Recently Released Blue Book Addresses Questions Posed by the New Partnership Audit Regime.

(Parker Tax Publishing MARCH 2016)

In the Bipartisan Budget Act of 2015, Congress repealed the TEFRA partnership audit procedures and replaced them with a centralized system for audit, adjustment, assessment, and collection of taxes. Certain eligible partnerships can elect out of the provisions. While the new rules are generally effective for partnership tax years beginning after December 31, 2017, partnerships may elect to apply them to any partnership returns for partnership tax years beginning after November 2, 2015, and before January 1, 2018.

Last week, the Joint Committee on Taxation released the General Explanation of Tax Legislation Enacted in 2015 (JCS-1-16), otherwise referred to as the "Blue Book." The Blue Book, which was prepared by the staff of the Joint Committee on Taxation in consultation with the staffs of the House Committee on Ways and Means and the Senate Committee on Finance, provides further insight into the overhaul of the partnership audit rules and addresses some of the questions that had been posed by practitioners on various aspects of how the new rules might apply.

New Streamlined Audit Approach Audits at the Partnership Level

The main feature of the new audit rules is the streamlined approach to partnership audits. Audits for a particular year will occur at the partnership level. An underpayment of tax determined as a result of an audit of a tax year is imputed to the year during which the adjustment is finally determined, and generally is assessed against, and collected from, the partnership with respect to that year rather than the year being audited.

For purposes of the centralized system, the partnership tax year to which the item being adjusted relates is called the "reviewed year." For example, in an audit of a partnership's 2018 tax year, 2018 is the reviewed year. The "adjustment year" refers to -

(1) in the case of an adjustment pursuant to the decision of a court (under the centralized system's judicial review provisions), the partnership tax year in which the decision becomes final;

(2) in the case of an administrative adjustment request, the partnership tax year in which the administrative adjustment request is made; or

(3) in any other case, the partnership tax year in which the notice of final partnership adjustment is mailed.

For example, in the case of adjustments with respect to a partnership's 2018 tax year resulting in an imputed underpayment assessed in 2020 that the partnership then litigates in Tax Court, the decision of which is not appealed and becomes final in 2021, the adjustment year is 2021.

Under the new rules, any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership tax year, and any partner's distributive share thereof, is determined at the partnership level.

Alternative to Partnership Paying Any Imputed Underpayment - Tiered Partnership Issues and Indemnification Agreements

As an alternative to having a partnership pay an imputed underpayment in an adjustment year, a partnership may elect to furnish to the IRS and to each partner of the partnership for the reviewed year, a statement of the partner's share of any adjustments to income, gain, loss, deduction and credit as determined in a notice of final partnership adjustment. In this case, each such partner takes these adjustments into account and pays the tax. In the case of an imputed underpayment for which this election is made, interest is determined at the partner level and it is determined at a modified and higher rate than that which would otherwise apply. Practitioners had questioned what would happen in a tiered partnership arrangement and what would be the effect of any indemnification agreements protecting reviewed-year partners.

According to the Blue Book, in the case of tiered partnerships, a partnership that receives a statement from the audited partnership is treated similarly to an individual who receives a statement from the audited partnership. In other words, the recipient partnership takes into account the aggregate of the adjustment amounts determined for the partner's tax year including the end of the reviewed year, plus the adjustments to tax attributes in the following tax years of the recipient partnership. The recipient partnership pays the tax attributable to adjustments with respect to the reviewed year and the intervening years, calculated as if it were an individual, for the tax year that includes the date of the statement.

The Blue Book notes that the recipient partnership, its partners in the tax year that is the reviewed year of the audited partnership, and its partners in the year that includes the date of the statement, may have entered into indemnification agreements under the partnership agreement with respect to the risk of tax liability of reviewed year partners being borne economically by partners in the year that includes the date of the statement. According to the Blue Book, because the payment of tax by a partnership under the centralized system is nondeductible, payments under an indemnification or similar agreement with respect to the tax are similarly nondeductible.

OBSERVATION: Because the Blue Book treats the upper-tier partnership as an individual and not as a partnership, it is unclear whether an upper-tier partnership to which adjustments are pushed out can also push adjustments out to its partners. Additional guidance may be required.

Basis Adjustments for Partnership-Level Tax

Under the centralized audit system, the flow through nature of the partnership is unchanged, but the partnership is treated as a point of collection of underpayments that would otherwise be the responsibility of partners. The Blue Book notes that a basis adjustment (reduction) to a partner's basis in its partnership interest is made to reflect the nondeductible payment by the partnership of the tax. Concomitantly, the partnership's total adjusted basis in its assets is reduced by the cash payment of the tax. Thus, parallel basis reductions are made to outside and inside basis to reflect the partnership's payment of the tax.

Clarification of How Opt-Out Election Applies

A partnership may elect out of the centralized system (and it and its partners are governed by the prior rules) for a partnership tax year if it meets certain eligibility requirements. One of the eligibility requirements is that, for the tax year, the partnership is required to furnish 100 or less Schedules K1 with respect to its partners. Another eligibility requirement is that each of the partners is an individual, a deceased partner's estate, a C corporation, a foreign entity that would be required to be treated as a C corporation if it were a domestic entity, or an S corporation (provided special rules are met). The law provides that the IRS may issue regulations or other guidance with respect to how this rule will apply to other partners.

Because partnerships that have a partnership as a partner are not listed as entitles that can opt-out, many practitioners assumed that a tiered partnership could not make the opt-out election. However, the Blue Book seems to negate that assumption. According to the Blue Book, to the extent that such rules are consistent with prompt and efficient collection of tax attributable to the income of partnerships and partners, IRS guidance may provide rules permitting an opt-out election in the case of a partnership (the first partnership) with one or more direct or indirect partners which are themselves partnerships. Under any such guidance with respect to tiered partnerships, the sum of all direct and indirect partners (including each partnership and its partners) may not exceed 100 persons with respect to which a statement must be furnished, and each partner must be identified. That is, eligibility of the first partnership to make the election requires the first partnership to include (in a manner prescribed by the IRS) a disclosure of the name and taxpayer identification number (TIN) of each direct partner of the first partnership and each indirect partner (including each partnership and its partners) in every tier, and requires that each is taken into account in determining whether the 100-or-fewer-statements criterion is met.

Practitioners had several other questions as to how the opt-out provision might apply. One question, for example, was how this provision might apply where a partnership has a disregarded entity or a trust as a partner, or a C corporation that is a real estate investment trust (REIT) or a regulated investment company (RIC). According to the Blue Book, a C corporation partner that is a REIT or a RIC does not prevent the partnership from being able to elect out, provided the applicable requirements are met. With respect to a partner that is a disregarded entity, the Blue Book has an example which assumes that a partner of a partnership is a disregarded entity such as a state-law limited liability company with only one member, a domestic corporation. According to the Blue Book, IRS guidance in this case may provide that the partnership can make the election if the partnership includes a disclosure of the name and TIN of each of the disregarded entity and the corporation that is its sole member, and each of them is taken into account as if each were a statement (i.e., Schedule K-1) recipient in determining whether the 100-or-fewer-statements criterion is met.

As another example, the Blue Book says that IRS guidance on the opt-out election may provide that a partnership with a trust as a partner can make the election if the partnership includes a disclosure of the name and TIN of the trustee, each person who is or is deemed to be an owner of the trust, and any other person that the IRS determines to be necessary and appropriate, and each one of such persons is taken into account as if each were a statement recipient in determining whether the 100-or-fewer-statements criterion is met. According to the Blue Book, similar guidance may be provided with respect to a partnership with a partner that is a grantor trust, a former grantor trust that continues in existence for the two-year period following the death of the deemed owner, or a trust receiving property from a decedent's estate for a two-year period.

Partners Bound by Actions of Partnership

Under TEFRA, there was a notification requirement where the IRS had to notify partners when an audit was begun and to notify partners of proposed adjustments. For purposes of the centralized system, the partnership acts through its partnership representative. The Blue Book makes clear that the partnership representative has the sole authority to act on behalf of the partnership under the centralized system. Under the centralized system, the partnership and all partners of the partnership are bound by actions taken by the partnership. Thus, for example, partners may not participate in or contest results of a partnership audit. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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