February 13, 2017
Clifton Larson Allen LLP
The Bipartisan Budget Act of 2015, signed into law on November 2, 2015, amends the Internal Revenue Code to make significant changes to the manner in which the Internal Revenue Service (IRS) audits partnerships. In general, the Budget Act repeals partnership audit procedures per the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and replaces them with new audit procedures that apply by default to all partnerships. The new provisions are effective for partnership returns filed for tax years beginning after December 31, 2017. Proposed regulations (Reg -136118-15) were issued on January 18, 2017.
Under the new audit provisions, the tax on audit adjustments imposed by IRS on partnership items of income, gain, loss, deduction, or credit is assessed and collected at the partnership level. The applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to such item is also determined at the partnership level. An underpayment of tax with respect to a partnership adjustment for any year is determined by netting all adjustments of items of income, gain, loss, or deduction and multiplying the net amount by the highest rate of Federal income tax applicable either to individuals or to corporations that is in effect for the year under audit. The product of that amount is then increased or decreased by any adjustments made to the partnership’s credits. Some exceptions apply to the use of the highest tax rate. For example, the underpayment will be determined without regard to the portion thereof that the partnership can show is allocable to a partner that would not owe tax by reason of its status as a tax-exempt entity. Also, a rate lower than the highest rate may apply to the extent that the partnership can show the partnership adjustment is attributable to a long-term capital gain or qualified dividends and these items are allocable to individual partners since these items of income are taxed at lower rates.
If the partnership does not elect to pass an adjustment through to its partners, (discussed later), the adjustment is determined with respect to the “reviewed year” (the year under audit) but is paid by the partnership in the “adjustment year” (the year the audit is finalized by IRS). Therefore, adjustments will be borne by the adjustment-year partners rather than by the reviewed-year partners even if the adjustment-year partners were not partners in the reviewed-year.
Proposed Reg. 301.6223-1 provides rules requiring a partnership to designate a partnership representative and rules describing the eligibility requirements for a partnership representative. A partnership must designate the partnership representative on the partnership’s return filed for the partnership taxable year and must designate a partnership representative separately for each taxable year. IRS may select any person to serve as the partnership representative if one is not made by the partnership.
The partnership representative does not need to be a partner but must have a substantial presence in the United States. Proposed Reg. 301.6223-2(c) provides that the partnership representative has the sole authority to act on behalf of the partnership in any examination. Generally, no partner (except for a partner who is the partnership representative) may participate in or contest the results of the examination or other proceeding involving a partnership.
Election to pass partnership adjustments through to partners
IRC Section 6226 and Proposed Reg. 301.6226-1provides an alternative to the general rule that the partnership must pay the tax on the adjustments at the partnership level. With a proper election, the partnership can “push-out” the adjustments to the reviewed-year partners rather than directly pay the tax on the adjustments. The election can be revoked only with the consent of IRS. The election must be made within 45 days of the mailing of the final partnership adjustment (FPA) and, if the FPA has more than one adjustment, the election must identify which adjustments the partnership is electing to push-out. Thus, a partnership is allowed to elect to push-out only some of the adjustments.
Electing out of the centralized audit rules
Proposed Reg. 301.6221(b)-1 provides that an eligible partnership may elect out of the centralized audit regime. A partnership is an eligible partnership if it has 100 or fewer partnerships during the year and, if at all times during the tax year, all partners are eligible partners.
The determination of whether the partnership has 100 or fewer partners is made by counting the number of statements required to be furnished under IRC Section 6031(b) (generally Schedule K-1). A husband and wife are not treated as a single taxpayer. Any statements required to be furnished by an S corporation partner for the tax year of the S corporation ending with or within the partnership’s tax year are taken into account for purposes of determining whether the partnership is required to furnish 100 or fewer statements for the tax year. For example, assume Partnership has 51 partners – 50 partners are individuals and S, an S corporation with 50 shareholders. Partnership has 101 partners – 51 statements furnished by Partnership to its partners plus 50 statements furnished by S to its shareholders. [Proposed Reg. Section 301.6221(b)-1(b)(2)(iii), Example 4]
All partners in the partnership must be eligible partners in order for the partnership to elect out. Proposed Reg. 301.6221(b)-1(b)(3)(i) defines the term “eligible partner” as any person who is an individual, C corporation, eligible foreign entity, S corporation, or an estate of a deceased partner. Therefore, a partnership (lower tier partnership) that has a partner that is a partnership (upper tier partnership) can not elect out of the centralized audit regime. The upper tier partnership can elect out if it is otherwise eligible.
A partnership makes the election only on a timely filed partnership return (including extensions) for the partnership tax year to which the election relates. The partnership must disclose to IRS the names, correct taxpayer identification numbers (TINs), and federal tax classifications of all partners of the partnership and, if there is an S corporation partner, the names, correct TINs, and federal tax classifications of all persons to whom an S corporation partner is required to furnish statements during the S corporation partner’s taxable year ending with or within the partnership’s tax year at issue. Additional information may be required by IRS in forms and instructions.
A partnership that elects out must notify each of its partners that the partnership made the election within 30 days of making the election. The notice may be in writing, electronic, or other form chosen by the partnership. Presumably, the notice can be made on Schedule K-1 or on a statement attached thereto.
IRS has scheduled a hearing on May 10, 2017 on the proposed regulations. Comments on the proposed regulations and requests to speak at the hearing are due 90 days after the proposed regulations appear in the Federal Register.
Note: On January 20 President Trump issued a presidential memorandum that institutes a moratorium on all federal rulemaking until the new administration can review all regulations in process. This includes the proposed regulations discussed above. It is possible that changes will be made before the regulations are submitted to the Office of the Federal Register.
Disclaimer: This article is designed to provide information in regard to the subject matter and has been prepared with the understanding that neither the Illinois CPA Society nor the author of this article is providing accounting, tax or legal advice or is performing any legal, accounting or other professional service. If accounting, tax or legal advice or other expert assistance is required, the services of a competent professional person should be sought.