Current Federal Tax Developments

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Partnership Provisions, Including Partnership Audit Reform, Included in Budget Bill


The Bipartisan Budget Act of 2015 at Title XI provides for changes to be made to partnerships.  The most significant is a major change in how examinations of partnerships will be handled by default, while a second change attempts to clarify the family partnership provisions of the IRC.

Partnership Examination Procedures

The new bill will repeal the TEFRA partnership audit rules and electing large partnership audit rules, replacing them with a new set of provisions dealing with examinations of partnership returns.  These rules will be effective for returns filed for tax years beginning on or after January 1, 2018, though the provisions may be elected for any partnership return filed after the date of enactment.

A new Subchapter C is added to Chapter 63 of the Internal Revenue Code to provide for this new set of procedures to be used.

Determination at the Partnership Level

By default rather than having a partnership exam result in tax being assessed at the partnership level, the new procedures will have the partnership pay a computed tax due at the end of any partnership examination.  [IRC §6221(a)]

While this is the default treatment, there are options.

Opting Out for Qualifying Partnerships

Under the prior TEFRA partnership rules, the rules specifically did not apply to a partnership that met certain criteria (less than 10 owners, and no disqualified owners) unless the partnership elected to be treated under those procedures (an opt-in system), under the new rules a partnership with less than 100 partners that meets other criteria may elect to not be covered by these rules (an opt-out system). [IRC §6221(b)]

To be eligible for the election, the following must be true

  • The partnership must make an election out of the new provisions
  • The partnership must be required to furnish 100 or fewer K-1s for the year
  • Each of the partners is an individual, C corporation, any foreign entity that would be treated as a C corporation if it was domestic, an S corporation and an estate of a deceased partner [IRC §6221(b)(1)]  The IRS is granted authority to expand this list to include other types of partners. [IRC §6221(b)(2)(C)]
  • The election must be made on a timely filed return and include the name and identification number of each partner.  The partnership must also notify each partner that the election has been made. [IRC §6221(b)(1)(D) and (E)] The IRS is permitted to provide for provisions to identify foreign partners for purposes of this disclosure.  [IRC §6221(b)(2)(B)]

If the partnership includes S corporation partners, the partnership making the election must also attach a disclosure of the name and taxpayer identification number of each shareholder of the S corporation.  As well, each S corporation K-1 is counted as if it were the partnership’s ownK-1 for purposes of computing the 100 K-1 limitation. [IRC §6221(b)(2)(A)]

Consistent Treatment

The new rules provide, similar to the old TEFRA provision, that a partner generally must report consistently with the partnership.  [IRC §6222(a)]  This rule does not apply if the partner files a notice of inconsistent treatment with his/her return.  Such a notice must also be filed if the partnership failed to file a return. [IRC §6223(c)(1)]

Similarly, the partner can establish that he/she reported the item consistently with the K-1 he/she received even though that K-1 was not one filed by the partnership, the requirement for consistency also will not apply if the taxpayer elects to be treated as if he/she filed a notice of inconsistent treatment.  [IRC §6223(c)(2)]

An IRS decision with regard to an inconsistent position where the taxpayer filed a notice of inconsistent treatment is not binding on the partnership.  [IRC §6223(d)]

In a case where the taxpayer fails to report in a manner consistent with the partnership and does not qualify for an exception noted above, the IRS may treat the adjustment made to restate the return on a consistent basis as a math error. [IRC §6223(b)]

Partnership Representative

The old “tax matters partner” of the TEFRA system is to be replaced by a “partnership representative” designated by the partnership.  This must be a partner with a substantial presence in the United States.  The representative will have sole authority to act on behalf of the partnership for purposes of the new exam rules. If no partnership representative is appointed by the partnership, the IRS has the right to appoint a partnership representative for the partnership.  [IRC §6223(a)]

The partners of the partnership will be bound by actions taken by the partnership under the new rules and by any final decision in a proceeding under these rules.  [IRC §6223(a)]

Adjustment of Partnership Items by IRS

In general for a partnership that does not elect out of the treatment under Subchapter C, the partnership pays an “imputed underpayment” in the adjustment year (that is, the year in which the exam adjustment is final).  If the adjustments do not result in an imputed underpayment (generally meaning that they reduce taxable income), they are taken into account by the partnership in the adjustment year either as a reduction in nonseparately stated income, an increase in nonseparately stated loss for the year or, for a credit, a separately stated item.  [IRC §6225(a)]

The imputed underpayment is computed by netting all items of income, gain, loss or deduction and multiplying them by the highest tax rate in effect for the reviewed year for individuals. A decrease in an item of loss is treated as an increase in income and an increase in an item of loss is treated as a decrease in income.  [IRC §6225(b)(1)] 

Changes in credits will be treated as an increase or decrease in the imputed underpayment.  [IRC §6225(b)(1)(C)]

If the change results in a reallocation of items between partners, the amount on which the imputed underpayment is to be computed will be calculated by ignoring the amount of decrease in the item of income or gain allocated to a partner and any increase in any item of deduction, loss or credit.  Note that the offsetting adjustment will be included in the calculation, thus meaning a tax will be computed for the partner that would be expected to see an increase in tax, but no offsetting effect would be given for the reduction in expected tax for the other partner.  [IRC §6225(b)(2)]

The law allows the IRS to publish procedures under which the imputed underpayment may be modified.  [IRC §6225(c)(1)]  Specifically, if any partners file amended returns that take into account their amount of adjustment and pay the tax due with such returns, their allocable amounts of the adjustment will be removed from the calculation of the imputed underpayment.  [IRC §6225(c)(2)]  However, this provision only applies when a distributive share of an item is reallocated from one partner to another if all affected partners file such amended returns.  [IRC §6225(c)(2)(B)]

As well, the procedures will provide for determining the imputed underpayment without taking into account amounts that would be allocated to a partner who would not owe tax because it is a tax exempt entity.  [IRC §6225(c)(3)]

Similarly, the procedures will allow for adjusting the rates for any year a partnership demonstrates an allocation of ordinary income to a C corporation or in the case of a capital gain or qualified dividend is an individual (including an S corporation).  The rate i this case will be the highest rate of tax applicable to such income for such taxpayers.  [IRC §6225(c)(4)(A)]  Special provisions that require a deemed sale calculation are triggered if the adjustment affects more than one item, and those items are allocated in different ratios for different partners.  [IRC §6225(c)(4)(B)]

Any information required to be submitted by the partnership to qualify for these lower adjusted rates must be submitted by 270 days after the notice of proposed partnership adjustment is mailed by the IRS unless the IRS consents to an extension of time to provide such information.  [IRC §6225(c)(6)]

If the partnership ceases to exist, the adjustment shall be taken into account by the individual partner as provided for in regulations to be issued by the IRS.  [IRC §6241(7)]

If a partnership return is filed by an entity that is later determined to not be a partnership, the new provisions apply to the entity and persons holding interests in the entity as provided for in regulations to be issued by the IRS.  [IRC §6241(8)]

Alternative to Payment of Imputed Underpayment

A partnership may elect within 45 days of the receipt of the notice of final partnership adjustment to use the alternative method in which the partners will be issued a statement showing their adjustments as determined by the final partnership adjustment.  If this method is chosen, no imputed underpayment will be due from the partnership, but each partner will need to take the adjustment into account. [IRC §6226(a)]

The taxpayer will be required to report any increase in tax for the reviewed year, as well as any increase in tax in subsequent years due to the adjustment of tax attributes affected by the change.  [IRC §6226(b)]

The partner will also be responsible for any penalties that may be due.  [IRC §6226(c)(1)]  Interest will be due at the federal short term rate plus 5 percentage points.   [IRC §6226(c)(2)]

Partnership Voluntary Request for Adjustment

The new provides for a method for the partnership to voluntarily request an administrative adjustment after the original return is filed. [IRC §6227(a)]  The partnership may request the adjustment be made under the imputed underpayment rules (where the partnership pays the amounts due) or via the alternative method. [IRC §6227(b)]  However, if no imputed underpayment would result, then the partnership would be required to use the alternate method.  [IRC §6227(b)]

If the imputed underpayment method is used, the calculation is the same as if the IRS had made the adjustment except the following modifications apply:

  • No options is available for certain partners to amend their returns and remove their adjustment from the calculation
  • There is no 270 day submission period for information necessary for adjustments
  • There is not an IRS approval required for the adjustments [IRC §6227(b)(1)]

If the partnership elects to use the alternate method, the general rules of the alternate method apply except that the higher interest rate on underpayments will not apply. [IRC §6227(a)]  

Any request for an administrative adjustment must be filed by the partnership no later than 3 or more years after the later of:

  • The date on which the partnership return for the partnership was filed or
  • The last day for filing the partnership return for the applicable year, determined without regard to extensions.   [IRC §6227(c)]

As well, the request may not be made after a notice of an administrative proceeding is issued to the partnership for the year in question.   [IRC §6227(c)]  

If the partnership is filing using the imputed underpayment method for its administrative adjustment request, the payment must be made at the time the adjustment is requested.  [IRC §6232(a)]

IRS Notice of Proceeding

The IRS must mail to the partnership and the partnership representative

  • Notice of any administrative proceeding initiated at the partnership level
  • Notice of any proposed adjustment resulting from such proceedings and
  • Notice any final partnership adjustment resulting from the proceeding. [IRC §6231(a)]

A notice of final partnership adjustment must be mailed within 270 days of the issuance of the proposed adjustment.   The 270 day rule also applies to an situation where the partnership makes a voluntary request for an administrative adjustment outside of an examination.  [IRC §6231(a)]

Absent a showing of fraud, the IRS may not issue a second notice of final partnership adjustment after the taxpayer has filed a court petition to challenge the original notice. [IRC §6231(b)]

With the consent of the partnership the IRS may rescind a final notice of partnership adjustment.  Once the notice has been withdrawn the partnership can no longer file a petition in court with regard to the withdrawn adjustment.  [I RC §6231(c)]

Effective Date

The new rules apply to returns filed for years beginning after December 31, 2017.  However, under regulations to be issued by the IRS, an election to apply these rules may be made for a partnership return for a year beginning after the date of enactment and before January 1, 2018.  [Act Section 1101(g)]

Family Partnership Clarification

Act Section 1102 enacted a clarification to the IRC §704(e) provisions, formerly titled the “Family Partnership” rules.  The law changes the title of that subsection to “Partnership Interests Created by Gift.”

Some advisers had argued that the old rules provided an alternative test to determine if a person was a partner.  As the Section by Section Summary of the Act issued by the House noted:

A partnership generally is an unincorporated organization in which the parties (typically referred to as partners) have joined together with the purpose of conducting an active trade or business. A person also may be recognized as a partner if capital is a material income-­‐producing factor, whether such interest was obtained by purchase or by gift. Congress intended this rule to clarify that a family member who receives via gift a capital interest in a partnership, where capital is a material income-­‐producing factor, should be respected as a partner in the partnership and should be taxed on the income from that partnership. Some taxpayers have argued that this family partnership rule provides an alternative test for determining who is a partner without regard to how the term is generally defined in the partnership tax rules. Thus, they assert that if a partner holds a capital interest in a partnership, the partnership must be respected regardless of whether the parties have demonstrated that they joined together to conduct an active trade or business.

The new law adds the following to the end of IRC §761(b):

In the case of a capital interest in a partnership in which capital is a material income-producing factor, whether a person is a partner with respect to suchinterest shall be determined without regard to whether such interest was derived by gift from any other person.

As the House document explains:

The provision would clarify that Congress did not intend for the family partnership rules to provide an alternative test for whether a person is a partner in a partnership. The determination of whether the owner of a capital interest is a partner would be made under the generally applicable rules defining a partnership and a partner. In addition, the family partnership rules would be clarified to provide that a person is treated as a partner in a partnership in which capital is a material income-­‐producing factor whether such interest was obtained by purchase or gift and regardless of whether such interest was acquired from a family member. The rule, therefore, is a general rule about who should be recognized as a partner.