United States

IRS issues proposed regulations for new partnership audit procedures


The IRS recently issued proposed regulations to implement Bipartisan Budget Act of 2015 (BBA). Congress enacted the BBA to replace the current rules governing partnership audits (TEFRA) with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level. The centralized audit regime becomes effective for partnership taxable years beginning after Dec. 31, 2017, and will be the exclusive method by which the IRS may audit partnerships in one unified proceeding. On Dec. 8, 2016, Congress introduced, with bipartisan support, the Tax Technical Corrections Act of 2016 (the Technical Corrections Act), which contains several technical corrections to a number of provisions of the partnership audit regime. This act has not been enacted by Congress, but its pendency has resulted in the IRS reserving on some issues on which they would otherwise be proposing regulations.

The proposed regulations are quite voluminous, and thus, this article will seek to highlight only the most significant proposals. Also please note that, pursuant to a memo issued by new White House Chief of Staff Reince Priebus, action on these regulations is temporarily halted until review by an appointee of the new administration.


The BBA, as enacted, provides that the partnership adjustment regime applies to any adjustment to ‘items of income, loss, deduction or credit.’ The IRS has taken a particularly expansive view of the definition of this phrase. The proposed regulations would provide that items of income, loss, deduction or credit would include any item shown on a return of partnership income, or any information found in the partnership’s books and records for the taxable year under examination. This would include non-income items such as contributions to and distributions from the partnership, allocations of partnership liabilities and items related to transactions between a partnership and any person. Although this may seem like a surprising interpretation of the statutory provision, it is generally consistent with the proposed amendment to the scope statute from the Technical Corrections Act.

The proposed regulations also provide that a BBA proceeding is this sole vehicle for considering the applicability of penalties to a partnership adjustment, including partner-level exceptions to any penalty. Therefore, a partner’s individual claim of reasonable cause, for example, would have to be raised by the partnership representative during the course of the BBA audit. The partner would be foreclosed from individually raising any partner-level defenses either during or after the completion of the audit.

Election out

Section 6221(b), as amended by the BBA, provides that partnerships can elect out of the BBA audit regime if they issue less than 100 Schedules K-1 and only have specified types of partners (specifically individuals, C or S corporations, estates of deceased partnership, and certain foreign entities that would be treated as C corporations if domestic). Although some commenters requested that the IRS use its regulatory authority to broaden the applicability of the election out, the IRS generally declined all such comments, choosing to interpret section 6221(b) narrowly. In particular, the IRS clarified that domestic partnerships, disregarded entities and all trusts are ineligible partners, preventing an election out of the BBA regime.

More technically, the IRS also proposed clarification to the counting of Schedules K-1 for purposes of the 100 Schedule K-1 limitation. For one, if multiple Schedules K-1 are issued to one partner (for example, if a partnership issues separate Schedules K-1 for a partner’s general partner and limited partner interest), those would be counted as one Schedule K-1, as only one was required. Separately, in the case of an S corporation, both the S corporation and all of its shareholders count separately towards the 100 Schedule K-1 limit.

Partnership representative

One of the major differences between the BBA and the partnership audit regime that preceded it is the increase in power given to the partnership representative (the ‘tax matters partner’ under old law). The BBA partnership representative has the sole authority to speak for the partnership in a BBA examination, and can bind all partners with respect to the tax treatment of partnership level items. The proposed regulations provide that a partnership representative would be designated on an annual basis on the partnership’s tax return for the year. This designation could not be changed except in the case of an actual examination or an administrative adjustment request (an AAR), in which case the partnership representative could resign or be removed by the partnership (an AAR is not allowed solely to change the partnership representative). When a valid designation by the partnership is not in effect, the IRS may designate a partnership representative. Although the regulations set out factors that this IRS would consider in this instance, the IRS has the ultimate authority to select any person as a partnership representative.

Although contractual or state law restrictions may be placed on the partnership representative (for example, by the terms of a partnership agreement), the regulations would disregard these limitations for federal tax purposes. Therefore, a partnership representative’s acts that violate a partnership agreement would nevertheless be valid (although they may expose the partnership representative to a civil cause of action for recovery of any damages).

Imputed underpayment

Section 6225 as amended by the BBA provides that, in order to determine the initial amount that could be collected from the partnership at the conclusion of an examination, all adjustments to income, loss or deduction are netted and, if the result is a positive adjustment, are multiplied by the highest rate of tax then in effect (adjusted by any corrections to credits). This was a subject of some controversy, as it seems to ignore any limitations or other effects that may be applicable at the taxpaying partner-level (e.g., alternative minimum tax or passive activity losses).

The proposed regulations provide that netting will not be implemented in quite as complete a manner as stated or implied by the statute. Specifically, adjustments would be grouped based on the type of adjustment (i.e., reallocation adjustments, credit adjustments, creditable expenditure adjustments and all other adjustments), and then would be subject to further subgrouping based on any limitations that could be applicable at partner-level. Only positive adjustments resulting from a group or subgroup would be taken into account in determining the total imputed underpayment.

Section 6225 also provides for several methods by which a partnership may reduce its imputed underpayment (for example, by showing that all affected partners had duly filed amended returns reflecting the partnership adjustments, or by the partnership showing that certain of its partners are tax-exempt). The regulations provide for specific procedures for how each of the requests for modification will be handled, and include rules for coordination between different types of modification request.


Section 6226, as amended by the BBA, provides that a partnership can avoid payment of an imputed underpayment (under section 6225) by issuing adjusted K-1s to its partners, who would compute any adjustments to tax in the adjusted year (and any subsequent years that might be affected), but pay any increased tax so computed, with interest, as part of their regular income tax filing for the year the adjusted K-1 was received. One of the most controversial aspects of the BBA was whether and how this ‘push-out’ regime would apply in the case of a tiered partnership structure. The proposed Technical Corrections Act would clarify that push-out applies to all of the partnerships in a tiered structure. Nevertheless, the IRS has reserved on this issue, explaining that the Technical Corrections bill has not yet been enacted. Nevertheless, the regulations do spell out other procedures related to push-out.

One noteworthy clarification is that, with IRS agreement, a taxpayer may elect to apply push-out to only part of the overall results of an examination (this would be accomplished by the IRS splitting the results of an examination into multiple imputed underpayments). Any imputed underpayments not elected for push-out would still be paid by the partnership, and would be subject to any of the modification procedures described above.

In addition, another innovation in the proposed regulations is that each adjusted K-1 would contain a ‘safe harbor amount’, which is an amount computed by the partnership that would approximate the partner’s share of the imputed under section 6225. A partner can elect, in lieu of computing the actual tax increase from the adjustments shown on the adjusted K-1, to simply pay the safe harbor amount. While the safe harbor amount will generally be more than the tax increase that would follow from a proper calculation, in the case of a small adjustment it may be prudent to pay the safe harbor amount to save on the administrative burden of re-computing tax in several prior years. For example, it would appear that the partner could effectively ignore the existence of a partner-level net operating loss (NOL) that would have sheltered the inclusion in the reviewed year, and thus, avoid the necessity of recomputing NOLs and other items for later years, as they would have been affected if the NOL had been used in the reviewed year.

Administrative adjustment requests

Finally, the regulations propose procedures by which a partnership would file an AAR (essentially the partnership version of an amended return). In general, the partnership can choose when filing the request to pay any additional tax due (similar to an imputed underpayment under section 6225) or push out any resulting adjustments (similar to the push out method of section 6226). If an AAR would not result in an imputed underpayment, then the partnership must follow the push-out method.

Unlike in a push-out scenario resulting from an audit adjustment, partners who receive AAR related adjusted K-1s could take into account tax decreases as well as increases resulting from those adjustments. In the preamble to the proposed regulations, the IRS has indicated this is essentially an ‘incentive’ for partnerships to file AARs. As with push-out under section 6226, the IRS has reserved on how push-out for AARs will apply to tiered entity arrangements. Note that the proposed Technical Corrections Act would allow partners who receive push-out statements to take into account tax decreases resulting from a push-out statement as well as tax increases. If that provision is enacted, the above-described incentive would be weakened or eliminated.


There is little in this package of proposed regulations that would either increase, or decrease, the immediate concerns of a partner, prospective partner, manager or prospective manager with regard to the possible effects of an audit of a partnership’s 2018 or later tax years. However, as we have indicated elsewhere, that does not mean that nothing should be done by existing partnerships (or limited liability companies) in anticipation of the new rules taking effect for tax years after 2017.

An inescapable and fundamental aspect of the new regime is the creation of new, potential business conflicts between the interests of current and former partners, between different classes of current partners, and between current or former partners and the partnership representative (or the person charged with instructing the partnership representative as to positions to be taken in an examination). Since there is no grandfather rule, existing partners and managers, as well as taxpayers who are contemplating become direct or indirect partners of an entity, or managers of such an entity, may wish to consult with their tax or business advisors and agree on an appropriate set of rules to govern how the partnership representative will conduct the audit. For example, a partnership agreement might provide that election of the push-out method is mandated or prohibited, might instruct the partnership representative to cooperate with all information requests, but to refuse consent to some or all the adjustments that the IRS might propose, unless expressly authorized to do so by the affected partners, unless the amounts are smaller than an agreed upon amount, etc.  

It may be easier to resolve such issues in the abstract, in advance, than later when there are actual issues pending before the IRS, or even when a transaction is executed or a proposed return position is being considered. Even though these proposed regulations have not been finalized, there is more than enough certainty in the statute, and the guidance provided by the proposed Technical Corrections Act, to permit partnerships to consider, plan for and potentially redraft their agreements in consideration of the new business issues presented by the new law.


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