Alert: What Partnerships and Limited Liability Companies Must Consider Now
PARTNERSHIP RETURN FOR 2018 REQUIRES LISTING PARTNERSHIP REPRESENTATIVE INFORMATION
Tax legislation enacted in 2015 changed the rules for how partnerships (including limited liability companies and any other entity classified as partnerships) respond to audits by the Internal Revenue Service. The IRS was unhappy with the old rules (TEFRA partnership audits), particularly with “interference” by limited partners and nonmanaging members (“investors”) in the audit process. The new law replaces the “tax matters partner” (the “TMP,” the partner responsible for dealing with the IRS) with a “partnership representative” (PR). Under the new rules, absent a contrary provision in the partnership's agreement, the PR has the unilateral power to conduct the audit and settle with the IRS without first even notifying the investors, let alone getting their input.
Completing 2018 Partnership Return Information:
The IRS is enforcing its PR audit power by requiring a partnership to identify the PR on page 3 of the 2018 partnership income tax return, Form 1065. (See www.irs.gov, click on “forms and instructions” and insert “1065”). Under “Designation of Partnership Representative” the partnership must state the name, U.S. address, U.S. telephone number and U.S. identification number of the PR. The PR rules require that where the PR is an entity (such as a limited liability company that is the general partner of a limited partnership) the PR must designate an individual (the “Designated Individual” or “DI”). Form 1065 must list the DI's name, U.S. address and phone number and U.S. taxpayer identification. Although the preparer of the 2018 Form 1065 is directed to “see instructions” on completing this part of Form 1065, instructions have not yet been issued for the 2018 Form 1065. We suggest, if you have not already done so, that you consult with counsel regarding the new audit regime, particularly whether the manager has the power under the limited partnership or operating/agreement, to designate the PR and DI, without seeking a vote of the investors. Further, a review of the extent of the power given to the PR/DI about conduct of an audit, particularly as to elections, may be appropriate.
The rest of this update reflects current thinking about how to approach the PR rules. First, there is an election out of the new regime, including PR designation, on a year-by-year basis, for partnerships issuing no more than 100 Schedule K-1s for the taxable year for which the election is relevant. All partners that year must be individuals, corporations or estates of a deceased partner. Partners that are themselves partnerships or disregarded entities disqualify a partnership from electing out and certain trusts and S corporations as partners are also problematic. Thus, a partnership all of whose partners are individuals may find this election attractive. The election out must be made on the return (with extensions) for the year the election is made, with information supporting satisfaction of the election-out rules. Partnerships that can qualify for the election out should seriously consider it for several reasons: the rules for the opting-out partnership can be less onerous than the new rules and the complexities of the as-yet untried new regime can be daunting for a small partnership.
Duties of the PR/DI:
Assuming no opt-out election applies, compliance with documenting compliance with the new regime is needed now. This is true even though the PR is not called upon to act until the partnership receives an audit notice from the IRS. Although statistically partnership audits have decreased in recent years and is generally are a low probability for hedge funds, ignoring Form 1065 is unwise. From the manager's standpoint, the manager will want to comply with the PR section of the 2018 as required by the 2018 Form 1065. An IRS clerk reviewing the tax return could view not completing this section as an audit “red flag.” Moreover, if the partnership were to file an amended return claiming a refund for the partners, not completing the PR section in the original Form 1065 could look odd. When in an audit a partnership is required to produce its documentation regarding its designation of a PR/DI, not having documentation contemporaneous with the filing of the partnership return may be seen as a “scofflaw” approach. Similarly, such failure may prove an issue if the case, unresolved, ends up in the U.S. Tax Court.
Because the PR need not be a partner, unlike the TMP rules, consideration can be given to selecting a third party as the PR. Thus, a third party services provider, such as an outside law firm not otherwise providing services to the partnership (and so not conflicted if it should come to audit representation), could be the PR. If a partner is designated as the PR (and, as needed, to provide the DI) then the partner must be advised about the duties of the PR. Although the PR rules do not per se require the PR or DI to notify the investors of the commencement of an IRS audit, best practices would indicate that the investors must be informed of the commencement of an audit and of developments. It is likely that the governing state law (usually Delaware) would require the PR to keep the investors advised on developments. How state law applies to the duties of the PR or DI, or counsel in an IRS audit, is a developing area of the law.
The PR is empowered to decide whether or not to make certain elections under the partnership audit regime. The most important election is the “push out election.” Under the TMP rules the partners who were partners in the year(s) being audited (“reviewed year partners”) are the parties liable for any increase in tax, interest and penalties that arises out of the settlement of the case. However, under the PR rules the partnership is liable for the amount due. Thus, partners in the year the case is settled bear the economic burden, whether or not they were reviewed year partners. The PR can elect, within 45 days of conclusion of the case, to “push out” the tax liability from the audit onto the reviewed year partners. In weighing the advantages and disadvantages of this election the materiality of settlement is. If it is a nonmaterial amount the PR may decide it is best to settle the audit at the partnership level and not go through the complex procedural and computational rules surrounding a push out election.
Selecting a Third-Party PR/DI:
The PR is exposed to risks in undertaking to serve as the PR, particularly if the PR or DI is an attorney. There is no statutory provision prohibiting an investor unhappy with the outcome of an IRS audit from suing the PR or DI for breach of fiduciary duties. The PR/DI can have conflicts of interests when the general partner/managing member's stake in the audit outcome conflicts with that of the investors. It is foreseeable that the return(s) being audited could reflect tax advantages to the general partner/managing member outweighing disadvantages to investors. The PR/DI is at risk of being sued for making, or failing to make, a particular tax election under the PR regime, or elsewhere in the tax law.
A person contemplating being named as the PR/DI in the 2018 Form 1065 may find it appropriate to request indemnification from the partnership with respect to all acts, except for gross misconduct. Such indemnification would include reimbursement for attorney's fees and other out-of-pocket costs. Further, the PR/DI not associated with a fund's manager (a third-party PR/DI) is not likely to be given the authority to select the counsel or other tax advisor, to represent the partnership in the audit. Thus, there may be disagreements between the PR and DI and counsel, or other tax advisor, which the PR/DI may be unable to resolve satisfactorily. It is apparent therefore, that a third-party PR/DI is undertaking significant risks and should request indemnification and appropriate compensation for its efforts and exposure to risks associated with the uncertainties in defending tax audits. A PR or DI selected from in-house personnel similarly faces risks, whose scope is uncertain at this time, so indemnification should be considered.
What Should Investors Look For:
From the standpoint of investor relations, an investor may expect to see a fund's documents provide for notice of the commencement of any tax audit, federal, state or local, and updates on developments as needed. Investors may expect to receive notice of any proposed settlement of a tax audit and the right to comment, but not to vote on it. Because a decision to make a particular tax election will depend on future events, requiring that the PR make a particular election, such as the “push out election,” or not, it may not be appropriate to bind the hands of the PR/DI far in advance.
The new partnership audit regime is complex and there are many uncertainties surrounding it. At this stage, completing the Form 1065 questions about the PR (and DI, if relevant) is an important decision that must be undertaken now. This is so even though the PR or DI may never be called upon to act because the IRS may never commence an audit. Disclosure of the PR's scope is now seen as an important partnership governance issue and fund managers must be prepared to field inquiries from investors about such items as notice, input and indemnification of the PR and DI.
For more information, contact Victoria Pellegrino, CPA, at VPellegrino@grassicpas.com / (212) 223-5082 or Roger Lorence at RLorence@grassicpas.com / (212) 223-5087.