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Dec. 7 — A federal law striving to simplify partnership audits became a curveball for states and taxpayers that are trying to determine how the new rules will hit them.
President Barack Obama in November 2015 signed into law the Bipartisan Budget Act of 2015 ( Pub. L. No. 114-74) (BBA), which modified rules governing federal audits of partnership entities. The default regime provides for assessment and adjustments at the entity level—rather than among individual partners—absent an election that would transfer liability to the partners.
An impetus for this seismic shift was lost collection opportunities for underpaid taxes from partnerships, which have been subject to record-low rates of federal audits that are resource-intensive and time-consuming. However, the seemingly streamlined regime has drawn a flurry of questions and concerns regarding its complexity.
States, in particular, are working through potential conformity problems and introducing stateside issues not present at the federal level—all while Congress mulls a technical corrections bill and tax overhaul threatens to walk back some of the impact from the new regime.
And while the law doesn’t take effect until 2018, practitioners stress the critical need for partnership entities to start reviewing and revising their operating and partnership agreements.
Below, Bloomberg BNA highlights the latest on what’s happening at the federal level and the stateside response to the new audit regime.
Incorporating a new partnership audit regime at the last minute, the BBA repealed the Tax Equity and Fiscal Responsibility Act (TEFRA) partnership audit rules and “electing large partnership” (ELP) rules.
The effort to streamline scrutiny of partnerships followed a September 2014 report from the U.S. Government Accountability Office, which recommended an entity-level system governing adjustments for large partnerships. The same report indicated that less than 1 percent of 2012 tax returns filed by partnerships with $100 million or more in assets were audited, compared to a 27 percent audit rate on similarly sized C corporations.
Research findings from the Treasury Department’s Office of Tax Analysis indicates that complex passthrough structures have contributed to a loss of business tax revenue. As of 2011, the average federal tax rate for passthrough entities was approximately 19 percent—significantly lower than the average corporate rate. By implication, the rise of passthroughs has reduced the average U.S. tax rate on business income, and by extension, tax revenue has declined.
According to the congressional Joint Committee on Taxation, the modified audit rules will raise an estimated $9.3 billion in additional revenue over 10 years.
The BBA has drawn criticism from tax professionals, both inside and outside the Internal Revenue Service, who consider the new regime largely unworkable.
IRS Commissioner John Koskinen shared frustration over the complexity of the federal law during a Nov. 15 presentation at the American Institute of CPAs National Tax Conference. His comments suggested that taxpayers and the agency may be worse off under the new system because “nobody quite asked, ‘Hey, would this really work?’” before the legislation was passed.
In a Nov. 17 letter addressed to leadership in the House Ways and Means Committee and the Senate Finance Committee, the AICPA proposed several revisions to the partnership audit regime. Select revisions touch on what is known as the “push-out election” under tax code Section 6226—the election permits a partnership to avoid the entity-level tax by pushing liability for an imputed underpayment to individual partners. Concerns include the possibility of partners overpaying income tax without a remedy.
During a Nov. 29 teleconference of the Multistate Tax Commission’s partnership work group, General Counsel Helen Hecht presented a memorandum analyzing how the push-out election may function and highlighting several issues and questions relating to what she said “seems to be a key, if not the key, element to the new federal audit and adjustment rules.”
All eyes are on Congress and the IRS for legislative revisions and administrative regulations.
Congress is expected to act on technical corrections legislation in 2017. The Tax Technical Corrections Act of 2016 (H.R. 6439/S. 3506) was introduced Dec. 6, but is unlikely to pass before year’s end.
Likewise, Treasury guidance isn’t anticipated until 2017—and may not arrive until later in the year. When released, those regulations will only be proposed—Jan. 1, 2018, is reportedly the federal target for final regulations, after a promulgation process likely to include public comments and hearings. However, IRS officials have assured that final regulations will pre-date the statute’s effective date.
Temporary regulations (T.D. 9780) were released in August addressing the election to opt-in early. However, practitioners don’t anticipate many partnerships making the election absent Treasury’s guidance on implementation.
The post-November political landscape has many wondering: Will 2017 be the year for tax overhaul?
Steve Wlodychak, a Washington-based principal with EY LLP’s Indirect (State and Local Tax) Practice, explained that one idea is to implement a “unified theory of federal taxation of business entities.” This could nullify the dichotomy between taxation of C corporations and taxation of passthrough entities—which currently bypass corporate-level taxes.
If there is an alignment of entity-level taxation, Wlodychak said that would “drastically transform what we do with partnerships”—which could negate the need for the federal partnership audit regime. If the differences remain, however, the new rules are necessary.
The possibility of “radical tax reform” is one reason that states shouldn’t rush into conformity, Wlodychak said, adding that states should defer legislative or regulatory action pending technical corrections.
The MTC has launched a Partnership Informational Project, intended to address questions and analyze ramifications arising from the new federal rules. During its annual meeting in July, the Uniformity Committee approved an expansion of the work group’s efforts to draft model language for states addressing the federal regime.
MTC staff have maintained a working issues list that sorts through the federal changes and summarizes several state-related issues. The list centers on those issues relating to reporting of state taxes associated with federal audit adjustments—issues associated with potential amendments to state audit and adjustment procedures will be fleshed out later.
During its Nov. 29 teleconference, the partnership work group agreed to place the drafting project on hold pending Treasury guidance or congressional technical corrections—which will better inform states on how to move forward.
The group will continue to host meetings for purposes of providing updates and disseminating information and analyses relating to partnership taxation and the federal rules. And the issue of partnership taxation is on the Dec. 14 meeting agenda for the MTC Uniformity Committee.
Arizona is the only state that has enacted legislation attempting to conform to the federal partnership audit regime. However, lawmakers are expected to amend the statute.
A task force of the American Bar Association tax section’s State and Local Tax Committee has partnered with an AICPA work group on a project addressing state implications from the federal law. Members of the ABA task force include officers from the Council On State Taxation (COST) and Tax Executives Institute (TEI).
During the inaugural meeting of the the MTC’s partnership work group in September, Bruce P. Ely, a partner at Bradley Arant Boult Cummings LLP and co-chair of the ABA task force, presented a memorandum generally urging state conformity and advocating for a model revenue agent report (RAR) statute. However, the task force recommended states allow an opt-out from the Section 6226 push-out election and Section 6225 “pay-up election"—intended to reduce administrative burdens by retaining liability with the partnership.
Members of the ABA task force will present on a draft model RAR statute during the MTC Uniformity Committee’s Dec. 14 meeting in Houston—and will request the committee approve a drafting project. Ely, COST and TEI staff attorneys are the principal authors of the draft RAR statute, and are basing it off the MTC statutory framework.
The ABA task force is initiating the ABA tax section approval process for the model RAR statute, which could take a couple months.
Both Ely and Wlodychak have stressed the need to start reviewing and revising all partnership agreements now. While the federal law takes effect for tax years after Dec. 31, 2017—so that practitioners don’t expect audits completed under the new rules until 2020—amending partnership agreements will take time.
One change, in particular, is a primary motivator for contemplating revisions. Under the federal regime, a “partnership representative” has sole authority to act on the partnership’s behalf during audit and adjustment proceedings. The partnership and all partners are bound by any actions and decisions made.
Wlodychak identified this feature as “the single most significant change in the whole structure of the new partnership audit regime,” moving away from the prior role of a “tax matters partner” that had significantly less authority.
“Who is going to direct the partnership representative to manage the audits on behalf of all the partners? How is he or she or it going to be indemnified for the actions that they take, and protected for the actions that they take?
“I have not seen anybody come up with model suggestions on how that should work,” he added. “But to me, that’s got to be a fundamental change that’s got to happen in every partnership agreement in America.”
Many practitioners have advised that the best strategy is to slow down and wait for Congress or Treasury to act. Rather than push through legislation in spring 2017, states have been advised to hold off until there is more clarity from the federal level.
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