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The following items highlight several of the important revisions to the new partnership audit rules that have either been enacted into law by Congress in amending the BBA through the technical corrections legislation passed in March, 2018 or under the final regulations under the electing out provision. Special attention should be given to the new pull-in modification procedure as well as the special assessment and collection provisions contained in new Section 6232(f). Proposed regulations have also been issued on tax attributes and basis adjustments as well on the application of the BBA to the international withholding rules. Final regulations are promised to be issued in the near future on the partnership representative provision. It is anticipated that the regulations projects will be completed sometime in the Fall which would presumably include proposed and temporary regulations on the recent technical corrections made to the BBA.
Final Regulations Issued on Electing-out of the Centralized Partnership Audit Rules: Limitations on Eligible Partners
Under Section 6221(b)(1) certain partnerships can elect out of the centralized partnership audit rules enacted in the Bipartisan Budget Act of 2015, P.L. 114-74, §1101. The partnership, through its designated partnership representative, makes the election-out as to a particular taxable year of the partnership provided it is required to furnish no more than 100 or fewer statements under Section 6031(b)(Forms K-1).
All partners must be “eligible” for the election-out to be filed even if the partnership has only 2 partners. An eligible partner is limited to an individual, a C corporation, any foreign entity that would be treated as a C corporation were it a domestic corporation, an S corporation, or an estate of a deceased partner.
The election-out rule allows each partner to be individually audited and subject to deficiency (and refund) procedures as under pre-TEFRA law and, with respect to the entity level audit rules under TEFRA, under the “small partnership exception”. The small partnership exception was limited to 10 or fewer partners each of whom is an individual (other than a nonresident alien) a C corporation or an estate of a deceased partner. Note that under the new rules, a non-resident alien is an eligible partner. See also Rev. Rul. 2004-88, 2004-2 CB 165. Under TEFRA, a partnership filing an election out was permanent unless revoked with the consent of the Service.
The election-out must be made on a timely filed return for such taxable year, including extensions, must include a disclosure of the name and taxpayer identification number of each partner of the partnership and further requires that the partnership notifies each such partner of the election in the manner provided in the regulations. Special rules apply to a partner which is an S corporation. See §6221(b)(1)(E).
On June 14, 2017, the Treasury Department and the IRS published in the Federal Register ( 82 FR 27334) a notice of proposed rulemaking ( REG-136118-15) proposing amendments to part 301 of title 26 of the Code of Federal Regulations (June 14 NPRM). The June 14 NPRM proposed rules under a number of provisions of the centralized partnership audit regime, including section 6221(b), the election out rule.
The government received much criticism from tax professionals and bar association in submitting requested comments that the limitation on who was an eligible partner was unreasonably restrictive. An ineligible partner would include a grantor of a grantor trust, single owner of a limited liability company, or a trust taxable under Subchapter J. Thus, the formation of a two member LLC with each member being a single member LLC would preclude an election-out.
Despite the calls for a more liberal approach, the Proposed Regulations kept the statutory limitation on the definition of an eligible partner. The Treasury and the Service rejected calls for a more liberal approach to be set forth in the final regulations (or perhaps, if required by technical correction).
The Service and the Treasury on January 2, 2018 (T.D. 9829) issued final regulations under the election out provision in Treas. Reg. §301.6221(b)-1. The final regulations parrot the language in Section 6221(b) in terms of who is an “eligible partner” and in describing the limitation of 100 or fewer partners rule. Treas. Reg. §301.6221(b)-1(b)(3)(ii) identifies persons who are not eligible partners, including (1) a partnership; (2) a trust; (3) an ineligible foreign entity; (4) a disregarded entity under Treas. Reg. 301.7701-2(c)(2)(i); (5) an estate of an individual other than a deceased partner; or (6) any person that holds an interest in the partnership on behalf of another person.
The election-out eligible partner limitation will have an adverse impact on many closely-held partnerships, including family partnerships. It is noted that certain trusts as well a single member limited liability company disregarded as an entity for federal income tax purposes may be a shareholder in an S corporation. An S corporation is an eligible partner.
The Preamble to the final regulations noted that the definition of “eligible partner” may be revisited by the Treasury and the IRS. There is speculation that the government may allow a single member LLC and grantor trust to become an eligible partner in the future.
Rules for Push-out Election under Sections 6226 and 6227 Including Provisions Allowing for Tiered Partnership Structures Adopted by Proposed Regulations and Then Under the Tax Technical Corrections Act of 2018
On December 19, 2017, the Treasury and the Service issued proposed regulations with respect to the push-out election under Section 6226(b). Where an operating or lower-tier partnership makes a valid push-out election, the partnership’s liability for assessment (and collection) for the imputed underpayment, including additions to tax under Section 6225, is generally eliminated
While a literal interpretation of Section 6226(b) might support the view that the push-out election could only move up one level, the June 14, 2017 notice of proposed rule-making, i.e., June 14, 2017 NPRM (REG-136118-15) acknowledged that consideration was being given to allowing partnerships to push-out beyond the direct partners to the ultimate taxpayer moving up each chain of ownership. See Joint Comm. On Tax’n, JCS-1-16, General Explanation of Tax Legislation Enacted in 2015 (2016). This broader view was widely endorsed by the persons who submitted comments to the Service and the Treasury.
The December 2017 proposed regulations adopted the multi-tiered partnership approach in applying Section 6226(b) so that upper tiered partnerships could elect whether or not to push-up the adjustments it received, e.g., as a direct partner to an indirect partnership, up to its partners, S corporation or its shareholders or beneficiaries of certain trusts.
Title II of the Tax Technical Corrections Act of 2018 (TTCA), P.L. 115-141 (March 23, 2018) revised portions of the centralized partnership audit rules enacted under the Bipartisan Budget Act of 2015 (§§6221-6241). One provision of the TTCA amended Section 6226(b) as reflected in Section 6226(b)(4) and adopted the December 2017 Proposed Regulations position to allow multi-tier partnerships to be part of a push-out election. In instances where the direct or indirect partners under an ownership chain of the partnership defaults in remitting its share of the imputed underpayment amount, the lower tier partnership may be called upon to pay such portion of the outstanding imputed underpayment. In addition, a push-out election statement issued to a partnership which itself has elected out of the partnership audit rules is still treated as a partnership for push-out purposes. See §6226(b)(4)(B).
TTCA Clarifies Scope of Adjustments Subject to the Partnership Audit Rules.
The TTCA amended Section 6241(2) which sets forth the definitions of a “partnership adjustment” and “partnership-related item”. The provisions eliminates prior reference to adjustments to partnership income, gain, loss, deduction, or credit, by use of term “partnership-related item” which is defined as any item or amount with respect to the partnership 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 an imputed underpayment and an item or amount relating to any transaction with, basis in, or liability of, the partnership. See §6241(a)(2)(B). The revision clarifies that the partnership audit rules do not apply to taxes imposed, or to amounts required to be deducted or withheld under chapter 2 (self-employment income), chapter 2A (tax on net investment income), chapter 3 (withholding on non-residents and foreign corporations) or chapter 4 (FACTA).
Netting in Determination of Imputed Underpayments Clarified in the TTCA
Section 6225(b) is amended to clarify the manner of netting items to determine the amount of an imputed underpayment of a partnership. It was understood from the June 14 (2017) NPRM that items of different character (capital or ordinary), for example, are not netted together in determining the amount of an imputed underpayment. This would preclude, for example, a long term capital loss increase from offsetting or reducing ordinary income. See §§6225(b)(1), 6225(b)(3). The TTCA makes this outcome crystal clear. Where the adjustment relates to the distributive share of any item from one partner to another, the adjustment is required to be taken into account by disregarding so much of the adjustment as results in a decrease in the amount of the imputed underpayment. See §6225(b)(2).
TTCA Adopts Pull-In Procedure As Alternative Procedure to Filing Amended Returns Under the Imputed Underpayment Modification Rule Under Section 6225(c)
The computation of the partnership’s imputed underpayment amount for a reviewed year is the sum of the netted items under each category of income or loss times the highest applicable tax rate. Modification of such amount can be reduced by the partnership’s proving that the applicable rate to one or more of the partners would be less than the highest applicable rate with respect to the proposed adjustments that produce the imputed underpayment for the reviewed year.
Another permitted modification under the BBA was the filing of one or more partners of amended returns for the reviewed year or years accompanied by payment of the taxes owed. There were concerns expressed by tax practitioners and bar associations that many partners may be resistant to filing amended returns for various reasons. An alternative “pull-in” procedure was recommended and was adopted by the TTCA.
Under the pull-in procedure, the Service 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, supply supporting information as is required and then pay the tax due, provided all other requirements of the pull-in procedure are met.
Pull-in requires the participating partner to pay the tax that would be due under the amended return filing procedure. The partner is responsible for remitting the payment unless the Secretary provides that another person, such as the partnership or a third party, may remit the payment on the partner's behalf. Payment is due within the period ending 270 days after the date the notice of proposed partnership adjustment is mailed (unless the period is extended with the Secretary's consent).
It is not required that all partners must participate in the pull-in procedure.
Added Interest Rate for Failure of Partnership or S Corporation to Pay Imputed Underpayment; Liability of Adjustment Year Partners (or Former Partners) for Outstanding Imputed Underpayment
The TTCA amends Sections 6232 and 6501(c)(4)(A) in providing that where a partnership (or S corporation under a push-out election notice) fails to pay an imputed underpayment (including interest and penalties) within 10 days after notice and demand, the applicable interest rate increases from 3 percentage points plus the Federal short-term rate (determined monthly) to 5 percentage points. Moreover, and perhaps of far greater significance, is new Section 6232(f)(1)(B) which provides that in the event the partnership does not make payment of the imputed underpayment within 10 days after notice and demand, the statute allows the Service to immediately assess each partner of the partnership determined as of the close of the adjustment year, or, if the partnership has ceased to exist as of such time, assess each former partner as provided under Section 6241(7), the amount of each partner’s proportionate share of imputed underpayment amount, plus interest and penalties. See also §6241(7). A partner is only liable for its proportionate share of the imputed underpayment and additions to tax. Partner payments reduce the amount of the partnership’s liability.
It is further important to focus on Section 6232(f)(6) which provides that the normal deficiency procedures are not applicable to any assessment or collection initiated under Section 6232(f) and that the date of the notice and demand for payment starts the running of a two-year period in which the Secretary may assess against the adjustment-year partners (or former partners). The two-year period of limitations also applies to a proceeding begun in court without assessment with respect to a partner. The period may be extended by agreement.