United States

IRS regulations address opting-out of new partnership audit rules

TAX ALERT  | 

On Jan. 2, 2018, the IRS published T.D. 9829, adjusting and finalizing rules allowing certain partnerships to elect out of the new centralized partnership audit regime that will apply to tax years beginning after 2017.

In general, the new rules would require partnerships and all of their direct and indirect partnerships to deal with the IRS through a single representative of the audited partnership, eliminating any right of dissent or disagreement with proposed settlements or concessions. In the event of an adjustment, a partnership would have to choose between paying an entity-level tax, computed under complex rules designed to estimate the partner-level effects or ‘pushing-out’ its adjustments to its partners, who would then be required to recompute their tax liabilities in light of the adjustments. Under another recent announcement, tiered partnerships would also enjoy the right to ‘push-out’ to upper-tier partnerships, and so forth. But private arrangements would likely be necessary – in the case of arrangements with multiple tiers – to ensure that the push-out process is completed in a timely manner. Otherwise, upper-tier partnerships that receive their information late in the process may be required to pay an entity level tax because there will not be sufficient time to push-out to another tier.

By statute, partnerships with only a limited number of partners would enjoy the right to elect out of these new rules and be audited solely at the individual partner level, an approach the IRS does not favor. Accordingly, the IRS and the private sector were at odds over how to interpret the opt-out provisions of the statute. In the final regulations the IRS took a relatively hard line and limited opt-outs to those clearly required by the statute.

Generally, to opt-out a partnership must have 100 or fewer partners at all times in the applicable year, the partners must generally be only individuals, corporations, estates of deceased individual partners and certain other foreign entities – but not including other partnerships, nominees and disregarded entities (even if they are wholly owned by an otherwise qualified partner). Married individuals who are both partners are treated as two partners in this enumeration, not one. In addition, in the case of an S corporation partner the S corporation’s shareholders (as well as the S corporation) are counted in determining whether there are 100 or fewer partners (or, in that case, shareholders counted as indirect partners). Some commentators argued that disregarded entities should be disregarded for this purpose, but that argument was rejected by the IRS.

The IRS’ relatively restrictive interpretation of the opt-out rules should be viewed in context. Now that the push-out method has been proposed in regulations to be permitted for single-tier and multi-tier partnerships – thus avoiding the risk of an entity-level tax – the burden of being subject to audit on a centralized basis, rather than partner-by-partner, should be less of a concern for most partnerships. In any event, the IRS views opt-outs with skepticism, because it makes it harder for them to audit a partnership, even one with only a modest number of direct or indirect partners.

The preamble to the final regulations explains the final election provisions by (1) clarifying how to determine the number of partners of a partnership for purposes of determining whether the partnership has 100 or fewer partners, (2) determining what partners constitute eligible partners for purposes of determining whether the partnership is an eligible partnership and (3) detailing the mechanics of making the election.

The preamble to the final regulations highlighted – but did not issue new rules on – certain other issues of potential concern. These include determining whether a partnership exists de facto even though no partnership return has been filed, or the treatment that results when two partnerships file as separate entities, perhaps to qualify under the opt-out rules, but are arguably one partnership in substance.   

The final regulations and their explanatory preamble also address mechanical issues of how to make the opt-out election, including rules for identifying the shareholders of an S corporation partner.

The final regulations can be found here.

For more background on the proposed partnership audit regime regulations, see our prior alerts: Proposed IRS partnership audit regulations allow tiered push-out; Proposed partnership audit regulations released by the IRS; and IRS issues proposed regulations for new partnership audit procedures.

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