Editor: Mary Van Leuven, J.D., LL.M.
The Bipartisan Budget Act of 2015 (BBA), P.L. 114-74, fundamentally changed the way partnerships are audited and partnership returns are amended for federal tax purposes, but the effect on state returns is still relatively uncertain. To date, only a handful of states have passed legislation in response to the BBA, which repealed the partnership audit provisions of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and implemented a new federal regime for auditing partnerships. Most pertinent here, the BBA also updated the process for amending federal partnership returns, requiring more than an amended Form 1065, U.S. Return of Partnership Income, to effectuate any changes to an originally filed Form 1065.
As a refresher, the BBA implemented a default rule requiring the partnership, as opposed to the individual partners, to pay any tax owed that is attributable to an adjustment on the partnership return. However, a partnership may elect to push out the adjustments to the partners, thus requiring the partners to pay the tax owed. For tax years beginning in 2018, any partnership that is required to file Form 1065 is subject to the BBA rules (BBA partnership), unless it makes a valid election to opt out.
Most states do not conform to the procedural rules in the Internal Revenue Code (the Code), and they currently have no formal state procedures to follow when a partnership is selected for a BBA audit or makes adjustments at the federal level. To fill this gap and promote uniformity in state rules governing partnership audits and amended returns after the BBA, the Multistate Tax Commission (MTC) developed a model act (MTC Model Act) that states can adopt. (For more on this, see Sherr, "Why States Should Adopt the MTC Model for Federal Partnership Audits," 51 The Tax Adviser 196 (March 2020).)
Given the BBA's effective date, it may be some time before the state procedures need to be addressed, although some BBA audits are currently in process at the federal level. However, any partnership that needs to amend a return must be aware of the implications of the federal adjustments for filing amended state returns. This discussion first provides a brief review of the federal filing requirements for amending partnership returns and then focuses on three states that have taken varying approaches to address the corresponding state effects of the BBA — Arizona, California, and Georgia.
Federal filing requirements
For federal income tax purposes, Sec. 6227(a) provides that a BBA partnership may file an administrative adjustment request (AAR) to request an adjustment to a partnership-related item originally reported on Form 1065. This means that a partnership cannot file a stand-alone amended Form 1065 to make such a change.
To file an AAR, a partnership may either file Form 1065-X, Amended Return or Administrative Adjustment Request (AAR), or electronically file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, with an accompanying revised Form 1065. If the partnership was required to electronically file the original Form 1065, it must file the AAR using Form 8082. At this time, Form 1065-X cannot be electronically filed.
Partnerships should be aware that after the enactment of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, the IRS issued Rev. Proc. 2020-23, which permits an "eligible partnership" a limited period to file a traditional amended return for tax years beginning in 2018 or 2019, rather than filing an AAR under the BBA rules.
State filing requirements
Generally, a federal final determination that adjusts an item of income, deduction, or exclusion, triggers a state filing requirement. Each state has its own set of rules that a taxpayer must use to determine the proper procedure to follow for state income tax purposes, with variations depending on the reason for the federal adjustment.
As noted above, the MTC Model Act provides an approach that state legislatures can follow for creating procedural rules addressing the effects of filing an AAR. Under the MTC Model Act, a partnership must comply with certain steps to report a federal adjustment to a state taxing authority. To begin with, no later than 90 days after the federal final determination date, the partnership must file with the state taxing authority a "federal adjustments report," which is typically a form that the state tax agency requires for taxpayers to report final federal adjustments. A partnership uses a federal adjustments report "to report additional tax due, report a claim for refund or credit of tax, and make other adjustments (including to its net operating losses)" resulting from adjustments to the partnership's federal taxable income. If a federal adjustment results from the filing of an AAR, the 90-day period for submitting the form runs from the date on which the AAR was filed. In other words, if a partnership makes a federal adjustment on an AAR (i.e., the new way to report federal adjustments), the partnership must file a specific state form (to be determined by each state) no later than 90 days from the filing of the AAR.
In addition, the MTC Model Act requires the partnership to notify the direct partners of their distributive share of the adjustment within 90 days following the AAR's filing. The partnership may also need to file amended composite and/or withholding returns under state law in the 90-day time frame, paying any additional amount that would have been due if the adjustment had been properly reported on the original return.
Direct partners report their distributive share of the adjustments and pay any additional tax due under state law within 180 days of the filing of the AAR, including any applicable penalties or interest, and less any credit for amounts paid on a composite or withholding return filed by the partnership (special timing rules may apply in a tiered partnership structure). Presumably, direct partners are not required to submit a report to the state taxing authority if the partnership has filed an amended composite return. While partnerships are generally able to make an election under the MTC Model Act to pay any additional amount due after an audit at the partnership level, this election is not available following the filing of an AAR, i.e., any adjustments must be pushed out to the individual partners.
Arizona was the first state to enact legislation in response to the BBA, less than one year after it became law. The Arizona legislation in fact predates the MTC Model Act, and while they are similar in some aspects, there are notable differences. For example, Sec. 6227 is not referred to in Arizona's law, and the term AAR does not appear in the instructions to Form 165PA, Arizona Partnership Adjustment — Federal Imputed Underpayment Assessment, which Arizona developed specifically for BBA partnerships to report adjustments resulting from a federal audit. Another difference is that Arizona law is consistent with the BBA default rule requiring any tax due to be paid at the partnership level.
Although Arizona law does not specifically provide guidance on the time period for notifying the state once an AAR has been filed, it generally requires a taxpayer to file a state amended return within 90 days of a federal final determination date. If any additional state tax is owed, the partnership must report the adjustment and pay the tax. The Arizona Department of Revenue has indicated informally that partnerships filing an AAR should also use Form 165PA to report adjustments.
In response to the BBA, California adopted some provisions of the MTC Model Act but deviated from it in a few important ways, including by adopting a default rule requiring the partnership itself to pay any state tax owed as a result of an adjustment to an originally filed partnership return. While California's law mentions AARs filed under Sec. 6227 and follows the MTC Model Act definition of a federal adjustment, it does not specifically provide guidance on how a partnership filing an AAR should proceed for state purposes.
Generally, though, adjustments must be reported in California within six months from the associated final federal determination. If a partnership reports the adjustment in a timely manner, California's Franchise Tax Board (FTB) has up to two years from that date to mail the partnership a notice of deficiency. Because so many changes can occur over a two-year span, including changes in partners, hopefully the FTB will work to issue notices much sooner than the allotted two-year time period.
Partnerships that make a federal election to push out adjustments to the partners must file an amended California Nonresident Group Return (using Form 540NR, California Nonresident or Part-Year Resident Income Tax Return) for all nonresident direct partners, along with payment for the additional tax due as a result of the adjustment. Notice must also be given to any partners not included in the Form 540NR so that each partner can file their own amended return; the partner has six months to file the amended return.
Georgia generally adopted the definitions and procedures provided in the MTC Model Act for partnerships filing an AAR, including the default rule that requires adjustments to be pushed out to the partners. The state form to be filed as the federal adjustments report is a Georgia amended return. Accordingly, Form 700, Georgia Partnership Tax Return, has been updated to include a box in which taxpayers may indicate that a return is being "Amended Due to IRS Audit." While there is no specific space for taxpayers to indicate that a return is being amended due to filing an AAR, the instructions imply that taxpayers in both situations should check the same box. The instructions further indicate that a schedule detailing the adjustment must be attached to Form 700.
The Georgia law does not indicate whether a specific form should be used to notify partners of their distributive share of the adjustment. Amended composite returns must be filed if one was originally filed. The partnership is also required to file an amended withholding return if the adjustments result in additional state tax owed.
Statute of limitation
BBA partnerships should be aware that filing an AAR restarts the statute of limitation at the federal level for the tax year affected by the AAR. Importantly, this applies to all items with respect to the tax year in question. The MTC Model Act, on the other hand, narrows any restarting of the statute of limitation to the adjustments contained within the federal adjustments report. Under the Model Act, if a timely federal adjustments report is filed, the statute of limitation is extended to the later of either the normal state statute of limitation or one year from the filing of the federal adjustments report. If a report is not filed in a timely manner, the time period is extended to the later of the time periods mentioned above or six years following the final determination date (i.e., the date on which an AAR is filed).
By comparison, Arizona law does not contain any specific provisions relating to changes in the statute of limitation; therefore, the general rules that apply to adjustments related to IRS audits or amended federal returns may apply. If a taxpayer fails to report a change or correction, Arizona law permits a deficiency assessment in the four-year time period following a reported adjustment to the IRS. That time period is shortened to six months when a report is timely filed.
California law keeps the statute of limitation open for two years following a timely filed report. For untimely filed reports or late payments, the statute of limitation remains open for four years following the later of the date the report was filed or the payment was due. Further, if no report is filed, a deficiency assessment may be made at any time.
Georgia law follows the MTC Model Act except that the six-year period for untimely filed returns is modified to five years following the date on which the IRS notifies the Georgia Department of Revenue of the federal adjustments.
Under Rev. Proc. 2020-23, mentioned above, filing an amended return does not restart the federal statute of limitation.
Challenges of nonuniformity
Now that the BBA is fully in effect, partnerships will be forced to navigate myriad new rules that come with it. With only a limited number of states implementing new procedures in response to the BBA, and because those states with procedures vary on how to approach federal adjustments, there is currently little uniformity in this area. For now, BBA partnerships filing an AAR that have nexus in a state with no formal guidance in place will have to wrestle with existing state procedures that do not align well with the BBA provisions.
For more on the BBA at the federal level, see Armstrong, "Administrative Adjustment Requests Under the BBA," also in this issue.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.