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The IRS has released highly anticipated proposed regulations (REG-136118-15) under the new centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015 (BBA), on November 2, 2015. The BBA significantly alters the audit and income tax liability rules governing partners and partnerships for tax years beginning after December 31, 2017, and for partnerships that elect into the regime for tax years after November 2, 2015, and before January 1, 2018. (The legislation is discussed in Tax Alert 2015-2085, and the election to apply the new rules for tax years that begin before 2018 is discussed in Tax Alert 2016-1344.)

Following their release, the proposed regulations were withdrawn from the Federal Register by the Trump administration as part of a review of all pending regulations packages by new department or agency heads. Given that the BBA regime cannot be administered without regulatory guidance, however, it is likely that these proposed regulations will eventually be issued in some form.

The proposed regulations provide additional guidance on the applicable procedures, the determination of the amount of taxes, interest, and penalties owed, and other consequences of an adjustment to a partnership tax return. Among other provisions, the regulations include procedures for opting out of the new regime, designating a partnership representative, filing administrative adjustment requests, and, most importantly, determining amounts owed by a partnership or its partners from adjustments following partnership exam.

Proposed regulations

Scope of BBA Rules

The BBA rules provide for a centralized partnership audit regime in which a "partnership representative" has sole authority to act on behalf of the partnership and its partners. Under the centralized partnership audit regime and implementing proposed regulations, all adjustments and items relating to a partnership are determined at the partnership level. This includes any adjustments to items of "income, gain, loss, deduction, or credit" — with such terms defined broadly to include, among others, the character, timing, source, and amount of items and of the partnership's activities, as well as contributions to and distributions from the partnership and the partnership's basis in its assets and the value of those assets. It also includes items related to transactions between a partner and a partnership, including disguised sales and guaranteed payments. Taxes resulting from adjustments to items under the regime are assessed and collected at the partnership level. Any penalties or additional amounts relating to such adjustments are also determined at the partnership level. The proposed regulations make it clear that they take an expansive view of the scope of the centralized partnership audit regime to cover all items and information related to or derived from the partnership.

Electing out

Consistent with the statute, partnerships are eligible to opt out of the regime if: (1) they have 100 or fewer partners during the year; and (2) all partners are "eligible partners" at all times during the tax year.

Under the proposed regulations, a partnership has 100 or fewer partners during the year if it is required to furnish 100 or fewer statements under Section 6031(b) during the tax year for which the partnership makes the election. A special rule applies for partnerships with S corporation partners: any statements required to be filed by the S corporation partner for the relevant tax year under Section 6037(b) are added to the number required to be filed by the partnership, for purposes of determining whether more than 100 statements are required to be furnished.

Regarding tiered partnership structures, the regulations would not expand the definition of "eligible partner" to include a disregarded entity. The proposed regulations define "eligible partner" as any person who is an individual, C corporation, "eligible foreign entity," S corporation (even if one of its shareholders is not) or an estate of a deceased partner. The term "eligible partner" does not include partnerships, trusts, foreign entities that are not eligible foreign entities, disregarded entities, nominees, other similar persons that hold an interest on behalf of another person, and estates that are not estates of a deceased partner.

Making the election

The proposed regulations set forth the time, form and manner for an election out of the partnership audit regime to be valid. The election would be made on a timely-filed partnership return (including extensions) for the tax year to which the election relates. The partnership would have to disclose to the IRS the names, correct TINs and federal tax classifications of all partners and all shareholders of a partner that is an S corporation. In addition, a partnership electing out of the regime must notify each of its partners of the election with 30 days.

Consistency requirement

Under the proposed regulations, a partner's treatment of each item of income, gain, loss, deduction or credit attributable to a partnership must be consistent with the treatment of those items on the partnership return (including with respect to the amount, timing and characterization). In addition, the proposed regulations state that consistency is determined based on the partnership return filed with the IRS, not by reference to the schedules provided to the partner.

If a partner reports in a manner that is inconsistent with the partnership's treatment, the proposed regulations state that the IRS may assess and collect any resulting underpayment of tax as if the resulting underpayment of tax were on account of a mathematical or clerical error appearing on the partner's return (math error treatment). A partner may not request an abatement of such an assessment. If the partner adopts a position that is inconsistent with the partnership's originally filed return, and the partner notifies the IRS of the inconsistency, the IRS may evaluate the partner's position in a proceeding that involves only that partner. Such a partner-level proceeding is not available when the partner takes a position that is inconsistent with an administrative adjustment request or the position a partnership adopts when making a "push-out election" under Section 6226.

Partnership representative

In any partnership proceeding, the partnership representative is the sole person with authority to act on behalf of the partnership and the partners. The proposed regulations would require a partnership to designate an eligible partnership representative. The partnership representative may be any person, as defined in Section 7701(a)(1), including an entity, and need not be a partner. If an entity is designated, however, the partnership must also appoint and identify an individual to act on the entity's behalf. To be eligible, the designated person must have the capacity to act as the partnership representative, effectively meaning that the partnership representative must be an individual. The partnership representative must have a substantial presence in the US — generally meaning the representative must: (1) be able to meet with the IRS in the US at a reasonable time and place as necessary, (2) be reachable during normal business hours at a US street address and have a phone number with a US area code, and (3) have a US TIN. In addition, a partnership representative designated by the partnership is deemed to satisfy the substantial-presence and capacity-to-act requirements, unless and until the IRS determines otherwise.

Designating the partnership representative

The proposed regulations set forth the manner for designating the partnership representative. The partnership must designate a representative on the partnership's return for each tax year — designations for one year do not carry over to other years. Generally, once made, a designation may not be changed until after the partnership receives a notice of audit. When filing an administrative adjustment request (AAR), the partnership may change the initial designation of partnership representative. The AAR may not, however, be used solely for that purpose. The IRS requests comments on other circumstances under which a partnership may wish to change the designated representative. In addition, a partnership representative may resign by notifying the partnership and IRS in writing. The proposed regulations also include rules for a partnership to revoke a designated representative and name a replacement.

Determination that a designation is not in effect and designation by IRS

If the IRS determines that no designation of a partnership representative is in effect, the proposed regulations stipulate that the IRS will notify the partnership and last representative, if there was one. Generally, the partnership would then have 30 days to designate a representative before the IRS designates one for the partnership.

If the determination has been made that no designation is in effect, the IRS may select any person to serve as partnership representative. The IRS will notify the partnership of the new representative, providing the name, address and telephone number. Once the IRS has designated a representative, the partnership may not revoke the designation without IRS consent.

Partnership representative's authority

Under the proposed regulations, the partnership and all partners would be bound by the actions of the partnership representative. The representative binds the partnership through various actions, including agreeing to settlements, agreeing to a notice of final partnership adjustment, making an election under Section 6226, and agreeing to an extension of the period for adjustments. Any administrative adjustment request submitted by the partnership is required to be signed by the partnership representative. The representative has the sole authority to act on behalf of the partnership in any examination. This authority may not be limited by state law, partnership agreement or otherwise.

Imputed underpayment and modification requests

Under the new audit regime, partnerships are generally responsible for paying any imputed underpayment that results from an IRS examination, but one or more partners in the year under examination (the reviewed year) may instead pay their share of the taxes owed either through a "modification process" or through a "push-out election."

If a partnership adjustment results in an imputed underpayment, the proposed regulations stipulate that the partnership must pay the imputed underpayment in the adjustment year. The proposed regulations include specific rules for calculating the imputed underpayment, including for the grouping and netting of adjustments, and allow for multiple imputed underpayments.

Under the proposed regulations, a partnership that has received a notice of proposed partnership adjustment (NOPPA) may request a modification of a proposed imputed underpayment. The proposed regulations include rules describing the effect of modification on the calculation of the imputed underpayment. They also set forth the time, form and manner for requesting modification.

Although the IRS may consider alternative forms of modification, the proposed regulations specifically describe seven types of modifications that the IRS will consider if requested by the partnership, including those relating to: (1) amended returns, (2) tax-exempt partners, (3) rate modification, (4) certain passive losses of publicly traded partnerships, (5) number and composition of imputed underpayments, (6) partnerships with partners that are Section 860 "qualified investment entities," and (7) partner closing agreements.

Grouping and netting of adjustments

Under the proposed regulations, adjustments are grouped together, which provides a framework for the netting of adjustments appropriately. Within each grouping, adjusted items may be further divided into subgroupings depending on their character or to account for preferences, sources, categories, limitations or other applicable restrictions. The preamble explains that groupings and subgroupings provide the IRS with the ability to net adjustments according to applicable limitations and restrictions.

The proposed regulations provide for three types of groupings of adjustments. First, adjustments that reallocate items among the partners (reallocation grouping) are grouped together. Second, adjustments to the partnership's credits (credit grouping) are grouped together. Third, all remaining adjustments (residual grouping) are grouped together according to the character, preferences, restrictions and other limitations of the item adjusted.

The proposed regulations contain rules for netting items after separating the items into their groupings and subgroupings. First, the IRS will net items within the same grouping or subgrouping. For instance, all ordinary adjustments (assuming no other restrictions under the Code) are netted against each other, regardless of whether such adjustments were part of related transactions or whether they were increases or decreases to income, but none of the ordinary adjustments are netted against the adjustments in the capital subgrouping. Adjustments in the capital subgrouping are netted against each other within that subgrouping. Adjustments from one tax year may not be netted against adjustments from another tax year, even if they would otherwise be part of the same subgrouping.

Multiple Imputed underpayments

The proposed regulations would allow for multiple imputed underpayments resulting from an IRS audit. Each administrative proceeding that ends with the determination by the IRS of an imputed underpayment would result in a general imputed underpayment. The IRS has the discretion to determine a specific imputed underpayment on the basis of certain adjustments allocated to one partner or a group of partners based on the items or adjustments having the same or similar characteristics, based on the group of partners sharing similar characteristics, or based on the partners having participated in the same or similar transactions. As a result, there may be multiple specific imputed underpayments depending on the adjustments. The partnership has the option to pay none, some or all of the imputed underpayments and file an election to "push-out" those adjustments resulting in imputed underpayments which the partnership chooses not to pay.

Adjustments that do not result in imputed underpayment

The proposed regulations also describe circumstances in which partnership adjustments do not result in an imputed underpayment. In general, such adjustments would be taken into account by the partnership in the adjustment year as a reduction in income or as an increase in loss depending on whether the adjustment is to an item of income or loss. The proposed regulations generally leave the allocation of adjustments that do not result in an imputed underpayment to the partnership agreement, but include rules for allocation in certain limited circumstances.

Election for alternative to payment of imputed underpayment

Under the proposed regulations, a partnership may elect under Section 6226 to "push out" adjustments to its reviewed year partners rather than paying the imputed underpayment. To be valid, this election must comply with all the regulatory requirements for such an election and the partnership must provide notice to the partners and IRS. The proposed regulations make it clear that the partnership is no longer liable for any imputed underpayment once a valid "push out" election is made. Elections once made may only be revoked by the IRS. If the IRS determines an election is invalid, it will notify the partnership and partnership representative within 30 days.

The proposed regulations stipulate that a partnership may only make an election under Section 6226 within 45 days of the date the final partnership adjustment (FPA) was mailed by the IRS. The regulations specify what information must be included when making the election. They also state that electing partnerships must furnish statements to the reviewed year partners with respect to the partner's share of the adjustments and also file those statements with the IRS in the time, form and manner prescribed. The proposed regulations contain a requirement that the statement issued by the partnership contain a "safe harbor" amount calculated by the partnership that a partner can elect to pay rather than have the partner compute any additional tax the partner may owe based upon the actual effect the adjustment will have on the partner's reviewed year and any intervening years. The regulations include requirements with respect to the contents of these statements and the reporting of the partner's share of adjustments and other amounts.

A reviewed year partner that is furnished with a statement from a partnership making the election under Section 6226 must pay any additional tax that results from taking into account the adjustments reflected in the statement. The proposed regulations include rules relating to calculating the aggregate of adjustment amounts. They also describe how a partner that is furnished a statement may elect to pay a safe harbor amount shown on the statement in lieu of the additional reporting year tax. Reviewed year partners are also liable for interest on any correction amount.

The proposed regulations also include provisions under Section 6226 to coordinate the partnership audit rules with the deficiency dividend procedures under Section 860 for regulated investment companies (RICs) and real estate investment trusts (REITS).

Administrative adjustment requests (AARs)

The proposed regulations include rules for filing an AAR. A partnership may file an AAR for one or more items of income, gain, loss, deduction or credit of the partnership and any partner's distributive share thereof for any partnership tax year. The partnership must determine whether the adjustments requested in the AAR result in an imputed underpayment. In that case, the partnership must generally pay the imputed underpayment. Only a partnership may file an AAR, not a partner (unless acting as partnership representative). A valid AAR must include the adjustments requested and any statements required by the regulations or other IRS forms or guidance. The proposed regulations contain a requirement that the AAR must be signed under penalties of perjury by the partnership representative.

The proposed regulations describe how a partnership determines and takes into account adjustments requested in an AAR, as well as rules for determining whether an imputed underpayment results. The partnership may reduce the imputed underpayment as a result of certain permitted modifications. When an adjustment requested in an AAR results in an imputed underpayment, the underpayment must generally be paid at the time the AAR is filed. Alternatively, partnerships may elect to have its reviewed year partners take into account adjustments requested in an AAR that result in an imputed underpayment.

Reviewed year partners must take into account adjustments requested in an AAR filed by a partnership in two circumstances, when: (1) an imputed underpayment results from the AAR and the partnership elects to have the partners take the adjustment into account, or (2) the requested adjustments do not result in an imputed underpayment.

Partnerships that cease to exist

Under the proposed regulations, if the IRS determines that a partnership has ceased to exist before a partnership adjustment takes place, certain former partners of the partnership must take the partnership adjustment into account. The IRS has the sole discretion to make the determination that a partnership has ceased to exist. For these purposes, "cease to exist" means either that the partnership has terminated (within the meaning of Section 708(b)(1)(A)) or it does not have the ability to pay in full any amounts owed relating to partnership adjustments. The IRS will not determine that a partnership has ceased to exist solely because it: (1) has technically terminated (under Section 708(b)(1)(B)), (2) made an election under Section 6226, or (3) failed to pay amounts liable relating to partnership adjustments.

If the IRS has determined that a partnership has ceased to exist, certain former partners take the partnership adjustment into account as if the partnership had made an election under Section 6226 and the accompanying regulations to "push out" its adjustments to its partners. Within 30 days of the IRS notifying a partnership that it has determined that the partnership has ceased to exist, the partnership must furnish statements to its former partners, and file statements with the IRS, reflecting the partners' shares of the adjustments.

Implications

The regulations as proposed, if resubmitted to the Federal Register, will have significant tax implications for partners of partnerships. Specifically, the powers of the partnership representative, the calculation of the imputed underpayment, the modification procedures, and the use of the push out election under Section 6226 are a sea change to how the IRS conducts IRS examinations of partnerships and who is responsible for payment of any liability to the IRS.

While intending to finalize the regulations by the end of 2017, the IRS and Treasury Department are interested in comments on the provisions in the proposed regulations. Affected partnerships should note that the proposed regulations reserve on a number of key issues. These include the issue of whether a pass-through partner is able to flow through the adjustments to its owners instead of paying tax on the adjustments at the first tier, as well as regarding adjustments to a partner's outside basis or capital account and a partnership's basis or book value in property when a partnership elects to apply Section 6226 to an imputed underpayment.

In addition, in December 2016, both the House and the Senate introduced bipartisan technical corrections that would address a number of issues discussed in the proposed regulations. See Tax Technical Corrections Act of 2016 (H.R. 6439, 114th Cong. (2016)); Tax Technical Corrections Act of 2016 (S. 3506, 114th Cong. (2016)). The House and Senate would need to introduce the technical corrections again in this new Congress. At this time, the timing of any such legislation is unknown, as well as when such legislation could be enacted and how any such legislation would affect the issuance of final regulations.

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