Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...
Alysse McLoughlin and Richard Call are partners and Nicole Ford is an associate in McDermott Will & Emery's state and local tax practice.
On November 2, 2015, significant changes to the rules governing federal tax audits of partnerships were instituted by the Bipartisan Budget Act of 2015 (the Act).1 The Act repeals the current Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) unified partnership audit rules and the electing large partnership rules and--absent an affirmative election made by the partnership--imposes an entity-level liability for taxes on partnerships with respect to Internal Revenue Service (IRS) audit adjustments. The Act also bifurcates the tax year being reviewed from the tax year in which any underpayment liability for the reviewed tax year will actually be imposed. While the Act will apply to all partnership returns filed for the 2018 tax year and later, taxpayers can choose to elect into the Act's provisions for tax years beginning after November 2, 2015 (the effective date of the Act).2
Not only does the Act represent a sea change for federal partnership audits, it contains significant implications--both substantive and procedural--with respect to the state tax treatment of entities taxed as partnerships. We have analyzed some potential state tax issues arising from the new partnership audit rules, both through internal discussions and discussions with various state tax officials. The following highlights some of our thoughts arising from those discussions, although we are certain there will be much more to think about as taxpayers and practitioners prepare for the 2018 change.
All entities classified as partnerships for federal income tax purposes will be governed by the Act's audit rules unless the partnership is eligible to, and does, elect out of the regime. Partnerships that are eligible to elect out of the Act's treatment include “small partnerships,” i.e., partnerships with 100 or fewer partners, as long as those partners are (i) individuals; (ii) C corporations (or comparable foreign entities), including registered investment companies (RICs) and real estate investment trusts (REITs); (iii) an estate of a deceased partner; or (iv) S corporations.3 When an S corporation is a partner, whether the 100 partner threshold is exceeded will be determined by taking into account the number of the S corporation's shareholders.4 If even one partner is itself a partnership, then no election out of the Act will be permitted. The election is an annual election that must be made when the returns are filed, not when an audit is commenced.5 If the partnership makes the election to opt out, it must notify its partners that it has made the election, and the identity of all partners must be disclosed to the IRS.6
If the small partnership opt-out election is either not available or not made, then under the default rule, any underpayment liability for the year under audit (the reviewed year) will be imposed on the partnership in the year the audit or any judicial review thereof is concluded (the adjustment year).7 The amount of the liability, referred to herein as the imputed underpayment amount, will generally be computed by multiplying the net of any partnership adjustments by the highest statutory corporate or individual tax rate in place for the reviewed year.8 The partnership as an entity will be liable for the imputed underpayment amount; there is no joint and several liability for partners under the Act.
There are four exceptions to the general rule concerning computation and imposition of the imputed underpayment amount. First, if the audit results in a reallocation of income among partners, then there will be no netting of adjustments, as netting would result in no additional tax due.9 Instead, any decrease in the partnership's income or gain will be ignored, as will any increase in deductions, losses or credits. Thus, there could essentially be double tax in the case of a reallocation of income. Second, if there is a tax-exempt partner, such as a pension fund, and the partnership can prove the partner's tax-exempt status, the partnership liability may be reduced to the extent of the liability attributable to such partner.10 Third, if one or more of the reviewed year partners files an amended return reflecting the adjustment and paying the tax that is due, the underpayment amount will be adjusted for the partnership.11 Please note, there do not appear to be any Internal Revenue Code rules forcing a reviewed year partner to file an amended return and pay the tax, so, where desired, partnership agreements may need to be drafted or amended to include such provisions.
Finally, the partnership can make an affirmative election under IRC section 6226 (the push-out election) that will allow it to push the underpayment amount liability out to the reviewed year partners by (1) making the affirmative election within 45 days of receiving the notice of final partnership adjustment and (2) issuing “statements” (effectively, adjusted schedules K-1) to every reviewed year partner and the IRS.12 If the push-out election is made, the reviewed year partners will be subject to tax in the year the statement is issued, rather than needing to file an amended return for the reviewed year.13 This contrasts with the rules in place under TEFRA, where partnership-level computational adjustments are automatically applied to the partners.14 Under the Act, while it is anticipated that partners will have to respond to and apply the adjustments reflected in the amended schedules K-1, no rules are yet in place specifying how this will occur. There is also no guidance regarding residual liability in the event that one or more partners do not pay.
One final change resulting from the Act is that the “tax matters partner” under TEFRA has been replaced with an expanded “partnership representative” role.15 Unlike the tax matters partner, the partnership representative is not required to be a partner and will have the sole authority to act on behalf of the partnership in an audit proceeding.16
Several of the issues that arise at the federal level under the new partnership rules also arise at the state level. For instance, there is the concern that current year partners may be liable for amounts attributable to previous partners. However, several other issues that are particular to the state tax realm are discussed below. Before doing so, however, a quick review of various state tax systems is helpful.
As a general rule, states and localities do not tax partnerships; they typically impose tax on their owners, e.g., individuals and corporations. Not surprisingly, exceptions exist. For instance, New York City and the District of Columbia impose net income taxes on unincorporated businesses.17 Additionally, Ohio imposes the Commercial Activity Tax and Texas imposes the Margin Tax on partnerships.18
Among the many jurisdictions that do not impose tax on partnerships, states have enacted a few different enforcement models in their attempt to impose tax on that portion of a partnership's income that is attributable to nonresident partners. Some states require withholding by the partnership for nonresident or nonfiling corporate partners.19 Others permit nonresident partners to elect to file and pay tax on a “composite return.”20 Some states simply require nonresident partners to file and pay estimated payments on their own.
The following are just a few of the many issues that will need to be addressed in the next few years. Though some of these present potentially thorny questions, we are confident that they can be resolved through the cooperation of state taxing authorities and the taxpayer community.
Nexus in Current But Not the Prior Year: One of the first questions that comes to mind is nexus. Consider, for example, a partnership that does not have nexus with a state in year 1, but does have nexus in year 5. If a federal partnership audit results in a change for year 1 that is reported in year 5, will the partners now have to pay the adjustment with respect to year 1 even though there is no connection with the state in the previous year? We believe that the application of adjustments in the current year could be unconstitutional if it would have been unconstitutional to impose tax due to the partnership's lack of nexus in the reviewed year.
Nexus in Prior Year But Not the Current Year: Conversely, assume that the partnership had nexus in year 1, but did not have nexus in year 5. Presumably, the state would not be precluded from collecting the tax attributable to year 1. The question then becomes the mechanics. Would a year 5 tax return be filed that only showed the year 1 change?
Residency Change: Another issue would be changes in residency of individual partners. Individual partners are generally taxed by their state of residence on their worldwide income and by other states in which the partnership does business on the income sourced to that state.21 They receive credits against their resident-state tax for taxes paid to other states based on source income.22 That means that for income derived from partnerships operating in multiple states, any income that is not taxed by those states (e.g., as a result of varying apportionment percentages) would be taxed by the partner's state of residence. What if the state of residency changes from year 1 to year 5? Which state would have claim to the unsourced income that the state of residence may tax?
Unity in Current But Not Prior Year: Another complex scenario could involve the year 1 acquisition of a partnership interest by a corporation. Assume that the corporation intended for the partnership to become part of the corporation's unitary business, but that process did not occur until year 3.23 If a federal partnership audit results in a change for year 1 that is reported in year 5, will the partners now have to pay the adjustment with respect to year 1 even though there is no unitary connection with the partnership in the previous year?
Differing Apportionment Year to Year: Perhaps the most common issue that we foresee is different apportionment formula percentages in different years. Even where a state maintains the same apportionment rules from year to year, taxpayers rarely have identical apportionment percentages year to year. Also, quite common are changes in the weighting of the state's apportionment formulas (e.g., equally weighted three-factor formula to three-factor formula with double-weighted sales). In either of the foregoing scenarios, which year's apportionment formula percentage will apply? Similarly, if there was a change from cost of performance to market sourcing, how will the apportionment formula for the adjustment be computed?
Federal Audit Results in Change to Apportionment: What if the federal audit actually results in a change to the apportionment factors of the partnership in year 1? For instance, the federal audit could easily result in an increase or decrease to a partnership's receipts in a way that affected the partnership's sales factor for state tax purposes. If this could cause a change in a previous year's apportionment formula percentage, should that adjustment be made?
This also raises a potential constitutional issue. Under the commerce clause, a state can only impose a tax that is fairly related to the income generated in the taxing state.24 The generation of income could be different in the year of the tax liability adjustment from the year in which the income was originally generated. Thus, it could be unconstitutional to impose tax based on current year apportionment formulas.
Reporting Federal Changes: Mechanically, in most states federal changes need to be reported to the states, but the statutes are typically phrased in the terminology of taxpayers having to report for specific tax years.25 This raises two issues. First, is there a change to the taxpayer's income when the partnership reports and pays the tax? Second, is there a change for the past year or is it just an amount at issue for the current year--so even if it the taxpayer was deemed to have a change, no adjustment would have to be reported?
It's too early to tell exactly what all the state tax effects of the federal change will be, but one thing is clear - there will be many state tax ramifications. Presumably, many of the issues can be addressed and resolved before 2018. However, unlike in the federal realm where it is hoped that these changes will streamline audits, the opposite may be true at the state level.
1 H.R. 1315, codified as IRC §§6221 - 62. See “New Partnership Audit Rules Impact Both Existing and New Partnership and LLC Operating Agreements,” McDermott Will & Emery Publications (Dec. 7, 2015), available at http://www.mwe.com/New-Partnership-Audit-Rules-Impact-Both-Existing-and-New-Partnership-and-LLC-Operating-Agreements-12-07-2015.
2 On March 4, 2016, the IRS issued an advance copy of Notice 2016-23, explaining that the IRS and Treasury Department intend to issue guidance implementing the new partnership audit regime - and in particular the election to opt in to the new rules in 2015 - in the “near future.” Taxpayers are urged to wait until this guidance is published before making the election. The IRS and the Treasury Department are also soliciting comments from the public on a number of the procedural and substantive aspects of the new rules; these comments are requested by April 15, 2016.
3 IRC § 6221(b)(1).
4 IRC § 6221(b)(2).
5 IRC § 6221(b)(1)(D).
7 IRC § 6225(a).
8 IRC § 6225(b)(1).
9 IRC §6225(b)(2).
10 IRC § 6225(c)(3). Treasury is directed to establish regulations implementing this modification to the general rules for computing imputed underpayment amounts.
11 IRC § 6225(c)(2)(A). Treasury is directed to establish regulations implementing this modification to the general rules for computing imputed underpayment amounts.
12 IRC § 6226.
14 IRC §§ 6230(a)(1), (c); 6231(a)(6).
15 IRC § 6223.
17 NYC Administrative Code §11-503; D.C. Code Ann. §47-1808.03.
18 Ohio Rev. Code Ann. §§5751.01, 5751.02; Tex. Tax Code Ann. §§ 171.001, 171.0002.
19 See,e.g., Pa. Stat. Ann. §7324 (the Pennsylvania withholding requirement is nominally a tax, but is listed as an enforcement mechanism because nonresident partners and nonfiling corporate partners receive a credit pursuant to Pennsylvania Statutes Annotated section 7324.2 for the amounts withheld).
20 See, e.g., N.J. Admin. Code 18:35-5.2.
21 See, e.g., N.Y. Tax Law §§ 611 (taxation of worldwide income of resident individuals); 631 (taxation of New York source income of nonresident individuals).
22 See Comptroller v. Wynne, 135 S. Ct. 1787 (2015).
23 Appeal of Dr. Pepper Bottling Co. of S. Cal., No. 90-SBE-015 (Cal. St. Bd. Equal., Dec. 5, 1990) (two merged companies found to be instantly unitary); Appeal of ARA Servs., Inc., No. 93-R-0262 (Cal. St. Bd. Equal., May 8, 1997) (nonprecedential decision) (two merged companies found not to be instantly unitary).
24 Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).
25 N.Y. Tax Law §21(3): “If the amount of taxable income for any year of any taxpayer (including any taxpayer which has elected to be taxed under subchapter s of chapter one of the internal revenue code), as returned to the United States treasury department is changed or corrected by the commissioner of internal revenue or other officer of the United States or other competent authority … such taxpayer shall report such changed or corrected taxable income … .”); Mass. G.L. c. 32C, §30 (“If the federal government finally determines that there is a difference from the amount previously reported in (1) the taxable income of a person subject to taxation under chapter 62, or (2) a federal credit to which such person may be entitled, but only if the calculation of such credit has an effect on the computation of the tax imposed under chapter 62, the final determination shall be reported, accompanied by payment of any additional tax due with interest as provided in section 32, to the commissioner within 1 year of receipt of notice of such final determination.”); N.J. Stat. Ann. §54:10A-13 (“If the amount of the taxable income for any year of any taxpayer as returned to the United States Treasury Department is changed or corrected by the Commissioner of Internal Revenue or other officer of the United States or other competent authority, or where a renegotiation of a contract or subcontract with the United States results in a change in said taxable income, or where a recovery of a war loss results in a computation or recomputation of any tax imposed by the United States, such taxpayer shall report such changed or corrected taxable income … .”).
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