April 20, 2018 Technical corrections to partnership audit rules included in Appropriations Act The Consolidated Appropriations Act, 2018 (the Act), enacted on March 23, 2018, amends the partnership audit rules established by the Bipartisan Budget Act of 2015 (BBA). The Act addresses a number of procedural and substantive rules under the BBA, including the scope, netting, push-out election, and special enforcement matters. The provisions in the Act are very similar to the bipartisan technical corrections that were introduced in both the House and Senate in December 2016, and many of its provisions are consistent with proposed regulations. The amendments are effective for tax years that are subject to the BBA (i.e., tax years that begin after December 31, 2017, or an earlier tax year for which the partnership has elected to apply the BBA rules). Background The BBA overhauled the manner in which partnerships are audited and how any resulting tax liability is computed, assessed and collected. Before the BBA, a partnership audit generally was conducted in accordance with the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which did not provide any statutory mechanism for collecting income tax at the entity level. Rather, the IRS generally had to seek payment of underpaid tax directly from the partners that would have owed such tax had the partnership properly reported the items on its tax return. The BBA brought in a new regime to allow for assessment and collection of tax at the partnership level under centralized audit procedures, along with a number of other changes to the partnership audit process. These new rules are generally effective for most partnerships for tax years starting after December 31, 2017. The IRS has issued multiple sets of regulations relating to the BBA. On August 4, 2016, the IRS released temporary and proposed regulations addressing the election to apply the BBA to tax years beginning after November 2, 2015 and before January 1, 2017. For a detailed discussion, see Tax Alert 2016-1344. On June 13, 2017, the IRS released proposed regulations providing 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 June proposed regulations include procedures for electing out of the new regime, designating a partnership representative, filing administrative adjustment requests, and determining amounts owed by a partnership or its partners from adjustments following a partnership exam. For a detailed discussion, see Tax Alerts 2017-0168 and 2017-1002. On November 30, 2017, the IRS issued proposed regulations providing guidance on the application of certain international tax rules under the BBA centralized partnership audit regime. For a detailed discussion, see Tax Alert 2017-2056. On December 19, 2017, the IRS published proposed regulations addressing Section 6226 push-out elections in tiered partnership structures. Those proposed regulations also address certain procedural issues, including tax assessment and collection, penalties and interest, periods of limitations, and judicial review of partnership adjustments. The December proposed regulations would allow an upper-tier partnership to make the Section 6226 push-out election, an issue reserved in the June proposed regulations. See Tax Alert 2017-2184. On January 2, 2018, the IRS issued final regulations on electing out of the BBA partnership audit regime. See Tax Alert 2018-0013. On February 2, 2018, the IRS issued proposed regulations relating to addressing the adjustment of tax attributes to reflect partnership adjustments under the centralized partnership audit regime. See Tax Alert 2018-0355. Technical Corrections in Act Scope of the partnership audit rules As originally enacted, the BBA provided that the BBA rules applied to any adjustment of a partnership's tax items (such as income or loss), and a partner's distributive share thereof. The statute did not explicitly include a partner's other tax items that relate to Subchapter K, such as gain recognized in a disguised sale under Section 707(a)(2)(B) or the character of gain recognized under Section 751(a) in the sale of a partnership interest. The Act amended the scope of the BBA rules so that they explicitly apply to items or amounts with respect to a partnership when those items or amounts are relevant in determining the tax liability of any person under chapter 1 of the Code. The rules therefore apply to a partner's treatment of items relating to a transaction with, basis in, or liability of the partnership, even if the item is not reflected on the partnership's return. This approach is generally consistent with the approach taken in the June 2017 proposed regulations. The Act also clarified that the partnership audit rules do not apply to taxes imposed, or to amounts required to be deducted or withheld, under the self-employment tax, net investment income tax, withholding tax on nonresident alien individuals or foreign corporations or withholding tax for certain foreign account rules. Any partnership adjustment determined under the BBA for income tax purposes, however, is taken into account for purposes of determining and assessing tax under these rules. Netting in the determination of imputed underpayments Under the BBA, a partnership might be paying tax (the imputed underpayment) on income that was omitted. Different types of income and losses are subject to different rules and limitations. For example, capital losses generally cannot offset ordinary income, and limitations apply to interest deductions. A partnership might overreport one type of income and omit a different type of income. If the partnership were allowed to pay tax only on the net adjustment, it would avoid the limitations that generally apply to the erroneously reported items. To prevent this result, the Act provided that a partnership generally cannot use an adjustment to one type of income to reduce the tax it owes with respect to a different type of income. Therefore, if a partnership reports $1M of ordinary income as capital gain, it will generally owe tax on the $1M of ordinary income that it omitted. The amount of tax will not be reduced by the excess capital gain that was reported, but the partnership or the partners might obtain some other benefit to correct the overreported capital gain. For example, the partnership might omit $1M of capital gain that it reports in a later year. These netting rules generally accord with the approach taken in the June proposed regulations. Alternative procedure to filing amended returns (pull-in) Under the BBA, a partnership might owe tax when the IRS makes an adjustment to an item that is within the scope of the BBA (e.g., an adjustment to the partnership's tax return). The amount of tax owed can be reduced if the reviewed-year partners amend their returns to take the adjustment into account and pay any additional tax that would be owed. The Act provides a new "pull-in" procedure that effectively provides the same result, without requiring amended returns. Under this pull-in procedure, a partner would be required to provide the Secretary with the information necessary to determine the additional amount owed by (or to) the partner, as well as how its tax attributes would be affected in subsequent years. This pull-in procedure is available for direct and indirect partners. The pull-in procedure is a welcome addition to the statutory system, as it will allow adjustments to be processed without partners filing complete amended returns. Section 6226 push-out election Under Section 6226, a partnership may make a so-called push-out election for an adjustment to be taken into account by the reviewed year partners, rather than the partnership itself. Consistent with the December 19, 2017 proposed regulations, the Act allows an adjustment to be pushed out through multiple tiers of entities. Therefore, if an adjustment is made to the return of a lower-tier partnership, that partnership may push the adjustment out to its partners, and if its partners are themselves partnerships, they may in turn push the adjustment out to their partners. As originally enacted, a Section 6226 push-out election would only increase the amount of tax a partner owed with respect to a particular tax year. If an adjustment would have decreased the amount a partner owed for a particular tax year, the partner would have generally obtained no benefit from that adjustment. The Act amended Section 6226 so that partners may receive the benefit of an adjustment that decreases the amount of tax owed for a tax year. This is a significant improvement to the BBA. It does not ensure, however, that a Section 6226 election will always produce the result that would have arisen had the partnership's original return reflected the adjustments made by the IRS. Special enforcement considerations Under the Act, the Secretary is authorized to issue regulations that address "special enforcement matters," and these regulations may adopt an approach that differs from the BBA rules. Special enforcement matters includes jeopardy assessments, criminal investigations, the failure of an upper-tier partnership (or S corporation) to satisfy its obligations under Section 6226 when a lower-tier partnership makes a push-out election, foreign partners or partnerships, and other matters presenting special enforcement considerations. US shareholders of CFCs treated as partners Except as provided by the Secretary, the Act treats its United States shareholders as partners in the partnership when a controlled foreign corporation is a partner in a partnership. Similarly, when a passive foreign investment company is a partner and has a shareholder that has made a qualified electing fund election under Section 1295, that shareholder is treated as a partner. It is difficult to assess the implications of treating shareholders as partners without further interpretive guidance, but it seems potentially significant in certain facts patterns. For example, if a US shareholder sells a CFC that is a partner in a partnership, if the partnership later elects to push out adjustments under Section 6226, it is possible that the former US shareholder could be allocated income under a settlement, and this might occur without any notice to the former shareholder. Treatment of shareholders as partners could affect a host of other circumstances, including whether a partnership is eligible to elect out of the BBA regime. Implications The Act makes helpful changes to the complex BBA partnership audit regime that is still in the process of being implemented. Before the Act, the Section 6226 push-out election generally did not let a partner obtain any benefit from an adjustment that would decrease the amount of tax owed. This could produce an unduly harsh result when income was misallocated or when an adjustment was made that would increase the amount of basis a partnership had in an asset. The Act now allows a partner to take into account such favorable adjustments, so a Section 6226 push-out election will produce a result that is fairer than under the original version of the BBA partnership audit regime. The Act does not ensure, however, that the partners will always be able to obtain the "correct" result (i.e., with the partners paying the amount of tax that they would have paid had all items been properly reported on the original returns) by having the partnership make a Section 6226 push-out election. For example, it appears that a Section 6226 election might not be available when there is no imputed underpayment. When a partner is a controlled foreign corporation or a passive foreign investment company, its United States shareholders will be treated as partners of the partnership for all purposes of the BBA. As a result, such shareholders may be liable for tax if the partnership makes a Section 6226 push-out election or if the partnership ceases to exist. The partnership's eligibility to elect out of the BBA may also be affected. Many of the other amendments are generally consistent with the regulations that have already been proposed. For example, a Section 6226 push-out election can be made up through tiers of entities, adjustments to different types of income will generally not offset each other when computing an imputed underpayment, and the pull-in procedure will enable partners to take adjustments into account without having to file amended returns. Additional guidance is still needed to implement these and other issues. ———————————————
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