State considerations for BBA exams and adjustments

Editor: Michael Wronsky, CPA, MST

By adopting a centralized partnership audit regime, the Bipartisan Budget Act of 2015 (BBA), P.L. 114-74, dramatically changed the procedures by which the IRS (via examination) or a partnership (via an administrative adjustment request (AAR)) can adjust a previously filed federal Form 1065, U.S. Return of Partnership Income.

From a federal perspective, a partnership must file a Form 1065 annually to report its income, gains, losses, and other information based on its operations. At the state level, a partnership’s taxation and filing requirements are more complicated and vary by state based on the partnership’s connection with and activity in a particular state. However, generally, states use federal taxable income as the starting point to determine the state taxable income and adjust it based on state-specific rules.

As a result, adjustments to Form 1065 may change a taxpayer’s state partnership income tax return. Since the enactment of the BBA, some states have adopted the BBA in its entirety, while others have expressly adopted some, but not all, BBA procedures. Additionally, very few states have adopted specific administrative procedures (e.g., forms and other administrative guidance) to implement the BBA. As a result, partnerships and practitioners are forced to make difficult decisions concerning state partnership income tax returns when adjustments to Form 1065 are made.

Summary of federal BBA procedures

When enacted, the goal of the BBA partnership audit provisions was to streamline the audit of complex and large partnerships. Under the centralized partnership audit regime created by the BBA, IRS examinations are centralized by assessing an imputed underpayment against the partnership. Specifically, each change on the tax return is considered separately as a positive or a negative adjustment. The adjustments are then grouped in conformity with Sec. 702(a) (i. e., how the adjustments would be reported on Schedule K, Partners’ Distributive Share Items).

The partnership may be able to net certain adjustments within each grouping, resulting in either a net positive adjustment or a net negative adjustment. In many cases, the partnership has both a positive and negative adjustment because of the limitations in grouping and netting. Ultimately, at the end of the examination, the IRS assesses an imputed underpayment based on the net positive adjustments multiplied by the highest applicable individual or corporate tax rate.

Generally, a partnership must pay the imputed underpayment. Alternatively, the partnership may elect to “push out” or distribute the positive adjustments to its partners for payment at the partner level. However, negative adjustments must be pushed out to the partners and cannot be handled at the partnership level. As such, the benefit of the push-out election is that it allows the partners to report the adjustments and pay tax based on their specific tax situations.

The BBA also created modification procedures to allow partnerships to pay an imputed underpayment using a more realistic tax rate (as opposed to the highest applicable individual or corporate tax rate). For example, an entity with a corporate partner could modify the imputed underpayment to apply the corporate tax rate, instead of the highest applicable tax rate (the individual tax rate of 37%), to the corporate partner’s share of the adjustments. The same applies to tax-exempt partners or international partners subject to a treaty.

The BBA centralized partnership audit regime involves several additional procedural postures and enforcement mechanisms (e.g., the concept of a partnership representative) that are beyond the scope of this item.

State-level considerations

Model Act: The Multistate Tax Commission (MTC) is an intergovernmental state tax agency with a mission “to promote uniform and consistent tax policy and administration among the states.” In 2019, the MTC adopted a model statute that details procedures at the state level like those of the BBA centralized partnership audit regime: Model Uniform Statute for Reporting Adjustments to Federal Taxable Income and Federal Partnership Audit Adjustments (the Model Act). The MTC’s guidance is influential but not necessarily indicative of any state’s laws or regulations. As drafted by the MTC, the Model Act provides a uniform recommendation for states to consider when drafting their own legislation, to promote consistency among the states.

The Model Act’s purpose is to provide procedures for taxpayers to report changes made to their Form 1065 resulting from an IRS exam, an amended federal return, or other federal determination to applicable state taxing authorities. Per the Model Act, the taxpayer must report the change to the state within 180 days of the federal determination date, as defined in Section A(9)(a) of the Model Act.

The Model Act differs from the BBA centralized partnership audit regime by defaulting to a push-out election for the adjustments (as opposed to the imputed underpayment assessment described above). The partnership files a federal adjustments report with the state and an amended composite or withholding return for partners and issues notice of each partner’s share of the adjustments. The partners must also file a federal adjustments report with their distributive share of the adjustments and pay any additional tax due as if the partners had properly reported the adjustments.

State conformity examples: Nine years after Congress enacted the BBA, many states still have not enacted centralized partnership audit regime legislation. The states that have adopted legislation in response to it vary widely in their application of reporting federal audit adjustments. Specifically, some states have adopted all or a portion of the Model Act, while others have enacted separate provisions. The lack of uniformity among the states often places administrative burdens on the partnership.

Specifically, California adopted Cal. Rev. & Tax. Code §18622.5 in 2018, making it an early adopter among the states. The statute differs from the Model Act, as it applies only to IRS adjustments made during an examination. The statute explicitly refers to “an adjustment under Section 6225 … as part of a Partnership Level Audit.” Section 18622.5 implies that a partnership will file an amended state-level return with California if it files an AAR with the IRS.

In contrast, Minnesota is an example of a state that adopted most of the Model Act (Minn. Stat. §§289A.381 and 289A.382). Minnesota’s rules apply to both federal examinations and partnership AARs. Minnesota and the Model Act differ from the BBA centralized partnership audit regime by requiring (directly or indirectly) an amended return for the review year (the year being adjusted). Further, Minnesota deviates from the Model Act by forgoing the Model Act’s provisions for (1) the modified reporting and payment method; (2) estimated tax payments during a federal examination; and (3) claims for refunds or credits arising from final federal adjustments or by an AAR. The latter rule is crucial, as an IRS examination may result in adjustments that are taxpayer-favorable but that the IRS may not finalize until after the statute of limitation for claiming a refund has passed at the state level (if the statute of limitation has not been extended for specific reasons). Centralized audit regime examinations can be extensive, given the standard field procedures and the 270-day period for partnerships to modify the imputed underpayment.

Example: Assume the IRS examines a partnership tax return for 2021. The examination concludes in July 2024, and the modification period lasts until March 2025. The examiner issues the notice of final partnership adjustment on May 1, 2025, and lists the following adjustments:

1. Increase in ordinary business income of $100; and

2. Decrease in net long-term capital gain of $50.

The partnership has an imputed underpayment on the ordinary business income of $37 ($100 × 37%). The partnership must push out the decrease in net long-term capital gain, which it will report to its partners on the 2025 Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. The partnership may elect to distribute the ordinary business income to its 2021 partner group. This example ignores penalties and interest for simplification.

Under the Model Act (and Minnesota and California law), the partnership will file a federal adjustment report and an amended return within 90 days to the state, and it will issue revised state Schedules K-1 to its partners. Within 180 days, the partners will file a federal adjustments report and pay any additional tax due on the ordinary business income. Under the Model Act, the partnership may include the reduction in net long-term capital gain in the state reporting, as the Model Act includes an automatic extension to the refund claim statute of limitation. States such as Minnesota, however, preclude the partners from including the reduction in net long-term capital gain if the partners did not extend their tax returns, as the notice of final partnership adjustment would have been issued after the close of the 2021 statute of limitation on claiming a refund.

The partnership will follow the same procedures if it makes these changes on an AAR and is subject to the Model Act or Minnesota law. If the partnership is a California filer, it will simply file an amended partnership return with the state.

These differences in state and federal procedures can add more complexity, confusion, and cost to an otherwise simple tax return adjustment. The partnership files an AAR at the federal level, including pages of Form 1065 that change. The partnership may pay the imputed underpayment with the AAR, and the partners will not have to take any action (if the only adjustment is positive). Even if the partnership elects to push out the positive adjustment, the partners will report the adjustment on their adjustment-year tax return. They will not have to file an amended federal return. For states such as California, the partnership will file an amended state return regardless of whether it pays the imputed underpayment or elects to push out the positive adjustments, and it will issue amended Schedules K-1 to its partners. In this example, the partners must file amended state income tax returns even though they will not do so at the federal level.

Many states have not adopted centralized audit regime procedures, magnifying the administrative complexity noted in the California example. Assuming the partnership files in five states, California and four states that have not adopted centralized audit regime legislation, then the partnership and partners will have to file five amended state tax returns, whether the adjustments arise from an IRS examination or a partnership’s AAR. This situation occurs whether or not the partnership pushes out any adjustment. In addition, administratively, the result is very burdensome, as the partnership representative must educate the partners on their new federal filing requirements while sending them amended state Schedules K-1.

State-specific rules require vigilance

The adoption of the centralized audit regime has streamlined the audit process for large partnerships at the federal level but has also initiated discussions and considerations at the state level. The variations in state-level adoption present complexities and challenges for partnerships and practitioners. Navigating the interplay between federal and state partnership tax adjustments requires careful consideration and awareness of the evolving state-level procedures. Partnerships and practitioners must stay updated with state-specific rules, administrative guidance, and legislative changes to manage their tax obligations and effectively ensure compliance. As the landscape evolves, staying informed and seeking expert advice will be crucial in navigating the complexities of partnership tax adjustments at the federal and state levels.

Editor Notes

Michael Wronsky, CPA, MST, is managing director of Baker Tilly’s Washington Tax Council.

For additional information about these items, contact Wronsky at michael.wronsky@bakertilly.com.

Contributors are members of or associated with Baker Tilly US, LLP.