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March 10 — The Internal Revenue Service isn't likely to be overly accommodating as it writes rules about which partnerships with fewer than 100 partners can opt out of a new audit regime.
“I don't think we're going to be all that lenient about electing out. Electing out really puts people into this prehistoric era,” Clifford M. Warren, special counsel in the IRS's Office of Chief Counsel (Passthroughs and Special Industries), said March 10. “If you have 99 partners, you could conceivably have 99 separate audits, 99 results, 99 appeals, 99 litigations, and I suppose 99 different agent teams working on that. It's very resource-intensive and inefficient.”
The agency is beginning to write regulations for an audit regime replacing the rules under the Tax Equity and Fiscal Responsibility Act, making it easier for the IRS to audit partnerships by collecting tax adjustments at the entity level, rather than from individual partners. Partnerships with fewer than 100 members can opt out and revert back to pre-TEFRA rules if all the partners are individuals, C corporations, S corporations or related estates.
The IRS has asked for comments about how to define a partnership that is eligible to elect out. It hasn't made a final decision about how to proceed, although the regulations will comply with the law, Warren said at a forum hosted by Tax Analysts (44 DTR G-8, 3/7/16).
The rules could be expanded to let partnerships with only a handful of partners, but multiple tiers, opt out of the rules, said Diana Wollman, a partner at Cleary Gottlieb Steen & Hamilton LLP.
“I think the 100 is a bit shocking. It is an extremely large number. It is a lot larger than the number under TEFRA,” which allowed partnerships with 10 or fewer partners to opt out, Wollman said. “I look at it and I think, what were they thinking?”
The IRS's Large Business and International Division could have its work cut out for it as it could be conducting audits under three separate regimes—TEFRA, non-TEFRA, and the new rules under the Bipartisan Budget Act—while the new regime is rolled out and audits opened prior are ongoing, said Cheryl Claybough, who directs LB&I's passthrough entities practice area.
LB&I is also in the process of reorganizing to focus on specific issues, called “campaigns,” in audits that will allow the unit to be more proactive and flexible as it approaches the new audit rules, she said.
The IRS can “look at all our systems and say, ‘where can we make this more efficient and effective and streamline what's there given this opportunity with the law,' ” Claybough said. “It's the same things with forms and schedules. It's a heavy life and it's a challenge, but we are looking at this as an opportunity to get it right.”
Partnerships faced the highest audit rate in a decade in 2015 even as the IRS has shifted declining numbers of revenue agents away from corporate examinations and toward passthrough entities, according to agency data. Partnerships, which have historically been audited at rates of less than 1 percent, were audited at a rate of 0.51 percent last year. Nearly 11.2 percent of large corporations were audited in the same year, a decrease from 18.6 percent a decade ago (35 DTR G-1, 2/23/16).
IRS Commissioner John Koskinen has said the partnership audit rate is expected to increase under the new audit regime, though most of that will come from increased efficiencies in the audit process and not additional resources allocated toward partnership examinations. About $9.3 billion in additional revenue is expected to be raised over a 10-year period, according to a Joint Committee on Taxation score of the law.
“Are we really expecting $9.3 billion to be collected through this process, or are we really saying we just don't want to have three million entities that are immune from audit, and we have to put the fear of God in these people?” said Don Susswein, a principal at RSM US LLP. Is it “that partnerships are going to voluntarily comply better because they know they can't get away with murder and they know the audit rate will increase?”
Cheaper to Be Contrary
It's generally expected that many partnerships will choose to “push out” the tax adjustment to the partners under tax code Section 6226, but there might be cases where it is advantageous for the partnership to pay the tax at the entity level, Wollman said.
The tax the partnership pays under the Section 6225 election might be less because it won't be subject to the net investment income tax and there won't be any affected item tax effects. The interest rate is also 2 percent lower and there's a chance some substantial understatement penalties could also be lower at the aggregate level, she said.
There's a “zinger” in Section 6226, that says you “compute your taxes for the year that was audited and for every year in between and you tally that all up and attach it to your current year return,” she said. But you only include those other years in between if those were years when your taxes increased.
“It's there and it was written on purpose,” Wollman said. If you have corresponding adjustments, maybe you sold your partnership interest and you would've had less tax. The way 6226 is drafted and enacted—I don't support it—you cannot take those lower years into account.”
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