Significant changes to how the IRS audits and assesses tax on partners and partnerships are set to take effect after 2017. So far, Arizona is the only state to adopt the federal government’s revised procedures. While the state’s early adoption of the new rules will have little impact on partnership compliance in the near future, it is likely to serve as a blueprint for other states.
On May 11, 2016, Arizona became the first state to adopt the federal changes to the partnership audit rules with the enactment of legislation (S.B. 1288), conforming Arizona law to the Internal Revenue Code in effect on Jan. 1, 2016.
Although Arizona was first to adopt the new federal rules, there is little expectation of an impact on partnership tax compliance in Arizona at this time, Michael G. Galloway, partner at Ryan Rapp & Underwood PLC, in Phoenix, and author of the Arizona chapter of the Corporate Income Tax Navigator (subscription required), told Bloomberg BNA. The rules “are still very new and, in the national picture, Arizona is the only state with them and is not a Texas, California or New York,” Galloway said.
New Federal Partnership Audit Rules
The federal Bipartisan Budget Act of 2015 (Pub. L. No. 114-74) implemented a single unified audit, adjustment and collection procedure for all partnerships for tax years beginning after 2017. Under the unified procedure, any adjustments to tax items of a partnership and any partner’s distributive share of those adjustments will be determined at the partnership level on a unified basis. The legislation requires the partnership to pay tax on the understated income on behalf of its partners at each partner’s top tax rate, which varies depending on whether the partners are individuals, corporations or tax-exempt entities.
Alternatively, the new procedures permit partnerships to elect to report the federal adjustments to the persons that were partners during the audited year on amended schedules K-1. These partners then have an obligation to pay additional taxes in the current year, based on the amount the partners would have owed if the original error on the partnership return had not been made.
New Arizona Partnership Audit Rules
Pursuant to the Arizona legislation, a partnership that is issued a final determination by the IRS under the new unified procedure and that does not make the election to provide amended schedules K-1 to its partners must report the federal adjustments on an amended Arizona return for the reviewed year within 90 days after the date of the federal final determination. If the Arizona return shows a net increase in taxable income, the partnership must pay the additional state tax due in lieu of passing the adjustments through to the partners.
Arizona tax is imposed on the portion of any increase in income derived from Arizona sources at the highest individual rate. Underpayment interest is computed for the period beginning on the day after the partnership return due date for the reviewed year, regardless of any extensions.
In two situations, the partnership must furnish a statement of the partner’s share of the federal adjustments to each partner and to the Arizona Department of Revenue within 90 days after the federal final determination:
Each partner then must file an amended Arizona return within 150 days after the federal final determination showing its respective share of the partnership adjustments reported in the statement. A partnership that had a net increase in Arizona taxable income and failed to timely provide the required statements to its partners or the Department will be required to pay the tax in lieu of the partners.
The new partnership audit regime is generally effective for partnership tax years beginning after Dec. 31, 2017. Partnerships may choose to apply the new federal rules to tax years beginning after Nov. 2, 2015.
In August, temporary Treasury Regulations were issued to provide guidance for partnerships electing to apply the new audit regime to returns filed for taxable years beginning before Jan. 1, 2018. To date, the IRS has published no other substantive guidance, but has solicited public comments in Notice 2016-23 on issues that guidance should address.
“There is a moratorium on new regulations in Arizona, and the Department of Revenue has not yet issued any informal procedure rulings on point,” Galloway explained. “Informal rulings tend to be issued when there is enough concern from the business community.”
Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: what issues should states address as they conform to the new federal partnership audit regime?
For more information about this and other state tax issues, sign up for a free trial of the Bloomberg BNA Premier State Tax Library.
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