December 15, 2022
IRS issues final regulations on excepting special enforcement matters under the centralized partnership audit regime with some clarifications
In final regulations (TD 9969) (released December 8, 2022), the IRS and Treasury Department modified and clarified provisions of the centralized partnership audit regime enacted under the Bipartisan Budget Act of 2015 (BBA). The final regulations address partnerships that cease to exist, certain partnerships' eligibility to elect out of the regime, treatment of "non-income items," calculating imputed underpayments and other "special enforcement matters." The final regulations mostly adopt the proposed regulations released in November 2020 while making some revisions for clarity (see Tax Alert 2020-2822).
The final regulations generally apply to tax years ending on or after November 20, 2020. The final regulations in Treas. Reg. 301.6241-7(b), however, apply retroactively to tax years beginning after December 20, 2018.
The BBA overhauled the manner in which partnerships are audited and how any resulting tax liability is computed, assessed and collected. The BBA adopted a new regime that allows for assessment and collection of tax at the partnership level under centralized audit procedures, along with other changes to the partnership audit process. These rules are generally effective for most partnerships for tax years starting after December 31, 2017.
Title II of the Consolidated Appropriations Act of 2018 (TTCA), enacted on March 23, 2018, amended the partnership audit rules established by the BBA. TTCA addressed several procedural and substantive rules under the BBA and added IRC Section 6241(11) on the treatment of special enforcement matters. The TTCA 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).
IRC Section 6241(11), as added by the TTCA, authorizes the Secretary of the Treasury to prescribe regulations providing that the centralized partnership audit regime does not apply to partnership-related items involving special enforcement matters. These items are subject to special rules the Secretary determines to be necessary for the effective and efficient enforcement of the Internal Revenue Code. For this purpose, "special enforcement matters" include:
In January 2019, the IRS issued final regulations (TD 9844) implementing the BBA centralized partnership audit regime and concurrently issued related guidance (Notice 2019-06) announcing plans to issue additional proposed regulations addressing special enforcement matters under IRC Section 6241(11) (see Tax Alert 2019-0110). The proposed regulations were released in November 2020 (see Tax Alert 2020-2822).
The final regulations make few changes from the proposed regulations. The IRS said in the Summary of Comments and Explanation of Revisions (Summary) that it revised some of the language in the proposed regulations that was potentially unclear but did not intend, unless specifically noted, to change the meaning of the language.
The IRS noted that it considered the three written comments and two statements made at a public hearing held on March 25, 2021.
The cease-to-exist rule and push-out elections by disregarded entities
Under IRC Section 6241(7), if a partnership ceases to exist before the partnership adjustments take effect, the adjustments are taken into account by the former partners of the partnership.
Under Treas. Reg. Section 301.6241-3(b)(1), a partnership ceases to exist for purposes of the centralized partnership audit regime only if the IRS determines that the partnership has ceased to exist because (1) the partnership terminates within the meaning of IRC Section 708(b)(1), or (2) the partnership is unable to pay any amount that may be due for which the partnership is or becomes liable (the IRS determines whether a partnership satisfies this standard ).
In response to practitioners' concerns, the final regulations clarify that (1) the IRS may not determine that a partnership has ceased to exist if the partnership made an IRC Section 6226(a) "push-out" election, and (2) an IRS determination that a partnership has ceased to exist does not prevent the resulting entity (e.g., a partnership that converted to a disregarded entity as a result of having a single owner) from requesting modification of the imputed underpayment.
Where a partnership has ceased to exist because it terminated within the meaning of IRC Section 708(b)(1) (e.g., by having a single regarded owner), the final regulations allow the resulting entity, which is not classified as a partnership for federal tax purposes (i.e., it is likely a disregarded entity), to still make a "push-out" election. This change clarifies that a partnership that becomes disregarded in an acquisition transaction and is later audited and assessed imputed underpayments may elect to push out those adjustments to the former partners, notwithstanding the fact that the partnership no longer exists for federal income tax purposes.
The final regulations do not adopt a change in the proposed regulations that would have defined former partners as those listed on the partnership's most recent federal tax return. The final regulations maintain the definition of former partners as the partners during the adjustment year or, if there are no adjustment-year partners, then the partners of the partnership during the last tax year for which the partnership filed a return.
Election out of the centralized partnership audit regime
Under IRC Section 6221(b)(1) and Treas. Reg. Section 301.6221(b)-1(b)(1), partnerships may elect out of the centralized audit regime if the partnership has 100 or fewer partners and all partners are "eligible partners." The final regulations update the list of ineligible partners in Treas. Reg. Section 301.6221(b)-1(b)(3)(ii) by (1) revising the language on a disregarded entity to define it as a wholly owned entity disregarded as separate from its owner for federal income tax purposes, and (2) adding a qualified subchapter S subsidiary (QSub) as an ineligible entity.
Adjustments to non-income items
The definition of "partnership related items" for purposes of the centralized partnership audit regime includes items that are not items of gain, income, loss, deduction or credit (non-income items) (e.g., allocations of partnership liabilities, basis of partnership property and partnership reporting of IRC Section 199A items). "Negative adjustments" (generally those favorable to taxpayers) are defined as a decrease to an item of income or an increase to an item of credit, while "positive adjustments" (generally those favorable to the IRS) are defined as any adjustment that is not a negative adjustment. Accordingly, adjustments to non-income items are always classified as "positive adjustments."
If the adjustment to a non-income item is made as part of an IRS audit and does not result in an imputed underpayment, the proposed regulations required the partnership to take the adjustment into account on its adjustment-year return by adjusting the non-income item. The final regulations adopt this rule under Treas. Reg. Section 301.6225-3(b)(8) and add examples under Treas. Reg. Section 301.6225-3(d) to illustrate how adjustments to non-income items are taken into account for purposes of applying the rule. Specifically, Examples 3 and 4 are added to demonstrate how to account for adjustments to the bases of partnership assets and partnership liabilities. Example 5 is added to demonstrate how a partner filing an amended return as part of modification, as part of an IRS audit under the centralized audit regime, applies when there are adjustments to non-income items.
Commentors had expressed concern that this rule could cause partnerships to recognize gain (the imputed underpayment on the adjustment to a non-income item) in years preceding the partnership's disposition of the underlying asset/recognition event and requested that the rules be modified to treat adjustments to non-income items as "zero" and thus neither a positive nor a negative adjustment. According to the Summary, Treasury declined to make this requested change, stating that it was outside the scope of the final regulations, and that the change is unwarranted because the tax liability computed under the centralized partnership audit regime is an entity-level calculation and not designed to reach the same consequences that would result had the partners properly taken into account the adjustments.
Adjustments to non-partnership related items
Prop. Reg. Section 301.6241-7(b) addresses how to treat a partnership-related item on the partnership's return (or in its books and records) if the item is based in whole or in part on information provided by the person under examination. In this situation, the IRS could determine the centralized partnership audit regime did not apply to an adjustment or determination of a partnership-related item if that adjustment or determination is part of, or underlies, an adjustment to a non-partnership-related item during an examination of a person other than the partnership.
In the final regulations, the IRS modified Treas. Reg. Section 301.6241-7(h)(2) to clarify that "the partnership and the other partners are not bound to any determination regarding a partnership-related item resulting from the partner-level examination," so they do not have to adjust their returns.
In addition, the IRS modified Treas. Reg. Section 301.6241-7(b)(1)(iii) to clarify that "the information provided by the partner that forms the basis of the reporting by the partnership must come from the partner's own books and records, not the books and records of the partnership."
The final regulations will generally apply in the context of an IRS audit under the BBA regime with the exception of the two special enforcement provisions that permit adjustments to partnership items during an audit of the partner rather than the partnership. These circumstances include when the partnership's treatment of a partnership-related item on its return or in its books and records is based in whole, or in part, on information provided by a person other than the partnership. Under this provision, the IRS may open an audit at the partner level and propose adjustment to those items without the need to open an audit of the partnership itself under the BBA rules. The final regulations also apply when a partnership structure comes within the "controlled partner" provision. In this situation, the IRS may determine that there is an open statute of limitations to audit a partnership-related item by reference to a "controlling partner's" open period of limitations on assessment of chapter 1 tax when the period of limitations on making adjustments to the partnership has expired, but the partner's period of limitations on assessment remains open. The final regulations make it clear that partnerships must also take into account adjustments to non-income items when filing an Administrative Adjustment Request.
Partnerships undergoing an IRS audit under the BBA regime will need to register for access and become familiar with the BBA audit procedures and the IRS BBA electronic submission filing platform that must be used by the partnership representative to submit any BBA audit closing documents, forms or elections to the IRS (Tax Alert 2021-0418). The filing of a valid "push-out" election by the partnership representative at the end of an IRS audit may be the only way for a partnership to avoid an imputed underpayment tax assessment at the partnership level, which may be based on adjustments to not only in income items but also to non-income items. Partnerships will also need to develop a process to report IRS adjustments to non-income items that do not result in an imputed underpayment on their federal tax return filed for the year those adjustments became final, as opposed to the year they were made.
The "cease to exist" rule, as drafted in the proposed regulations, could have been interpreted to prevent BBA partnerships from making a valid IRC Section 6226(a) "push-out" election if they terminated (e.g., in a Revenue Ruling 99-6, Situation 2 transaction) and became classified as disregarded entities. The final regulations clarify that a partnership that converts to a disregarded entity, and is later audited and assessed imputed underpayments, may elect to push those adjustments out to the former partners. This is welcome news for those partnerships.
While the Preamble to the final regulations states that the IRC Section 6241(7) regulations (i.e., Treas. Reg. 301.6241-3) were never intended to prevent a partnership from making an IRC Section 6226(a) "push-out" election, it does not specify that the changes permitting disregarded entities to make "push-out" elections are a clarification of existing law. The changes are effective for determinations made for tax years ending on or after November 20, 2020. This creates uncertainty about whether a former partnership that is classified as a disregarded entity and wishes to make a "push-out" election for tax years before November 20, 2020, may validly do so. The final regulations also confirm the reversal of the IRS's former position in Notice 2019-06 and provide that a partnership with a qualified subchapter S subsidiary (Q-sub) as a partner is not eligible to elect out of the BBA regime. Partnerships with QSubs partners should consider restructuring if the partnerships desire to elect out of the centralized audit regime.
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor