On January 18, 2017, the IRS released unofficial proposed regulations on the new partnership audit rules in the Bipartisan Budget Act of 2015 (“BBA”). The rules are “unofficial” because they have not yet been published in the Federal Register. As observed by Mary A. McNulty in a recent Law 360 article (subscription required), the regulations close gaping holes in the statute. She expects the same regulations with some clean up to be reproposed in the near future, after Treasury determines how the Trump Administration’s freeze on new regulations impacts these and other tax regulations.
The proposed regulations attempt to balance fairness to taxpayers with ease of IRS administration and reflect similar rules to those in the Tax Technical Corrections Act of 2016 (the “Technical Corrections Act”) that has not yet been enacted and is discussed in more detail here. Some of the significant rules in the unofficial proposed regulations are summarized below.
Scope of the Partnership Audit
Under the BBA, partnership “income, gain, loss, deduction or credit” are determined in a centralized partnership audit. The proposed regulations broadly interpret this language to include, for example, items related to a disguised sale, the partners’ basis in their partnership interests and whether a person is a partner in the partnership. This approach is very similar to the approach in the Technical Corrections Act.
- Eligible Partners. The BBA allows for a partnership with 100 or fewer partners that are all “eligible partners” to elect out of the centralized partnership audit regime. The BBA defines eligible partners as an individual, C corporation, eligible foreign entity, S corporation or an estate of a deceased partner, and allows for the IRS to expand the definition of “eligible partners” by regulation. The IRS did not, however, noting that a broader election-out would cause the IRS to face additional administrative burdens in auditing the entities that elected out. As a result, a partnership with a trust, disregarded entity, partnership or nominee as a partner will not be eligible to elect out of the centralized audit regime. In addition, unlike in the small partnership exception in TEFRA, a husband and wife are not treated as a single partner for purposes of determining whether the partnership has 100 or fewer partners.
- Making the Election Out. The proposed regulations conform with the statute and require the election out to be made on a timely filed partnership return (as extended). The IRS declined to adopt the suggestion of commenters that the election out should be available to a partnership that does not timely file a return. The proposed regulations also require the partnership to notify each of its partners of the election out within 30 days of making the election.
- Effect of the Election Out. The preamble to the proposed regulations makes clear that the IRS intends to carefully review a partnership’s decision to elect out of the centralized audit regime. Such review will include whether two or more partnerships that have elected out of the centralized audit regime have formed a constructive or de facto partnership, which would be subject to the centralized audit regime.
Under the BBA, the partnership representative represents the partnership in the audit. Selection of the partnership representative is critical because the partners do not have a right to participate in the audit. For example, the partnership audit may address issues that depend on facts and evidence specific to a partner, such as determinations regarding a partner’s outside basis, disguised sales, whether a person is a partner, and partner-level defenses to penalties. However, unless that partner is the partnership representative, the partner has no right to participate in the proceeding. Thus, selection of the partnership representative is critical in ensuring the partners’ interests are adequately represented.
The proposed regulations impose restrictions on who can serve as the partnership representative and provide that the partnership representative must have the capacity to act and a substantial presence in the US. A person has a substantial presence in the US if the person (i) is able to meet with the IRS at a reasonable time and place as is necessary and appropriate; (ii) has a US street address and telephone number with a US area code; and (iii) has a US tax identification number. To the extent the partnership designates an entity to serve as the partnership representative, the entity must identify an individual to act on the entity’s behalf that also has a substantial presence in the US and the capacity to act.
- Designation by the Partnership. The proposed regulations provide that the designation of the partnership representative is made on the partnership’s tax return, and the partnership must designate a partnership representative separately for each taxable year. The partnership may designate a different person as the partnership representative each year. In order to avoid unnecessary resignations or revocations of the partnership representative designation, the rules provide that a partnership representative for the year of designation may not be changed until the IRS issues a notice of administrative proceeding to the partnership for that year.
- Designation by the IRS. If the IRS has to designate the partnership representative, the IRS may designate any person after first considering partners from the reviewed year or at the time the designation is made. The proposed regulations provide the IRS can consider the following factors in making this designation: (i) the views of the partners with a majority interest in the partnership; (ii) the general knowledge of the person in tax matters and administrative operations of the partnership; (iii) the person’s access to the partnership’s books and records; and (iv) whether the person is a US person.
Modification of the Imputed Underpayment
The proposed regulations provide that adjustments are grouped in three groups: (i) reallocation adjustments (adjustments that move an item from one partner to another); (ii) credit adjustments; and (iii) residual adjustments. Similar to the Technical Corrections Act, the proposed regulations provide that items of different character are not netted together in determining the amount of an imputed underpayment.
- Multiple Imputed Underpayments. The proposed regulations allow for multiple imputed underpayments, so taxpayers can request that the IRS separate adjustments into separate imputed underpayments. This is a taxpayer-favorable change that provides taxpayers with flexibility. For example, this could be beneficial if certain adjustments are allocable to one partner. In that case, the partnership representative can request such adjustments be a separate imputed underpayment, which the partnership could then push-out to the relevant partner.
- Modifications. The regulations allow for the imputed underpayment to be modified in the following seven circumstances: (1) amended returns filed by a reviewed year partner; (2) tax-exempt partners; (3) tax rate modification; (4) certain passive losses of publicly traded partnerships; (5) modification to separate the imputed underpayment into multiple underpayments (discussed above); (6) qualified investment entities (i.e., regulated investment companies and real estate investment trusts); and (7) closing agreements entered into by partners. In addition, the IRS may consider alternative types of modifications that are not specifically enumerated in the proposed regulations.
- Pre-NOPPA Modifications. The preamble to the regulations suggests that prior to the issuance of the notice of proposed partnership adjustment (“NOPPA”), the IRS can consider information provided by the partnership to reduce the imputed underpayment. That is, the formal processes for reducing an imputed underpayment described above may not be necessary if the taxpayer works with the IRS to determine the correct amount of tax prior to the issuance of the NOPPA. Practitioners should keep this in mind during the partnership audit.
Under the BBA, the partnership may elect to “push out” the adjustments to its reviewed year partners rather than pay the imputed underpayment. If the partnership makes the election, the partnership must furnish statements to the reviewed year partners regarding the partner’s share of the adjustments.
- Safe Harbor Amount. The proposed regulations provide that a partner may elect to pay a safe harbor amount in lieu of computing the correct amount of tax for the reviewed year. The partnership will calculate and include the safe harbor amount on the statement that the partnership furnishes to the reviewed year partners with the partner’s share of the adjustments. The safe harbor amount is calculated like the imputed underpayment, except based only on the partner’s share of the partnership adjustments. The purpose of the safe harbor amount is to provide a simplified means for the partner to take into account its share of the adjustments.
- Tiers. The proposed regulations reserve on whether a pass-through partner may push-out the adjustments to its partners. The Technical Corrections Act would allow a pass-through partner either to pay the adjustment or to push-out the adjustments to its partners. The preamble notes that the approach in the Technical Corrections Act presents significant administrative concerns. As a result, the preamble requests comments on how the IRS may administer a push-out election in tiered structures, while minimizing administrative cost and noncompliance and collection risks.
If you have any questions about the proposed regulations or partnership audits, please contact one of us or any of the other Tax lawyers at Thompson & Knight.