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Considerations for Modifying Partnership Agreements and LLC Operating Agreements in the Wake of the New Centralized Audit Regime


The centralized partnership audit regime was introduced in the Bipartisan Budget Act of 2015 (“BBA”). Significantly changing the procedures for partnership audits, the BBA provides for the assessment and collection of tax at the partnership level rather than with the individual partners. These centralized procedures are effective for IRS audits of partnerships (including LLCs taxed as partnerships) for tax years beginning on or after January 1, 2018.

With this new audit regime in effect, existing partnerships and LLCs taxed as partnerships (collectively referred to as “partnerships”) should plan on revising their partnership or operating agreements (collectively referred to as “partnership agreements”) to account for the new procedures. Unfortunately, there is not a “one-size-fits-all” approach for these amendments. Thus, partners and LLC members (collectively referred to as “partners”) should evaluate which provisions make the most sense in light of the partnership’s size, operations, type of management, and types of partners, among other characteristics. This article will highlight the various factors partnerships should consider before making substantive changes to their partnership agreements to account for the new audit rules.

Tax Matters Partner

One of the more significant changes made by the new centralized regime is the replacement of the tax matters partner (“TMP”) under the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) with a new concept . . . and a new name – the “Partnership Representative.” Under TEFRA procedures, the IRS was able to make adjustments to certain “partnership items” in a single partnership-level proceeding with the TMP appointed to handle audit-related communications. However, only after the partnership-level proceeding was finalized could adjustments be made to the individual partners’ returns. Partners were also able to raise defenses on non-partnership items in separate partner-level proceedings.

The multi-level procedure of passing the adjustments through to the partners resulted in a lengthy and time consuming process that placed the burden of identifying the partners for the reviewed (i.e., audited) year on the IRS. The new procedures attempt to address this shortcoming by placing this burden on the partnership itself. Under the BBA, the IRS may both assess and collect at the partnership level, without pursuing the individual partners. Additionally, the new audit procedures do not distinguish among partnership items, affected items, computational adjustments, or non-partnership items.

The new regime’s effective date of January 1, 2018 means that partnerships in existence before the effective date must retain or include the TMP language in their partnership agreements, at least until the statute of limitations for audit expires for those tax years governed by TEFRA. Additionally, because it is uncertain whether the IRS or a court will find a person appointed as TMP to function as the Partnership Representative, partnerships in existence prior to the effective date of January 1, 2018 should be sure to both limit the TMP’s authority to tax years beginning before the effective date and appoint a Partnership Representative for tax years beginning on or after the effective date. 

Tax return preparers should not assume that a partnership’s TMP for the 2017 tax year will be the same person appointed as Partnership Representative for the 2018 tax year. Since this appointment is made on the partnership’s tax return, members should ensure the return preparer is aware of this designation, as well as other potential elections that are desired to be made as a result of the new audit rules.

The Partnership Representative

The Partnership Representative is the sole individual (or entity) with the ability to act on behalf of the partnership in relation to the IRS. The Partnership Representative has significant authority to bind both the partnership and the partners in administrative proceedings and judicial actions. Partners do not have the ability to appeal or challenge the decisions of the Partnership Representative, but are still generally required to report consistent with the positions and allocations determined by the partnership.

While the broad authority of the Partnership Representative cannot be limited by the partnership agreement from the IRS’s perspective, provisions should be put in place to outline decision-making procedures and to require the Partnership Representative to follow such decisions. The following is a brief list of topics to consider when drafting provisions addressing the Partnership Representative:

Selection: Because of the significant authority vested in the Partnership Representative, care should be taken in this appointment and the partnership should include provisions either naming the Partnership Representative or providing a clear mechanism for appointing the Partnership Representative, especially in the event the Partnership Representative is removed, resigns or becomes incapacitated. Unlike the TMP, the Partnership Representative is not required to be a partner in the partnership.   

Limits on Decision-making Authority: The partnership may want to include procedures for pre-approving the decisions of the Partnership Representative made in connection with an audit and establish communication requirements between the Partnership Representative and the partnership’s management or partners. While any such limitations are contractual in nature and not binding on the IRS, such procedures can provide additional protections for the partners. 

Standards of Care and Indemnification: Standards of care and indemnification of managers and partners are functions of state law. Currently, there is no specific statutory indemnification of a Partnership Representative. However, with significant authority comes a great deal of risk for the Partnership Representative. Appropriate standards of care and indemnification provisions should be included in the partnership agreement in order to afford the Partnership Representative a certain level of protection from claims made by disgruntled partners or former partners. 

Allocations and Contributions for Reviewed Years

Under the new regime, when a partnership is audited, the IRS divides items into groups and subgroups (e.g. ordinary income, long-term capital gain, deductions, long-term capital loss, etc.) and makes one set of adjustments at the partnership level. If the adjustment is positive for any of the groups, the IRS will then apply the highest tax rate in effect for the reviewed year to the net adjustment to arrive at the imputed underpayment.

Unless the partnership requests a modification or elects to push out the imputed underpayment to the partners (discussed below), the imputed underpayment must be paid by the partnership in the year the adjustment is finalized. What’s key is that the partners in the adjustment year may not be the same as those in the reviewed year, resulting in current partners bearing the cost of decisions in which they did not participate and that may have benefitted only former partners. Attorneys should consider the following when drafting provisions related to the allocation of adjustments to the partners:

Contribution Requirements: For audits of years beginning on or after January 1, 2018, if adjustments are made, the partnership agreement should provide for whether a former partner during the audited year should be responsible for contributing to the liability of the partnership, should one result from the audit. Otherwise, current partners will bear the cost for the entirety of the adjustment.

Amended Returns: Partnerships will need to decide whether or not to require current and/or former partners to file amended returns should the Partnership seek a modification of an imputed underpayment. A proper modification could reduce the imputed underpayment the partnership is required to pay.    

Push-Out: Partnerships should consider whether or not to allow the Partnership Representative to make a push-out election for any reviewed tax year. If the election is made, the partnership would no longer be responsible for the imputed underpayment. Rather, the reviewed year partners (which could include former partners) will bear the costs of adjustments for that year, and calculate their share of tax, interest, and penalties. Proposed Regulations have been issued that contain specific timing and procedural requirements in order to make an effective “push-out” election.

Information Sharing: In addition to information sharing between the Partnership Representative and the partners, the partnership agreement should also provide for certain information the partners should be required to share with the Partnership Representative. Such a requirement is particularly important if the reviewed year partners are no longer associated with the partnership and the partnership desires to leave open the possibility of making a future push-out election.

Electing Out

Regulations finalized on January 2, 2018 provide that a partnership may opt out of the centralized audit regime if it both qualifies as an eligible partnership and makes a valid election on a timely-filed tax return. Partnerships that make a valid election will not be audited at the partnership level under the centralized regime. Rather, any adjustment relating to the partnership’s return would be made through an audit of any or all of the partners in separate partner-level proceedings, in accordance with pre-TEFRA law.

To be an eligible partnership, the partnership must (1) have 100 or fewer partners and (2) all partners must be eligible partners at all times during the taxable year. Whether a partnership has 100 or fewer partners is determined by the number of statements (Schedules K-1 (Form 1065)) the partnership is required to furnish under the Internal Revenue Code of 1986, as amended. An eligible partner is defined as any person who is an individual, C corporation, “eligible foreign entity,” an S corporation, or an estate of a deceased partner.

The regulations’ narrow eligibility requirements limit the number of partnerships that are able to elect out of the centralized audit regime. Thus, partnerships that are currently eligible to elect out and desire to maintain that eligibility should consider amending their agreements to impose restrictions on the number and types of new partners. Further, the partnership agreement should provide whether or not such election should be made and the person responsible for making it. 

Final Considerations

Although the new partnership audit rules went into effect on January 1 of this year, the IRS has finalized only one set of regulations, which govern the eligibility and procedures for electing out. Several other sets of regulations have been proposed; however, until the regulations are finalized, uncertainty remains as to how the IRS will interpret and enforce the new regime. Thus, partnerships and their advisors should consult with a tax attorney to ensure they have the most current information before amending their partnership agreements. Furthermore, newly formed partnerships should include in their partnership agreements appropriately tailored provisions addressing the centralized partnership audit regime, as discussed above.  

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