Advising partnerships on audit rules
Tax professionals should insist on CPAR-related operating agreement language for partnerships.
Partnerships—especially smaller, “simpler” ones—tend to gloss over (or outright omit) the centralized partnership audit regime (CPAR) in their operating or partnership agreements (OAs). However, ignoring CPAR or failing to update OAs to include relevant provisions and decision-making procedures can lead to big headaches if the IRS audits a partnership return.
The evolution of the centralized partnership audit regime
The current CPAR seeks to streamline partnership audits through a single, powerful individual. This approach has its roots in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97–248, which sought to facilitate IRS audits of partnerships. Before TEFRA, the IRS audited partnership activity at the partner level, leading to inconsistent treatment of partners. Under TEFRA, IRS audited partnerships, made adjustments to “partnership items,” and assessed additional tax at the partner level if necessary. Each partnership designated a tax matters partner (TMP) to coordinate the audit or judicial proceedings. Still, each partner received audit notices, retained the right to participate in the audit or proceedings, and could negotiate separately with the IRS.
In 2014, the U.S. Government Accountability Office (GAO) reported that the IRS audited a significantly smaller proportion of large partnerships than comparably large corporations.1 Passing partnership adjustments to partners, especially in large partnerships and multi-tiered structures, was costly and inefficient. Moreover, the statute of limitations on partners’ returns continued to run while the IRS audited the partnership. Despite attempting to simplify partnership audits, the TEFRA CPAR ultimately resulted in administrative burdens on the IRS, partnerships, and partners.
Congress responded to the GAO report by entirely replacing the TEFRA CPAR with a new one in the Bipartisan Budget Act of 2015 (BBA), P.L. 114–74. The BBA made two critical changes:
First, the BBA replaced the TMP with a partnership representative (PR). Only the PR (or a designated individual [DI], if the PR is an entity) receives notices, participates in the audit or judicial proceedings, and makes decisions on behalf of the partnership regarding an audit. The PR (and DI) need not be a partner but must be substantially present in the US.2
Second, the BBA simplified tax assessment and collection by imposing an imputed underpayment (IU) at the partnership level, following all adjustments to income, gains, losses, deductions, or credits. The IU uses the highest marginal tax rate—corporate or individual—of the reviewed tax year.3 The PR (or DI) can elect to “push out” the adjustments to partners; however, they pay an additional 2 percent interest rate on the underpayment.4 The PR (or DI) ultimately has the final, irrevocable say.
Congress resolved the flaws of the TEFRA CPAR by replacing the TMP with a fully empowered PR, which can decide whether to bind the partnership to pay additional tax after an audit or to push the adjustments to individual partners. Given this potential power, partnerships should carefully consider the role when crafting their foundational agreements and designating a PR.
Operating agreement issues for managing partnership representatives and audits
The U.S. Small Business Administration recommends each LLC have an operating agreement (OA). An OA “outlines the business’ financial and functional decisions including rules, regulations and provisions” by “govern[ing] the internal operations of the business in a way that suits the specific needs of the business owners.” They usually include, at minimum, a breakdown of members’ ownership percentages, voting rights, and duties; guidelines regarding distributions of profits and losses; and procedures for transferring interests or in the event of a member’s death.
Most OAs I have seen discuss tax issues minimally, usually focusing on a few provisions in the Internal Revenue Code’s (IRC) Subchapter K of Chapter 1, which covers partnership tax rules. I have yet to see an OA that mentions CPAR rules, found in Chapter 63 of the IRC.5 This is a significant oversight with severe potential ramifications for the partnership and its partners.
Tax advisors should explain the importance of CPAR to their partnership clients and encourage them to add language to their OAs regarding CPAR when possible. To help guide the discussion, partners should answer the following questions:6
Should the operating agreement include a requirement to elect out of CPAR (if eligible) or establish a procedure for the partnership to decide whether to elect out of CPAR each year? Eligible partnerships may elect out of CPAR each tax year.7 Partners should establish a clear rule for making the election (or not) or mandate that the partnership automatically elects out (or not) if it qualifies.
Should the operating agreement prohibit transfers of partnership interests to persons who would terminate or prohibit an election out of CPAR? As a follow-up to the prior question, it must maintain its eligibility if the partnership mandates electing out of CPAR. Bringing on a partner or transferring a partner’s interest to another individual or entity may disqualify the partnership from electing out of CPAR. The partnership should anticipate this possibility in its OA.
Should the operating agreement include a procedure for designating a partnership representative? If the partnership does not elect out of CPAR, it must name a PR on its Form 1065, U.S. Return of Partnership Income, or risk letting the IRS designate one in an audit. Partners should protect their ability to assign a PR of their choosing whom they trust to make decisions in their best interests. A partnership should also include a provision for revoking its designated PR.8
Should the operating agreement describe how and when the partnership will elect to push out the burden of a positive adjustment to the partners? The PR ultimately decides whether the partnership elects to push out the tax burden of positive adjustments to partners; however, the partners should establish a procedure for determining whether to instruct the PR to make that election.
Should the operating agreement establish whether or not partners who did not own an interest during a reviewed year are liable for tax paid by the partnership for that year? If the partners have changed since the reviewed year, current partners perhaps should have some clear recourse if the PR chooses to have the partnership pay the imputed underpayment.
Partnerships should provide written answers to these questions, preferably in an operating agreement or contract with the PR (and DI) and with the advice of a qualified attorney and tax advisor.
Caveat socius: Limits on partners’ ability to constrain a partnership representative
Given a PR’s relatively immense and unchecked power during an audit, partnerships should consider contractual limits on them. At a minimum, the OA should answer the questions posed above.
The OA, or a separate contract with the PR (and DI, if applicable), should ensure the partners maintain as much decision-making authority as possible. It should also include provisions for revocation or restitution if the PR (or DI) acts incompetently or contrary to the partnership's interests or desires.
But the partners must keep the following two points in mind as they plan for constraining a PR:9
Contractual restrictions on a PR (or DI) do not bind the IRS. Partners may have a cause of action against a PR who settles an audit in violation of the OA or a contract, but they cannot contest the adjustment or assessment of tax with the IRS after it has been stipulated by a PR (or DI).
Seeking damages from a PR may produce a limited benefit. An entity PR may have little or no assets against which the partners could collect a judgment. Also, an external PR could require indemnity from the partnership in its contract.
Any partnership can wind up in an IRS audit. One can find itself in a difficult situation without taking necessary precautions in preparing an annual tax return, especially including either an intentional election out of CPAR or properly designating a qualified, trustworthy PR. As tax advisors, we should push our small business clients to ensure they have the necessary discussions and written provisions with their partners and legal advisors to mitigate stress and harm during an audit.
U.S. Government Accountability Office, 2014, “Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency.”
IRC §6223; Treas. Reg. §301.6223-1, 2.
IRC §6225.
IRC §6226.
I am not alone, based on this informal poll.
I adapted these questions from Donald Williamson, 2016, “Partnership Audit Rules for the Next Decade,” The Tax Adviser.
IRC §6221(b). A partnership qualifies as long as it has 100 or fewer partners and none of the partners is a partnership, trust, or disregarded entity. For electing out of CPAR, each S corporation shareholder counts toward the 100-partner limit.
See Treas. Reg. §301.6223–1(e).
I adapted these points from Ellen S. Brody, 2024, “What Accountants Need to Know About the BBA,” The Tax Adviser.