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Texas Bar Tax Section Issues Comments Regarding New Partnership Audit Rules

By Stephen A. Beck on May 3, 2016

On April 26, 2016, the Tax Section of the State Bar of Texas (“Tax Section”) submitted to the Internal Revenue Service comments (the “Comments”) regarding the implementation of the new partnership audit regime (the “Partnership Audit Rules”) that was enacted as part of the Bipartisan Budget Act of 2015. Stephen Beck of Meadows Collier participated as a principal drafter of the Comments in his capacity as Vice Chair of the Tax Section’s Partnerships and Real Estate Committee. Click here for a copy of the Comments.

The Partnership Audit Rules are effective for partnership tax years beginning after December 31, 2017 and will drastically change the manner in which tax liability resulting from partnership adjustments will be assessed and collected. Under the Partnership Audit Rules, the partnership itself generally will be liable for payment of tax resulting from a partnership adjustment. In contrast, under the partnership audit rules that are currently in effect through year-end 2017 (the “TEFRA Rules”), the adjustment is made at the partnership level, but the Internal Revenue Service (“IRS”) assesses and collects the resulting tax from the partners of the partnership for the year for which the adjustment was made.

The Comments address and provide suggestions with regard to many different issues arising under the Partnership Audit Rules. Certain of those issues and suggestions are summarized below. 

1.         The Election Out From the Partnership Audit Rules.

The Partnership Audit Rules provide that a partnership may elect out of the application of the Partnership Audit Rules (the “Election Out”), provided that: (i) each of its partners is either an individual, C corporation, foreign entity treated as a C corporation, S corporation, or estate of a deceased partner; and (ii) the partnership has 100 or fewer partners, which is determined based on the number of Schedules K-1 issued by the partnership. See I.R.C. § 6221(b)(1) (2018). If a partnership elects to avail itself of the Election Out, the audit rules generally applicable to taxpayers will apply to the partners of that partnership. Accordingly, the tax liability from a partnership would be determined in a separate deficiency proceeding for each partner of that partnership.

The Partnership Audit Rules, however, do not specify how the Election Out requirements are applied in the context of a partnership that has at least one partner who owns his/her interest in that partnership through an entity that is disregarded for federal income tax purposes (a “DRE”). The Comments suggest that the Treasury Department (“Treasury”) promulgate rules to disregard the separate existence of a DRE for purposes of the Election Out requirements, both for determining whether: (i) each of the partners of the partnership is an eligible partner; and (ii) the partnership has more than 100 partners.  See Comments at 5-6. Likewise, the Comments suggest that Treasury promulgate rules to disregard the separate existence of a grantor trust for purposes of the Election Out requirements. See id. at 7.

In addition, the Election Out is not available to a partnership that has as one of its partners another partnership (i.e., an “upper-tier partnership”) or a trust. See I.R.C. § 6221(b)(1)(C) (2018). Congress, however, has authorized Treasury to prescribe Election Out rules for partnerships with other types of partners that are not explicitly listed as eligible partners under the Partnership Audit Rules. See I.R.C. § 6221(b)(2)(C) (2018).

Accordingly, the Comments suggest that Treasury prescribe rules that would provide limited eligibility for the Election Out by partnerships with partners that are trusts or upper-tier partnerships. See Comments at 8. The Comments also suggest a potential framework Treasury could use as the basis for its rules allowing limited use of the Election Out by a lower-tier partnership with a partner that is an upper-tier partner. See id. 

The Partnership Audit Rules also do not address the impact of community property laws for purposes of the Election Out’s 100 partner limit. The Comments suggest that Treasury treat a married couple in a community property jurisdiction as a single shareholder for purposes of the 100 partner limit. See id. 

2.         Partnership Representative.

Under the Partnership Audit Rules, the partnership must designate a “partnership representative” (the “Partnership Representative”) to handle tax matters with the IRS. I.R.C. § 6223(a) (2018). The Partnership Representative is similar to the “tax matters partner” (the “TMP”) under the TEFRA Rules, but the Partnership Representative in some ways has broader authority than the TMP. The Partnership Audit Rules provide that the Partnership Representative is the only person who has authority to act on behalf of a partnership during a partnership audit, and the Partnership Representative’s actions are binding on all former and current partners. See id. 

The Partnership Audit Rules provide that, if the partnership does not designate a Partnership Representative, then the IRS has the authority to select “any person” as the Partnership Representative. See id. The Partnership Audit Rules merely provide that the Partnership Representative must be a “partner (or other person) with a substantial presence in the United States” and do not otherwise provide any limiting criteria for whom the IRS may appoint as Partnership Representative. Id. 

The Comments suggest a criterion for IRS selection of the Partnership Representative. See Comments at 10. Under the suggested criterion, the IRS would generally automatically designate as the Partnership Representative the partner with the largest profits interest that has a substantial presence in the U.S. Similarly, the Comments suggest other criteria for the IRS’s selection of the Partnership Representative when none of the partners of the partnership have a substantial U.S. presence. See id. at 11.

3.         Partnership Level Assessment.

The general rule under the Partnership Audit Rules is that the partnership itself is liable for payment “in the adjustment year” of the tax liability resulting from the partnership adjustment. I.R.C. § 6225 (2018). (This general rule is hereafter referred to as the “General Method.”) Thus, under the General Method, the partners of the partnership for the adjustment year (generally, the partnership taxable year in which the IRS audit is finally resolved) (the “Adjustment Year”) bear the economic burden of the tax liability resulting from a partnership adjustment, notwithstanding that a different set of partners for the partnership tax year that was the subject of the audit (the “Reviewed Year”) may have received the tax benefits that gave rise to that partnership adjustment. 

The Partnership Audit Rules do not provide clarity regarding the effect of the partnership’s payment of tax on the Adjustment Year partners’ tax attributes in the partnership. As a result, the Comments suggest an example that could serve as the basis for a regulatory example to illustrate the manner in which the partnership’s tax payment would affect the amount of an Adjustment Year partner’s outside basis and capital account. See Comments at 12-13.

The Partnership Audit Rules also provide an exception (the “Amended Return Exception”) to the General Method through which one or more Reviewed Year partners may file an amended return for the Reviewed Year to report and pay the tax resulting from their allocable share of the partnership adjustments. See I.R.C. § 6225(c)(2) (2018). The Comments suggest an example that could serve as the basis for a regulatory example to illustrate the tax effects of the Amended Return Exception on the Adjustment Year partners’ outside bases and capital account balances. See id. at 14.

The Comments also highlight a problem under the Amended Return Exception that could result in a Reviewed Year partner effectively being taxed twice on the same partnership adjustment. See id. at 15. The Comments suggest in general terms a potential solution that Treasury could promulgate to prevent the inequitable double taxation result. See id.

4.         Partner-Level Adjustments.

The Partnership Audit Rules provide an exception to the General Method through which the partnership can elect for the Reviewed Year partners to take into account their shares of the adjustments that would otherwise be made at the partnership level. See I.R.C. § 6226 (2018). (This exception is hereafter referred to as the “Alternative Method.”) The Comments suggest an example that could serve as the basis for a regulatory example to illustrate the manner in which partner-level adjustments would impact the Reviewed Year Partners. See Comments at 16-18.

The Comments also highlight an issue through which the Alternative Method could essentially result in the Reviewed Year Partner paying tax twice in connection with a single partnership adjustment. See id. at 17-18. The Comments suggest in general terms a potential solution Treasury could promulgate to prevent the double taxation of the Reviewed Year Partner. See id. 

In addition, the Partnership Audit Rules do not explain the manner in which the Alternative Method would apply in a tiered partnership scenario. As a result, the Comments suggest an example that could serve as the basis for a regulatory example to illustrate the potential tax effects to an upper-tier partnership of a lower-tier partnership’s election to utilize the Alternative Method. See id. at 18-19.

5.         Partnership Administrative Adjustment Requests.

The Partnership Audit Rules provide that a partnership may file a request for an administrative adjustment (“AAR”) for any partnership tax year. See I.R.C. § 6227 (2018). Because of the wording of the Partnership Audit Rules, however, it is unclear whether a partner could ever claim a refund in connection with an AAR. The Comments suggest that Treasury promulgate rules to make clear that a partner may claim a refund in connection with an AAR. See Comments at 21.

6.         Partner Notice Rights.

The Partnership Audit Rules require that Treasury mail to the “partnership and partnership representative” certain notices relating to the partnership audit. See I.R.C. § 6231 (2018). The Partnership Audit Rules, however, do not contain any obligation on the part of any person to provide notice to the partners of the partnership or otherwise keep them informed of the partnership audit. 

The TEFRA Rules, in contrast, require that Treasury generally must provide notice to each partner regarding the beginning of an administrative proceeding at the partnership level and the final partnership administrative adjustment resulting from that proceeding. See I.R.C. § 6223. The TEFRA Rules also provide that the TMP must keep each partner informed of all administrative and judicial proceedings relating to the partnership adjustment. See I.R.C. § 6223(g).

As mentioned above, the Partnership Representative in some ways has more authority than the TMP. As a result, partners of a partnership are in at least as much need of information relating to the partnership proceeding under the Partnership Audit Rules as they are under the TEFRA Rules. The Comments therefore request that Treasury promulgate rules that would require the Partnership Representative to keep the Adjustment Year Partners informed of important steps of the partnership audit to the same extent as is presently required under the TEFRA Rules. See Comments at 21.

7.         Statute of Limitations.

The Partnership Audit Rules provide a limitations period within which the IRS generally must make an adjustment. See I.R.C. § 6235(a) (2018). In particular, the Partnership Audit Rules provide that the limitations period for making an adjustment generally expires on the date that is 330 days after the date of the Service’s notice of proposed partnership adjustment (“NPPA”). See I.R.C. § 6235(a)(3) (2018). The Partnership Audit Rules, however, do not explicitly establish any timeframe by which the Service must issue the NPPA. As a result, the Comments request that Treasury promulgate rules to clarify the timeframe within which the NPPA must be issued and that the issuance of the NPPA will cause the extension of the statute of limitations for making an adjustment only with respect to the issues addressed in that NPPA. See Comments at 23.

Conclusion

As discussed above, the Partnership Audit Rules will cause significant changes to the manner in which the IRS audits and collects taxes from partnerships. Moreover, the Partnership Audit Rules may significantly impact which partners will bear the economic burden of taxes from the partnership. If anyone has any questions or would like to discuss the potential impact of the Partnership Audit Rules in their particular situation, please call Stephen Beck at 214-749-2401.