The IRS's ability to examine certain partnerships was greatly strengthened by the Bipartisan Budget Act of 2015, P.L. 114-74, which, effective for partnership tax years beginning after Dec. 31, 2017, repeals the electing large partnership and Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) partnership audit rules of chapter 63 of the Internal Revenue Code.
Under the Budget Act, and similar to the TEFRA and electing large partnership audit rules, any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership's tax year, as well as the partner's distributive share thereof, will be determined at the partnership level. The applicability of any penalty, addition to tax, or additional amount that relates to an adjustment also will be determined at the partnership level under the new law (Sec. 6221(a), effective for partnership tax years beginning after Dec. 31, 2017).
This general rule, however, will not apply to electing partnerships (1) that are required to issue 100 or fewer Schedules K-1, Partner's Share of Income, Deductions, Credits, etc., with respect to their partners; and (2) in which each of the partners is either an individual, C corporation, a foreign entity that would be treated as a C corporation if it were domestic, an estate of a deceased partner, or an S corporation.
Partnerships that meet those two conditions must affirmatively elect out of the general rule, and, even then, the election must be made on a timely filed return that contains the name and taxpayer identification number (TIN) of each partner of the partnership, and the partnership must notify each partner of the election.
Although the affirmative election out of the general rule will allow the partnership to exclude having adjustments apply at the partnership level, this also means that the IRS will have to examine each partner separately, which could result in inconsistent treatment among partners.
It is important to note that these requirements will be analyzed by the IRS and Treasury Department, which will provide guidance on the proper procedures for the election, as well as notification of the IRS and the partners.
Regarding partners that are S corporations, the partnership will also be required to disclose the name and TIN of each S corporation owner. Moreover, the number of S corporation owners will count toward the 100-partner maximum for allowing a partnership to elect out of the general rule (Sec. 6221(b)(2)(A), effective for partnership tax years beginning after Dec. 31, 2017).
The Budget Act's qualifying partnership rules described above effectively combine the thresholds and rules under the current TEFRA and electing large partnership statutes. Under TEFRA, all partnerships are treated as a TEFRA partnership unless they qualify as a "small partnership" (seeSec. 6231(a)(1), effective for partnership tax years beginning before Jan. 1, 2018). The small-partnership exception allows certain partnerships to be assessed at the partner level rather than the partnership level if the partnership has 10 or fewer partners, each of which is an individual, C corporation, or estate of a deceased partner.
The electing large partnership rules under currently effective Subchapter D of Chapter 63 of the Code allow electing large partnerships to pay the amount of the imputed underpayment, interest, and penalties to the IRS directly on behalf of their partners, so long as the electing large partnership elects to do so under Sec. 6242(a)(2). An electing large partnership is defined under Sec. 775(a)(1) as having 100 or more partners. The Budget Act borrows from both the TEFRA and electing large partnership thresholds, as well as in having the imputed underpayment liability rest with the partnership. However, as described below, the partnership will be able to elect under the Budget Act to shift the liability of the imputed underpayment to the partners on a proportional basis.
Arguably, the most significant change from TEFRA is the Budget Act's treatment of partnership adjustments, which creates a general rule that the partnership will pay any imputed underpayment with respect to an adjustment made in an adjustment year (Sec. 6225(a)(1), effective for partnership tax years beginning after Dec. 31, 2017). Adjustments that do not result in imputed underpayments will be taken into account by the partnership in the adjustment year as a reduction in nonseparately stated income or an increase in nonseparately stated loss under Sec. 702(a)(8), except for items of credit (Sec. 6225(a)(2), effective for partnership tax years after Dec. 31, 2017).
The Budget Act also will require a partnership adjustment to be determined by netting all adjustments of items of income, gain, loss, or deduction and applying the highest rate of tax in effect for the reviewed year under Sec. 1 or 11, before taking into account any adjustments to items of credit (Sec. 6225(b)(1), effective for partnership tax years after Dec. 31, 2017). Adjustments that reallocate the distributive share of any item between partners are taken into account without regard to any decrease in any item of income or gain or any increase in any item of deduction, while still applying the highest rate of tax under Sec. 1 or 11 (Sec. 6225(b)(2), effective for partnership tax years after Dec. 31, 2017).
The Budget Act also allows the IRS to enact rules and procedures to modify the amount of the imputed underpayment that would be paid by the partnership, in cases where a partner files an amended return and takes into account the allocable share of the underpayment (Sec. 6225(c)(2), effective for partnership tax years after Dec. 31, 2017).
In a change from an earlier version of the legislation (the Partnership Audit Simplification Act of 2015, H.R. 2821), the Budget Act directs the IRS to write rules on determining the imputed underpayment of the partnership when taking into account tax-exempt partners as well as the varying tax rates of the individual or corporate partners (Secs. 6225(c)(3) and (c)(4), effective for partnership tax years after Dec. 31, 2017). These provisions will allow the partnership to pay an imputed underpayment amount that is reduced by the portion of the underpayment that is allocable to tax-exempt partners and taking into account lower applicable tax rates for partners that are C corporations (in the case of ordinary income) and individuals (in the case of capital gains or dividends).
As an alternative to the general rule that the partnership would pay the imputed underpayment, the legislation creates an affirmative election for the partnership that will allow it to shift the burden of adjustment and payment to the partners (see generally Sec. 6226, effective for tax years after Dec. 31, 2017). The election, once made, cannot be revoked without IRS consent. The partnership will have 45 days from the date of the notice of final partnership adjustment to make the election (the details of which are left to the IRS) to furnish to the IRS and the partners "a statement of the partner's share of any adjustment to income, gain, loss, deduction, or credit (as determined in the notice of final partnership adjustment)" (Sec. 6226(a)(2), effective for tax years after Dec. 31, 2017). Once the statement is furnished to the partners and the IRS, the partner would have the burden of paying its proportional share of the imputed underpayment, along with any penalties and interest in the year of adjustment (Sec. 6226(b)(1), effective for tax years after Dec. 31, 2017).
Administrative Adjustment Requests
The Budget Act modifies the current rules regarding administrative adjustment requests (AARs), which allow the tax matters partner (TMP) of the partnership acting on behalf of the partnership and its partners, or an individual partner acting on his, her, or its own behalf, to file an AAR adjusting the amount of one or more items of income, gain, loss, deduction, or credit (Sec. 6227(a), effective for partnership tax years beginning before Jan. 1, 2018).
Under TEFRA, a partnership submitting an AAR does so by filing either Form 1065X, Amended Return or Administrative Adjustment Request (AAR), or Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR). The Budget Act retains both the concept of an AAR or a notice of inconsistent treatment, but it remains to be seen whether and how the IRS will modify Forms 1065X and 8082 to reflect the statutory changes.
New Sec. 6227(b)(1) allows a partnership to file an AAR under rules "similar to" those of new Sec. 6225 (the general rule by which the partnership pays the imputed underpayment on behalf of its partners) or new Sec. 6226 (the alternative rule whereby the partners pay the imputed underpayment). However, for AARs that do not result in an imputed underpayment (e.g., where the partnership would be in a position to claim a refund or credit), the alternative rule would apply, resulting in the partnership's issuing new statements to the partners and the IRS's describing the individual partner's adjusted share of income, gain, loss, deduction, or credit.
Sec. 6230(d)(5), effective for partnership tax years beginning before Jan. 1, 2018, requires the IRS to issue refunds of overpayments attributable to partnership items or affected items to partners without requiring the partners to file claims for refund. However, those refunds are to be made by the IRS "to the extent practicable." The IRS had claimed that it was not practicable for it to issue refunds directly to partners, given budget and personnel constraints, but stated that it was developing guidance to formalize a process by which partners would file amended returns to claim the amount of credit or refund (see Elliott, "IRS Developing Guidance to Expedite Large Partnership Refunds," 2015 TNT 39-1 (Feb. 27, 2015)). As of early December, that guidance had not yet been issued. The IRS likely will provide guidance on the AAR process in the context of partnership refunds.
New Sec. 6223, effective for partnership tax years beginning after Dec. 31, 2017, will require each partnership to designate a partner or other person with a substantial presence in the United States as the representative of the partnership "who shall have the sole authority to act on behalf of the partnership." If the partnership fails to designate such a representative, the IRS may select any person as the partnership representative.
Under TEFRA and Sec. 6223, effective for tax years beginning before Jan. 1, 2018, the partnership is supposed to appoint a TMP to represent the partnership in controversies with the IRS and keep other partners informed of the proceedings. Often, an inability to designate a TMP has resulted in the IRS's taking considerable time to locate or designate a TMP for the partnership under audit (see U.S. Government Accountability Office, Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Efficiency, Rep't No. GAO-14-732). Also, under TEFRA, the TMP has to have been a general partner in the tax year for which the partner is designated the TMP (Regs. Sec. 301.6231(a)(7)-1(b)). The Budget Act loosens this requirement by allowing the partnership representative to be "a partner (or other person) with a substantial presence in the United States" (Sec. 6223(a), effective for partnership tax years after Dec. 31, 2017). However, this designation must be made in a manner prescribed by the IRS.
Consistency of Partner Returns
The Budget Act, like the TEFRA and electing large partnership rules, requires a partner's return to treat each item of income, gain, loss, deduction, or credit attributable to a partnership in a manner consistent with the treatment of those items on the partnership's return (Sec. 6222(a), effective for partnership tax years after Dec. 31, 2017). Partner returns that fail to comply with this consistency requirement, unless the partner notifies the IRS, will be treated by the IRS as reflecting math or clerical errors under new Sec. 6222(b).
Under the IRS's math or clerical error authority, deficiency procedures, which can protect taxpayers, do not apply. This is important because, under Sec. 6213(a), if the IRS believes a deficiency assessment should be made against a taxpayer, the IRS must issue a notice of deficiency to the taxpayer, and the taxpayer typically has 90 days to petition the Tax Court for a redetermination of the deficiency. Sec. 6213(b)(1), however, creates an exception to the normal deficiency procedures for math errors under which a taxpayer "shall have no right to file a petition with the Tax Court based on such notice." Sec. 6213(b)(2) allows a taxpayer to request an abatement of those math error assessments, but under the Budget Act, abatement will not be possible for inconsistent partner returns where a partnership is a partner in another partnership (Sec. 6232(d)(1)(B), effective for partnership tax years after Dec. 31, 2017).
The math error authority given to the IRS for inconsistent treatment resulting in an underpayment on a partner's return under the Budget Act is consistent with the electing large partnership rules under Sec. 6241(b), effective for partnership tax years beginning before Jan. 1, 2018. Under the TEFRA rules, the IRS can deem an adjustment on the partnership return to be a math error subject to the rules of Sec. 6213(b). A partner can, however, challenge the math error within 60 days' notice of correction of the error. Similar rules exist under the Budget Act for adjustments on a partnership return, but as described previously, those abatements do not exist for adjustments to partner returns where the partner is a partnership.
As described previously, if the partner notifies the IRS of the inconsistent treatment, then the math error assessment will not apply (Sec. 6222(c)(1), effective for partnership tax years after Dec. 31, 2017). Similarly, the Budget Act allows a partner that receives incorrect information from the partnership to elect and demonstrate to the IRS's satisfaction that the treatment of the item on the partner's return is consistent with the treatment of the item on the Schedule K-1 (Sec. 6222(c)(2), effective for partnership tax years after Dec. 31, 2017).
Effective Date and Next Steps
Although the Budget Act's partnership provisions apply to returns filed for partnership tax years beginning after Dec. 31, 2017, a partnership may elect to have them apply earlier, as prescribed by the IRS. The effective date gives the IRS time to write rules and regulations to implement the new law. Just as important, the effective date gives partnerships time to consider what changes they need to make to their partnership agreements as a result of the new law.
The author thanks David Auclair and Dustin Stamper, both of Grant Thornton LLP, for their helpful comments, edits, and insights. Any errors are the author's.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.