Treasury and the IRS released proposed regulations (REG-136118-15) implementing the new centralized partnership audit regime enacted as part of the Bipartisan Budget Act of 2015 (BBA), which replaces the partnership audit rules of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). These proposed regulations are substantially similar to draft proposed regulations that were released publicly by the IRS in January 2017, but were withdrawn before being published in the Federal Register as part of the new Trump administration's initial freeze on regulatory activity.
The BBA is effective for partnerships with tax years beginning after Dec. 31, 2017. In August 2016, the IRS and Treasury issued proposed and temporary regulations on the method by which a partnership could elect into the BBA early. Those regulations are not modified as a result of these new proposed regulations. While some groups have lobbied Congress and Treasury for a delay in the effective date of the new audit rules, it is unclear whether a delay will be enacted or implemented.
The BBA presents a profound shift not only for the partnerships themselves, but also for many C corporations, tax-exempt entities, S corporations and trusts that are partners in partnerships. The rules are designed to shift the burden for actually assessing tax after a partnership-level adjustment from the IRS to the partnership and partners. Partnerships will need to consider changes to their partnership and operating agreements and other transaction documents, like purchase and sale agreements, to respond to the BBA, especially considering the proposed regulations, which tend to place greater import on the relationship between the partners and the partnership representative than between the IRS and the partnership.
In addition, the proposed regulations mention the Tax Technical Corrections Act of 2016, which was introduced but ultimately not enacted by Congress. That legislation would have made both minor and major changes to the BBA, including allowing pass-through partners the ability to make subsequent push-outs to their partners. The proposed regulations lay out "significant administrative concerns" associated with allowing pass-through partners to make a push-out election on the part of the IRS and reserve the issue for future guidance, which is expected in the near future. The IRS also seeks comments on how to administer a system by which a pass-through partner can make a subsequent push-out.
Scope of the centralized audit procedures
The IRS takes a broad approach to the government's ability to make adjustments at the partnership level under the proposed regulations. The statute provides that any adjustment to "items of income, gain, loss, deduction, or credit" of a partnership for a partnership taxable year and any partner's distributive share thereof is determined at the partnership level. The same is true for tax attributable to such items, and the applicability of penalties and additional amounts.
The proposed regulations define the phrase items of income, gain, loss, deduction or credit expansively to mean "all items and information required to be shown, or reflected, on a return of a partnership," which in turn is defined broadly to include, among other things:
Grant Thornton Insight: The broad approach of the scope may cause adjustments related to certain events that would generate a gain or loss at the partner level, e.g., disguised sale of property or a partnership interest by a partner, to be included as an adjustment at the partnership level, to be potentially shared by or burden all of the partners and not just the partner(s) causing the event that triggers the gain or loss.
- Character, timing and source of partnership activities
- Contributions to and distributions from the partnership
- The partnership's basis in its assets, including the character and type of the assets; the amount and character of partnership liabilities
- The separate category, timing and amount of the partnership's creditable foreign tax expenditures
- Elections made by the partnership and the consequences thereof
- Items related to transactions between the partnership and any person, including disguised sales
- Items resulting from a partnership termination under Section 708(b)(1)(A), including as a result of a transaction under Rev. Rul. 99-6
- Items and effects arising from a technical termination, and partnership capital accounts
Penalty defenses must be raised by the partnership in a partnership-level proceeding, regardless of whether the defense relates to facts and circumstances relating to a person other than the partnership under the proposed regulations. The proposed regulations give examples of how the penalty defense would apply, requiring the partnership to put forth any argument for reasonable cause. For example, if after the issuance of a notice of proposed partnership adjustment (NOPPA) that imposes an accuracy-related penalty with respect to an imputed underpayment on the grounds that the imputed underpayment is attributable to negligence, the partnership can show that a partner subject to the proceeding had reasonable cause and acted in good faith with respect to how the partner reported those items that were adjusted and gave rise to the underpayment attributable to the penalty. The IRS will take that penalty defense into account when determining the portion of the penalty that relates to the adjustments attributable to the partner.
Electing out of the BBA rules
All partnerships are subject to the new BBA rules unless they fall under the so-called small partnership exception. Partnerships with 100 or fewer partners can opt out of the new audit procedures on an annual basis only if their partners are limited to individuals, C corporations (including foreign entities that would be considered C corporations if domestic), S corporations (each shareholder counts toward the 100-partner limit) and estates of deceased partners. Partnerships with a partner that is another partnership would not be able to opt out of the new audit procedures, much like under TEFRA.
The proposed regulations provide a list of partners that are not eligible partners for purposes of electing out, which are partnerships, trusts, certain foreign entities, a nominee that holds an interest on behalf of another person, the estate of an individual other than a deceased partner, and perhaps most notably, a disregarded entity, such as a grantor trust or single-member limited liability company.
Grant Thornton Insight: The IRS's decision to consider disregarded entities as ineligible partners means that any partnership with a disregarded entity as a partner would be subject to the BBA rules. Thus, partnerships will need to know the entity classification for federal income tax purposes of each partner that directly owns an interest in the partnership. In addition, unlike under TEFRA, where a partnership had to affirmatively elect in to the centralized partnership audit regime, under the BBA, a partnership will have to affirmatively elect out.
The proposed regulations also state that, unlike under TEFRA, a husband and wife who are each partners in a partnership are not considered to be a single partner. Rather, each of them would count toward the 100-partner limit. A partnership meeting the requirements of the eligible partner rules must also affirmatively elect out of the BBA, unlike under TEFRA, where such a small partnership would be required to elect into TEFRA.
The proposed regulations require the partnership to make the election out of the BBA on a timely filed partnership return, including extensions, for the taxable year to which the election applies, and in accordance with information required by IRS forms, instructions, and other guidance. The election must also include information about the partnership's partners, and once made, the election may not be revoked without the consent of the IRS. The partnership is required to notify each of its partners within 30 days of making the election.
A partner's return must be consistent with the partnership's return under the BBA and the proposed regulations. This is no different from the rules under TEFRA and the electing large partnership rules. Under the BBA, if a partner fails to treat items attributable to a partnership consistently with the treatment of those items on the partnership's return, the IRS may assess and collect any underpayment of tax as if it were on account of a mathematical or clerical error, thereby allowing the IRS to bypass deficiency procedures, unless the partner notifies the IRS of the inconsistent treatment.
Grant Thornton Insight: While the BBA is not dissimilar to the consistency requirements currently in place under TEFRA, it is important to note that the BBA significantly limits the ability of a partner to challenge a deficiency assessment when the partner has not notified the IRS of an inconsistent treatment.
The proposed regulations provide that a partner must identify its return as being inconsistent by attaching a statement identifying the inconsistency. A partner will be protected from the IRS's assessments based on math error authority only to the extent that each inconsistency is reported. So, if a partner has multiple inconsistencies, each must be reported. In addition, a partner may demonstrate that the partner has complied with the consistency requirement by showing the partner received incorrect information from the partnership and by making a timely election after receiving a notice of inconsistency from the IRS.
The examples provided in the proposed regulations regarding inconsistent treatment contemplate several situations, such as where a cash method partnership received an advance payment for services in one year, but the partner reported the payment in a subsequent year, and where a partnership treated certain costs as being capitalized, but the partner treated those costs as deductible. There are several other examples.
One of the most important aspects of the BBA is the authority placed on the partnership representative (PR). Under the BBA, each partnership must designate a PR, who will have sole authority to act on behalf of the partnership. If the partnership does not designate a PR, then the IRS may select any person as the PR of the partnership.
Grant Thornton Insight: A partnership subject to the BBA should be careful in determining who to appoint as a PR, given the level of authority a PR is granted under the Internal Revenue Code and regulations. The partnership and its partners should consider whether to impose any internal limitations on the PR's ability to act on his or her own. The partnership may also want to consider potential for conflicts of interest if the PR is a partner, and whether the PR must notify the partners of the PR's actions.
Unlike under TEFRA, where the tax matters partner was required to be a partner in the partnership, the PR need not be a partner. Rather, any person may serve as a PR, so long as that person has a substantial presence in the United States. The proposed regulations also contain guidance on how a PR is designated by the partnership, when a PR's designation may be revoked, how a PR may resign and the method by which the IRS may designate a PR.
The actions taken by the PR bind the partnership, including all the partners of the partnership. For example, a settlement agreement entered into by the PR (or a notice of final partnership adjustment (FPA) that is not contested by the partnership or PR) binds the partnership, the partners and any other person whose tax liability is determined in whole or in part by taking into account directly or indirectly adjustments determined under the BBA.
Adjustments by the IRS
The BBA reflects a shift in the burden of tax assessment and collection by the IRS. Partnerships subject to TEFRA are examined on a partnership basis, but any adjustments to tax resulting in an underpayment (or potentially a refund) are made at the partner level.
Under TEFRA, the IRS has to collect any underpayment from each partner of the partnership. The BBA, under Section 6225, creates a default mechanism for the collection of imputed underpayments, whereby the partnership pays the underpayment in the same manner as if it were a tax imposed for the year in which the IRS made the adjustment (the so-called adjustment year). Under Section 6226, the partnership may push out the adjustments to the partners under certain circumstances.
Under the default method, the imputed underpayment is set forth in the NOPPA, which may then be subject to modification. The imputed underpayment is calculated by multiplying the total netted partnership adjustment by the highest rate of tax under Sections 1 or 11. That amount is then increased or decreased by any adjustment made to the partnership's credits.
Adjustments may be grouped together, and within each grouping, adjusted items may be subgrouped depending on their character or to account for preferences, sources, categories or limitations, such as a subgrouping based on short- or long-term capital gain. The proposed regulations provide for three types of groupings: (1) Adjustments that reallocate items among the partners (reallocation grouping); (2) adjustments to the partnership's credits (credit grouping); and (3) remaining adjustments (residual grouping). After the items are separated into groups and subgroups, they are netted to separate items based on character, either ordinary or capital.
After each group or subgroup has been netted, the adjustment will either be net positive or net nonpositive. Those adjustments that are nonpositive (except for grouped credits) are disregarded for purposes of calculating an imputed underpayment.
Once the imputed underpayment has been calculated through the groupings and nettings described above, the partnership that received the NOPPA may request a modification of the proposed imputed underpayment through the PR. Modifications may not be requested for adjustments that do not result in an imputed underpayment.
The proposed regulations provide for different types of modifications to the proposed imputed underpayment, including through the filing of an amended return filed by a partner of the partnership for the year under examination (the reviewed year) that takes into account all of the partnership adjustments properly allocable to that partner. The partnership may also request modifications based on adjustments allocable to tax-exempt partners, adjustments attributable to rates of tax lower than the highest applicable tax rate, and passive losses of publicly traded partnerships, among other things.
Importantly, these modifications must be approved by the IRS, and the proposed regulations specifically state that the IRS may initiate an administrative proceeding against a partner even if the IRS approves of the modification. For all requests for modifications, the partnership and/or partners must satisfy the IRS's requests for documents and details surrounding the modification.
The statute prescribes the treatment of the imputed underpayment as a nondeductible payment by the partnership, but is otherwise silent regarding the effect of the adjustments themselves on the partnership and its partners. The proposed regulations reserve on rules regarding adjustments to partners' capital accounts and outside basis and to the partnership's basis and book value in property, though the IRS and Treasury explained that they intend to adopt an approach of providing that a partnership that pays an imputed underpayment attributable to an adjustment to an item of income, gain, loss or deduction allocate that item in the adjustment year to the adjustment year partners treating such items as items of income, gain, loss or deduction as nontaxable or deductible under Sections 705(a)(1)(B) or (2)(B).
Push-outs to partners
Under Section 6226, a partnership may elect to push out adjustments to the reviewed year partners rather than paying the imputed underpayment described in Section 6225. The partnership under examination, which is also referred to generally as a source partnership, may elect to push out the underpayment with respect to one or more imputed underpayments identified in the FPA. Nonetheless, while properly and timely electing the push-out method may relieve the partnership of remitting to the IRS for the underpayment, the election does come with an additional cost of two percentage points of interest to the partners for the underpayment.
The push-out election must be made within 45 days of the date the FPA is mailed by the IRS, and the proposed regulations state that this time period may not be extended. In addition, the election must be signed by the PR and include:
- The name, address and correct taxpayer identification number (TIN) of the partnership
- The taxable year to which the election relates
- The imputed underpayments to which the election applies (if there is more than one)
- Each reviewed year partner's name, address and correct TIN
- Any other information required by forms, instructions or other guidance
A copy of the FPA must also be attached to the election.
The partnership making the push-out election must furnish "statements" to the reviewed year partners with respect to each partner's share of the adjustments, and file those statements with the IRS. The proposed regulations differentiate the statements from Schedules K-1 and, in fact, the statute under Section 6226 specifically refers to statements, as opposed to Schedules K-1. Accordingly, the partnership may not include the adjustments that are to be taken into account by the reviewed year partners under Section 6226 in any Schedule K-1 that is required to be furnished under Section 6031(b).
The statements must be provided to the reviewed year partners within 60 days from the time the partnership adjustments are finally determined. A partnership adjustment becomes finally determined upon the later of the expiration of the time to file a petition under Section 6234 or, if a petition is filed, the date when the court's decision becomes final. The proposed regulations contain an example describing this sequence.
Grant Thornton Insight: A partnership contemplating making an election under Section 6226 to push out statements reflecting the partners' allocable share of the imputed underpayment should carefully consider the consequences, and weigh the costs and benefits of such an election (and whether the partnership agreement should provide restrictions on the decision in advance). While pushing out the imputed underpayment could more equitably separate the amount of any imputed underpayment between partners (including past and current partners), the partnership should consider not just the potential administrative cost of issuing statements to the partners and the IRS, but also the additional 2% interest charge, as well as the fact that certain additional taxes, such as the net investment income tax and the additional Medicare tax, are not borne at the entity level, but rather are paid at the partner level, which could be partner-favorable. The BBA is designed to encourage collections from the partnership, not the partners, and this interplay between the election under Section 6226 and the default rules of Section 6225 are the clearest reflection of that divide.
If the push-out election under Section 6226 is timely and properly made, then all reviewed year partners are bound by the election and must take the adjustments on the statement into account. Accordingly, a reviewed year partner may not take an inconsistent position with regard to those items reflected on the election statement.
The statements must include:
- The name and correct TIN of the reviewed year partner
- The current or last address of the reviewed year partner that is known to the partnership
- The reviewed year partner's share of items originally reported to the partner, taking into account adjustments, if any, under Section 6227
- The reviewed year partner's share of the partnership adjustments, and any additions to tax, penalties or additional amounts
- Modifications attributable to the reviewed year partner
- The reviewed year partner's share of amounts attributable to adjustments in the partnership's tax attributes in any intervening year resulting from the partnership adjustments allocable to the partner
- The reviewed year partner's safe harbor amount and interest safe harbor amount
- The partnership taxable year to which the adjustments relate
- Any other information required by forms, instructions or guidance by the IRS
A reviewed year partner that is furnished a statement is required to pay any additional tax under Chapter 1 of the Code for the partner's taxable year, which includes the date the statement was furnished to the partner (known as the reporting year). This additional tax is either the aggregate of the adjustment amounts or a safe harbor amount, described in more detail in the following section. Generally, the push-out amount must be applied against the partner's individual liability for the reviewed year to adjust any tax attributes, if applicable, and to each successive year up to the reporting year. The allocable amount of the underpayment is then paid by the partner in the reporting year.
Where a partner of the partnership under examination is itself a pass-through partner (e.g., a partnership), numerous commentators had suggested that the pass-through partner that receives a statement pursuant to a push-out election should be able to flow through the adjustment to its owners instead of paying tax on the adjustments at the first tier. The result under this approach would be that the adjustments would flow through the tiers until a partner that is not a pass-through entity receives the adjustment. The proposed regulations reserve on this issue, but the IRS, in the preamble to those rules, raised potential administrative concerns in that approach, noting that the technical corrections bill contained such a proposal. The IRS has indicated that an approach for pushing adjustments beyond the first tier partners will be the subject of other proposed regulations to be published in the near future. The government has also requested comments on how the IRS might administer the requirements of Section 6226 in tiered situations.
Partner's election to pay safe harbor amount
Grant Thornton Insight: The safe harbor election contained in the proposed regulations would allow a partner that is furnished a statement to pay additional amounts owed in the reporting year, rather than require the partner to apply the safe harbor amount in the partner's reviewed year and each successive year up to the reporting year. While this calculation may be simpler for the partner to make, it may also provide a less favorable answer for tax purposes, especially if the imputed underpayment can be potentially absorbed against other tax attributes in a previous tax year.
The proposed regulations require the partnership to calculate a safe harbor amount and an interest safe harbor amount, neither of which can be less than zero, for each reviewed year partner. The safe harbor amount is calculated in the same manner as the imputed underpayment under the default procedures under Section 6225, except the reviewed year partner's share of the adjustments on the statement are substituted as the partnership adjustments taken into account.
Under the proposed regulations, a partner that is furnished a statement may elect to pay the safe harbor amount in lieu of the additional reporting year tax. That election is made on the partner's return for the reporting year.
Administrative adjustment requests
Under the proposed regulations, the partnership may file an administrative adjustment request (AAR) with respect to one or more items of income, gain, loss, deduction or credit of the partnership, and any partner's distributive share thereof for any partnership taxable year. Unlike under TEFRA, only the partnership, and not a partner, unless in his or her capacity as a PR, may file an AAR. In addition, the AAR may only be filed within three years after the latter of (1) the filing date of the partnership return or (2) the original due date of the partnership return (i.e., not including extensions). However, an AAR for a partnership taxable year may not be filed once a notice of administrative proceeding has been mailed by the IRS.
The AAR must also be signed by the PR, which is also a divergence from TEFRA, where the AAR had to be signed by the person authorized to sign a partnership return. If the AAR results in an imputed underpayment, the partnership must take into account the adjustments and pay the imputed underpayment with the AAR, unless the partnership elects to have the reviewed year partners take the imputed underpayment into account in the reporting year.
If the AAR does not result in an imputed underpayment (for example, if the partnership determines that it is entitled to a refund), then the adjustments are taken into account by the reviewed year partners in the reporting year.
Overview and outlook
The IRS is requesting comments and has scheduled a hearing for Sept. 18, 2017. Although the Trump administration's freeze on regulatory actions delayed the formal issuance of these proposed regulations, the IRS and Treasury are still working toward finalizing the rules before the law becomes effective for tax years beginning after Dec. 31, 2017. Even then, however, the BBA's collection and assessment procedures would not apply until after the return is chosen for examination, which would be months after the return is actually filed.
In the meanwhile, businesses that are organized as partnerships, or taxpayers who are partners in partnerships, should seriously consider the impact of these rules, including any necessary modifications to partnership agreements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.