While much attention has been focused on the impact the new partnership audit rules (“Audit Rules” or “Rules”) will have on IRS audits and the federal tax impact of these rules, less attention has been paid to the fact that the Audit Rules will have a significant impact on state taxation.
Some states are already amending their laws to account for the federal changes. For instance, Arizona and Montana recently initiated changes to their laws to account for the new Rules. These states have amended their laws despite the fact that many of the details of the federal rules remain unanswered.
In fact, in anticipation of the new Audit Rules, the American Institute of CPAs has organized a multi-organization task force to study the impact on state taxation. The Council on State Taxation (COST), the State and Local Tax Committee of the American Bar Association (ABA), and the Tax Executives Institutes (TEI) are all working together with the Multistate Tax Commission (MTC) to provide guidance to state taxing authorities. Materials from the MTC’s partnership project are already available online.
The new Audit Rules will significantly affect state taxation because federal audit adjustments often require corresponding state level adjustments as well. For many states, the starting point for personal or corporate income tax is the taxpayer’s federal adjusted gross income. Many states, therefore, require taxpayers to file amended state returns in the event that there are federal audit adjustments. Aggressive states may go so far as to review the entire amended state return despite federal adjustments that are limited to discrete issues.
As our prior alerts have explained, the Rules are novel, among other reasons, because they would make audit adjustments to partnerships at the entity level rather than at the partner level. We have further discussed that there are several ways for the partnership to opt out of the partnership level adjustments. Due to this framework, states will have to consider whether to require taxpayers to follow the same federal elections at the state level, or to allow some choice.
There are serious practical issues with the application of the New Rules at the state level. For example, if the partnership makes the federal election to “push out” the assessment to the partners, states may consider allowing the partnership to report all of the individual partners’ adjustments at the entity level for state tax purposes. If states do not, each partner in a multistate partnership could incur significant administrative costs filing amended returns in dozens of states. States may therefore want to consider composite entity-level returns to report federal partnership audit adjustments, even if the partnership did not originally file as an entity at the state level.
If the partnership does NOT opt out of the New Rules, some states will have to provide a new method for causing the partnership itself to report the adjustment since under the New Rules it is the partnership that pays the tax at the federal level. The revised Arizona statute addresses this issue by providing that the partnership itself also pays any additional Arizona tax within 90 days after the assessment is made. Like the federal rules, this tax is paid at the highest Arizona individual tax rate.
In addition, several timing issues arise at the state level under the new Audit Rules. The Rules provide that if the IRS makes an adjustment due to the partnership’s tax liability for a prior year (the “reviewed year”), the partnership is currently responsible for the adjustment in the year the audit or further judicial proceeding concludes (the “adjustment year”).
As a consequence, states will need to clarify their laws to account for changes between the “adjustment year” and the “reviewed year.” For example, if partners move to other states or partnerships move their operations, states may need to clarify that partner’s residency status and the partnership’s method of computing its formulary apportionment relates to the reviewed year. Nexus issues may also arise due to these timing differences.
As the Jan. 1, 2018, effective date for the new Audit Rules approaches, states will invariably confront these and other issues in one way or another. We will keep you posted with the developments, hopefully through some type of uniform agreement among the states.