On September 23, 2018, Senate Bill 274, Administration of taxes: notice of deficiency assessment (SB-274), was signed into law by Governor Jerry Brown of California. With the enactment of SB-274, California has adapted its income and franchise tax audit procedures to accommodate the federal partnership audit rules that were established by the Bipartisan Budget Act of 2015 (the "centralized partnership audit regime"), which generally applies to audits of federal partnership income tax returns filed by certain partnerships1 for any taxable year beginning on or after January 1, 2018.

SB-274 provides certainty regarding how federal partnership audit adjustments will affect California state income and franchise tax liabilities of partnerships and partners and the reporting obligations of, and elections available to, partnership and their partners for California tax purposes; it does not, however, otherwise change the procedures applicable to an audit of a partnership by California tax authorities.

Under the centralized partnership audit regime, unless a partnership elects otherwise, taxes arising from IRS audit adjustments must be paid by the partnership rather than separately by the partners. SB-274 applies immediately, meaning that it applies to any partnership taxable year to which the centralized partnership audit regime applies.

Under SB-274, any partnership that is required to file a California state income tax return must file a report with the California Franchise Tax Board (FTB) within six months after the final determination of any audit adjustment to the partnership's federal return that is made pursuant to the centralized partnership audit regime.

Under the centralized partnership audit regime, a partnership generally may elect (the "push-out election") to require its partners to pay the additional federal income tax that results from the partners' including their share of partnership audit adjustments on their own amended tax returns, in lieu of the partnership paying federal income tax on the net increase in partnership taxable income resulting from the audit adjustments. Under SB-274, the partnership's push-out election (or decision not to make a push-out election) applies by default for California purposes except that, notwithstanding the election made for federal purposes, (1) if the partnership is part of a unitary group, any partner that is also part of the group is treated as having filed an amended return that reduces the partnership's tax liability and that partner must then actually file such an amended return and (2) any partnership can ask the FTB for permission to make a push-out election decision different from their federal push-out election decision, so long as the partnership establishes that its election will not impede the state's ability to collect taxes.

With respect to tiered partnerships and other tiered pass-through structures, an audited partnership's indirect partners are subject to the same election, reporting and payment requirements as the partnership and its direct partners. As a practical matter, this will mean that indirect partners subject to California tax must report to the FTB federal audit adjustments occurring at the lower-tier partnership level.

In a case where the partnership does not make a push-out election for California purposes, the direct and indirect partners are not required to pay additional California tax with respect to the federal audit adjustments and a tax is imposed instead on the partnership. The partnership-level tax is calculated in a manner designed generally to approximate the amount of California tax that would be owed if a push-out election were made, by taking into account both whether the partners are corporations, resident individuals, non-resident individuals, partnerships or tax-exempt entities, and the extent to which the federal audit adjustments are allocable or sourced to California; the applicable tax rates are the highest rate that would be applicable to each type of partner (i.e., corporation or individual). The partnership will be required to pay tax only on the California-source portion of the adjustments that are allocated to a partner that is itself a partnership, regardless of who owns the upper-tier partnership.

Finally, under SB-274 only the partnership's "partnership representative" has the authority to make decisions for the partnership relating to the procedures described above, and these decisions will bind the direct and indirect partners of the partnership regardless of whether they have consented to such decisions. The California partnership representative for each tax year under federal audit is also the partnership's federal partnership representative unless another person is designated by the partnership. Unlike the federal rules, SB 274 does not require a partnership representative that is an entity to appoint a single individual to act on its behalf.


1 Partnerships with fewer than 101 partners can elect out of the centralized partnership audit regime but only if none of the partners are a partnership or a trust.

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