Remember that last contract you signed? Are you sure you know what you signed up for?
In a bench opinion (The Christopher Howard Companies, docket #5664-17), the taxpayer, a limited liability company, says an agreement signed by a member allows that member to sign partnership tax returns.
The IRS disagrees.
If the IRS is right, the taxpayer did not file a valid tax return for 2010, and the statute of limitations (internal revenue code section 6229) is still open, meaning the IRS can make adjustments to the return. If the taxpayer is right, the statute of limitations has expired.
In 2010, the taxpayer was a limited liability company and was treated as a partnership for federal income tax purposes. The taxpayer had five members. Member 1 owned 55%, Member 2 owned 30%, and the remaining members owned the balance.
Member 1 was listed as the “tax matters partner.” He did not file or sign a 2010 federal income tax return for the taxpayer, which was due April 15, 2011. Member 2 signed and filed Form 1065, US return for partnership income, for 2010, on October 20, 2011. On March 16, 2012, Member 2 filed a second tax return for tax year 2010.
The IRS did not accept or process either return.
While auditing the taxpayer for tax year 2010, the IRS initially corresponded with Member 2 and treated him as the tax matters partner. However, during the audit, the IRS determined that Member 2 had not properly signed the federal income tax return. On January 20, 2016, the IRS prepared a substitute return for the taxpayer.
The taxpayer says the statute of limitations for making changes has expired since the return was properly signed and should have been accepted as properly filed.
The IRS says the taxpayer’s operating agreement does not authorize Member 2 to sign the tax return. The IRS argues that section 6063 of the internal revenue code restricts the signing of partnership returns, or in this case a return on behalf of a limited liability company, to partners with authority.
Specifically, the IRS relies on provision 5.1 in the operating agreement.
“The business of the company shall be managed by one manager, Member 1. The manager shall serve until either removal by resignation or removal by a majority of the members. The manager has the sole authority to manage the company and is authorized to make any contracts, including but not limited to, employment contracts for officers of the company; enter into any transactions; and make and obtain any commitments on behalf of the company to conduct or further the company’s business. The manager may, in writing, delegate to an employee of the company any of the manager’s responsibilities and authority. This provision does not alter or waive any duty that a manager may have to the company concerning the manager’s exercise of management.”
A related provision, 5.4, of the operating agreement says:
“Except as authorized by the manager no member is an agent of the company or has authority to make any contracts, enter into any transactions, or make the commitments on behalf of the company.”
The taxpayer says the longstanding practice of Member 1 was that Member 2 was responsible for the financial operations of the company.
The taxpayer points to the fact that over the years, Member 2 entered into three separate agreements with the company. All of the agreements were signed by Member 1, both personally and as manager of the company, and by Member 2. In each agreement, Member 2 agreed to loan the company various sums of money, ending with a total balance of $1,182,518 on the date of the final agreement in 2009. Provisions in each of these agreements state that until the loans were paid in full, Member 2 would have operational control of the limited liability company.
The taxpayer also says that for the years prior to 2010, Member 2 filed returns for the company without argument or incident.
The IRS says that despite the loan agreements, Member 1 failed to delegate the authority given to him in the operating agreement, and therefore Member 2 was not authorized to sign the federal income tax returns.
The fact that Member 2 filed returns in previous years did not matter, because each year stands alone.
WHAT WOULD YOU DECIDE?
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For the taxpayer.
We focus our inquiry on whether Member 2 was authorized to file the returns on behalf of the taxpayer for 2010.
The IRS relies on article 5.1 of the operating agreement. The IRS is not persuaded by the fact that Member 2 operated in a manner consistent with his longstanding practice with Member 1, which was understood by Member 1 to be Member 2’s role in the company.
In other words, the IRS strictly relies upon the fact that Member 1 was the managing partner and that he had not authorized Member 2 to file the federal income tax returns in writing.
Our analysis of the agreement would lead us to a different conclusion than the IRS.
We believe that Member 2 was authorized to file the returns pursuant to article 5.4 of the operating agreement and the understanding that he had with Member 1 that Member 2 was responsible for the financial matters of the company.
In addition, we do not read article 5.1 as directly relating to federal income tax returns. In any event, the agreements entered into by Member 2 with Member 1 specifically gave operating authority to Member 2. The agreements were in writing and meet the requirements of article 5.1 if, in fact, it applied to the filing of federal income tax returns.
We note that Member 1 never revoked this transfer of written authority as regards the 2010 federal income tax return. We also note that the operating agreement does not specifically address the authority to sign tax returns, and as we previously stated, Member 1 and Member 2 had long taken the position that Member 2 was authorized to file returns and that for the years prior to 2010, Member 2 had filed returns for the company without argument or incident.
Member 1’s approval of Member 2’s filing of those returns is consistent with our interpretation of the agreement that the provision in article 5.1 did not apply to federal income tax returns.
There’s no question that between Member 1 and Member 2, Member 2 was the member of the company who was responsible for all financial matters and that Member 1 was very comfortable with things operating that way.
On the record before us we hold that the operating agreement did not restrict Member 2’s authority to sign the tax returns.
This holding results in our determination that the statute of limitations provided by section 6229 has expired and that the taxpayer has a valid affirmative defense in the present case based upon the fact that the IRS may no longer assert adjustments, as they were sent to the taxpayer after the period of limitations had expired.
EDITORIAL NOTE: This case is provided for instructional purposes only. CPAs are not authorized to provide legal opinions and should consult with a lawyer when questions arise regarding operating agreements and other contracts.
Also note that new rules relating to partnership audits apply to internal revenue code sections 6221 through 6241 beginning January 1, 2018.