Michael T. Donovan, Member

On August 6, 2018, the Internal Revenue Service (IRS) released final regulations (TD 9839) regarding (i) the designation and authority of the partnership representative under the new centralized partnership audit regime (CPAR) rules governing federal income tax audits of partnerships, and (ii) the election to apply the CPAR to partnership taxable years beginning after November 2, 2015 and before January 1, 2018. These regulations affect partners in partnerships, including members in limited liability companies treated as partnerships for U. S. federal income tax purposes.

Background

The Bipartisan Budget Act of 2015 (BBA) dramatically changes the manner in which partnerships are audited for U. S. federal income tax purposes. One of the key changes was the creation of the role of “partnership representative,” which would have sole authority to act for and bind the partnership in audits and judicial proceedings under the CPAR. This authority is not subject to limitations imposed by state law, the partnership agreement, or any other agreements. The new final regulations provide important guidance on the designation, removal and replacement, and authority of the partnership representative.

Designation of Partnership Representative / Designated Individual

Under the CPAR, a partnership generally must designate a “partnership representative” for each partnership taxable year who has the sole authority to act for the partnership and its partners in federal income tax audits for that taxable year. If the partnership representative is an entity, the partnership must also appoint an individual to act as the “designated individual” for the partnership, in which case the designated individual is the sole person with the authority to act on behalf of the partnership.

Except to the extent provided in forms, instructions, and other guidance the IRS might issue in the future, the initial designation of the partnership representative and the initial appointment of a designated individual (if one is required) is made annually on the partnership’s tax return. A partnership may have a different partnership representative for different years, but at any given time, there can only be one designated partnership representative (and only one designated individual) for a partnership taxable year. Once a person is designated as the partnership representative or is appointed as a designated individual, he or she generally retains that status for that year unless the designation is terminated as a result of a valid resignation, a valid revocation, or a determination by the IRS that the designation is not in effect.

To illustrate, a partnership could designate Company X as partnership representative and Andrew designated individual on its 2018 tax return. The partnership could designate Barbara as partnership representative on its 2019 tax return. That Barbara is designated as partnership representative for 2019 does not affect Company X’s designation as partnership representative for 2018 or Andrew’s appointment as designated individual for 2018. Thus, if the IRS audits the partnership for 2018 and 2019, Andrew will be the sole person entitled to act for the partnership with respect to the audit of 2018, and Barbara will be the sole person entitled to act for the partnership with respect to the audit of 2019.

Who May Serve as a Partnership Representative / Designated Individual

A partnership representative or designated individual is not required to be a partner (or a member or manager in the case of an LLC), but must have a “substantial presence” in the US. This requirement is deemed satisfied if the person (i) makes himself or herself available to meet in person with the IRS in the US at a reasonable time and place as determined by the IRS, and (ii) has a taxpayer identification number, a street address in the US, and a telephone number with a U. S. area code. Thus, a person who works in a foreign country and spends the majority of his or her time there can nonetheless be designated as partnership representative, if he or she meets these requirements.

Resignation or Revocation of the Partnership Representative

The partnership representative or designated individual can resign for any reason, but can do so only at specific times and by following the procedures outlined in the final regulations. The partnership representative or designated individual must give written notice to the IRS. However, a written notification of resignation is valid only after the IRS issues a notice of administrative proceeding (NAP) for the partnership taxable year for which the partnership representative designation is in effect, or at such other time as prescribed by the IRS in forms, instructions, or other guidance.

Similar restrictions apply to a partnership’s ability to revoke the designation of a partnership representative or appointment of a designated individual. A valid revocation (i) generally can be made only after the IRS issues a notice of selection for examination or a NAP for the partnership taxable year for which the designation or appointment is in effect, (ii) must be signed by a person who was a partner for at least some of the partnership taxable year to which the revocation relates, and (iii) must satisfy other requirements in the final regulations. A valid revocation can also be made at the time a partnership files a valid administrative adjustment request (AAR) for a partnership taxable year, in accordance with Code Section 6227, but an AAR cannot be used solely for the purpose of making a revocation.

These restrictions are intended to ensure that the IRS can easily determine who has the power to act for the partnership. However, one consequence is that a person who has ceased to have any involvement with the partnership, or who is in a dispute with the other partners, will retain the status of partnership representative or designated individual and the powers accompanying that status, because no valid resignation or revocation can be made yet. The preamble to the final regulations states that the IRS might consider expanding the circumstances under which resignations or revocations can be made and reflecting this in future forms, instructions, or other guidance.

Consequences if No Valid Designation Is Made or in Effect

If the IRS determines that a designation of a partnership representative is not in effect for a partnership taxable year, the IRS generally will notify the partnership, which then has 30 days to make a valid designation (and appointment of designated individual if applicable). If the partnership fails to do so, the IRS may designate the partnership representative (and designated individual, if applicable). The final regulations contain factors that the IRS generally will take into account in selecting a partnership representative, and those regulations provide that the IRS will not designate a current employee, agent, or contractor of the IRS, unless that employee, agent, or contractor was a partner for the year under audit or is currently a partner in the partnership. Nevertheless, having a partnership representative appointed by the IRS is not an enviable situation, because the partnership may not revoke that designation without IRS approval.

If there are multiple revocations by a partnership within a 90-day period, the IRS may (but is not required to) determine that there is no valid designation or allocation in effect and appoint a partnership representative without waiting 30 days to give the partnership the opportunity to do so. This rule is aimed at preventing partnerships from using multiple revocations as a delay tactic in an audit. The preamble recognizes that multiple revocations could be the result of a genuine disagreement between the partners as to who has the authority to designate the partnership representative, rather than a delay tactic, but the IRS does not want to be the arbiter of such disputes and therefore is not required to analyze the reasons for the multiple revocations. To avoid such situations, the partnership agreement should clearly state who has the authority to designate the partnership representative.

Practical Considerations

The partnership representative has enormous power to bind the partnership and its partners in any proceeding under the CPAR. Partnerships failing to properly designate a partnership representative may end up with one appointed by the IRS. Key issues to consider include the following:

• Who has the authority to designate the partnership representative (or to appoint the designated individual if one is needed)?
• Who has the authority to revoke the designation of the partnership representative?
• Is the partnership representative required to give partners copies of audit notices and keep them informed of the progress of audits?
• Is the partnership representative required to obtain consent of the partners, members, or managers for certain actions, such as elections, extensions of the statute of limitations, or settlements?
• Should the partnership representative be required to make certain elections, such as the election out of the CPAR if the partnership is eligible to do so; or should such decisions be left to the discretion of the partnership representative?
• What fiduciary duties does the partnership representative have to the other partners? Under what circumstances will the partnership representative be indemnified by the partnership?
• Because there are constraints on when a partnership representative may resign or the designation of partnership representative may be revoked, a person whom the other partners no longer trust may remain the partnership representative. Are special protections necessary in such circumstances to ensure that the partnership representative acts in the best interests of the partnership?
• If the partnership representative is not a partner in the partnership, how will the partnership be sure that he or she is bound by the provisions of the partnership agreement? Should the partnership representative be obligated to execute a joinder to the partnership agreement or other document agreeing to be bound by the provisions of the partnership agreement relating to the CPAR?

These are only a handful of the issues that well-drafted provisions in a partnership agreement might need to address with respect to the CPAR. Therefore, partnerships that have not already done so should amend their partnership agreements (and LLCs should amend their operating agreements) to reflect the changes made by the CPAR.