A New Breed of Fiduciary: the Partnership Representative

• Jurisdiction: United States,Federal,California
• Author: Phillip L. Jelsma
• Citation: Vol. 2017 No. 4
• Publication year: 2017

A New Breed of Fiduciary: The Partnership Representative

Phillip L. Jelsma

Phil Jelsma is a tax partner at the San Diego law firm of Crosbie Gliner Schiffman Southard & Swanson LLP (CGS3). He specializes in real estate taxation, closely held businesses, investment, tax and nonprofit organizations. He was formerly a tax partner with Luce Forward Hamilton & Scripps LLP and McKenna Long & Aldridge LLP. He is an Adjunct Professor at the University of San Diego Law School and is a graduate of Stanford Law School. He is the Executive Editor of the CEB Publication "Understanding Fiduciary Duties in Business Entities."

The Bipartisan Budget Act of 2015 ("BBA") (Pub. L. 114-74) brought a number of changes to the income tax landscape, but the one that has drawn the most attention is the new centralized partnership audit regime. Although gallons of ink have been spilled in discussing the various features of the BBA, one of the lesser discussed topics is the creation of the partnership representative (the "Representative").¹ The Representative is the sole decision-maker for a partnership or LLC in an IRS examination. Almost unnoticed has been the question of the potential liabilities of the Representative under state law, specifically California law. The Representative was intentionally empowered by Congress with sweeping authority to act on a partnership or LLC's behalf and to bind both the partnership or LLC and its partners or members, without their direct involvement or discussion, concerning the IRS audit. As such, the Representative should be considered a fiduciary. However, a Representative should carefully consider its fiduciary duties, in particular the obligation to refrain from self-dealing.

Under the new, centralized partnership audit regime, any IRS assessment of tax, penalty, or interest is paid by the partnership or LLC unless: (1) the partnership or LLC elects out of the centralized partnership audit regime, so that the assessment is made at the partner or member level,² or (2) the Representative elects to push out the adjustments to the partners or members (the so-called "push-out election"³). Under many partnership agreements and operating agreements, the decision to elect out of the centralized partnership audit regime will be left to the Representative. In effect, the Representative has the ability to cause the partnership or LLC to pay the tax for the partners or members. If the Representative decides to have the partnership or LLC pay tax, penalty, or interest instead of being paid by the partners or LLC, is that potentially self-dealing? For example, assume the IRS disallows a $100 deduction and assesses the LLC a $35 tax. The manager, who is also the Representative, was allocated 80% of the deduction, but has only a 20% profit and capital interest. If the Representative elects out of the centralized partnership audit rules, he or she would pay $28 (80% of $35), but if he or she decides to have the LLC pay the tax under the provisions of the operating agreement, his or her capital account is reduced by only $7 (20% of $35). If the Representative causes the LLC to pay the IRS assessment, is it self-dealing? Could the Representative have an interest adverse to the LLC and the other members? In Boland v. Daly, 318 A.2d 329 (Pa. 1974), the court ruled that a majority partner could not force a partnership on an accrual accounting method to employ an accounting procedure that favored him at the other partner's expense. Does the election of the manager in this example favor its interest at the expense of the other members? In other words, if the Representative has several choices, can it elect the choice that minimizes its taxable share of the tax liability, potentially transferring that liability to the other partners or members?

Role of the Representative

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Prior to the BBA, tax law recognized the tax matters partner as the spokesperson for a partnership or LLC. The BBA eliminated the tax matters partner ("TMP") because the IRS felt that it often ran into problems or difficulties with the TMP. These problems included the following: (1) the TMP had to be a partner or member; therefore the partnership or LLC could not designate a nonpartner or nonmember, such as a manager of an LLC, even if that person was in the best position to handle the audit; (2) the IRS might not be able to contact the TMP because the TMP is out of the country or unreachable; and (3) although the TMP could bind the partnership or LLC, it could not bind the partners or members. A partner or member who was not a TMP also had rights during the examination, including certain notification rights and rights to participate in the proceeding.⁴

The BBA created the role of the Representative.⁵ A partnership or LLC can have only one designated Representative during the tax year, and the designation remains in effect until terminated by a valid resignation, revocation, or determination by the IRS.⁶ Under the BBA, a Representative need only satisfy two requirements: it must be a person with a substantial presence in the United States, and it must have the capacity to act.⁷ A person has a substantial presence in the U.S. if (1) the person is able to meet in person with the IRS in the United States at any reasonable time and place as is necessary or appropriate, as determined by the IRS; (2) the Representative has a street address in the United States and phone number with a U.S. area code where the Representative can be reached by mail and telephone during normal business hours; and (3) the person has U.S. taxpayer identification number.⁸

If the partnership or LLC has designated an entity as a Representative, the partnership or LLC must appoint an individual as the sole individual to act on behalf of the entity Representative.⁹ That individual must also meet the substantial presence test. If the partnership or LLC fails to appoint a designated individual, the IRS can disregard the designation of Representative.¹⁰ With respect to the requirement that the person have the capacity to act as a Representative or designated individual on behalf of an entity Representative, proposed Treasury Regulation section 301.6223-1(b)(4) describes specific events that will cause the person to lose the capacity to act, including a catch-all provision for unforeseen circumstances in which the IRS reasonably determines that the Representative or designated individual may no longer have the capacity to act.¹¹ The Representative is designated in the tax return for the partnership or LLC, and cannot be changed until the IRS issues a notice of administrative proceeding to the partnership, except where the partnership files a valid or administrative adjustment request (AAR).¹² A Representative may resign, the partnership or LLC may revoke the designation, or the IRS could determine that the designation is no longer in effect.¹³

Adecision by the Representative binds the partnership or LLC and all of its partners or members.¹⁴ Thus, the Representative could bind the partnership or LLC and its partners or members by agreeing to a settlement with the IRS, agreeing to a notice of final partnership adjustment, making the push-out election under Internal Revenue Code (I.R.C.) § 6226, or agreeing to an extension of the statute of limitations. (The push-out election allows the IRS adjustments to be moved from the partnership or LLC to the individual partners or members.) In addition, all persons whose tax liabilities are determined in whole or in part by the adjustments made in a notice of a final partnership adjustment would also be bound. This binding authority extends to all partners or members. The Representative has the sole authority to act on behalf of the partnership or LLC. Without the permission of the IRS, the partners or members will not have the ability to participate in or contest the results of an examination involving a partnership or LLC without the permission of IRS. The proposed treasury regulations also provide that no other person, regardless of whether that person's tax liability is affected by the adjustments, will be able to participate in the partnership audit proceeding.¹⁵ Further, the broad authority of the...