Corporate Close-Up: New Federal Partnership Audit Rules Are Expected to Present Administrative Challenges for States and the Potential for New Revenue


 

The Bipartisan Budget Act of 2015, signed into law on Nov. 2, presents a new challenge for state taxing authorities and tax practitioners alike. The Budget Act repealed the audit and adjustment rules for partnerships enacted in 1982 as part of the Tax Equity and Fiscal Responsibility Act (TEFRA), and replaced them with new procedures that apply by default to all partnerships. States now must examine their willingness and ability to conform to the federal legislation and assess its impact on state auditing processes.

Currently, the TEFRA rules provide for three different sets of partnership audit procedures:

  • unified audit procedures that determine the tax treatment of all partnership items at the partnership level, after which the IRS may assess persons who were partners during the audited year for their share of the assessment;
  • simplified audit rules that can be elected by partnerships with 100 or more partners (electing large partnerships) under which adjustments flow through to persons who are partners in the year the adjustments take effect; and
  • for certain small partnerships, generally applicable audit procedures for determining adjustments for each partner in separate proceedings.

Under the new audit rules, adjustments to partnership items are determined at the partnership level, and any additions to tax, plus penalties and interest, are assessed and collected at the partnership level, unless the partnership elects to pass the adjustment through to its partners by issuing amended information returns to each of the audit-year partners and the IRS. Either alternative shifts some of the audit burden from the IRS to the partnership: the partnership pays any deficiency, or allocates the deficiency among the partners and identifies them to the IRS.

State Composite Returns

It is not unusual for states to make partnerships, and LLCs filing as partnerships, a part of their tax compliance efforts, well before an audit, by having them file a composite return on behalf of nonresident owners and pay tax on income allocated to those partners or members, or "withhold" tax with respect to each nonresident owner's distributive share of income. As reported by Jennifer McLoughlin in the Nov. 23rd Daily Tax Report, practitioners are questioning how states with these taxing mechanisms can account for and fairly attribute an increase in tax liability following an audit to all appropriate taxpayers, including both resident and nonresident partners.

Resident partners generally do not participate in composite returns and are not subject to withholding taxes. Without audit procedures similar to those enacted by the Budget Act, states may end up with the responsibility of tracking down in-state partners to apportion the tax liability that results from an audit adjustment. States may also face problems tracking down nonresidents who were partners during the audit year but have since sold their interests because states would not be able to assess current income for a share of any deficiency.

Federal-State Information Sharing

If the new procedures reduce the IRS' difficulty in auditing partnerships, as intended, there should be an increase in the number of partnership audits with a corresponding increase in federal tax collections. In fact, the Congressional Joint Committee on Taxation estimates the new audit procedures will result in roughly $9.3 billion in additional revenue over 10 years. As McLoughlin reported, practitioners anticipate that greater federal audit activity will result in a greater exchange of information between federal and state taxing authorities. Whether additional information will translate into increased revenue for the states may depend on whether states conform their audit procedures to the new federal regime.

The new federal audit rules will be effective for taxable years beginning on or after Jan. 1, 2018, although partnerships may elect to apply them sooner. The delayed effective date gives partnerships time to adjust and gives the Treasury Department and IRS opportunity to draft regulations and other guidance to fill gaps in the statutes. States also have time to tailor their conformity statutes and likely will be motivated by the prospect of new revenue to take action.

An Illinois statute, 35 ILCS 5/502(f-5), may serve as an example of how states may conform to the federal regime. Under that statute, the Department of Revenue may adopt rules to provide that, when a partnership has made an income computation error on its return that affects a partner's tax liability, the partnership may report the changes in liabilities of its partners and claim a refund of the resulting overpayments, or pay the resulting underpayments, on behalf of its partners.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: What actions do you think states will take in response to the Budget Act amendments to the federal partnership audit rules?

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