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Beware of Audit Regime Push-Out Adjustments, Practitioners Warn

Posted on Aug. 20, 2019

One aspect of the centralized partnership audit regime that provides flexibility could end up costing partners in the long run.

Practitioners also say it’s possible a partner might not even know the partnership was subject to an audit until it’s too late, and even if she is aware, favorable adjustments received from the so-called push-out election may never be used.

The centralized partnership audit regime was created in the Bipartisan Budget Act of 2015 and is effective for the 2018 tax year. The new regime allows the government to audit partnerships at the entity level, an issue the IRS has struggled with for decades.

Final rules implementing the various aspects of the regime have been released over the past year, including rules on selecting the partnership representative who has the sole authority to bind the partnership and on using the push-out election that sends adjustments determined at the entity level to partners.

Now that final rules have been released, practitioners have noticed aspects of the push-out election and administrative adjustment requests (AARs) that give cause for concern.

With a push-out election, a partner could owe more or less tax depending on her share of the adjustment. Because the adjustment from the audit has been pushed out to the partner, that amount will affect the partner’s current-year tax return, referred to as the reporting year.

That may limit the amount of the benefit a partner can obtain from a favorable adjustment.

Use It or Lose It

When a push-out results in a downward adjustment because it is determined that the partner shouldn’t have paid tax in the reviewed year in the first place, that downward adjustment is treated as a credit that may be used to reduce the amount of tax owed for the reporting year. However, it’s treated as a nonrefundable credit.

The taxpayer must use that downward adjustment amount in the reporting year or it’s gone forever, according to Kate Kraus of Allen Matkins Leck Gamble Mallory & Natsis LLP.

For example, say a partnership originally allocated $1 million of income to partner A in 2018 and she paid $200,000 of tax based on that allocation. If the partnership is selected for an audit in 2020 and the IRS reduces the 2018 income allocated to partner A by $1 million, the first question is whether a push-out election is allowed.

A push-out election can’t be made unless there is an imputed underpayment for the year at issue, and the $1 million adjustment wouldn’t generate an imputed underpayment, Kraus said.

If there is another adjustment for 2018 that results in an imputed underpayment but doesn’t affect partner A, and if the partnership makes a push-out election, partner A would reduce her 2020 tax bill by $200,000 if she received a push-out adjustment reflecting that change, Kraus said.

But if in 2020 that partner received large loss amounts and didn’t owe tax for that year (before taking the push-out adjustment into account), the $200,000 reduction in the 2020 tax bill couldn’t be used and it also wouldn’t be refundable, Kraus said. What’s more, it couldn’t be carried forward into future tax years, she added.

“All it will do is reduce the tax you owe for the year you take the adjustment into account,” Kraus said. It’s not clear that the partner would retain the associated $1 million of outside basis that resulted from the excess $1 million of income reported in 2018, she said.

That’s a problem with the push-out election, but it’s also a problem if the partnership does an AAR because those rules piggyback off the push-out election rules, Kraus said. If a partner doesn’t owe enough tax in the year it receives a favorable AAR adjustment, the benefit of the adjustment may be gone forever, she added.

That result is based on language in the final rules (T.D. 9844) released in December 2018 that states: “The final regulations under §301.6226-3(b)(1) were further revised to provide that nothing in §301.6226-3 entitles any partner to a refund of tax imposed by chapter 1 to which such partner is not entitled.” Reg. section 301.6227-3(b)(2) has similar language.

The proposed version of the regs provided an example in which a partner was allowed a refund in the reporting year as a result of downward adjustment from an AAR.

The example in the proposed regs posited a scenario in which a partner owed $75 in the reporting year and had a $100 negative adjustment based on an AAR from a prior year. The proposed rules said the taxpayer would be entitled to a refund of $25 in that scenario.

However, the final regulations revised that example to provide that the amount that can be refunded cannot be more than the “overpayment,” and the preamble explains that overpayment means amounts actually paid for the reporting year and not the reviewed year.

For example, if in the reporting year the partner had paid $10 of estimated tax and then received the negative adjustment, she could get a refund of the $10. But if taxes hadn’t been paid yet, a refund wouldn’t be available, Kraus said.

What Audit?

Bahar A. Schippel of Snell & Wilmer LLP discussed the possibility of a partner being unaware of a liability resulting from an audit until it’s too late.

Another problem is that under the law, only the partnership representative has the authority to challenge an IRS determination in court, regardless of whether a push-out election has been made.

Schippel said that when representing a partner who’s not the partnership representative, it’s wise to add provisions to the agreement that would provide some reasonable ability to compel the representative to litigate the client’s issue.

“What scares me is that unless the partners contractually ask for notice rights, as the law is written the first time a partner may hear anything about an IRS audit is when the partner receives a statement reflecting the partner’s share of the partnership adjustments resulting from the push-out election,” Schippel said.

And by the time the partner receives a pushed-out adjustment, it could be up to 60 days after the determination has become final and it can no longer be challenged in court.

“I see many partnership audit provisions that provide full power and authority to the partnership representative to take any and all actions without asking for notice rights,” Schippel said. “If you represent a partner who is not the partnership representative and did not ask for notice rights, you might be in some trouble.”

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