Among the 2,009 pages of the Omnibus Spending Bill passed last December is a small section that should be required reading for tax advisors of business partnerships, according to Scott Harty, a partner in Alston & Bird’s Federal & International Tax Group.
“A seismic shift has occurred with respect to partnership audits that will have aftershocks for years to come,” he said. “Although the new rules do not take effect until 2018, it is imperative that partnerships begin to understand the implications of these changes and take action.”
The changes he refers to are the new rules that have replaced the current TEFRA partnership audit provisions and will have a significant impact on partnership tax audits and their effect.
“The use of partnerships has grown dramatically since [the Tax Equity and Fiscal Responsibility Act of 1982] was enacted, challenging the IRS to keep pace. These new rules should streamline the audit process for the IRS as well as the collection of tax. For example, the new rules do not require the IRS to collect tax directly from the partners but rather shift this responsibility to the partnership and rely on self-assessment,” he said. “As a result, it is likely we will see increased partnership audits in future years.”
“Under Subchapter K of the Tax Code, a partnership is a pass-through entity that is not subject to federal income tax,” said Wes Sheumaker, a partner at Sutherland Asbill & Brennan LLP. “Historically, when a partnership has been audited, any adjustments to partnership tax items have been passed through to the partners for the year under audit, and any resulting tax liability has been imposed on those partners. The new budget act rules take an entirely different approach. The new rules generally impose tax liability arising from partnership audit adjustments on the partnership rather than the partners, which is a radical departure from the historic treatment of a partnership as a pass-through entity.”
“With the growth of technology and multi-tiered partnerships, it became a nightmare for the IRS,” said Barry Weisman, a tax partner at Top 100 Firm Anchin, Block & Anchin LLP.
“It became an administrative nightmare for the IRS,” he continued. “They did very few audits and there was a lot of noncompliance. On a multi-tiered partnership with thousands of K-1s, they would shy away from making an adjustment.”
“That’s what the new regime is supposed to cure,” Weisman added. “But the devil is in the details — sometimes the cure is worse than the disease.”
Unless a partnership makes an election to opt out of the new rules, they will apply even to small husband-and-wife partnerships, he indicated. “Every single partnership is affected by the rules because they must make an affirmative election not to be covered. The election must be made on a yearly basis,” he explained.
“Internally, the partners will have to decide who will bear the burden,” he said. “And there’s another thing — the states don’t have this. If a partnership files in 20 states, it’s an issue as to how the state gets its money.”
“A CPA might have a client that knows nothing about what is going on in the partnership, but all of a sudden the IRS is going after the client personally for partnership matters,” said Weisman. “If you have a client that wants to invest in a partnership, and if the IRS audits your client, they could bear the burden of prior years when they were not even a partner. You have to be cautious when you invest as to whether or not an audit is in process. Every partnership and every new partner is affected.”
“Under the TEFRA rules, the partnership designates a tax matters partner to act on behalf of the partnership in dealing with the IRS,” Sheumaker explained. “While the tax matters partner has significant authority under TEFRA, the other partners are granted certain rights, including rights to notice and to participate in partnership audits and any resulting administrative and judicial proceedings. In contrast, under the budget act rules, the partners do not have any meaningful rights.” Under the new rules, the “partnership representative” has the sole authority to act on behalf of the partnership and all actions of the partnership are binding on the partners.
The new rules apply to every partnership that is required to file a partnership tax return, according to Sheumaker.
“State law is not determinative as to whether a partnership exists for federal tax purposes,” he cautioned. “If two parties are engaged in a joint undertaking which involves the sharing of profits, the relationship may be a partnership for federal tax purposes, which could subject the parties to the new rules.”
REGS ON THE WAY
The budget act rules generally are effective for business partnership taxable years beginning in 2018.
Many details surrounding the budget act rules are to be set forth in regulations, which have not yet been issued. “The service has indicated that it will issue proposed regulations by the end of this year,” Sheumaker said. In certain circumstances, partnerships may elect to have the new rules apply to partnership taxable years beginning after Nov. 2, 2015, and before Jan. 1, 2018.
Meanwhile, in early October the American Institute of CPAs submitted more than 40 specific recommendations to the IRS in advance of the anticipated regulations.
“Implementing the regime will require balancing a simplified assessment and collection process imposed at the partnership level against the general expectation that tax is imposed only on the appropriate taxable individual or entity, only on the properly calculated amount of taxable income and only at the appropriate rate of tax as enacted in the applicable section of the Internal Revenue Code,” the letter said.
The AICPA’s recommendations are focused on the new procedures that will occur prior to an exam, between the time an assessment is proposed and made final by the examiner, as well as the determination of which individuals and entities are ultimately responsible for paying the appropriate share of an assessment.
Specifically, the recommendations cover issues related to the small partnership opt-out, selection of the partnership representative, calculation of the “modified imputed underpayment,” the election to push-out adjustments to the partners, and filing administrative adjustment requests with the IRS.
The letter stated that the AICPA’s recommendations are designed to “balance the IRS’s desire to simplify the assessment and collection of audit adjustments from complicated multi-tier partnership structures with the Tax Code’s basic principles of fairness and equity.”
A subsequent letter was expected to address the AICPA’s concerns regarding the impact of the new regime on Subchapter K tax issues related to Subchapter S corporations. It was also expected to address state-level tax adjustments resulting from partnership audits under the regime.