Most multi-member LLCs are taxed as partnerships and must comply with the federal tax rules that apply to partnerships. These rules require the LLC to designate someone—called a partnership representative in the tax law—to represent the LLC before the IRS in an audit.
A well-drafted LLC operating agreement will include provisions identifying the partnership representative—also called a tax matters partner, tax matters member, LLC representative, or tax matters representative—and defining the scope of the representative’s authority. This article discusses the different terminology and roles involved and provisions that should be included in the LLC operating agreement.
What is a Tax Matters Partner?
The term tax matters partner was used in the now-repealed Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) to refer to a partner designated by a partnership to represent the partnership before the IRS. As the name suggests, only a partner could be a tax matters partner. The partnership could not, for example, designate a third-party accountant to represent the partnership before the IRS.
TEFRA gave the tax matters partner the ability to extend the statute of limitations and act as the representative of the partnership before the IRS in any audit proceedings. But even with these responsibilities, the authority of the tax matters partner was not exclusive. Other partners could participate in the audit process.
What is a Partnership Representative?
The Bipartisan Budget Act of 2015 (BBA) repealed TEFRA and replaced the term tax matters partners with the term partnership representative. Like a tax matters partner, a partnership representative can represent a partnership in IRS audits. But, unlike a tax matters partner under prior law, a partnership representative need not be a partner. Anyone with a substantial presence in the United States can serve as the partnership representative.
BBA gives partnership representatives more authority than tax matters partners had under TEFRA. Under BBA, the partnership representative has exclusive authority to represent the partnership in IRS audits, and the partnership and each partner are bound by the decisions of the partnership representative. The IRS may choose a partnership representative if the partnership fails to do so.
What is a Partnership Representative for an LLC?
Most multi-member LLCs are taxed as partnerships. For these LLCs, the owner of the LLC—called a member—is treated as a “partner” under BBA, and the LLC must designate a partnership representative to act on behalf of the LLC. For LLCs that are taxed as partnerships, the discussion of “partners” and “partnership agreements” in the tax law apply equally to “members” and “operating agreements,” respectively.
The application of partnership audit rules to LLCs results in changed terminology. Because a member of an LLC is not typically referred to as a “partner” in the operating agreement and other company documents, most documents will replace partnership terminology with LLC terminology. For example, a partnership representative under tax law may be referred to as a company representative or LLC representative in the LLC operating agreement. (This was also the approach taken under TEFRA, where tax matters partner was often replaced with tax matters member to reflect the different form of entity.)
Planning Opportunities for LLC Operating Agreements
Given BBA’s expansion of authority, LLC members should choose the partnership representative carefully. Depending on the circumstances, it may be desirable to limit the otherwise broad discretion given to partnership representatives under the BBA. This raises several planning opportunities when preparing LLC operating agreements:
- Include provisions appointing the partnership/tax matters representative and defining the role.
- Specify whether the partnership representative must also be a member.
- Consider requiring that the partnership representative obtain the approval of the members before making any decisions that would bind the partnership.
- Consider imposing fiduciary duties on the partnership representative (requiring the partnership representative to act in the best interest of all members).
An LLC operating agreement should also deal with differences in terminology. The best practice is to use a defined term for the partnership representative, making sure that the definition explicitly references the definition section of the Internal Revenue Code. For example, the operating agreement could use the term Tax Matters Representative as a defined term, coupled with a definition that defines Tax Matters Representative as equivalent to the term “partnership representative” as that term is used in IRC § 6223(a).
Opting Out of Audit Rules
The LLC operating agreement should also include provisions dealing with BBAs new audit rules. Prior law (TEFRA) created three categories of partnerships for audit purposes:
- Partnerships with ten or fewer partners are audited at the partner level. The IRS may not make partnership level adjustments if only individuals, estates, or C corporations are partners. Partnership tax returns are only audited in connection with audits of partners’ tax returns.
- Partnerships with more than ten partners are audited under unified TEFRA procedures that are binding on the partners. The IRS may adjust partnership-level items and re-assess partners for the tax resulting from the adjustment.
- Partnerships with 100 or more partners can elect to be treated as electing large partnerships (ELPs). The IRS uses unified audit procedures for ELPs. Any adjustments or assessments occur at the partnership level.
BBA replaced these rules with new rules designed to streamline partnership audits. These new rules allow the IRS to assess and collect taxes resulting from partnership audits at the partnership level instead of passing the adjustments through to the partners.
If an audit requires adjustment to partnership items or allocations, BBA requires the partnership to pay the resulting taxes. These taxes are referred to as the “imputed underpayment amount” (IUA). The IUA is calculated using the highest tax rate applicable to individuals or corporations in the audited year. When computing the IUA, the partnership may not deduct tax, interest, or penalties paid by the partnership during that year.
This new system shifts financial responsibility for tax adjustments. Where TEFRA assigned liability for audit adjustments to the partners, the BBA assigns liability for IUA to the partnership. Under the new rules, it is the partnership itself—and not the partners—that is responsible for the IUA.
This shift of tax liability from the partners to the partnership can increase the IUA. Because the IUA is computed at the partnership level, the partners’ individual tax attributes are ignored. For example, a partner’s net operating losses do not offset the partnership’s IUA, even though the net operating loss would have offset the partner’s share of the income had it been distributed. Similarly, income that would be allocated to a tax-exempt partner (and thus escape taxation) is now computed at the partnership level, where the partner’s exempt status is ignored.
Some partnerships may opt out of the new regime and be subject to partner-level audits under the same rules that apply to individual taxpayers. To qualify, a partnership must meet these eligibility requirements:
- For the taxable year in question, the partnership cannot be required to furnish more than 100 Schedule K-1s to its partners (100-partner limitation).
- Each of the partners must be an individual, a C corporation, any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner.
Although a partner that is an S corporation does not preclude the election, each of the S corporation’s shareholders is considered partners of the partnership and count toward the 100-partner limitation. But partnerships with trusts or other partnerships as partners cannot currently opt out of the new rules.
The partnership must make the election annually on a timely return. The partnership must notify each partner of the election. The partnership must also give the IRS the information it needs to identify the partners. This information includes the name and tax identification number for each partner or shareholder of an S corporation that is a partner.
An LLC operating agreement should provide specific guidance about electing out of partnership-level tax treatment. If the LLC qualifies and the members prefer to be subject to partner-level audits, the operating agreement should include provisions requiring the partnership representative to annually file the election elect out of the revised partnership audit rules. Otherwise, the operating agreement should give the partnership representative the authority to make any elections required under the revised audit rules.
If the partnership wants to preserve the ability to make the election, the partnership agreement should also restrict any transfers to ineligible owners that would cause the partnership to fail to meet the eligibility requirements for opting out of partnership-level taxation. These types of restrictions are customarily included in the transfer restrictions section of an operating agreement.
Indemnifying the Partnership Representative
Many businesses want to protect those that serve in fiduciary roles from becoming personally liable for decisions involving the LLC. It is not uncommon for operating agreements to indemnify members or managers against liabilities resulting from actions taken on behalf of the LLC, as long as the action is taken in good faith and without negligence or intentional misconduct. Similar principles apply to the partnership representative. Depending on the goals of the members, the LLC operating agreement could include provisions indemnifying the partnership representative for good-faith decisions involving the LLC.