“LLCs”) taxed as partnerships, are subjected to the provisions of the BBA. However, there are exceptions to the rule including allowing certain partnerships with 100 or fewer eligible partners, measured by the number of Schedule K-1’s issued including Schedule K-1’s by an S-Corporation partner, to elect out of the provisions of the BBA annually. The number of eligible partners for this exception is defined to mean individuals, corporation, foreign entities taxed as corporations, and estates of deceased partners. For purposes of this exception, an eligible partner does not include a partnership, limited liability company, or trust that may hold an interest in the partnership.
While the new regulations under the BBA provide the partnership representative or the designated individual with an incredible amount of authority there are internal steps that you can take in order to reduce and limit the risk to the partnership. Some of the most important steps are updating the partnership agreement and/or executing a separate agreement with the partnership representative or designated individual to:
- Limit the express or implied authority of the PR or DI;
- Require the PR/DI to provide notice to the other partners of communications;
- Require the PR/DI to provide regular and consistent status updates;
- Require notice to the partnership of any engagement of third-party representation; and
- Require notice and/or a formal vote, of the partnership, before entering into a binding agreement with the IRS including extending the statute of limitations.
If your partnership (operating) agreement has not been updated in a while or you have not necessarily paid attention to the thing in a while, now is the time to take the opportunity to ensure that agreement meets your needs. If you have questions or would like to better understand the impact of these changes, we would be happy to talk with you.