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?