In 2015, Congress enacted a centralized partnership audit regime (the Partnership Audit Rules) that assesses and collects any federal taxes due as a result of a partnership audit at the partnership entity-level. As emphasized in our prior client alert, “Updating Partnership Agreements for 1 January 2018 Audit Rules” distributed on 10 October 2017, these rules are fully effective for partnership taxable years beginning after 31 December 2017.
In December 2018, Treasury and the IRS issued final regulations implementing the Partnership Audit Rules (TD 9844). The final regulations affect partnerships for taxable years beginning after 31 December 2017 and ending after 12 August 2018, as well as partnerships that make the election to apply the Partnership Audit Rules to partnership taxable years beginning on or after 2 November 2015, and before 1 January 2018.
The final regulations largely adopt the proposed regulations issued in August 2018 (83 FR 41954), with a few clarifying items. Highlights of these clarifications are discussed below.
The Partnership Audit Rules apply to any “partnership-related item.” This term includes (1) any item or amount with respect to the partnership which is relevant in determining the tax liability of any person, and (2) any partner’s distributive share of any such item or amount.
The final regulations clarify that items or amounts relating to transactions of the partnership are items or amounts with respect to the partnership only if those items or amounts are shown, or required to be shown, on the partnership return or are required to be maintained in the partnership’s books and records. Thus, items or amounts shown, or required to be shown, on a return of a person other than the partnership (or in that person’s books and records) that result after application of the Internal Revenue Code (Code) to a partnership-related item and that take into account the facts and circumstances specific to that person are not partnership-related items and, therefore, are not determined at the partnership level under the Partnership Audit Rules. However, as noted above, items reflected on the partnership tax return (or are required to be maintained on the partnership’s books and records) in any manner are partnership-related items. For example, while a disguised sale would be taxable only to the contributing partner, the determination of whether a partner sold assets to a partnership would require a partnership-level audit even though the sale would be a taxable event to the partner--this occurs in part because the property subject to the disguised sales analysis is maintained on the partnership’s books and records.
With respect to items or amounts in the partnership’s book or records, the phrase “required to be maintained” was added to exclude items that may be maintained in the partnership’s books and records on a voluntary basis. For example, a partnership may choose to maintain the outside basis of each of its partners in its books and records, even though the Code does not require this information be maintained by the partnership. The final regulations make clear that the voluntary recording of an item in the partnership’s books is not determinative of the meaning of the phrase “item or amount with respect to the partnership.” A partnership cannot convert an item or amount that is not with respect to the partnership into an item or amount that is with respect to the partnership merely by including that item or amount in the partnership’s books and records.
Partner’s Return Must Be Consistent with Partnership Return
The Partnership Audit Rules require that a partner’s return be consistent with the partnership return. To clarify that this requirement applies to each return of the partner, the final regulations provide that the term “partner’s return” includes any return, statement, schedule, or list, and any amendment or supplement thereto, filed by the partner with respect to any tax imposed by the Code. Accordingly, a partner on either an original or an amended return must treat partnership-related items consistently with how those items were treated on the partnership return filed with the IRS. Partners that do not retain this consistency are at risk of the IRS treating the discrepancy as a math error and assessing an adjustment.
As an exception to the math error approach, so long as a partner notifies the IRS of an inconsistent treatment of a partnership-related item by attaching a statement to the partner’s return on which the partnership-related item is treated inconsistently, the consistency requirement (and the effect of inconsistent treatment) does not apply to that partnership-related item. The final regulations clarify that the term “partner’s return” for these purposes includes any amendment to the partner’s original return. When a partner on an amended return treats a partnership-related item inconsistently with how the item was treated on the partnership return, the partner is making a request for an administrative adjustment of that partnership-related item.
The final regulations provide that a partner may not notify the IRS that the partner is treating an item inconsistently with the partnership return for a taxable year after a notice of administrative proceeding with respect to such partnership taxable year has been mailed by the IRS. This rule clarifies that once the IRS initiates an administrative proceeding with respect to a partnership taxable year, any adjustment to a partnership-related item for that year must be determined exclusively within that partnership-level proceeding. Neither the partnership, through filing an administrative adjustment request, nor a partner, by taking an inconsistent position, may adjust a partnership-related item outside of that proceeding. Any actions taken by the partnership and any final decision in the proceeding are binding on the partnership and all its partners.
Section 6225(b)(1)(B) provides that the determination of any imputed underpayment is made by “applying the highest rate of tax in effect for the reviewed year under section 1 or 11.” The preamble to the final regulations notes that such mandate is unambiguous, and there is no exception for any particular partnership or for any specific type of partner. To account for unique circumstances of specific partners, a partnership and its partners may request modification under section 6225(c). For example, the partnership may request modification with respect to partnership adjustments that are allocable to a tax-exempt entity or with respect to adjustments to capital gains or qualified dividends that are attributable to an individual. The partnership may also make a “push out” election under section 6226 (discussed below), allowing the partners to pay tax using their respective marginal tax rates, including, with respect to individual partners, taking into account the alternative minimum tax.
The modification provisions are designed to determine an imputed underpayment amount that reflects, as closely as possible, the tax the partners would have paid had they correctly reported the adjusted items, while at the same time maintaining the efficiencies of a streamlined examination and collection process. Under the final regulations, a partnership may request modification with respect to reviewed year partners (direct partners), including pass-through partners, and indirect partners. A partnership may not request modification, however, with respect to a direct or indirect partner that is a wholly-owned entity disregarded as separate from its owner for Federal income tax purposes.
Push Out Election
The default under the Partnership Audit Rules is that the partnership must pay any imputed underpayment resulting from the partnership adjustments. However, a partnership may make an election under section 6226 (“push out election”) to shift the imputed underpayment adjustment to its partners. A push out election applies to all partners, and must be made within 45 days of the date on which the notice of final partnership adjustment is mailed by the IRS. This 45-day period cannot be extended, and once made, the election may only be revoked with the consent of the IRS.
A partnership that makes a push out election must furnish to each reviewed year partner a statement reflecting the partner’s share of partnership adjustments associated with the imputed underpayment for which the election was made. If a partnership discovers an error in a statement within 60 days of the statement due date, the partnership must correct that error, and may do so without IRS consent. If a partnership discovers an error more than 60 days after the statement due date, the partnership may only correct the error after receiving IRS consent.
Push out elections must be accompanied by significant information reporting to the IRS with respect to each partner to whom a push out is made. The final regulations clarify that the IRS may not invalidate a push out election based on errors that are timely corrected by the partnership. However, any errors in any statements furnished by the partnership are subject to penalty under section 6722 and the regulations thereunder. In the case of errors discovered by the IRS, the IRS is under no obligation to require the partnership to provide additional information or to correct any errors discovered or brought to the IRS’s attention at any time. The IRS may, instead, invalidate the election.