Adopt or adapt? New IRS partnership audit rules affect states
In this edition of Inside Deloitte, the authors summarize the new federal partnership tax audit rules and discuss some of the state tax mechanisms that require or allow partnerships to remit taxes to state authorities on behalf of the partners. They also discuss the complexities states may face if they adopt similar audit rules or choose not to adopt similar audit rules.
Bipartisan Budget Act of 2015
Each state has its own system of tax audit procedures that present challenges for taxpayers and tax authorities alike, with a multitude of additional potential complexities arising out of the recent federal changes applicable to the tax audit of partnerships. The federal changes, adopted in the Bipartisan Budget Act of 2015 (Budget Act)1—effective for returns filed for partnership tax years beginning after December 31, 2017—will significantly affect taxpayers and state tax authorities, regardless of whether the states adopt the new federal audit rules.
The Budget Act was enacted on November 2, 2015, and it includes significant rule changes for partnership tax audits and adjustments. The Budget Act completely replaces the current Tax Equity and Fiscal Responsibility Act2 procedural rules for partnership audits and adjustments. It provides for one set of partnership-level audit rules that will apply to all partnerships, subject to an opt-out election available to some partnerships with 100 or fewer partners.3 Under these streamlined audit rules contained in the Budget Act, the IRS will examine partnership items for a particular year (the reviewed year), and any adjustments will be taken into account by the partnership at the partnership level in the year the audit or judicial review is completed (the adjustment year).4 This is a significant change from the current TEFRA provisions because it shifts the cost of any adjustment to the partners in the adjustment year rather than flowing the adjustments through to the partners who benefited from the underpayment of tax in the reviewed years.
Under the Budget Act, the partnership will pay the tax, interest, and penalties on underpayments.5 The tax due is calculated by multiplying the net of the adjustments by the highest statutory corporate or individual rate.6 Any adjustments not causing underpayments will then flow through to the partners in the year of the adjustment.7 The amount of the underpayment at the partnership level could be reduced by (i) the tax reported on the underpayment by partners filing amended returns;8 (ii) the tax attributable to tax-exempt partners;9 and (iii) the tax rate differential due to a lower corporate tax rate or lower capital gain and dividend rate.10
Alternatively, under the Budget Act, partnerships may elect to issue adjusted information returns to the reviewed-year partners, who would then take the adjustments into account on their individual returns in the adjustment year through a simplified amended return process.11 Those partners would calculate the additional tax owed for the reviewed year and then pay the tax (and interest and penalties) from that prior year with the tax return for the year when they receive the statement of adjustments.12 The partnership is not required to ensure that each of its reviewed-year partners actually take the adjustments into account and pay any tax due. Once this election is made, it may only be revoked with the consent of the US Treasury secretary.13
The statute of limitations for assessments is determined based on when the partnership’s return was filed and considers extensions between the IRS and the partnership, rather than taking into account partners’ individual assessment statutes of limitations.14 The statute of limitations for filing partnership refund claims is based solely on when the partnership return was filed and cannot be extended by agreement.
Small partnerships with 100 or fewer qualifying partners are allowed to elect out of the new rules, and those partnerships and partners are subject to the general rules that apply to auditing individual taxpayers.15 To elect out, the partners must all be individuals, C corporations, foreign entities that would be treated as C corporations if domestic, S corporations, estates of deceased partners, or others if the Treasury secretary prescribes in guidance.16 Thus, partnerships with partners that are themselves partnerships or trusts are unable to elect out absent further guidance. The provision also contains several consent and election rules, with special rules for specific partners, such as S corporations.17 The election to opt out is made for a particular year with a timely filed return for that tax year.18
Audits will be handled by a designated partnership representative, who can be a partner or non-partner with substantial presence in the United States.19 The partnership representative is granted broad authority to resolve any partnership audit, and the resolution would be binding on all partners.20
For a complete list of references, download the full article.
If you have questions regarding this edition of Inside Deloitte, please contact:
Gregory Bergmann, partner, Deloitte Tax LLP
Michael Bryan, director, Deloitte Tax LLP
Matthew Polli, partner, Deloitte Tax LLP
Tamar Narinian, manager, Deloitte Tax LLP
The authors thank Robert Ybarra for his contributions to the article, along with Fred Paladino and Amy Sutton for their helpful review and editorial guidance.