Technical corrections bill introduced to fix partnership audit rules
Tiered partnerships covered by new audit rules
TAX ALERT |
In coordinated House and Senate actions, the Tax Technical Corrections Act of 2016 was introduced by the bipartisan leaderships of each chamber’s tax-writing committee. Among other technical corrections, this bill provides for several much needed updates and clarifications to the new partnership audit rules, originally included in the Bipartisan Budget Act of 2015 (BBA). Along with the new proposed statutory provisions, the Joint Committee on Taxation published a technical explanation. Typically, such provisions represent noncontroversial technical clarifications that are routinely enacted, typically with retroactive effect, as soon as an appropriate legislative vehicle, like a major tax reform bill, is identified. Below are highlights of some of the more significant proposed clarifications or changes to the BBA audit rules.
Scope of the audit rules
As originally enacted, the BBA audit rules applied only to adjustments to partnership ‘income, gain, loss, deduction or credit’ that was arguably narrower than the scope of the previous partnership audit regime (the TEFRA regime). The new bill would expand this to any adjustment to a ‘partnership-related item, which in addition to the original items included in the BBA would include any item affecting a partner’s tax liability with respect to that partnership (to include basis, liability sharing, etc.).
At the same time, the bill would also clarify that taxes other than income tax (such as self-employment taxes and net investment income taxes) are not assessed at the partnership level through the BBA regime. However, adjustments to partnership items determined in a BBA audit that affect such taxes may give rise to additional tax liabilities outside of a partnership audit (for example, through direct billing to the affected individual partners).
Computation of imputed underpayment
The BBA, as enacted, provided that the imputed underpayment, potentially to be collected from the partnership at the conclusion of the examination, would be determined by netting all increases and decreases to the income of the partnership and multiplying the result by the highest tax rate in effect. Several commenters raised concerns that this had the potential to disadvantage the government in cases where such items would not be netted against each other at the partner level, such as capital losses and ordinary income.
The new bill would provide that all adjustments would first be determined separately within each category of item that is separately reported to partners on Schedule K-1, and then only netted thereafter if appropriate. In addition, any adjustments that could be subject to a limitation at the partner level (for example, an increase in loss that could potentially be limited by the passive loss rules), would not be allowed in computing the imputed underpayment, except as provided by subsequent regulations.
Modification or elimination of the imputed underpayment
The BBA originally provided several mechanisms by which a partnership could reduce or eliminate the imputed underpayment for which it would be potentially liable.
Most notably, the BBA provided that partnerships could choose to ‘push out’ any adjustments to their reviewed year partners, who would pay tax in the year the adjustment went final ‘as if’ the adjustment were taken into account in the reviewed year. In what may have been the most controversial aspect of the original statute, it was ambiguous as to whether or not a partner that is itself a partnership could further push out the adjustment to its partners (and so on, if applicable), or whether it would be subject to an entity level tax. The technical correction bill affirmatively provides that these partners would have the choice to push out further or pay the entity level tax. If they did choose to push out further, they would need to furnish information to the IRS showing the allocation of their share of the adjustment. The technical corrections bill also provides a definite timeframe in which this pushout must occur; a provision notably absent from the original BBA. In addition, the bill clarifies that tax overpayments, as well as underpayments, are taken into account by partners reconciling their liability based on information they receive with push-out statements.
In addition, the bill liberalizes the option of avoiding entity-level tax by providing proof of amended return filings by partners that take into account, and pay tax on, their share of the partnership adjustments. The technical corrections bill preserves this mechanism with several small clarifications, but also provides that reviewed year partners can establish to the IRS what the tax due on an amended return would be, and pay that tax, without filing a formal amended return. This was apparently included to allay concerns that some commenters had about having to recertify items on their original tax return that were not affected by the partnership audit.
The new partnership audit rules will apply to taxable years beginning after 2017, with no grandfather rules for existing arrangements, unless they are ‘small’ partnerships eligible for exemption from the new rules. Although these proposed technical corrections are subject to revision, they appear to represent a broad consensus by tax experts in Congress, the Treasury and the IRS as to the proper operation of the new rules. As a result, the IRS is expected to rely on this bill, and assume its eventual enactment, as they craft proposed regulations implementing the BBA. By the same token, partnerships that are otherwise adopting or making changes to partnership agreements should consider this an opportune time to consider adjustments necessary to comply with this new regime. Prospective investors may also wish to review their rights and responsibilities under the newly proposed clarifications.