There is good news for partnerships and their counsel who spent the last five months studying proposed centralized partnership audit regulations that the IRS issued on January 18 and withdrew on January 20: the proposed regulations reissued on June 14 (REG-136118-15) are essentially the same as those published in January.
The proposed regulations implement the new centralized partnership audit regime enacted as part of the Bipartisan Budget Act of 2015 (BBA). The new regime and the proposed regulations generally apply to returns filed for partnership tax years beginning after December 31, 2017, though partnerships have the option to elect early application.
There are two minor changes to the re-issued regulations: the removal of an example dealing with the netting of ordinary income and depreciation (the January version of Prop. Reg. §301.6225-1(f) Ex. 3), and an expanded section asking for comments about allowing tiered partnerships to pass thru “push-out” adjustments to ultimate partners. Otherwise, the proposed regulations reissued in June are the same as the version issued in January.
Centralized Audit Regime Summary
On November 2, 2015, the BBA effectively repealed the TEFRA and electing large partnership (ELP) procedures and replaced them with new centralized audit procedures. The BBA procedures fundamentally change how partnership adjustments are determined. Under the new centralized audit approach, the IRS will audit the partnership’s items of income, gain, loss, deduction, credit and partners’ distributive shares for a particular year of the partnership (the “reviewed year”). Any adjustments will be made at the partnership level and taken into account by the partnership in the year that the audit or any judicial review is completed (the “adjustment year”).
In a significant departure from TEFRA, the general rule under the new regime is that an “imputed underpayment” will be assessed and collected at the partnership level. An adjustment that does not result in an imputed underpayment generally will be taken into account by the partnership in the adjustment year as a reduction in non-separately stated income or an increase in non-separately stated loss, or in the case of a credit, as a separately stated item.
Partnerships will have the option of modifying the imputed underpayment by following rules published in the regulations. A partnership generally will have 270 days to submit information to the IRS to modify the imputed underpayment amount following receipt of a notice of proposed partnership adjustment. One method would be the filing of amended returns by one or more reviewed year partners. Those amended returns would take into account the adjustments allocable to the partners, and include payment of any tax due with the amended return. In that case, the imputed underpayment at the partnership level will be determined without regard to the portion of adjustments taken into account by the partners’ amend returns. In addition, the existence of tax-exempt partners, as well as the proper application of lower tax rates to certain partners, may be taken into account to reduce the imputed underpayment.
As an alternative to the general rule that an imputed underpayment is assessed and collected at the partnership level, a partnership may elect to ‘‘push out’’ adjustments to its reviewed year partners. The partnership must make this election no later than 45 days after the date of the notice of final partnership adjustment. If the partnership makes this election and sends the required adjustment statements to reviewed year partners and the IRS, the imputed underpayment is paid by the reviewed year partners.
The Partnership Representative
One of the most significant concerns under the centralized audit procedures is the designation of a partnership representative that, unlike the familiar tax matters partner, does not necessarily need to be a partner. Under the proposed regulations, any action taken by the partnership representative with respect to the centralized partnership audit regime would be valid and binding on the partnership and partners for purposes of tax law regardless of any other provision of state law, the partnership agreement, or any other document or agreement. Nevertheless, setting out standards for actions by the partnership representative (such as settling an audit) in the partnership agreement will be important.
The proposed regulations detail eligibility requirements and the procedures for designating the representative. Under the proposed rules, a partnership must designate the partnership representative for each tax year and makes the designation on the partnership's return filed for the tax year. A designation for one tax year is not effective for any other tax year.
Generally, a partnership representative designation may not be changed (either by resignation or revocation) until the IRS issues a notice of administrative proceeding to the partnership, except when the partnership files a valid administrative adjustment request (AAR). There are, however, proposed rules allowing the partnership to revoke the partnership representative designation and designate a successor.
Scope of the Audit Procedures
The proposed regulations would give broad scope to the centralized audit regime, providing that all adjustments and items relating to a partnership, including both the applicability of and defenses to penalties, are determined at the partnership level. Of particular note, only the partnership representative would be permitted to raise defenses to penalties, additions to tax, or additional amounts, including the partnership's defenses and defenses that relate to any partner. For example, according to the Preamble, if the partnership believes it has a viable reasonable cause defense, the partnership representative must raise this defense as part of the partnership proceeding. Any defense, whether it relies on facts and circumstances relating to the partnership or one or more partners or any other person, that is not raised by the partnership before a final determination, would be waived and would not be considered if raised by any other person, including a partner that receives a §6226 statement as a result of the partnership making a push-out election under §6226.
In addition to defining the scope and procedures of the centralized audit regime, the proposed regulations provide detailed rules regarding the ability of an eligible partnership with 100 or fewer partners to elect out of the regime and how to make the election. As written, the proposed regulations do not expand the type of partners that can be in an eligible partnership; trusts, other partnerships and disregarded entities are still excluded, although IRS has expressed an interest in expanding the list if doing so would make the auditing process more efficient.
The proposed regulations would clarify that any such election by a partnership that is itself a partner (a “partnership-partner”) has no effect on the application of the centralized partnership audit regime to that partnership-partner in its capacity as a partner in another partnership. A partnership-partner that elected out of the regime would still be subject to the centralized audit regime in the context of determining its liabilities as a partner in a non-electing partnership.
The IRS is concerned with the potential abuses that might occur among partnerships that wish to avoid being subject to the centralized audit procedures. To ensure that the election out rules are not used solely to frustrate IRS compliance efforts, the IRS intends to carefully review a partnership's decision to elect out, including analysis of whether the partnership has correctly identified all of its partners and evaluation whether two or more partnerships that have elected out should be recast under existing judicial doctrines and general federal tax principles as having formed one or more constructive or de facto partnerships for income tax purposes.
IRS Concerns About the “Push Out” Election
Among the concerns the IRS has with the centralized audit regime is the so-called push out election, whereby a partnership may elect to push out adjustments to its reviewed year partners. If the partnership makes this election and sends the required adjustment statements to reviewed year partners and the IRS, the imputed underpayment is paid by the reviewed year partners. Whether tiered partnerships can push out adjustments beyond the first tier has been a matter of debate since the BBA was enacted. The Joint Committee on Taxation's description of the law suggests the adjustments can only be pushed out once. Leading members of the congressional tax-writing committees introduced technical corrections legislation in 2016 that would have clarified that adjustments can be pushed out to the ultimate investors. The legislation has yet to be reintroduced this year and it isn't certain when Congress will move a tax bill to which the technical corrections can be attached as a rider. The proposed regulations reserve this issue.
The Preamble to the proposed regulations published in January outlined the IRS’s concerns, and the June version expanded that discussion. The IRS is concerned that “[a]llowing such entities to flow through the tiers will result in complexities, challenges, and inefficiencies similar to what occurred under” the previous audit rules. “Allowing partners under BBA to flow adjustments through the tiers presents similar, if not greater, burdens since multiple returns are implicated, from the reviewed year through the adjustment year and all intervening years, in verifying, assessing and collecting the tax, interest and penalties,” the IRS wrote. Of course, those complexities are present when the original returns are being prepared and filed.
According to the Preamble, the IRS is considering an approach that will be the subject of other proposed regulations to be published in the near future. The IRS invited comments on how it might administer the audit regime in tiered structures. This would include comments on information tracking and information sharing from the partnership to the IRS so that the IRS can monitor whether adjustments properly flow through the tiers and to determine that the proper taxpayers take into account the correct amount of adjustments. According to the Preamble, the IRS is specifically interested in comments on reducing noncompliance and collection risk in tiered structures, while at the same time limiting the administrative costs of the IRS.
Preparing for the New Regime
Many partnerships (and limited liability companies taxed as partnerships) will find it necessary or desirable to amend the partnership (or operating) agreement in response to the new audit rules. For example, partnerships should carefully choose their representative and evaluate how the partnership agreement might be amended to provide guidance for the exercise of the representative's broad statutory authority. Partnerships also should consider the ramifications of various partnership actions and elections, including the push out election, that affect both the partnership's own financial condition and the tax attributes passed through to the partners. As well, the new rules provide that partners generally may not participate in or contest the results of an examination or other partnership proceeding without permission of the IRS. Therefore, the partnership should consider what safeguards might be appropriate to protect its own and its partners' interests in the event of an audit.
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