TSCPA Urges IRS to Interpret Partnership Audit Provisions Broadly

The proposed regulations do not allow a partnership to elect out if it has a disregarded entity as a partner. For most purposes of the Internal Revenue Code, save, for example, domestic disregarded LLCs with a single foreign owner or for limited employment tax purposes, disregarded entities are treated as if they do not exist; we see no reason there should be an exception here. We believe the IRS could allow the election out for partnerships with disregarded entities as partners in a similar manner to the treatment of partnerships that have S corporation partners. A partnership with an S corporation partner may opt out of the partnership audit regime but must include the shareholders that are required to receive a Schedule K-1 from the S corporation in its count toward the 100-partner maximum for electing out.¹ This would allow more partnerships to make the election out and would not unduly burden the IRS.

For the purposes of the 100-partner limit for opting out, we believe spouses should be counted as a single partner. The statute is silent on this matter, but the proposed regulations would count each spouse as an individual partner. This is inconsistent with other tax provisions, may confuse taxpayers and seems unnecessary to ease the IRS’ audit burden because married couples generally file joint returns, with only one audit per couple.

In an attempt to simplify partnership audits, the proposed regulations unfairly remove many relevant distinctions between different types of items and adjustments and net items that do not properly net against each other at the entity level. These include intangible drilling costs, section 1231 gains and losses and whether a partner is considered active or passive in his or her relationship to the partnership. The regulations should allow partners to provide information to the partnership, and the partnership and the IRS should apply this information to more accurately compute the required adjustment.

In addition, there needs to be a procedure for partners who are passive investors with respect to the partnership to have an opportunity to claim passive losses for net partnership adjustments on audits that increase income and cause the partnership to pay tax on their behalf. The partnership should be able to notify its passive investor partners of the allocable amount of such gross income adjustment, so that they can potentially claim passive activity losses in the year of the partnership adjustment to offset the effect of the tax paid by the partnership on their share of “passive income” taxed due to the partnership adjustment.

In simplifying the partnership audit, section 6225(b)(1)(A) uses the highest marginal tax rate to calculate the amount of tax on any net adjustments. This is unfair to taxpayers who may not be taxed at the highest marginal rate, particularly with respect to adjustments for qualifying dividends or capital gains. This is particularly inequitable where a partner is subject to alternative minimum tax (AMT) or a tax-exempt organization.

The proposed regulations recognize that in some circumstances a partnership otherwise subject to the rule imposing adjustments on the current partners should have the option to elect out of the general rule and “push-out” tax adjustments to the partners in place in the year of the adjustment. The ability to elect the push-out provision is very important and it should be made easily available. Section 6226 states the election must be made within 45 days after the date of the adjustment notice. The proposed regulations state that this 45-day period cannot be extended. The decision limiting the timeframe to merely 45 days should be reconsidered, particularly where the partnership includes tiers of owners, such as an S corporation, where added time is needed to process, explain and convey information at every level.

In many cases, the adjustments will have significantly different and complex tax effects for the current partners compared to the impact the adjustments would have for the partners of the year under examination. A 45-day period is not sufficient to notify all the partners, explain the effect the election would have on them and develop a consensus as to whether to make the “push-out” election. An extension of the 45-day limitation is important for the fairness of this election.

Texas has many tiered partnerships in real estate, farming and ranching, energy and other areas. We strongly believe a pass-through partner who receives a statement described in proposed section 301.6226-2 should also have the option to flow the adjustment through to its owners instead of paying tax on the adjustment. This is the approach taken in proposed technical corrections legislation, but even if it is not enacted, we believe the IRS should adopt this approach through regulation. Under this approach, the adjustment could flow through the tiers of the partnership electing to push the lower tier partnership adjustment out to its partners until it reaches a partner that is not a pass-through who pays the tax. We could support a limit in the number of ultimate owners to 100 Schedule K-1 recipients for each intervening partnership to keep the process manageable, consistent with the elect-out part of the proposed regulations. We might also agree that the adjustment that flows through should be not less than a certain amount, say $10,000, so the IRS is assured someone pays the tax and it is not diluted away through tiers of partnerships to an insignificant amount. We do not believe many large partnerships will elect to flow through adjustments because good investor relations compel partnerships to avoid unnecessarily interrupting the partners or confusing them with tax-related notices. We believe allowing the election to flow through adjustments as described above would not be burdensome to the IRS because each intervening partnership electing to push out its share of an audited partnership’s adjustment would have to map out the adjustments, rather than the IRS having to do so under the current TEFRA² partnership audit procedures. We do not believe allowing the intervening partnerships to push out the adjustment would result in significant noncompliance or collection risk with these proposed restrictions.

Section 6222(c)(2) provides that a partner receiving incorrect information from the partnership representative will be treated as having notified the IRS of the error if the partner satisfactorily demonstrates that the treatment on the return was consistent with the statement received from the partnership and the partner elects to have the section apply. Guidance is needed as to how such an election is made.

In general, section 6213(b)(1) permits the IRS to immediately assess and collect tax that arises on account of a mathematical or clerical error appearing on a taxpayer’s return, and the taxpayer has only 60 days to request an abatement of the assessment. Such a correction will often involve extensive communication between the partnership representative and the affected partner. Accordingly, the 60-day time limit should be increased to at least 90 days to give the partner sufficient time to address the issue and determine the accuracy of the assessment.

Under the proposed regulations, a partnership that has made the push-out election must provide statements to the partners within 60 days of the final determination of the partnership’s tax liability. This deadline does not coincide with the due date of the partnership’s Schedule K-1 and will create confusion among the partners and likely result in less timely compliance. Additionally, extensions of this deadline must be permitted to allow the often-complex calculations necessary for the accurate distribution of the adjustments among the partners.

The proposed regulations provide that only the partnership representative, not any of the individual partners, can raise a reasonable cause defense against the imposition of a penalty on the partnership. If the defense is not raised by the representative, the ability to raise it is waived for all the partners. This is contrary to general principles of fairness and to the basic principle that a partnership at its most basic level is a collection of individuals, a purely legal entity — not itself a cognitive human being — and lacks any capacity to form intent. All taxpayers should have the right to defend themselves against the imposition of a penalty. In many cases, a partner will have a stronger reasonable cause defense than the partnership as a whole.

We previously recommended that the IRS should give notice of significant developments to all partners in an administrative proceeding to enable them to make the representative aware of any particular issues of concern to them. The proposed regulations only require notification to the partnership representative who may (or may not) give notice to the other partners. Additionally, proposed regulation section 301.6223-2(c)(1) provides that partners may not participate in or contest the results of an examination or other proceeding involving a partnership without the IRS’ permission. While this may be expedient for the IRS, it may do great injustice to individual partners whose unique tax situations that have merit under the tax law may not be known by the representative. A partner may not be aware of significant interests at stake until the partnership adjustments are settled and they have no opportunity to raise issues particular to his or her tax situation.

The partnership audit may be completed after the statute of limitations for amending an individual return has expired. If an audit results in an adjustment that decreases a partner’s income, the statute of limitations should be automatically extended to allow the individual taxpayer to file an amended return and claim the refund.

Internal Revenue Code Section 6221(b) allows certain partnerships to elect out of the new centralized partnership audit regime. Only partnerships that satisfy a number of statutorily prescribed criteria are eligible to make such an election. Among those criteria is a requirement that the partnership’s partners consist only of certain specified types of partners and that the partnership be required to furnish 100 or fewer statements (i.e., Schedules K-1) under Section 6031(b) with respect to those partners.

Guidance is particularly needed with respect to the types of partners the IRS will allow a partnership to have and still remain eligible for the 6221(b) election, as well as how the IRS will treat any stakeholders (e.g., owners, shareholders or partners) of such partners for purposes of the “100-or-fewer-statements” rule. For instance. Section 6221(b)(1)(C) provides that a partnership may have an S corporation as a partner and remain eligible to elect out of the new audit regime, but Section 6221(b)(2)(A) provides that each statement the S corporation is required to issue with respect to its shareholders shall be treated as a statement issued by the partnership for purposes of the 100-or-fewer-statements rule. We believe future regulations should specifically address the treatment of partners that are trusts or estates with multiple beneficiaries. A partnership with such an entity as a partner should not necessarily be rendered ineligible for the election out provided by Section 6226(b). Moreover, in the interest of administrative simplicity, we believe the IRS should provide that if an estate or trust is a partner, such entity only constitutes a single statement for purposes of the 100-or-fewer-statements threshold if the entity’s interest in the partnership at issue is less than a specified amount; 5 percent is an appropriate threshold for these purposes. Beyond this suggested administrative "de minimus" rule, the IRS should consider issuing regulations that are similar to the rules for counting shareholders of an S corporation in addressing whether and how estate and trust beneficiaries count when applying the 100-or-fewer-statements threshold.

Section 6223 provides rules for designating a partnership representative during the review process if one has not previously been designated. Specifically, Section 6223(a) provides that “[i]n any case in which such a [partnership representative] designation is not in effect, the Secretary may select any person as the partnership representative.” Notably, the partnership representative has authority to bind all partners of the partnership and represents both the partnership and its partners in essentially all key phases of the procedures established under the new audit rules. Considering the broad scope of this authority and the partnership representative’s central role, future regulations should make every effort to ensure that any person designated by the IRS as a partnership representative truly represents the interests of the other partners. Future guidance should prohibit the designation of an IRS employee as a partnership representative. Such guidance should also prescribe a prioritized list of partners that can be designated as a partnership representative, and should give preference to general partners and persons who exhibit objective characteristics that indicate they will likely continue to be a partner for an extended period.

Regulations should require that notice of the designation of a partnership representative be provided to all partners of the partnership to ensure they have knowledge of the appointment, have an opportunity to provide input in the audit process and have an opportunity to exercise any legal rights (whether federal or otherwise) with respect to the process.

In computing the underpayment, the revised statutory partnership audit procedures provide for netting items that do not properly net against each other at the entity level. These include intangible drilling costs (IDCs), Section 1231 gains and losses, and whether a particular partner is considered active or passive in his or her relationship to the partnership. The regulations should include a requirement that partners be allowed to supply information to the partnership and that the partnership and the IRS must apply this information in calculating the required adjustment. For example, information about passive activity losses for the adjustment year or a passive activity loss carryover with respect to that partnership at the partner level should be communicated to the partnership and used to calculate the partnership adjustment at least with regard to that partner’s share of the partnership adjustment. Such treatment would require that the partner supplying such tax information adjust its tax attributes to the extent used by the partnership in calculating the net adjustment.

Section 6226 allows the partnership to elect to avoid the tax at the partnership level if it provides a statement detailing each partner’s share of any adjustments within 45 days of the notice of final partnership adjustment. However, many partnership structures are complicated and limiting this period to 45 days imposes an administrative hardship. Especially where ownership structures include a tiered partnership, S corporation, estate or trust, regulations should provide an additional 45 days so such entities can submit the necessary information for their owners and beneficiaries.

The regulations should also provide guidance on how to deal with changes in ownership between the year under audit and the current year to fairly allocate any adjustments and resulting tax payments by the partnership.

Applicable Tax Rate

Section 6225(b)(1)(A) generally requires that the “highest rate of tax in effect for the reviewed year” be applied after the “netting of all adjustments.” Section 6225(c)(4)(A) empowers the IRS to take into account a lower tax rate in circumstances where a partner is a C corporation with ordinary income under Section 6225(c)(4)(A)(i) or, “in the case of a capital gain or qualified dividend,” where a partner is an individual under Section 6225(c)(4)(A)(ii). The regulations should require that the audit notice be provided to all partners to allow them to provide relevant information during the review to appropriately adjust the applicable tax rate. A failure to require such notice raises due process concerns.

Applying the maximum tax rate in effect to the net adjustment ignores numerous items that may impact the tax effect at the partner level. In addition to the lower maximum rate for C corporations with ordinary income and the lower rates available to individuals for long-term capital gains and qualifying dividends, many other factors should be taken into account. For instance, many individuals are subject to Alternative Minimum Tax (AMT). This may be due, for example, to high state taxes or miscellaneous itemized deductions not allowed in calculating the AMT and that do not give rise to an AMT credit. For these individuals, imposing tax at the maximum rate on partnership adjustments is particularly unfair. In addition, the partner may be a tax exempt organization that is not subject to income tax, except to the extent income would be unrelated business taxable income. Ignoring these factors would have an unintended punitive effect on businesses treated as partnerships for federal tax purposes.

Other Issues

The partnership audit rules provide for imposing tax at the highest applicable rate. In fairness, deductions should also be maximized. In computing the imputed underpayment, the regulations should presume each partner was eligible for the maximum deduction for all expenditures passed through the partnership where the deduction or tax rate is determined at the individual level. This includes such items as IDCs and capital losses. Additionally, the maximum rate should be applied only after assuming partners would have been fully capable of utilizing any capital or Section 1231 losses and Section 754 adjustments should be considered for a partnership with such an election in place.

Only items subject to a partnership adjustment are taken into account in computing the net adjustment. However, Section 754 and other adjustments could be relevant when calculating the partnership adjustments and net adjustments. Information from individual partners may be necessary to perform such calculations. The same is true, for example, for Section 59(e) elections made at the partner level. Regulations should allow for the effect of the Section 59(e) election at the partner level to be taken into account by the partnership in calculating the partnership adjustment for an item like IDC to determine the net adjustment on which taxes will be calculated.

The revised partnership audit procedures also complicate other partnership computations, such as basis in the partnership and basis in partnership property. For example, whether a Section 754 election has been made will affect how the imputed underpayment may impact the adjustment to basis of the partnership property following an IRS audit. Future regulations should address these issues.

The new statutory audit rules create a number of issues related to basis and gain. Future regulations should carefully consider and provide examples to minimize the adverse impact of these rules. For example, regulations should provide that a notice of audit adjustments be issued to partners so they can make any necessary basis adjustments and avoid later double taxation. The regulations should also provide guidance directing partnerships on how to adjust the paying partner’s capital account. For instance, if a general partner elects to pay the tax calculated for the audit adjustment to avoid the complexities of passing it through to other partners, the paying partner’s capital account should be adjusted to reflect this (i.e., increased by the amount of the net adjustment on which the tax was paid). This would require both an adjustment to the partner’s capital account and an adjustment for payment of the tax. Likewise, if a partnership pays the imputed tax and a partner is allocated an adjustment, relevant information should be required to be distributed to all relevant persons required to make adjustments in capital accounts and taxable income based upon payment by the partnership.

Partnership agreements will have to be revised to provide rules for allocating payments resulting from audits and the IRS should generally respect partnership agreement provisions negotiated by the partners. If the agreement does not specify, the default rule should allocate payments based on ownership percentage, considering the terms of the partnership agreement, including the distinction between capital and profits interests. Section 6226 regulations should provide “push out” procedures for payments due from partners, particularly where a partnership lacks adequate funds to pay the adjustment. The regulations should also address how to treat indirect partners, such as the shareholders of an S corporation partner. As it currently stands, the rules seem to provide that only items that increase taxes be considered for allocating the payment. In fairness, both increases and decreases should be considered, with decreases pushed out to partners, as well as increases.

Applicable Tax Rate

Section 6625(c)(4)(A) requires the IRS to provide procedures for applying a rate lower than the highest tax rate to a portion of the underpayment that the partnership demonstrates is allocable to a partner that is a C corporation for ordinary income or a partner who is an individual in the case of a capital gain or qualified dividend. As part of its review, the IRS should accept the partnership’s documentation of its partners’ composition and base the computation of tax related to any adjustment on that composition. As discussed above, it would be inappropriate and unfair to taxpayers to apply the maximum tax rate in circumstances where a portion or all of adjustment relates to a capital gain; it would also be inappropriate where a partner had reported a tax loss for the reviewed year.

The regulations should clarify how an IRS adjustment that does not result in an understatement should be reported to taxpayers. In most circumstances, such an adjustment can be addressed by adjusting the partners’ bases in the partnership. In such cases, the basis reduction used to compute the underpayment should be required to be communicated to the partners to enable them to make any necessary basis adjustments.

Section 6225(c)(2) permits the adjustment amount at the partnership level to be avoided to the extent one or more partners file returns for the partners’ taxable year that includes the end of the partnership’s reviewed year and report all adjustments properly allocable to such partner(s), along with payment of any tax due. Where the modification procedure is applied, the partnership should be responsible for preparing “amended” K-1s for the year under review and submitting them to the partners that held partnership interests in the reviewed year, with copies to the IRS. The IRS should issue regulations as permitted by Section 5525(c)(7) interpreting the statute to allow amended K-1s to not be due any earlier than the later of 45 days after the conclusion of the audit process or, if adjudicated, the conclusion of the court process. Issuing and filing amended K-1s will enable the affected partners to take their specific tax characteristics into account in computing the tax effect and will identify to the IRS any partner failing to file an amended return to reflect the adjustments. Section 6225(c)(2) requires the partners to submit the amended returns no later than 270 days after the date the partnership adjustment is mailed under Section 6231 unless that time is extended by permission of the Secretary, which should be extended by regulation.

Regulations should direct the partnership to provide to examining agents the percentage ownership and tax attributes, such as capital losses, operating losses, IDCs and so forth, to each partner that owned an interest in the reviewed year, which should be incorporated in preparing their reports and computing the maximum applicable tax rate. As discussed above, adjustments to the preliminary audit results may be necessary to account for such items as benefit carryovers available to the partnership.

The regulations should address carryforwards and carrybacks so a loss in one year would net against any gain in another year over time. Section 6226 requires partners to consider adjusted items not only in the reviewed year, but also in the subsequent year only if the adjustment increases the partner’s tax due, imposing an unduly harsh burden on partnerships. The regulation should enable a partner to take the benefit of a reduction as well.

If the partnership pays the deficiency, the partnership could allocate the payment proportionally through the partners’ capital accounts. The regulations should consider how the capital accounts can be fairly adjusted to reflect the payment of taxes by the partnership on behalf of the partners.

The regulations should also provide rules for adjustments to the partners’ capital accounts to effectuate audit adjustments that may affect partnership attributes.

One area that may need special attention is the area of partnership item deductions that are subject to an additional election under Section 59(e). This includes items that Texas CPAs often encounter, like IDCs, mining exploration costs, and research and experimentation costs. If a partner properly makes the election under Section 59(e), the partner’s share of such costs is subject to a 10-year amortization (and in the case of IDCs, over 60 months beginning with the month the IDC was paid or incurred). If such a cost is adjusted at the partnership level under audit, how is the amortization under Section 59(e) to be handled at the partner level?

For example, assume for simplicity AB Partnership is owned 50 percent each by corporate partners A and B. AB Partnership incurs $100,000 of IDC for year 20XX in July, which is later determined on exam by the IRS should be $93,000 of IDC and $7,000 of capitalized equipment cost (subject to a seven-year Modified Accelerated Cost Recovery System life in a year when no bonus depreciation applies). Assume further that the adjustment will be made at the partnership level and any additional tax paid by the partnership. Partner A deducted its entire allocation of IDC. but Partner B made a Section 59(e) election with respect to its entire $50,000 allocation of IDC.

At the partnership level, the net adjustment would be additional income of $6,000 being a loss of $7,000 of IDC deductions, offset by an increase in depreciation deductions of $1,000. The tax to be paid by the AB Partnership would be $2,100. For Partner A. the corporate deduction of $50,000 of IDC has effectively been offset by the payment of tax on $3,000 of additional income. The additional income creates basis in a depreciable asset and will come back to it as future depreciation deductions. Partner A’s outside basis in the partnership, however, needs to be increased by the $3,000 of income on which it has paid tax to keep its inside basis consistent with the outside basis. In addition. Partner A’s outside basis needs to be decreased by its 50 percent share of the tax paid on its behalf (i.e., $1,050) as if it had received a cash distribution and paid its own tax on the adjustment with the distribution.

Partner B’s treatment is not as straightforward. If the goal of the new code section is simplicity, even if it only accomplishes rough justice, it would seem that Partner B ends up effectively pre-paying tax on the elimination of a deduction, which it has not yet claimed. Partner B would only have deducted one tenth (i.e., 6/60ths) of the $50,000 IDC allocated to it. but would effectively pay tax up front on 100 percent of its $3,500 share of the adjustment to IDCs through the AB Partnership (offset by its $500 share of an increased depreciation deduction).

Presumably. Partner B would continue to amortize its $50,000 share of IDC allocated on which it made a 59(e) election as if there were no partnership adjustment consistent with the Schedule K-1 it received from the partnership. Partner B’s outside basis in the partnership, however, needs to be increased by the $3,000 of net adjustment to income on which it has effectively paid tax to keep its inside and outside basis in sync after the IRS adjustment. In addition. Partner B’s outside basis needs to be decreased by its 50 percent share of the tax paid on its behalf (i.e., $1,050) as if it had received a cash distribution and paid its own tax on the adjustment with the distribution.

Partner B should be allowed to avoid this result if an amended return is filed by Partner B under Section 6225(b)(2)(A). This would allow Partner B to reduce its allocable share of IDCs by $3,500 and accordingly its current year deduction for IDCs after the Section 59(e) election would be $4,650 instead of $5,000, a reduction of only $350. In addition, a $500 decrease to ordinary income allocated by the partnership due to the increase in depreciation would be applied. Thus, Partner B would actually report $150 less income than on the original return if a Section 6225(b)(2)(A) amended return is filed.

Partnerships tend to linger rather than die quickly. The IRS regulations should clarify when and what consequences occur with respect to a partnership that ceases to exist (or never existed) for purposes of the partnership audit regime. For example, does a partnership cease if partners are continuing business in a new partnership? What is the effect of a Section 708 termination? Similarly, the regulations should address the effect of various stages of bankruptcy proceedings from insolvency to filing for adjudication.

The statute requires any notice of final partnership adjustment to be issued to the designated partnership representative. The regulations should protect the rights of non-management partners where the partnership representative fails to timely respond or notify the partners. Regulations should also provide that notice of appointment of a partnership representative appointed outside the partnership agreement be given to all partners.

No comment at this time.