Individuals Suggest Rules for Partnership Audit Regime

This comment is respectfully submitted by Donald B. Susswein, a principal in RSM US LLP, and Ryan C. McCormick, Senior Vice President & Counsel of the Real Estate Roundtable, in our individual capacities. It does not necessarily reflect the views of our organizations. Kindly direct any questions or requests for additional information to Mr. Susswein at don.susswein@rsmus.com or 202-370-8216.

Our comments principally address the implementation of section 6226 of the Internal Revenue Code as amended by Balanced Budget Act of 2015.¹ To some extent, section 6226 builds on recommendations that were submitted to Congress in September 2015 by the Tax Policy Advisory Committee of the Real Estate Roundtable. The undersigned were the principal drafters of those recommendations.²

In addition to addressing several specific issues in the Notice, these comments outline the major procedural steps we believe the IRS should consider taking to ensure that section 6226 serves its intended purpose -- while doing so at the lowest possible cost in terms of IRS resources. This includes an extensive discussion of how the IRS can most readily ensure that section 6226 operates appropriately for multiple-tier arrangements. Where appropriate, we recommend what we consider to be the most important regulatory rules to get the system up and running.

• After an audit is completed, the partnership is required to provide its partners with information reports -- adjusted K-1s -- reporting their allocable share of any adjustments.

• Where there are multiple tiers of partnerships, we understand that Congress intended similar reports to be issued by partners that are partnerships, effectively passing on an allocable share of the adjustment and the associated tax liability to their partners, although some technical clarifications or corrections to the statutory language may be required in that regard.⁴ This cascade of information reports is similar to the process that occurs every filing season for original K-1s.

• Finally, the items ultimately reported to each ultimate partner -- individuals, C corporations, or trusts -- are then subject to tax on their current tax returns for the year the information report is issued. However, the amounts due, including interest and penalties where applicable, are computed in a manner similar to what would be required if they had filed amended returns for the reviewed year, and for all later affected years, reporting the impact of the adjustments on their taxes determined under chapter 1.

We offer one possible protocol that could fulfill these objectives:

For a variety of reasons, we believe a technical correction providing a similar result would be preferable both for the IRS and for taxpayers. For the reasons explained in the footnote below, Congress should consider adding a sentence to section 6226 along the following lines: "In the case of any partner that is a partnership, unless the partner elects to apply section 6225 to the amounts reported to it under section 6226(a), the partner shall be subject to the requirements of section 6226(a) with respect to such amounts." We believe this would be helpful for the government as well as taxpayers.⁹

Be that as it may, in the absence of such a statutory change, it is essential that the IRS, by regulations, forms, or other guidance, allow all partnerships that invest in other partnerships to make an anticipatory, protective AAR on their original tax return or at any later time such an election would be timely, with respect to any statements it may receive under section 6226. That will ensure that, upon such receipt, they will be required and enabled either to pay an entity level tax under rules similar to section 6225 or to comply with rules similar to section 6226.

Protective AARs for tax refunds are currently permitted by the instructions to Form 1065X "when the right to a refund is contingent on future events and may not be determinable until after the period for filing an AAR has expired." There does not appear to be any good reason not to allow similar protective AARs to deal with the possibility of adjusted K-1s being issued by lower tier partnerships.

Incidentally, this is not only a concern under section 6226. Without a solution to this statute of limitations problem the provisions of section 6225 will also not be available with respect to the tax supposedly imposed by section 6226(b). Thus, for example, a partnership that has exclusively tax-exempt partners -- or individual partners in the 15 percent bracket, all of whom are willing to file amended returns paying taxes on the adjustment at that rate -- would be subject to an entity-level tax at the top individual rate on any amounts reported on an adjusted K-1 by an audited partnership.

In addition, regulations should clarify that partnerships that have elected out of the new rules should be able to file AARs if they receive adjusted K-1s from lower-tier partnerships, and that partnerships should be able to file AARs that apply solely to the items on any adjusted K-1s they receive -- without reopening the entire return -- at least where the sole purpose for filing the AAR is to avoid what we believe to be a technical omission. That is, section 6226 should include a simple statement: "In the case of any partner that is a partnership, unless the partner elects to apply section 6225 to the amounts reported to it under section 6226(a), the partner shall be subject to the requirements of section 6226(a) with respect to such amounts." Presumably, this rule should apply even to partnerships that have opted-out of the new rules.

Assuming that a timely and valid election under section 6227 is in place for a PSP that has received an adjusted K-1, and assuming that the PSP has elected to apply section 6226, what are the main issues that will arise, in addition to those we have addressed in the context of a single-tier arrangement?

In such cases the IRS will be required to obtain the original returns of the non-existent PSP for that year, make reasonable allocations of the statement information to its partners, and issue them adjusted K-1s -- or perhaps even direct tax bills to those partners that are individuals, corporations or trusts. Even if this had to be done for a considerable number of PSPs, it would still seem to be a major advance over the TEFRA rules, where something very similar has to be done for every PSP. If this becomes a major administrative problem down the road, statutory or regulatory revisions could be considered to help ensure that PSPs make suitable arrangements that will remove this burden from the IRS.

In that regard, there is a significant potential problem with the literal language of section 6226(b) as it applies to situations where a partnership adjustment results in an overpayment for certain partners for certain years. Although a technical correction would be ideal, it may be possible to address the problem under the broad regulatory authority of section 6225(c)(6).¹³

In its simplest form, the problem would arise if a hypothetical partnership adjustment for 2018 and 2019, in an audit concluded in 2025, concluded that the partnership had reported $200,000 of income for 2018 that should properly have been reported in 2019. Assuming that $100,000 were allocable to a corporate partner taxable in 2019 at the 35% rate, that should give rise to an overpayment of $35,000 for 2018 and an underpayment of $35,000 for 2019. In other words, no taxes should be due and the IRS should pay the corporate partner interest for paying his taxes too early. Under the literal language of section 6226(b), it appears that the corporate partner receiving an adjusted K-1 would be liable to pay additional taxes -- with its 2025 return -- of $35,000 with respect to 2019 without any credit or offset for the overpayment of $35,000 for 2019. In addition, 7 years of interest would be due to the IRS. There are myriad other examples, including situations where the adjustment shifts income from one partner to another, or a partner who theoretically underpaid taxes in one year also theoretically understated a basis adjustment and thus theoretically overpaid taxes in a later year on the sale or disposition of the partnership interest.

Although such problems could all be addressed, without regard to the statute of limitations, under section 6225(c)(2), that process could be cumbersome for the IRS and very cumbersome for all concerned in the case of a multiple tier partnership.

In our view, Congress could not have intended to collect taxes from partners when it was clear that there were no underpayments, or to collect underpayment interest from partners that bears no relationship to the period of any underpayments. Accordingly, the IRS should consider issuing regulations to clarify that the total of the positive or negative adjustments to a partner's tax required under section 6226(b)(2) for the current year should equal the total amounts that would be due to the IRS, or refunded to the taxpayer, if amended returns for all affected years prior to the current year were filed (notwithstanding any limitations otherwise imposed by section 6511) solely reflecting the effect of the partnership adjustments on the partner's tax under chapter 1, together with any interest or penalties that would have been applicable thereto.

In addition, as regards penalties, regulations should clarify that a partner's potential liability for a penalty should be determined at the partnership level, insofar as the liability would turn on the behavior of the partnership (such as negligence or disregard of rules and regulations in connection with return filing, or lack of substantial authority for a position). However, the amount of any penalty should be determined at the partner level. Thus, for example, if a tax-exempt partner has no underpayment of tax, there should be no related penalty even if the position would have given rise to a penalty for disregard of rules and regulations if it had caused any underpayment. Similarly, if a position was taken without substantial authority, but it did not give rise to a substantial understatement with respect to a particular partner, that partner should not bear any substantial understatement penalty.

² See, Tax Policy Advisory Committee of the Real Estate Roundtable, "Improving the Partnership Audit Process" (Sept. 2015), Donald B. Susswein and Ryan P. McCormick, "Fixing the Partnership Audit Process," Tax Notes, Oct. 5, 2015, Donald B. Susswein and Ryan P. McCormick, "Understanding the New Partnership Audit Rules," Tax Notes, December 2, 2015.

³ Those rules require a recalculation of income taxes for prior years when estimates that were properly used to file prior returns vary from the taxpayer's actual later experience. Interest is then paid by the taxpayer in the current year to compensate for any unwarranted tax deferral in past years resulting from estimates that later proved to be inaccurate.

⁴ In addition, special issues may arise in the case of trusts and S corporations that receive adjusted K-1s issued under section 6226. It is unclear whether they will require clarifying legislation or may be dealt with in regulations. The process issues are similar to those discussed here, but the technical issues are beyond the scope of this paper.

⁵ As to issue 6-a in the Notice, no information appears to be needed other than the fact of the election. Elsewhere, we suggest that at the commencement of the audit the IRS should compile a list of all of the partnerships that were direct or indirect partners in the audited partnership. This can readily be done by examining the original return of the audited partnership, that of each partner that was a partnership, and so on.

For a number of reasons, the IRS might wish to consider providing a box on the original partnership return in which the section 6226 can be elected in advance, for the avoidance of uncertainty. The partnership would then retain the right to revoke the election until 45 days after the issuance of an NFPA, or later with the permission of the IRS. In addition, the IRS might consider making such an election automatic or mandatory for all returns that are open when any final return of a partnership is filed. This appears to be what is contemplated by section 6241(7) for a partnership that "ceases to exist."

⁶ The statute should be interpreted and applied to relieve the partnership of any risk of an entity-level tax upon a good faith election to apply section 6226. Thereupon, the full panoply of civil and potentially criminal penalties should apply to any partnership that fails to comply with section 6226(a), in the same manner as those provisions apply to failures to comply with the provisions of section 6031 with respect to an original return.

Although we think there is regulatory authority to achieve this result, Congress could consider a technical correction or clarifying amendment that might add to Section 6226(a) language like the following: "Following an election under this section, any failure to furnish such statements may be treated as a failure by the partnership and its agents to comply with section 6031 and may be treated in whole or in part as if the partnership ceased to exist under section 6241(7) but shall not result in the application of section 6225."

⁷ See, e.g., TIGTA report on September 25, 2006 on the Schedule K-1 Matching Program (https://www.treasury.gov/tigta/auditreports/2006reports/200630159fr.html).

⁸ One alternative, subject to possible concerns arising under section 6103, would be for the IRS to provide the partnership with the IRS' most recent address for a given TIN -- based on the most recent return filed. Although some taxpayers might have moved and left no forwarding address since the filing of their most recent tax return, this should eliminate the lion's share of missing or incorrect addresses. Even if a reasonable user fee were charged for such a service it might be the most economical result overall, since the information appears much more readily available to the IRS than to the partnership. Regarding section 6103, if providing the address would be a violation of that provision, and no legislative solution to that problem is forthcoming, the IRS could allow partners to provide their partnerships with an anticipatory waiver of section 6103 solely for the purpose of allowing the IRS to provide its most current address for a given TIN. Finally, if all else fails, it would seem that the IRS audit team could, in the case of former partners where the partnership appears to lack an accurate current address, transmit the adjusted K-1 information directly to the last address for the taxpayer that is known to the IRS, based on the most recently filed return, perhaps seeking confirmation that it has been received. In the relatively rare case where it is not received because the taxpayer has moved, it could be resent the following year immediately after the filing of the taxpayer's next return.

⁹ According to the recently issued Bluebook, an upper-tier partnership that receives an adjusted K-1s from a lower-tier partnership is subject to tax under section 6226(b) -- unless it elects to apply provisions similar to section 6226(a) which it may due upon filing a timely AAR under section 6227. As a purely technical matter the first point is open to question. In the case of adjustments to the reviewed year, the statute provides for an addition to "each partner's tax imposed by chapter 1 for the taxable year which includes the date the statement was furnished." The addition to tax is equal to "the amount by which the tax imposed under chapter 1 would increase if the partner's share . . . [of the audit adjustments] were taken into account for such taxable year." That amount appears to be zero, inasmuch as no partnership would incur any increase in any tax imposed under chapter 1 on account of any additional amount of taxable income.

It is true that section 6221 speaks of any tax attributable to an adjustment being "assessed and collected . . . at the partnership level pursuant to this subchapter." But this language appears to be merely descriptive, not prescriptive. Even if there is a determination under section 6221 that a partnership has more income than it reported, no tax can be assessed and collected on a partnership with respect to that income, under section 6221, if there is no provision there or elsewhere in the Code imposing a tax. Typically, that would require some statutory provision specifying a tax base and a tax rate to be applied to that base for a particular category of taxpayer. Section 6221 does not provide any information as to what the tax base is or what the tax rate is. It is only section 6225, where applicable, that provides a tax rate to apply to certain items of a partnership. Section 703 is not to the contrary, since it only provides that the partnership's income is computed as if it were an individual. It does not provide for the determination of any tax as if the partnership were an individual.

This is evidently why sections 6225 and 6232 were needed, in the first instance, to impose an entity level tax, even under prior versions of the legislation. If partnerships were subject to tax as individuals under chapter 1, then once an FPA were issued the IRS could have assessed the tax against the partnership under sections 6201 and 6212. There would have been no need for sections 6225 and 6232. The drafters of predecessor bills, as well as this law, evidently realized that the IRS could not have assessed any tax under chapter 1 against a partnership, due to the clear language of section 701.

This reading of the statutory language does not create a loophole or produce an absurd result, although it does impose an administrative burden on the IRS. If section 6226(b) does not override or displace section 701, the IRS can protect the government's interests by placing the upper-tier partnership under audit and issuing it a NFPA the amounts shown on the adjusted K-1 of the audited partnership. This is not that different from what occurs under TEFRA. If there were a concern with expiring statutes, all of the partnerships in a tiered arrangement could be put under near simultaneous audit. This would obviously be cumbersome for the IRS, which is why we believe a technical correction is warranted.

¹⁰ We note that many partners who invest in partnerships may wish to ensure that their partnership agreements require those partnerships -- and any partnerships in which they may invest -- to keep the partners at each level informed of the years of any lower tier entities that are still open. This will help enable PSPs to ascertain the point when there are no open years of any partnerships in which they are direct or indirect partners. At that point, they can relatively safely liquidate or terminate without making extensive arrangements for continuing representation to handle adjusted K-1s.

¹¹ As discussed above, we note that many partners who invest in partnerships may wish to ensure that their partnership agreements require those partnerships -- and any partnerships in which they may invest -- to keep the partners at each level informed of the years of any lower tier entities that are still open.

¹² For example, there will be no need for the IRS to confirm representations regarding the applicable tax rates of any partners, and no need to review and approve amended returns of partners before closing the partnership audit.

In addition, when the liability for taxes arising from a partnership audit is borne by the ultimate taxpayers, it may be far easier for the IRS to reach a settlement with the partnership on the substantive matters potentially in dispute. Indeed, where the partners disagree on the appropriate handling of a dispute at the partnership level, section 6226 may enable the IRS to continue to deal with only a single partnership representative -- unlike TEFRA -- but still effectively enter closing agreements at the partnership level that quickly resolve a dispute (and collect added taxes) from certain partners willing to accept a settlement, while the partnership continues to pursue the controversy exclusively on behalf of any dissenting partners. For example, a partnership-level closing agreement could provide for the issuance of certain adjusted K-1s to certain partners willing to settle, while the partnership continues to dispute an adjustment, the consequences of which would only affect the amounts ultimately contained on the adjusted K-1s issued to the other partners.

Interestingly, and perhaps ironically, that approach may also tend to encourage settlement, even by those inclined to dissent, because they will presumably have to bear the full costs of pursuing matters at the partnership level after other partners have settled their ultimate tax liability, and are no longer affected by any further proceedings.

¹³ Section 6225(c)(6) provides the Treasury with broad authority to reduce the imputed underpayment on the basis "such other factors as . . . are necessary or appropriate to carry out the purposes" of section 6225. In theory -- even if section 6226 did not exist -- the Treasury would seemingly have the authority to provide that the imputed underpayment would be reduced to zero if the partnership agreed to issue adjusted K-1s to its partners and those partners agreed to include an appropriately computed tax on their share of the adjustment so reported, either in their current year returns or in amended returns filed after the closing of the partnership audit. That would certainly be consistent with the policy of section 6225(c)(2) -- with the variances being that the amended partner returns would be filed after the partnership audit, and not in resolution of that audit, that such amended returns could be effectively filed as attachments to the current return, and that they would be limited to changes resulting from the partnership adjustments.

If that authority would theoretically exist, it would appear that the Treasury would similarly have the authority to provide for a modification of the computations required under section 6226(b) to provide results closer to those that would apply if actual amended returns had been filed under section 6225(c)(2).

In our view, regulations pursuant to section 6225(c)(6) should provide that the total of the positive or negative adjustments to a partner's tax required under section 6226(b)(2) for the current year will equal the total amounts that would be due to the IRS, or refunded to the taxpayer, if amended returns for all affected years prior to the current year were filed (notwithstanding any limitations otherwise imposed by section 6511) solely reflecting the effect of the partnership adjustments on the partner's tax under chapter 1, together with any interest or penalties that would have been applicable thereto.

In order to provide certainty to the markets on an expedited basis, Congress could also consider a technical correction or clarifying statutory amendment that would include in section 6226 language like the following: "In all events, the total of the positive or negative adjustments to a partner's tax for the year in which the statement is furnished or deemed furnished shall equal the total amounts that would be due to the IRS or refunded to the taxpayer if amended returns for all affected years prior to that year were filed (notwithstanding any limitations otherwise imposed by section 6511) solely reflecting the effect of the partnership adjustments on the partner's tax under chapter 1, together with any interest, penalties or other amounts that would have been applicable thereto, and the partner's tax attributes shall be adjusted accordingly."