The Internal Revenue Service (IRS) uses three different regimes for auditing partnerships. Under the first, for partnerships with 10 or fewer partners, the IRS usually applies the audit procedures for individual taxpayers, resulting in separate audits for the partnership and each partner.
Under the second regime, for most audits of large partnerships with more than 10 partners, the IRS conducts a single administrative proceeding under the rules that were adopted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Accordingly, once the audit is completed and the resulting adjustments are determined, the IRS must recalculate the tax liability of each partner for the tax year.
For partnerships with more than 100 partners that choose to be treated as Electing Large Partnerships (ELP), a third audit regime applies. Under the ELP rules, partnership adjustments usually flow through to the partners in the year in which the adjustment takes effect, not the year of the audit, as under the TEFRA regime. One result of the ELP regime is that the current-year partners’ share of current-year partnership income, gains, losses, deductions, or credits are adjusted to reflect partnership adjustments relating to a prior-year audit that takes effect in the current year. Generally speaking, these adjustments do not affect the prior-year returns of any partners.
Since the federal Bipartisan Budget Act of 2015 became law last November, much has been made of a provision concerning the above described partnership audit rule changes. A summary document explains that the provision would repeal the ELP and TEFRA rules, and streamline partnership audit rules into a single set of rules for auditing partnerships and their partners at the partnership level.
The provision, which would take effect for tax years beginning after 2017, would allow partnerships with 100 or fewer qualifying partners to opt out of the new rules, resulting in partnership and partner audits under the general rules applied to individual taxpayers. In addition, among other things, the IRS would examine the partnership’s items of income, gains, losses, deductions, credits, and partners’ distributive shares for a particular year of the partnership and account for adjustments, taken by the partnership and not individual partners, in the year that the audit or any judicial review is completed.
Impact on the states
A Law360 article warned that this partnership audit overhaul warrants state tax revisions, because most have partnership tax rules that mimic the federal partnership tax regime that is being eliminated. Most states do not treat partnerships as separate entities for tax purposes, and any adjustments made to a partnership’s taxes flow through to the individual level.
The piece quoted Dennis Rimkunas, who is concerned that when the new federal scheme takes effect, the resulting disconnect between state and federal rules will amount to a “fundamental problem” unless states take action. In his opinion, “[t]he No. 1 issue…is that the states currently do not have a statutory mechanism to account for the changes under the new regime.”
For example, unless partnerships with 100 or fewer partners opt out of the new regime, any IRS adjustments to a partnership’s tax liabilities resulting from an audit will apply to the year the adjustment is made, by default, rather than to the year of the tax return in question.
Bruce P. Ely told Law360 that he also had questions. What happens if a partner’s state of residence changes from the reviewed year to the adjustment year? Attempting to track the taxpayer and collect on delinquent income tax payments could create due process issues. Ely predicted that every state “will have to address the new rules in some form or other before 2018. States could choose to adapt to them by amending their statutes through legislative changes or by issuing new regulations.”
Ely pointed out that some states may not have the resources to adjust to the new rules in time, so tax practitioners are offering to help them understand the complexities of the changes, and are also serving on various panels to help spread awareness to work through the issues together.
In addition, the Multistate Tax Commission (MTC) wants to work with the American Institute for Certified Public Accountants and the Council on State Taxation to craft a set of uniform rules for implementing state changes, and the American Bar Association already held a panel discussion in early May to tackle the matter.
Bruce J. Fort, MTC counsel, noted that “[i]t is critical to uniformly address these problems to avoid undue compliance burdens and avoid double taxation.” Nevertheless, he is confident that states would take action in time; New York and California are two that have already formed study groups.