Effective for tax years beginning after December 31, 2017, new IRS audit rules ("New Rules") require partnerships to appoint a "partnership representative" ("PR") for each tax year to manage the audit process with the IRS. The PR wields considerable authority and must have a substantial presence in the US, which could prove problematic for non-US fund managers without suitable US employees who can fill the role.
The PR role
The PR role replaces and greatly expands upon the "tax matters partner" position under prior law. Like the old tax matters partner, the PR serves as designated liaison for the partnership with the IRS during audits. The PR, however, has significantly greater authority, including the power to bind the partnership and all former and current partners with respect to the audit process. So, for example, the PR could enter into an audit settlement agreement with the IRS which would bind the partnership, its partners and any indirect partners who have invested in the partnership through other pass-through entities (such as other partnerships or limited liability companies). Under the New Rules, the PR has absolute power to conclude audit matters regardless of any limitations on the PR's authority in the partnership agreement.
Any person or entity can serve as PR provided the person has a "substantial presence" in the US. A substantial presence requires the PR to (i) make themselves available to meet in person with the IRS at a reasonable time and place and (ii) have a US taxpayer ID number and an address and phone number in the US. If the PR is an entity, the partnership must appoint an individual who meets the substantial presence requirements to act as the "designated individual" of the entity serving as PR.
Partnerships covered by the New Rules
The New Rules apply to all entities taxed as partnerships. This includes limited partnerships, general partnerships and limited liability companies electing partnership tax treatment. It also includes foreign entities that are engaged in a US trade or business and file US partnership tax returns.
Electing out of the New Rules
If eligible, certain partnerships can elect out of the New Rules on a yearly basis. To qualify, the partnership must have 100 or fewer partners, and each of the partners must be an individual, a C corporation (or foreign entity taxed as a C corporation), an S corporation or an estate of a deceased partner. Notably, a partnership fails eligibility to elect out if it has any partner which is a partnership, trust or disregarded entity. This partner limitation will make it difficult for many investment fund partnerships to elect out of the New Rules.
Fund managers should asses their funds formed as US partnerships to see if they can elect out of the New Rules. (While beyond the scope of this article, the New Rules contain a number of harsh audit provisions, and partnerships will likely elect out whenever possible.) If the New Rules apply, managers should then determine whether they can staff the PR position internally or whether engaging a trusted and experienced service provider would provide a better solution. While the PR has broad powers, a well-crafted service agreement with limitations on discretion, combined with a knowledgeable PR, can give the manager and the partners comfort that the PR will faithfully represent the partnership.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.