State Questions Abound on Proposed Partnership Audit Rules

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By Paul Shukovsky

State tax commissioners were bombarded with questions about a new federal partnership audit regime just hours after the IRS released revised proposed rules for implementing it.

“This new federal law is going to require some adaptation by the states,” Multistate Tax Commission General Counsel Helen Hecht said of the rules (REG-135118-15), re-issued June 13, and the underlying Bipartisan Budget Act of 2015. Hecht led a panel discussion that day at the Federation of Tax Administrators annual meeting in Seattle, which shed light on not only what may be the most arcane part of the tax code, but also the importance of partnerships in the economy.

Noting that more than half the business income produced in the U.S. is reported in the form of passthrough income, Hecht said an MTC work group’s efforts are focused on how states should adapt to federal changes with respect to partnerships. She called partnership regulation “probably the most complex part of the very complex federal tax system.”

Chapter K of the Internal Revenue Code has spawned highly complicated partnership structures, said Hecht, who displayed a slide of a multi-tiered partnership that looked like the family tree of Genghis Khan, founder of the Mongol Empire. Such complex structures have meant “the IRS has found it virtually impossible to audit at the taxpayer level and trace that income back through and understand that it was, in fact, reported correctly, allocated correctly to the partners,” she said.

Shifting Burden

The new rules—which apply to multi-tiered partnerships of more than 100 partners—shift from the IRS to partnerships the burden of identifying who among the partners is responsible for tax in the wake of an audit, Hecht said. Despite the new rules, the states still have a lot of work to do.

Tracee Abel, a passthrough expert from the Montana Department of Revenue, zeroed in on the important question of how to treat tiered partnerships, an issue she said the 2015 BBA didn’t completely address. Fellow panel member Nikki Dobay, Council On State Taxation (COST) senior tax counsel, said the IRS has yet to answer the question in the new proposed rules, instead seeking input from practitioners.

Dobay said there is a technical corrections bill being floated in Congress that hasn’t moved on its own but might have a chance of being attached to another bill. It wouldn’t make substantive changes, but would address elements in the original statute that are unclear. “We’re still holding hope that something will happen on that,” Dobay said.

Abel briefed the assembled tax commissioners on some of the many issues relevant to states, including how to:

  •  treat resident versus nonresident partners;
  •  handle adjustments when a partnership no longer exists; and
  •  adjust outside basis, particularly when reviewed-year partners differ from adjusted-year partners.

Partners Suing Partners

Passthrough expert Sue Leighton of the Pennsylvania Department of Revenue shared with the tax administrators her state’s experience with imposing tax at the partnership level. If the department makes an adjustment at the entity level, amended Schedule K1s, Partner’s Share of Income, Deductions, Credits, etc., are issued to let the partners know that they have to adjust their outside basis. “They’ll be notified that a payment has been made on their behalf,” she said. “So it really puts the onus on the partnerships because the statute mandates for them to issue the K1s.”

Said Dobay: “I keep telling my lawyer friends that in about five years, litigation among partners will be through the roof. Nobody is going to be suing the IRS. They’re just going to be suing each other.”

Dobay said a document called Draft Model Uniform Statute and Regulation for Reporting Adjustments to Federal Taxable Income and Federal Partnership Audit has been developed by a group of interested parties involved with the MTC process. The parties include COST, the American Bar Association SALT Committee Task Force, the American Institute of CPAs, the Institute for Professionals in Taxation, and the Tax Executives Institute.

Hecht said the draft will be available on the MTC Partnership Work Group website, and she encouraged comment from practitioners.

To contact the reporter on this story: Paul Shukovsky in Seattle at PShukovsky@bna.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bna.com

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