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Treasury and IRS Release New Round of BBA Partnership Audit Proposed Regulations

Posted on Dec. 14, 2020

Today we welcome back guest blogger Rochelle Hodes, a Principal with Crowe LLP and a former Associate Tax Legislative Counsel in Treasury’s Office of Tax Policy.  Rochelle discusses the new proposed regulations under the BBA partnership audit rules that were released just before Thanksgiving.  While the proposed rules primarily address special enforcement matters, the proposed rules would also amend the final BBA regulations in significant and consequential ways that practitioners and taxpayers ought to be attune to.  Rochelle would like to thank her former government colleague Greg Armstrong, a Director with KPMG LLP, for his helpful review and comments.  Rochelle and Greg worked together on, and continue to update, Chapter 8A in Saltzman Book IRS Practice and Procedure regarding the BBA partnership audit rules. Les

On November 24, 2020, Treasury and the IRS published proposed regulations under the centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015 (BBA).  The BBA regime generally applies to partnership tax years beginning in 2018.  This post addresses proposed §301.6221(b)-1(b)(3)(ii)(G) regarding eligibility to elect out of BBA if a partner is a qualified S corporation subsidiary (QSub), proposed §301.6241-3 regarding treatment of partnerships that cease to exist, and proposed §301.6241-7 regarding treatment of special enforcement matters. In general, the proposed applicability date for these rules is November 20, 2020.

These proposed regulations are being released at the end of a presidential administration.  It is unclear how finalizing these proposed regulations will fit into the new administration’s priorities and whether policy decisions embedded in the proposed regulations will be reconsidered.  However, even with this uncertainty, the proposed regulations are important because they give taxpayers and practitioners a window into the IRS’s thinking on the BBA rules at a time when it is increasing its focus on partnership reporting and compliance.

QSubs

All partnerships required to file Form 1065 are subject to the BBA regime unless the partnership is eligible to elect out of the regime and does so on its timely filed original return.  The election out of BBA is an annual election.  

A partnership is eligible to elect out of BBA if the partnership has 100 or fewer eligible partners.  Partnerships, trusts (including grantor trusts), disregarded entities, and nominees are not eligible partners and therefore partnerships with these types of partners cannot elect out of BBA.

Section 6221(b) specifically provides that an S corporation is an eligible partner.  However, in the case of an S corporation a special rule applies for purposes of determining whether the partnership has 100 or fewer partners.  Under the special rule, all shareholders to whom the S corporation is required to furnish a Schedules K-1, plus the S corporation itself, are counted as a partner to determine whether the number of partners exceeds 100.  

Under the proposed regulations, a QSub is not an eligible partner, and therefore, a partnership with a QSub cannot elect out of BBA.  This is a reversal of the position taken by the IRS and Treasury in Notice 2019-06.  In Notice 2019-06, the IRS identified partnerships that are owned by a QSub as a special enforcement issue because such partnerships could have more than 100 owners when looking through the QSub to the S corporation and its shareholders. Accordingly, Notice 2019-06 stated that generally a partnership with a QSub as a partner would not be eligible to elect out of BBA, but that Treasury and the IRS intended to publish proposed regulations to allow partnerships with QSub partners to elect out of BBA under rules similar to S corporations.   But why did Treasury and the IRS reverse its position in Notice 2019-06?  It appears that a long simmering debate among practitioners about the nature of a QSub may be the cause.  The preamble includes a discussion of two comments addressing a rationale not to prohibit partnerships held directly by a QSub from electing out of BBA: one that relies on the fact that a QSub is a C corporation and the other that relies on the fact that for partnership reporting the S corporation, not the QSub, is treated as the partner.  The preamble then describes the reason for changing the government’s position in Notice 2019-6 as follows:

“Although Notice 2019-06 states that the proposed regulations would have applied a rule similar to the rules for S corporations under section 6221(b)(2)(A) to partnerships with a QSub as a partner, the Treasury Department and the IRS have reconsidered that approach.  Under § 301.6221(b)-1(b)(3)(ii), partnerships that have disregarded entities as partners may not elect out of the centralized partnership audit regime.  QSubs are treated similarly to disregarded entities for most purposes under the Code in that both QSubs and disregarded entities do not file income tax returns but instead report their items of income and loss on the returns of the person who wholly owns the entity.”  

85 FR 74943 (November 24, 2020).

Treatment Where a Partnership Ceases to Exist

Section 6241(7) provides that if a partnership ceases to exist before a BBA partnership adjustment takes effect, such adjustment shall be taken into account by the former partners of such partnership under regulations prescribed by the Secretary.

The current regulations under §301.6241-3 generally provide that partnership adjustments take effect when all amounts due under BBA resulting from the adjustment are fully paid.  The current regulations also provide that the former partners are the partners for the adjustment year with respect to the reviewed year to which the adjustments relate, but if there are no partners in that year, the former partners are the partners during the last taxable year for which the partnership filed a return.

The proposed regulations would modify several parts of the cease-to-exist regulations, but the two most consequential are the rules for when an adjustment takes effect and who are former partners.  The proposed regulations provide that the partnership adjustments take effect when the adjustment becomes finally determined, when there is a settlement, or if the adjustment relates to an item on an administrative adjustment request (AAR), when the AAR is filed.

Under the proposed regulations, former partners would be 1) the partners during the last taxable year for which the partnership filed a return or an AAR or 2) “the most recent persons determined to be partners of the partnership in a final determination (for example, a defaulted notice of final partnership adjustment, final court decision, or settlement agreement) binding on the partnership.”  The proposed regulations do not set up an order of priority of which condition would take precedence.

The preamble to the proposed regulations states that these changes are necessary to coordinate section 6241(7) with section 6232(f), which was enacted by the Tax Technical Corrections Act of 2018.  Section 6232(f) provides that the IRS can assess tax upon the adjustment year partners if the partnership fails to pay the imputed underpayment within 10 days of notice and demand.  Section 6232(f) includes a rule allowing assessment against former partners determined under section 6241(7) if the partnership has ceased to exist.  Though section 6232(f) has been on the Treasury and IRS Priority Guidance Plan for a while now, no guidance under this section has been issued to date.  

Special Enforcement

Section 6241(11) generally provides that in the case of partnership-related items which involve special enforcement matters, the Secretary may prescribe regulations to provide that BBA does not apply to the items and that the items are subject to special rules necessary for the effective and efficient enforcement of the Code.  The statute lists certain special enforcement areas, including termination and jeopardy assessments, criminal investigations, and indirect methods of proof of income.  The IRS had similar statutory authority with respect to special enforcement matters under TEFRA.

In addition to the special enforcement areas described above, the proposed regulations identify other special enforcement matters:

  • Partnership-related items underlying non-partnership-related items.  This provision would allow the IRS to determine that the BBA rules do not apply to adjustments of partnership-related items if all of the following apply:
    • An examination is being conducted of a person other than the partnership,
    • A partnership-related item is adjusted, or a determination regarding a partnership-related item is made, as part of, or underlying an adjustment to a non-partnership-related item of the person whose return is being examined, and
    • The treatment of the partnership-related item on the Schedule K-1 or the partnership’s books and records is based in whole or in part on information provided by the person whose return is being examined.  
  • Controlled partnerships and extensions of the partner’s period of limitations.  This provision would allow the IRS to adjust partnership-related items outside of BBA if the period of limitations to make partnership adjustments under section 6235 has expired but the partner’s period of limitations on assessment for chapter 1 tax has not expired.  This provision applies to direct or indirect partners that are related to the partnership under section 267(b) or section 707(b) or direct or indirect partners that consent to extend the period of limitations to adjust and assess any tax attributable to partnership-related items.
  • Penalties and taxes imposed on the partnership under chapter 1.  This provision would allow the IRS to adjust any tax or penalty imposed on, and which is the liability of the partnership, under chapter 1 of the Code without regard to BBA.  It would also allow the IRS to “adjust any partnership-related item, without regard to [BBA], as part of any determination made to determine the amount and applicability of the tax, penalty, addition to tax, or additional amount being determined without regard to [BBA].  Any determinations under this [provision] will be treated as a determination under a chapter of the Code other than chapter 1 for purposes of § 301.6241-6 [coordination with other chapters of the Internal Revenue Code].”
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