States Eager to Act Must Wait for Model Law on Partnership Audits

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By Che Odom

Most states seeking to address the new federal partnership audit regime are in a holding pattern as they look for a model statute to provide guidance.

Several groups of tax practitioners and the Multistate Tax Commission likely have several weeks of work ahead of them on a model partnership audit statute that responds in part to the federal regime.

The practitioners, known as the “interested parties,” come from the Council On State Taxation, Tax Executives Institute Inc., the Institute for Professionals in Taxation, the American Institute of CPAs, and a task force of the American Bar Association tax section’s State and Local Tax Committee. They had hoped to finalize the model statute and get it adopted by the Multistate Tax Commission before state legislatures began meeting this year—allowing state lawmakers the opportunity to enact the statute to facilitate uniformity with partnership audits. Some legislative sessions have already begun.

The MTC and the interested parties are attempting to resolve areas of concern that states have with the model law. However, the issues surrounding multi-tiered partnerships and the various approaches taken by states complicate things, according to participants during an MTC conference call Jan. 18.

They may be able to buy some time, as many state legislatures and tax officials have their hands full examining the impact that the 2017 federal tax act ( Pub. L. No. 115-97) will have on their revenue. Some have begun introducing bills and floating proposals in response.

“Good news, bad news. State legislatures and revenue departments now are heavily focused on the tax reform issue, which affects their revenues tomorrow,” Jonathan Horn, senior manager at the American Institute of CPAs, said during the call. “But this is going to repercolate up real soon.”

Still, the issue of the Internal Revenue Service’s new centralized audit regime for partnerships hasn’t gone unnoticed. California has already taken steps towards legislation.

“We’re already hearing from a number of our state societies,” Horn said. “State revenue departments are starting to talk to them, saying, ‘Hey, we need to do something.’”

Holding Off

The interested parties, most of which consist of tax professionals who represent businesses, hope that state lawmakers hold off on adopting laws until their model statute is available. They say the statute would promote uniformity across states and predictability for taxpayers, making compliance easier.

Alysse McLoughlin, a partner at McDermott Will & Emery LLP and one of the practitioners working on the model act, said she knows some state lawmakers may feel compelled to act before they can finish.

“From a policy perspective, it would be much better for states to wait to adopt new rules so that such rules are more likely to be consistent among the states,” she told Bloomberg Tax. “This area is already so complex for taxpayers and layering on different reporting and payment requirements among the states will just increase the burdens on taxpayers of trying to comply with the rules.”

California Takes Steps

However, California’s Franchise Tax Board isn’t eager to wait. The board is asking lawmakers to enact a bill making federal partnership-level audit elections binding for California income tax purposes as a key piece of its 2018 legislative agenda. The board voted in December 2017 to seek a lawmaker to introduce a bill when the Legislature reconvenes in January as the federal partnership audit rules take effect.

However, board members said they’re open to modifying the proposal when the MTC model state statute comes to fruition.

Helen Hecht, general counsel to the MTC, said she understands the desire of some state officials to move forward.

“I think the states want to at least begin to look at enacting the model act this year,” she told Bloomberg Tax. “They could wait until next year, and that might be best, but they want to at least start considering it now.”

Often times, legislatures must hold hearings before a statute such as this one is passed, Hecht said.

IRS Regulations Effective

The AICPA and other groups had hoped the IRS would delay implementing the new rules, which will apply to the 2018 tax year, to buy them more time to develop a uniform state response. But that didn’t happen.

The Internal Revenue Service’s regulations (REG-136118-15, RIN:1545-BN77) offer guidance on how the government will implement the new audit regime, created by the Bipartisan Budget Act of 2015, which took effect Jan. 1. The Bipartisan Budget Act’s auditing approach replaces a partner-by-partner audit system with a centralized audit approach that, in general, assesses and collects tax at the partnership level.

However, the Bipartisan Budget Act and IRS regulations have generated a host of questions and concerns over the flow-through impact at the state level.

That’s what the interested parties and the MTC are attempting to address sooner than later.

“I don’t know when the Act will be completed, but the MTC group working on the Model Act does seem to understand the importance of acting quickly in this area since the new federal audit partnership rules are effective this year,” McLoughlin told Bloomberg tax in an email.

‘Difficult Task’

Drafting the model statute is a “difficult task” because of the complexity of issues concerning the partnership audit rules, McLoughlin said. The complexity is “exacerbated by the proliferation of tiered partnerships and by the constitutional limitations that constrain the states’ abilities in certain situations,” she said.

When the MTC and the interested parties settle on language for the model statute, then it will go to the states.

The biggest challenge facing states, and the MTC, is to ensure that there’s no incentive to underpay federal taxes, Hecht said.

“If taxpayers can effectively avoid paying the full amount of state taxes owed on federal audit adjustments, that provides an incentive to be more aggressive and ‘play the audit lottery,’ knowing that even if the federal taxes are audited and adjusted, taxpayers can still avoid paying the full amount of state tax owed,” she told Bloomberg Tax in an email.

“That kind of unintended incentive would be bad for the federal government and for the states,” she added.

With assistance from Laura Mahoney in Sacramento, Calif.

To contact the reporter on this story: Che Odom at codom@bloombergtax.com

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

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