Spending Bill Corrections Raise Specter of the Partnership Audit Rules (article)
President Trump on March 23 signed into law the Consolidated Appropriations Act, 2018 (CAA), providing for government funding through the end of the fiscal year. Included in the CAA were changes and corrections to the partnership audit rules. When the partnership audit rules were originally introduced in the Bipartisan Budget Act of 2015 (BBA), the rules included numerous provisions that were unclear or unfair. Congress proposed legislation in 2016 to fix these perceived ambiguities or slights. The legislation, however, never passed. The IRS subsequently published proposed regulations that embraced many principles of the draft legislation, and the legislative changes to the partnership audit rules confirm these principles. Most of the changes to the partnership audit rules are innocuous, and indeed some are very favorable. But other changes in the CAA are deterimental; regardless, these provisions emphasize the harsh reality that the new rules are now in effect.
The new partnership audit rules were created under the BBA and overhaul the process by which the IRS will conduct audits of partnerships and LLCs treated as partnerships (collectively partnerships, and partners and members of LLCs will collectively be referred to as partners). The rules are effective for tax years beginning after Dec. 31, 2017, and are designed to make it easier for the IRS to collect underpaid tax attributable to partnerships.
The provisions include a default rule that makes the partnership liable for payment of tax attributable to adjustments discovered during an audit. Several options are provided to shift the tax payment responsibility back onto the partners, but it takes informed and timely decisions by the partnership representative to accomplish this result. In many cases, the tax consequences from these choices will favor certain partners while costing other partners. Conflicts of interest and adversarial situations are prone to arise without careful planning, and every partnership is strongly encouraged to review and amend the partnership or LLC agreement to address these situations before an audit commences.
As noted above, the changes to the partnership audit rules included with the CAA track closely with the 2016 draft legislation. One significant change made by the CAA to the rules relates to push-out adjustments.
Push-out Adjustment Changes
Generally, a partnership can make a push-out election during an audit that has the effect of pushing audit adjustments out of the partnership and onto the same partners as the tax year being audited (reviewed year partners). This is one example of the partnership’s options to shift the tax payment responsibility back onto its partners. Under the BBA however, it was uncertain whether the partnership could effect a push-out election through tiers of ownership in situations where the audited partnership had other partnerships or S corporations (collectively, pass-through partners) as direct partners.
After some hesitation, the IRS proposed a procedure that would permit an audited partnership to implement a push-out election through all tiers of ownership. This proposed regulation allows audited partnerships to push out audit adjustments through each tier to the ultimate indirect owners, or alternatively, any pass-through partner can choose to pay its share of tax as though it were a taxable entity in lieu of pushing the adjustment further.
The changes in the CAA officially conform to these principles. The CAA requires that any pass-through partner must file a tracking report to specify information pertaining to its subsequent push-out adjustments, and that the pass-through partner must then disseminate push-out statements to its partners or shareholders (indirect owners), or alternatively pay its share of tax as though it were a taxable entity. These same procedures are applicable at each successive ownership tier.
The due date for the filing of the tracking report, push-out statements, and tax under the push-out election (collectively Tier Reports) is the return due date (including extensions) for the adjustment year of the audited partnership. The adjustment year generally is the tax year during which the notice of final partnership adjustment (NFPA) is mailed. For example, an audit of the 2018 tax year that results in the mailing of an NFPA in 2020 means the Tier Reports are due by the extended due date of the audited partnership’s 2020 tax return. Depending on when during 2020 that the NFPA letter is mailed, this could leave very little time for pass-through partners to complete these Tier Reports, particularly when there are many tiers of ownership. Additionally, interest accrues on any tax due from the time of the indirect owner’s original tax payment due date through the due date of the additional tax payment under the push-out election. Indirect owners are permitted to make a deposit prior to the due date of the payment under the push-out election in order to toll the continuing interest charge.
The tiered push-out availability under the CAA is one way that the push-out election was made more desirable. Another major change made to the push-out election was the elimination of the “increases only” rule. The BBA originally required that only increases (unfavorable audit adjustments) could be taken into account by partners under a push-out election. The CAA removed this restriction; partners now can take into account decreases (favorable audit adjustments) applicable under a push-out election. This resolves major problems possible under the former law, particularly where partners are required to capture the effects of audit adjustments from one year for intervening years (the years between the reviewed year and the adjustment year). For instance, an unfavorable adjustment to the partner’s reviewed year could cause a collateral favorable adjustment to the partner’s subsequent year, and under the BBA that collateral adjustment was apparently lost. Because the CAA now permits favorable adjustments under a push-out election, this whipsaw situation will not result.
No Escape from Self-Employment and Net Investment Income Tax
Some partnerships may find the default rule, where the partnership is liable for tax payment resulting from audit adjustments, desirable. This might be because the adjustments are small, or because there is a large partner population. In either case, the partnership’s tax payment would be an administrative convenience for the partners, as they would not be required to amend returns and to calculate and pay income tax resulting from the partnership’s audit adjustments. This remains a viable strategy, but it only works for income tax.
The CAA clarified that a partner remains liable for self-employment tax and net investment income tax that results as a consequence of the partnership’s audit adjustments. Worse yet, these taxes are assessed and collected outside of proceedings under the new partnership audit rules. This is a perilous situation for partnerships and partners selecting the default rule, because it means two separate procedures apply to audit adjustments, and that partners will not be insulated from audit adjustments under the default rule in the manner they expected. Any income tax resulting from an audit adjustment is paid by the partnership, but the partnership cannot pay any self-employment or net investment income tax that result from the audit adjustments. Instead, the IRS is authorized to assess the partners individually to collect those taxes.
Even if the IRS does not assess partners for resulting self-employment and net investment income tax, the CAA confirms that these taxes nevertheless are due. Partners therefore are obligated to pay these taxes, and will likely have to prepare and file amended returns. This also means that the partnership must supply each partner with information needed to calculate the self-employment and net investment income tax. Because of the time it takes to complete audits, the statute of limitations may be close to expiring for these affected partners; however, the CAA extends the time for assessing these additional taxes to one year plus 90 days from the mailing of the NFPA (or if later, the date when a decision in a court proceeding becomes final). Because partners cannot escape these responsibilities, the previous strategies for utilizing the default rule will no longer be as desirable.
The CAA made some other important changes to the partnership audit rules. The scope of the rules was broadened to include any item or amount with respect to the partnership that is relevant in determining the income tax liability of any person. This includes an item or amount relating to any transaction with, basis in, or liability of, the partnership. Under the BBA, the scope was defined with reference to income, gain, loss, deduction, or credit, and left some question as to whether other items (such as liability allocations) were covered. With the new rule, items such as liability allocations and a partner’s basis in the partnership interest are included, but only if relevant in determining the partner’s income tax liability. This seems to place the onus of such determination on the IRS, which will necessarily involve added data sharing from the partners.
Another change involves the manner in which audit adjustments can be netted. The BBA provides that favorable adjustments do not produce refunds, and instead are taken into account by the adjustment year partners under the default rule. Unfavorable adjustments are payable by the partnership under the default rule. To implement these principles, the IRS provided in its proposed regulations that certain adjustments cannot offset other adjustments. For instance, items of a different character (capital or ordinary) are not netted, where separate favorable adjustments are taken into account by the adjustment year partners and where the separate unfavorable adjustments are payable by the partnership.
The CAA confirmed and clarified these principles, and also provided that taxpayers cannot net items of partnership loss that could be subject to the passive loss rules of Section 469 . For example, consider an unfavorable adjustment (increase) to interest income, and a favorable adjustment (decrease) to ordinary income. If the decrease to ordinary income is allocable to a partner that could be subject to passive loss rules, then this new rule suggests it cannot be offset--netted--against the increase to interest income. The only situation where a decrease to ordinary income would not be subject to Section 469 is if that provision does not apply to a partner (for example, most C corporations). The CAA indicates that partners will be able to demonstrate that they are not actually subject to Section 469, and that will be one more item needed from them during the audit proceedings to achieve the desired results.
The CAA also added a new procedure by which the partnership may modify the IRS calculation of tax payable by the partnership under the default rule. Referred to as the “pull-in procedure,” some or all of the reviewed year partners calculate and pay individual taxes, and make adjustments to their tax attributes, attributable to partnership audit adjustments. The partners do not actually file amended returns, however. The pull-in procedure essentially is the same as the existing amended return procedure, except no return is filed, and notably, there are no corollary effects of the partners’ recalculated returns on other tax years beyond the effects on tax attributes. The IRS is to provide guidance on how partners report and pay under the pull-in procedure.
One last provision that is significant under the CAA pertains to modification procedures in general. Previously, the modification procedures (including amended return filings and tax rate modification requests that can be used in lieu of the default rules) only applied when some portion of the audit adjustments resulted in a tax payment. This meant that audit adjustments that were purely favorable would not be eligible for a modification procedure; the default rule would be the only option. The CAA removed this restriction, making modification procedures available in any case. Because favorable adjustments under the default rule are allocated only to adjustment year partners (who may not be the same partners as the reviewed year partners), the new availability of modification procedures for purely favorable adjustments allow such allocations to benefit the reviewed year partners.
The technical corrections to the partnership audit rules provided some needed clarification in many areas, together with very favorable changes to the availability of the push-out election. However, the clarifications made to the applicability of self-employment and net investment income taxes will make for a burdensome compliance regime when the default rule is selected. Partners also must be prepared to supply additional information regarding Section 469 in appropriate circumstances. In any event, all partnerships should evaluate changes needed to partnership and LLC agreements to ensure that the rights of the partnership and the partners are protected, together with appropriate protections for the partnership representative. For more information about the new partnership audit rules, please contact your local CBIZ MHM tax professional.
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