Technical Corrections Provisions Impact Partnership Audit Rules
Over recent months, taxpayers, professional tax advisors and commentators have rightfully focused on the provisions of the 2017 Tax Cuts and Jobs Act (“TCJA”), perhaps the most significant tax legislation in the last 30 years. However, other legislation enacted during this period has also contained important tax provisions – namely, the Consolidated Appropriations Act, 2018. While the focus of that bill was the continuation of funding of U.S. government programs through September 30, 2018 (the federal government’s fiscal year-end), it contained overdue technical corrections (the “Technical Corrections”) to legislation that previously overhauled partnership audit rules. With the exception of one provision dealing with the taxation of grain cooperatives, the Technical Corrections do not address the myriad of provisions in the TCJA that need correction; that will require another legislative vehicle.
Background – Bipartisan Budget Act of 2015
As we have previously reported, the partnership audit rules were substantially overhauled in 2015 as part of the Bipartisan Budget Act of 2015 (the “BBA”). Generally effective for taxable years beginning after December 31, 2017, the BBA repealed the Tax Equality and Fiscal Responsibility Act of 1982 and electing large partnership rules and replaced them with a single set of rules for auditing partnerships and partners at the partnership level. As enacted in the BBA, the IRS will examine a partnership’s items of income, gain, loss, deduction, credit and partners’ distributive shares for a particular year of the partnership year (the “reviewed year”), with adjustments taken into account by the partnership in the year the audit or judicial review is completed (the “adjustment year’) rather than the reviewed year. Any tax deficiency arising from the partnership level adjustment (the “imputed underpayment”) is calculated using the maximum statutory individual and corporate income tax rates.
However, the imputed underpayment may be reduced (a) to the extent partners voluntarily file amended returns for the reviewed year, the returns take into account all adjustments properly allocable to such partners and any tax due by such partners for the reviewed year is paid with the returns or (b) if the partnership demonstrates that a portion of the imputed underpayment is allocable to partners that are tax-exempt or are taxed at lower than the maximum corporate or individual tax rate used in computing the imputed underpayment.
In lieu of taking adjustments at the partnership level, the partnership can elect (the “push-out” election) to issue adjusted Form K-1s to the reviewed year partners. Those partners then take their share of any adjustments into account on their individual returns in the adjustment year, together with interest and penalties running from the reviewed year.
Meanwhile, partnerships with 100 or fewer partners are able to elect out of the new regime for any tax year provided that each partner is an individual, a C corporation, certain foreign entities, an S corporation or an estate of a deceased partner.
The Technical Corrections
Following are key highlights of the Technical Corrections made to the partnership audit rules.
- As previously noted, the provisions, as originally enacted, applied to “items of income, gain, loss, deduction or credit.” Instead, the Technical Corrections refer to adjustments to “partnership-related items.” That is generally defined as any item or amount with respect to the partnership which is relevant in determining the income tax liability of any person, without regard to whether the item or amount appears on the partnership’s return and including any imputed underpayment and any item or amount relating to partnership transaction, basis or liability. It also includes any partner’s distributive share of any such amount or item. This is clearly a significant expansion of scope. For example, because a partnership-related item includes an item or amount relating to any transaction with the partnership, an item or amount relating to a partner’s transaction with a partnership other than in his capacity as a member of the partnership is a partnership-related item for this purpose.
- The Technical Corrections clarify that the partnership audit rules do not apply to any tax imposed or withholding required under the self-employment tax, the net investment income tax, the nonresident alien and foreign corporation withholding provisions or FATCA withholding. However, a partnership adjustment with respect to income tax is taken into account for purposes of determining the tax under these provisions. So, for example, if a partnership adjustment results in a change in the amount of income of an individual from a partnership, the change is reflected as required in the calculation of the individual’s net earnings from self-employment with respect to the partnership, and the self-employment tax may be collected through a process outside the partnership audit rules.
- In determining the amount of the imputed underpayment, items of different character, either capital or ordinary, may not be netted together to determine an imputed underpayment. This netting rule may result in higher imputed underpayments.
- The Technical Corrections address the situation of a partnership (or an S corporation) that is a direct or indirect partner of an audited partnership (i.e., a tiered structure) which has elected to push-out adjustments of partnership-related items to partners (or S corporation shareholders). The provision sets forth applicable requirements and the time frame for satisfying these requirements.
- New “pull-in” procedure: The Technical Corrections provide an alternative procedure to filing amended returns. Under this pull-in procedure, the IRS determines the partnership’s imputed underpayment as reduced by the portion of the adjustments to partnership-related items that direct and indirect reviewed-year partners take into account and with respect to which those partners pay the tax due, provided the requirements of the pull-in procedure are met.
Under this procedure, reviewed-year partners pay the tax that would be due with amended returns, make binding changes to their tax attributes for subsequent years and provide the IRS with the information necessary to substantiate that the tax was correctly computed and paid. However, partners do not file amended returns. As noted in the Joint Committee on Taxation technical explanation, “[t]hus, there are generally not corollary effects on the partners’ returns beyond the effects on tax attributes, in other taxable years, of the adjustments to partnership-related items.
“Pull-in” is available generally to direct and indirect reviewed-year partners, in the case of tiered partnerships. And, it does not require the participation of all direct and indirect reviewed-year partners of the partnership.
- The interest rate on amounts owed, after an assessment, upon a partnership’s failure to pay an imputed underpayment within ten days after the IRS provides notice and demand, is increased to the federal short term rate (determined monthly) plus five percentage points (from three percentage points). An S corporation and its shareholders are treated like a partnership and its partners under this provision. A partner is liable for no more than the partner’s proportionate share of the imputed underpayment, interest and penalties, measured on the basis of the partner’s distributive share, with the aggregate proportionate shares totaling 100%. The distributive shares set forth in the partnership agreement, or as determined for purpose of Schedule K-1, may serve as a measure of a partner’s proportionate share. Partner payments under this provision reduce the partnership’s liability to pay. However, the partnership’s liability is not reduced by partner payments made after the date on which the partnership pays. For purposes of this provision, an S corporation and its shareholders are treated in same manner as a partnership and its partners.
Tax, interest and penalties on the proportionate share of each partner (as of the close of the adjustment year of the partnership) can be assessed without regard to normal deficiency procedures generally applicable to income tax. However, assessment may not be made (or proceeding in court without assessment) after the date that is two years after the date on which the IRS provides notice and demand.
- Before the due date for payment of an imputed underpayment, a partnership (or in certain specified cases a partner) may make a cash deposit to suspend the running of interest. The deposit is not treated as a tax payment.
With the calendar well into 2018, the new partnership audit rules are now a reality. It is incumbent on existing partnerships and partnerships under consideration to evaluate the impact of these rules on their operations and documentation and to take all appropriate actions.
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