Practical effects of the new IRS audit and collection procedures for partnerships
Vol. 75, No. 4 / July-August 2019
Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.— Judge Learned Hand
Norman S. Newmark
Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.— Judge Learned Hand
As a result of the new IRS audit and collection rules related to partnerships and entities taxed as partnerships, certain partners may be responsible for paying the taxes of other partners — even if lawful measures are taken to reduce taxes on the returns, as suggested by Judge Hand. Moreover, the rights of partners to contest partnership-related taxes in court are curtailed or eliminated. While the new rules are bound to spark litigation among partners in future years, there are steps that can be taken to ameliorate the impact of the new rules in operating or other agreements.
For federal income tax purposes, businesses and their owners pay taxes based upon various recognized forms of business under the Internal Revenue Code. Generally, these forms consist of the sole proprietorship, partnership, S corporation, and C corporation. Business owners and their advisors can select the form of entity most suitable to the particular business for both tax and non-tax purposes, often called “choice of entity” decisions. Under these rules, the owners of an unincorporated entity such as a limited liability company (“L.L.C.”) can generally choose any form of business taxation for the L.L.C. depending upon the number of owners and other factors. In this connection, many L.L.C.s elect to be taxed as partnerships for a variety of tax reasons, the primary being the “pass-thru” of business income, loss, credits, etc. to the partners (called “pass-thru items” in tax parlance).
Traditionally, the procedures under which the IRS audits returns, assesses taxes, and collects taxes related to partnership entities have not been at the forefront of entity choice decisions for investors and their advisors. Before now, there have been two basic principles underlying IRS audit and collection procedures for partnership entities (and their equity owners, called “partners” generically for purposes of this article), and other taxpayers. First, each partner is responsible for reporting his or her share of pass-thru items. If the IRS audits the partnership’s returns and finds improper reporting of such items, each partner for the reported year is also responsible for the payment of any additional tax, penalty, and interest on his or her share of additional income or reduced loss, etc. Conversely, a new partner is not responsible for the pass-thru items of prior years. Second, each partner is generally entitled to contest the IRS’ determinations in court for his or her own account. In short, each partner is responsible for, and has some degree of control over, his or her own tax bill for partnership pass-thru items and need not worry about paying other partners’ taxes or turning over litigation control to some other person.
For entities taxed as partnerships, however, these underlying principles have changed dramatically for tax years beginning after December 31, 2017, under new procedures commonly referred to as the “BBA procedures” in tax parlance. The BBA procedures may well influence the choice of entity decisions going forward or encourage existing partnership entities to change tax status to S or C corporations inasmuch as the basic principles underlying IRS audit and collection procedures no longer hold true for entities taxed as partnerships. These changes can be summarized as follows:
(1) The partners for the audited year are generally not responsible for additional taxes, penalties, and interest as assessed by the IRS in a later year. Instead, either the partnership as an entity, or the partners as of the time the IRS’ determinations become final, will be required to pay the IRS.
(2) The right of each partner to contest the IRS’ determinations in court is gone, and such right is vested solely in a newly designated person or entity known as and denominated the “partnership representative” to speak on behalf of the partners and the partnership.
These changes make the partnership form of entity less desirable, inasmuch as current partners will not want to pay the tax bills of the prior year partners, either indirectly due to payment of taxes from the business, or directly in the form of a personal IRS assessment. Moreover, few partners will want to assign their rights to litigate with the IRS to the partnership representative, who may have conflicting interests or simply fail to properly contest an IRS determination. In short, the BBA procedures provide a strong disincentive to create or invest in an entity taxed as a partnership, both as to the risk of an unknown amount of tax liability for prior tax years in which the partner was not affiliated with the partnership, and the inability of each partner to personally mount a defense against the liability in a court of law, regardless of whether the partner was so affiliated.
Part I of this article will discuss prior law IRS audit and collection procedures for partnerships under traditional IRS tax audit and collection principles. Part II will delve into the new BBA procedures, and Part III will conclude with some suggestions for mitigating the effects of the BBA procedures by making certain tax elections or drafting BBA provisions in partnership documents. Part IV will provide some examples and conclusions.
Part I: Prior IRS Procedural Law
Prior to the enactment of the Tax Equity and Fiscal Responsibility Act of 1982 ( TEFRA), the IRS would essentially audit individual partners on their respective shares of partnership pass-thru items and collect additional tax revenue through normal individual audit and collection procedures. This proved difficult for the IRS to administer and sometimes produced inconsistent results, especially where a given partnership had partners subject to different assessment limitation periods or case law in various jurisdictions, with different results for partners in the same partnership.
1982 TEFRA Rules
In 1982, as part of TEFRA, Congress added TEFRA audit rules to provide unified rules for adjustments at the partnership level in most circumstances. The goal was to treat all partners uniformly, in one proceeding.
Essentially, these audit rules provide for an IRS determination of partnership level items and allocations thereof for the audited partnership tax year in a single proceeding applicable to all partners of the audited years. TEFRA audit rules also require the designation of a “tax matters partner” (TMP) to receive various IRS notices, work with the IRS in resolving any audit, file or intervene in a lawsuit for a readjustment of partnership items as stated on an IRS notice of final partnership administrative adjustment, and provide various notices to partners in given circumstances. However, generally other partners can also participate in administrative and court proceedings, with or without the concurrence of the TMP. The TMP can bind only certain partners in any settlement.
At the conclusion of any TEFRA administrative proceeding or court case, the IRS must assess and collect any additional tax, penalty, and interest from each of the affected partners based upon his or her share of additional income or reduced loss, etc. for the tax year(s) involved.
It’s key to note that both the pre-TEFRA rules and the TEFRA system follow the traditional principles of IRS audit and collection procedures, in that each partner for the tax year(s) in question must pay taxes on his or her share of additional taxable income or reduced loss as finally determined, and in general each such partner may contest the IRS’ determinations in court. It is also worth mentioning that the TEFRA rules will continue to apply for partnership tax years beginning at or prior to December 31, 2017. This is the effective date of the BBA procedures, and thus will be used by the IRS and partnerships until the applicable statutes of limitation expire for such years.
Part II: New BBA Procedures
After more than 30 years’ experience with the TEFRA rules, the IRS determined that it lacked the ability to audit and collect taxes on income from a substantial portion of partnership entities, given the increased complexity, size, and number of partnerships. As evidence, the Treasury Department noted the audit rate for large partnerships under TEFRA (i.e., those with 100 or more partners or $100 million or more in assets) had been substantially less than the comparable audit rate for large corporations under traditional deficiency procedures, due in part to difficulties in determining which partners were ultimately responsible for paying the tax bill in tiered partnerships, i.e., partnerships owning other partnership interests.
In response to a request from Congress, the Government Accountability Office (GAO) issued a report in 2014 indicating that the IRS audit rate for partnership entities was comparatively low and that the IRS’ ability to audit and collect taxes on partnership income would not improve under existing TEFRA rules. GAO recommended new legislation to address the matter.
As a result of the GAO report and other activities, Congress passed the Bipartisan Budget Act of 2015, as amended by the Protecting Americans from Tax Hikes Act of 2015. In 2018, the Tax Technical Corrections Act of 2018 became effective, amending the BBA procedures. The new BBA procedures replace TEFRA audit rules for partnership tax years that begin after December 31, 2017, except as otherwise elected by a partnership.
Under the new regime, partnerships will still be pass-thru entities and still file returns reporting pass-thru items to their partners for proper tax reporting. However, in the event the IRS pulls a given partnership return or other items for examination, the new BBA procedures will come into play unless otherwise elected by a partnership.
Unlike the TEFRA rules, the BBA procedures provide for a “centralized partnership audit regime” generally applicable to partnerships or entities taxed as partnerships. This allows the IRS to audit and collect taxes from the partnership entity for the audited years (called “reviewed years”) instead of the individual partners as under TEFRA. Mechanically, the BBA procedures will work for a given partnership entity under the general rules as follows:
First, the partnership will appoint a representative on its IRS 1065 partnership return for each tax year after the effective date of the BBA; this appointment cannot be revoked or amended unless in accordance with applicable regulations. The actions of the partnership representative will be binding upon the partnership and the partners until the effective date of the termination of the partnership representative.
Second, assuming the IRS selects the partnership’s return for examination, the IRS will send the partnership and the partnership representative a notice of administrative proceeding to initiate the proceedings for the reviewed year.
Third, after examining returns and other partnership information, the IRS may determine to adjust “partnership-related items” with respect to the partnership. Such adjustments in general are called “partnership adjustments” for BBA purposes. The term “partnership-related items” means any partnership item or amount which is relevant in determining the federal income tax liability of any person (regardless of whether it appears on the partnership tax return) or any partner’s distributive share of such item.
The IRS will determine whether there is an “imputed underpayment” as to its partnership adjustments to partnership-related items, roughly meaning the tax which would have been paid by the reviewed year partners if the partnership adjustments were properly reported, but taxed instead to the partnership entity at the highest tax rate for the reviewed years in question. Under these calculations, the IRS will group and sub-group and net like-items of partnership adjustment together (e.g., adjustments to capital gains and losses) to determine if there is an imputed underpayment of tax. There are rules for separate groupings of partnership adjustments, including tax credits and reallocation of partnership-related items among the partners. Also note that any calculation not resulting in an imputed underpayment is instead taken into account by the partnership and the partners in the year the adjustments become final. The IRS will then send a notice of a proposed partnership adjustment (NOPPA) containing any imputed underpayment.
Fourth, the NOPPA calculation of imputed underpayment is then subject to various reductions and modifications which can be requested via the partnership representative, as authorized and determined under BBA procedures (called “modifications”).
Fifth, the IRS will send a notice of the final partnership adjustment (FPA) to the partnership and partnership representative. The imputed underpayment as so modified is subject to penalties and interest.
Sixth, if the partnership (via the partnership representative) agrees with the FPA, the partnership may simply pay the IRS a set amount. After payment, the matter will be put to rest for federal purposes, if not for state tax purposes.
Alternatively, if the partnership disagrees with the FPA, the partnership representative may file a petition in the U.S. Tax Court, the federal district court for the district in which the principal place of business lies, or the U.S. Court of Claims for a readjustment within 90 days after the FPA is mailed if other procedures are followed.
Seventh, once a final determination is made on the FPA, the IRS may proceed to assess and collect the imputed underpayment and penalties, as well as any interest, from the partnership entity as though it were a tax imposed upon the partnership. The assessment is made for the “adjustment year,” generally meaning the year in which the adjustment becomes final. That said, payment is not due with the adjustment year IRS 1065 partnership return filed in the following year, but rather upon notice and demand from the IRS. Tax attributes affected by the payment of the imputed underpayment – such as the tax bases of partnership assets and interests, and the partners’ capital accounts – are adjusted under various rules contained in the regulations.
Eighth, and finally, if the imputed underpayment, penalties, and interest are not paid by the partnership entity in full after IRS demand, the partners as of the end of the adjustment year may be assessed by the IRS for the balance owed on the basis of proportionate partnership interest. This provision indicates that the liable partners for the imputed underpayment are determined as of the close of the adjustment year. Query if the IRS will face collection issues if there is a delay in assessment so that the adjustment year partners can be determined as of the end of the adjustment year.
Special rules apply the tax to former partners if the partnership does not exist at the time a partnership adjustment occurs. In addition, there are special rules if a given partner does not report pass-thru items consistently with the partnership tax return, allowing the IRS to immediately assess and collect additional taxes, penalties, and interest from the partner as though a mathematical error. These are different from the general rule where the partnership entity is liable for the tax, possibly because each partner must pay taxes on pass-thru items under general partnership tax principles, and the IRS wants to collect taxes from the responsible parties in the absence of business entity existence or fault.
III. Mitigating the Effects of BBA Procedures
In the long run, the BBA procedures could make life easier for the IRS’ audit and collection efforts against partnership entities and investors, assuming no major court challenges or substantial amending legislation. In the short term, tax administration in complicated cases could prove challenging. Additional legislation, regulatory activity, IRS rulings, and case law may be needed to iron out the wrinkles.
The more immediate and practical concern for legal practitioners is the potential for, if not the probability of, litigation by or among partners and partnership representatives over payment of tax liabilities. If current partners end up paying the partnership tax bill of former partners, or if the partnership representative abuses or neglects his authority, someone is bound to be an unhappy taxpayer. The practitioner’s near-term goal, then, is to figure out how to mitigate the litigation risks.
There are a couple of avenues to consider for such purpose. First, the BBA procedures themselves offer some relief. Second, the partnership, operating, or other agreement can be a vehicle to address potential conflicts. The following reviews these options in more detail.
Relief Provisions of the BBA
There are three provisions built into the BBA procedures to safeguard against or ameliorate the impact of the new rules on partnerships and partners.
For certain partnership entities, it is possible to elect out of the BBA procedures and fall back on pre-TEFRA rules. Such election-out procedures can only occur if the partnership has 100 or fewer partners as defined and determined in the statute and regulations. Even then, each partner must be an “eligible partner” as defined in the statute and applicable regulations. Eligible partners include individuals, estates of deceased individual partners, C corporations, S corporations, and certain foreign entities, but do not include other partnerships, trusts, nominee holders, disregarded L.L.C.s, or other single-member entities, non-eligible foreign entities, or estates of individuals other than deceased partners.
An election out will relieve each partner from concerns about paying for another partner’s taxes and restore the individual right to mount a defense against the IRS in court. Arguably, relying on the election out provision for anything other than a given year or so is not advisable, considering the scope of ineligible partners and the chances of an otherwise eligible partner becoming ineligible. For example, if an individual partner becomes legally disabled and requires a conservatorship, the partnership can no longer make the election out for future years, presumably until the conservatorship is terminated by the partner regaining capacity or dying, or perhaps more likely, until the partnership interest is sold to an eligible partner. In addition, an innocent transfer of an individual partner’s partnership interest to a revocable living trust – for estate planning purposes, for example – would make the partner ineligible and prohibit the partnership entity from making the election out for the years in which the trust holds the interest.
Moreover, even if the election out is successfully made for a given year, some partners may not be pleased. For example, inasmuch as under the pre-TEFRA audit rules the IRS will conduct individual partner audits, the IRS is likely to examine certain non-partnership (unrelated) items in addition to partnership items. Alternatively, a passive investor may want the partnership entity to bear the burden of any tax under BBA procedures, having dutifully reported the amounts shown on IRS Schedule K-1 forms for the years in question with little knowledge of the issues at hand and little ability to mount a defense in case of audit.
Modification of Imputed Underpayment.
As mentioned, the partnership via the partnership representative may attempt to reduce the imputed underpayment in the NOPPA by means of modification. There are several means to do this under the statute and regulations. A few examples include:
(a) A modification for the reviewed year partners filing amended tax returns taking into account (and paying for) the partnership adjustments;
(b) A modification for reviewed year partners using an alternative to amended returns, called the “pull-in” procedure, wherein the partners pay applicable taxes, penalties, interest, etc. by agreeing to adjust tax attributes and provide information in lieu of amended returns; and
(c) A modification to the tax rate applied in the imputed underpayment in cases of C corporation partners or individual partners with partnership capital gain or qualified dividend income.
Generally, modifications must be requested by the partnership representative within 270 days of the date the IRS mails the NOPPA, unless extended by the IRS. Modification procedures may be of limited value where the reviewed year partners are unenthusiastic about filing amended returns, using the pull-in procedure, or paying additional taxes, penalties, and interest, and where no other modification avenues exist under the circumstances.
Push-Out of Imputed Underpayment.
The partnership may elect to “push out” the imputed underpayment to the reviewed year partners. That means reviewed year partners will be liable for the imputed underpayment (or its equivalent) and associated penalties and interest, instead of the partnership entity. To make the election, the partnership representative must file completed and signed IRS forms within 45 days of the date the IRS mails the FPA, and the partnership must seasonably send appropriate statements of adjustments to the reviewed year partners and the IRS, i.e., within 60 days of when the partnership adjustments become final.
Mechanically, the “push-out” adjusts the tax bill for the partner in the year in which the statements are sent, roughly by re-computing the amount of tax owed by the partner in the reviewed year (and other years in which tax attributes are affected) as if his or her partnership adjustments had been properly taken into account, and subtracting the actual tax reported. Penalties and interest apply and the applicability of penalties is determined at the partnership level; however, the calculation of the penalty and interest for each partner is determined at the partner level, and penalty defenses may apply.
At first blush, the “push-out” might seem like the ideal solution because the reviewed year partners will bear the tax burden as finally determined. However, bear in mind these drawbacks:
(a) The push-out must be made within 45 days of the FPA and there is no extension date for a late filing, even if, for example, the partnership representative becomes incapacitated before a replacement can be made.
(b) The push-out must be made by the partnership representative, who may be a reviewed year partner but not a partner at the time of the FPA. In this case, he or she could have a selfish incentive not to push out the tax liability to himself or herself but let the partnership entity bear the tax.
(c) The reviewed year partners have no ability to contest the push-out amounts shown in the statements, and the partnership representative may not be willing to go to court, especially if he or she is not also a reviewed year partner or if his or her tax is de minimis.
(d) There is no ability for reviewed year partners to remove and replace the partnership representative unless it is approved by the partnership at the time of or after the notice of examination or the notice of administrative proceeding.
Additionally, there may be a delayed removal beyond the 45-day time limit even if the partnership representative is conflicted.
In summary, the built-in procedures may work in given circumstances from time to time, but should not be relied on when a practitioner drafts documents or otherwise plans for future partnership taxes. Instead, the practitioner should consider contractual remedies first and only fall back on the built-in procedures when it is possible and more desirable to achieve the intended result or avoid partner litigation.
Possible Relief Provisions in Partnership-Related Agreements/Contractual Remedies
No doubt the BBA procedures will evolve as new legislation, regulations, IRS rulings, and case law come about. In any event, practitioners should consider taking remedial steps in partnership entity documentation to avoid or reduce the chances for partner and partnership representative conflicts while the mechanisms of the BBA procedures are clarified. Practitioners may also want to consider the circumstances of each partnership entity before inserting standard or boilerplate language. And, of course, as new law appears, the agreements can occasionally be updated.
As practitioners become more familiar with the BBA procedures, they can consider these examples of possible contractual provisions:
1. Rules for the selection and removal of the partnership representative, for example, upon majority vote of the partners or as selected by the L.L.C. manager, and mandatory use of third-party partnership representatives to avoid potential conflicts of interest;
2. “Safe harbor” or de minimis rules for the partnership representative’s conduct in such areas as pre-approved dollar amounts for IRS settlements or professional fees, i.e. without prior partnership consent, or even mandatory partnership entity payments for the benefit of passive investors, and perhaps tax reserves for such purposes;
3. Requirements for the partnership representative to obtain pre-approval of the manager or partners in the selection and payment of counsel, accountants and experts, any communication with the IRS, any settlement above the safe-harbor amount, and for any extension of the applicable statute of limitations;
4. Compensation, confidentiality, exculpation, fiduciary, and indemnification provisions for the partnership representative;
5. Requirements for the partnership representative to include the manager and perhaps other partners as part of strategic decision-making with counsel (subject to attorney/client privilege considerations) and to provide all IRS notices and periodic status updates to management;
6. Rules for the “push-out” election, e.g. mandatory push-out unless the imputed underpayment is at or below the safe-harbor amount for partnership-level IRS settlement;
7. Requirements that the partnership representative obtain manager or partnership approval before engaging in litigation with the IRS, and perhaps for reviewed year partner approval and indemnification of the partnership representative for legal expenses and costs where the push-out has been elected;
8. Mandatory cooperation of reviewed year partners in filing and seasonably notifying the partnership representative of amended returns or using the “pull-in” option for modification of the imputed underpayment, and for other pertinent information (e.g., tax status as a C corporation for the reviewed years);
9. Mandatory cooperation of the partnership to provide reviewed year partners information, not only as mandated for the push-out but for filing amended returns or the pull-in under circumstances where the push-out is not viable;
10. Liquidated damage provisions for partnership representative misconduct, such as gross negligence or malfeasance;
11. Reviewed year partner indemnification provisions to the partnership or the last partners before the partnership’s termination, if, for example, the push-out or pull-in is not available, at least for imputed payments above the safe-harbor amount;
12. Restrictions on transfer so that the partnership may elect out of the BBA procedures; and
13. Automatic indemnity provisions requiring a partner who sells his interest to another partner or a third party to indemnify the buying partner for any taxes directly or indirectly paid in connection with reviewed and related years during which the selling partner was a partner.
Part IV: Examples and Conclusion
Here’s how the BBA procedures might work out in practical terms by looking at some examples.
Example 1. Ella, Bella, and Stella form EBS, L.L.C. on January 1, 2017 (“EBS”). Ella is an individual, Bella is a domestic C corporation (wholly owned by Bella, an individual), and Stella is the trustee of a revocable trust. EBS is taxed as a partnership with calendar tax year reporting.
Ella, Bella, and Stella contribute equally to EBS and each has an equal share of EBS interests (i.e., profits, losses, etc. are divided equally). EBS is not eligible to elect out of the BBA rules because Stella has transferred her member interest to a revocable trust for estate planning purposes. Ella is appointed as the partnership representative on the IRS 1065 partnership tax return for 2018 as filed in 2019, and, in accordance with regulations, no election out of the BBA procedures is made. However, the operating agreement is not updated to include provisions for BBA procedures.
In 2020, there is a falling out among the EBS members, and Ella is asked to leave. She sells her interest in equal shares to Bella and Stella, at fire-sale prices. Later that same year, the IRS audits the 2018 partnership return and finds that $300,000 of ordinary income was not reported, resulting in an imputed underpayment of $111,000 ($300,000 x 37 percent) and penalties and interest of $30,000.
Ella is the partnership representative under BBA procedures, even though she is no longer a member. Due to an ongoing dispute between Bella and Stella, Ella is not replaced as partnership representative before she settles with the IRS for the amount in the FPA. Ella does not elect the push-out inasmuch as Ella is a reviewed year partner and would otherwise bear an equal share of the tax bill personally. Moreover, Ella does not attempt to modify the imputed underpayment, even though Bella was a C corporation during the 2018 reviewed year and hence subject to a lower tax rate in 2018 (21 percent).
EBS and its members are bound by the determinations of Ella for BBA tax purposes and have no appeal rights to any court to litigate the tax bill. Hence, under BBA procedures, EBS must pay the IRS the full $141,000, effectively borne by Bella and Stella. If EBS has insufficient funds to pay the $141,000 in full, the IRS may assess Bella and Stella personally for the balance, in equal shares. Ella pays nothing and has the last laugh until the matter is litigated in state court; even so, there are no contractual remedies for Bella and Stella, so Ella may be victorious.
The facts are the same as in Example 1, except the IRS determines that EBS has sufficient equity in some real estate to cover the $141,000 due. They file a notice of federal tax lien on the property before proceeding against Bella and Stella. The real estate is worth $600,000 with a pre-existing bank mortgage of $400,000. The bank forecloses on the real estate and sells it for $475,000, paying off the mortgage and the IRS to the extent of $45,000, after costs. The IRS will personally assess Bella and Stella for the balance owed ($96,000) in proportion to their membership interests, or $48,000 each. Once again, Ella pays nothing.
The facts are the same as in Example 1, except that Ella sells her membership interest to third party Della, an individual. EBS pays the IRS in full, meaning that Della has indirectly paid Ella’s tax bill to the extent of about $46,953 (33 1/3 percent x $141,000). If EBS can only pay $100,000, the IRS can assess Della personally for her share of the balance owed or $13,653 (33 1/3 percent x $41,000).
The facts are the same as in Example 1, except that before the IRS settles with Ella, Bella and Stella replace Ella with Stella as partnership representative. Moreover, Stella agrees with the IRS to allocate the entire imputed underpayment, penalties, and interest to Ella and Bella and uses the push-out, with the result that neither EBS nor Stella bear any portion of the tax bill.
The facts are the same as in Example 1, except that the EBS operating agreement has been modified for the BBA procedures such that the partnership representative is personally liable in the event there is no push-out. If the push-out is not viable, the reviewed year partners must reimburse or indemnify EBS and adjustment year partners for the reviewed year partners’ respective shares of any imputed underpayment, penalties, and interest. As a result, EBS and perhaps Bella and Stella must pay the IRS. However, they have the contractual right to sue Ella in state court for breach of contract and for indemnity.
The BBA procedures represent a sea change in partnership taxation, not only as to audits and collections, but as to a very real and practical possibility of litigation among partnership constituencies outside of the taxation arena. Practitioners should review existing and new partnership, L.L.C. operating, or other agreements in conjunction with BBA rules and determine the best means of avoiding or reducing conflicts for each partnership client and its constituencies. Alternatively, where appropriate, the practitioner may want to review the possibility of S corporation (or even C corporation) status to avoid such conflicts in the first place.
1 Norman S. Newmark is a lawyer with AEGIS Law in Frontenac. He is a graduate of Boston University (B.A., cum laude, 1984), and Washington University School of Law (J.D., Order of the Coif, 1987, LL.M. in Taxation, 1991). He is a member of The Missouri Bar and the Oklahoma Bar, and is admitted to practice before the U.S. Tax Court. The author gives many thanks to Doug Mueller, CPA, who provided invaluable input for this article, but the author’s comments are his own. The buck stops here…
2 Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293 U.S. 465 (1935).
3 For unincorporated entities, see generally Treas. Reg. § 301.7701-1(a)(4) and Treas. Reg. § 301.7701-3(b)(1)(ii) (sole proprietorships), and I.R.C. § 761(a) and I.R.C. § 7701(a)(2), and Treas. Reg. § 301.7701-3(b)(1)(i) (partnerships). For corporations, see generally I.R.C. § 1361, I.R.C. § 1362 , I.R.C. § 7701(a)(3), Treas. Reg. § 1.1361-1(b), and Treas. Reg. § 301.7701-2(b) (S corporations), andI.R.C. § 7701(a)(3), Treas. Reg. § 301.7701-2(b) and Treas. Reg. § 301.7701-3(a) (C or regular corporations). A detailed comparison and discussion of various tax and non-tax attributes, benefits, and detriments of these kinds of businesses is beyond the scope of this article.
4 See I.R.C. § 7701 and Treas. Reg. § 301.7701-3.
5 See generally I.R.C. §§ 701-761 (“Subtitle A, Subchapter 1, subchapter K – Partners and Partnerships”), as in effect for tax years beginning after 12/31/2017.
6 See I.R.C. § 701 and I.R.C. § 704 for the flow-through of partnership income, etc. and allocations thereof among the partners, and see generally I.R.C. §§ 6221-6234 (“Subtitle F, chapter 63, subchapter C – Tax Treatment of Partnership Items”), as in effect for tax years starting at and prior to 12/31/2017, for audit and collection procedures under prior law.
8 See I.R.C. § 6226, as in effect for partnership tax years starting at and prior to 12/31/2017, for jurisdiction and procedures in U.S. Tax Court, federal district court, and U.S. Court of Claims.
9 Bipartisan Budget Act of 2015, P.L. 114-74, as amended by P.L. 114-113 and P.L. 115-141, commonly known as the “BBA” for short, generally effective for partnership tax years beginning after 12/31/2017.
10 See I.R.C. § 6221(a), I.R.C. § 6225, and I.R.C. 6232, as in effect for partnership tax years beginning after 12/31/2017.
11 I.R.C. § 6223, as in effect for partnership tax years beginning after 12/31/2017.
12 Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248, as amended.
13 See generally I.R.C. §§ 6201-6216 (“Subtitle F, chapter 63, subchapter A – In General, and subchapter B – Deficiency Procedures in the Case of Income, Estate, Gift and Certain Excise Taxes”).
14 See generally NPRM 136118-15, filed with the Federal Register on June 14, 2017, TD 9, for a brief history.
15 See generally I.R.C. §§ 6221-6234 (“Subtitle F, chapter 63, subchapter C – Tax Treatment of Partnership Items”), and I.R.C. §§ 6240-6255 (“Subtitle F, chapter 63, subchapter D – Treatment of Electing Large Partnerships”), as in effect for tax years starting at and prior to 12/31/2017.
16 See NPRM 136118-15, supra.
17 See I.R.C. § 6221, as in effect for tax years starting at and prior to 12/31/2017, and the regulations thereunder. See generally I.R.C. § 704 and applicable regulations, under which items of income, loss etc. of the partnership entity are allocated among the partners on the basis of the partnership agreement, or the interests of the partners as determined by the IRS if the agreement does not have “substantial economic effect” as determined under applicable regulations. Those regulations are too numerous and complex to summarize here.
18 See I.R.C. § 6231, as in effect for tax years starting at and prior to 12/31/2017, and Treas. Reg. § 301.6231(a)(7)-1 and Treas. Reg. § 301.6231(a)(7)-2, as in effect for tax years starting at and prior to 12/31/2017, for procedures to designate the TMP. Note that under those procedures, the TMP must be either a general partner or a member-manager in an L.L.C.
19 See generally I.R.C. § 6223, I.R.C. § 6224, and I.R.C. § 6226, as in effect for tax years starting at and prior to 12/31/2017, and the regulations thereunder.
21 See I.R.C. § 6224(c), as in effect for tax years starting at and prior to 12/31/2017.
22 See I.R.C. § 6231(a)(6), as in effect for tax years starting at and prior to 12/31/2017, and Treas. Reg. § 301.6231(a)(6)-1, as in effect for tax years starting at and prior to 12/31/2017, with respect to computational adjustments on the partners’ returns as a result of a TEFRA adjustment.
23 See I.R.C. § 6229, as in effect for partnership tax years starting at and prior to 12/31/2017, for applicable limitation periods. See also I.R.C. § 6235 for limitations under BBA procedures for tax years beginning after 12/31/2017.
24 See NPRM 136118-15, supra.
26 See U.S. Gov’t Accountability Off., GAO-14-732, Large Partnerships: With Growing Number of Partnerships, IRS Needs to Improve Audit Efficiency, 13 (2014).
27 Bipartisan Budget Act of 2015, P.L. 114-74, as amended by P.L. 114-113 and P.L. 115-141.
28 See § 1101(g)(4) of P.L. 114-74 and Treas. Reg. 301.9100-22 (right to elect to apply the BBA procedures for tax years beginning after Nov. 2, 2015, and before Jan. 1, 2018).
29 See I.R.C. § 701 and I.R.C. § 6031.
30 See I.R.C. § 6221(b), as in effect for partnership years beginning after 12/31/2017, Treas. Reg. § 301.6221(b)-1, and discussion in Part III on an election out of the BBA for certain partnerships.
31 See I.R.C. § 6221(a) andI.R.C. § 6225, as in effect for partnership tax years starting after 12/31/2017.
32 See generally I.R.C. § 6241 as in effect for partnership tax years starting after 12/31/2017 andTreas. Reg. § 301.6241-1(a) for definitions including “reviewed year” under the BBA procedures.
33 See discussion on I.R.C. § 6226 in Part III for special additional rules where the tax liability is “pushed-out” to the reviewed year partners.
34 See I.R.C. § 6223(a) as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6223-1.
35 See Treas. Reg. § 301.6223-1 and Treas. Reg. § 301.6223-2.
36 See I.R.C. § 6231(a)(1) as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6231-1(a)(1).
37 I.R.C. § 6241(2)(A) as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6241-1(a)(6)(i).
38 I.R.C. § 6241(2)(B), as in effect for partnership tax years starting after 12/31/2017. Such items might include, for example, not only ordinary pass-thru income items, but items relating to the tax basis of a partnership interest (if related to an item required to be reflected on the partnership’s tax return or in its records) or the partnership’s basis in partnership property. See Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the House Amendment to the Senate Amendment to H.R. 1625 (Rules Committee Print 115-66), JCX-6-18 (March 22, 2018), andTreas. Reg. § 301.6241-1(a)(6)(ii)-(vi).
39 See I.R.C. § 6225(a)(1) and I.R.C. § 6225(b)(1), as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6225-1.
40 See I.R.C. § 6225(b) as in effect for partnership tax years starting after 12/31/2017, Treas. Reg. § 301.6225-1.
41 See I.R.C. § 6225(b)(2), as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6225-1(b) and (c). See also I.R.C. § 704 and Treas. Reg. § 1.704-1(b) regarding proper allocation of partnership items among the partners.
42 See I.R.C. § 6225(a)(2), as in effect for partnership tax years starting after 12/31/2017, Treas. Reg. § 301.6225-3, and Treas. Reg. § 301.6225-1(f).
43 I.R.C. § 6231(a)(2) as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6231-1(a)(2).
44 See I.R.C. § 6225(c), as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6225-2, and discussion in Part III..
45 I.R.C. § 6231(a)(3) as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6231-1(a)(3).
46 I.R.C. § 6233, as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6233(a)-1, related interest and penalties for the reviewed year. See also Treas. Reg. § 301.6233(b)-1 for penalties and interest related to the adjustment year for the failure to pay an imputed underpayment after assessment by the due date.
47 Not all states will adopt procedures similar to the BBA procedures, so we will see what happens on a state-by-state basis. Some states have already adopted BBA procedures, See Cal. Rev. & Tax Code §18622.5, conforming California tax laws with the BBA, and W. Va. Code Ch. 11, Art. 21A et seq. (effective July 1, 2019, to same effect for West Virginia). See also Jerald David August, Repeal of the TEFRA Entity Level Audit Rules Under the Bipartisan Budget Act of 2015: The Adoption of a New Paradigm for Assessing and Collecting Income Taxes from Partnerships, J. of Tax Practice and Procedure, Aug-Sept.2016.
48 See I.R.C. § 6234 as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6234-1. See also I.R.C. § 6223(b), as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6223-2, stating the sole authority of the partnership representative to act on behalf of and bind the partnership and partners under BBA procedures.
49 Assuming the partnership loses in court. See I.R.C. §6221(a), I.R.C. § 6225(a)(1), and I.R.C. § 6232, as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6232-1(a).
50 See I.R.C. § 6225(a)(1) and I.R.C. § 6232, as in effect for partnership tax years starting after 12/31/2017, Treas. Reg. § 301.6232-1(a), and Treas. Reg. § 301.6241-1(a)(1). The adjustment year can also occur in the year there is an administrative adjustment request under I.R.C. § 6227, as in effect for partnership tax years starting after 12/31/2017, not relevant for purposes of the analysis here.
51 See I.R.C. § 6232, and Treas. Reg. § 301.6232-1(b).
52 See Prop. Reg. § 301.6225-4 and Treas. Reg. § 301.6241-1(a)(10), and see generally Prop. Reg. 1.704-1(b)(1)(viii), and the proposed regulations cited therein. See also I.R.C. § 6226(b(3) for tax attribute changes in the case of the “push-out” discussed in Part III.
53 See I.R.C. § 6232(f). See also I.R.C. § 6232(f)(2) for rules on assessing partners that are themselves pass-thru entities, i.e., partnerships or S corporations. See also I.R.C. § 6226(b(4) and Treas. Reg. § 301.6226-3(e)(4) with respect to assessments against pass-thru entities in the case of the “push-out” discussed in Part III..
54 See I.R.C. § 6241(11) as in effect for partnership years beginning after 12/31/2017, giving the Treasury Department the ability to promulgate regulations as to special enforcement matters, e.g., jeopardy assessments and other rules for enforcement of the BBA procedures. As of press, these rules have yet to be written, though the IRS has announced there will be regulations forthcoming on matters unrelated to determinations of partners under I.R.C. § 6232(f), i.e., rules where the BBA may not be strictly applied and rules for partners that are qualified subchapter S subsidiaries (“QSUBS”) electing out of the BBA. See IRS Notice 2019-6.
55 See I.R.C. § 6241(7) as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6241-3.
56 See I.R.C. § 6222 as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6222-1(b). See also Treas. Reg. § 301.6232-1(d) for mathematical or clerical assessments against a partnership entity.
57 See James R. Malone Jr., All Partners are Small Partners: The Due Process Implications of the New Partnership Audit Regime, J. of Tax Practice & Procedure, April, 2017.
58 See, e.g., T.D. 9844 (2018) in which the Treasury Department has issued final regulations for much of the BBA, but nonetheless has reserved several areas for future regulation. See also J. Leigh Griffith, PASSTHROUGH PARTNER-TEFRA IS DEAD AND CPAR LIVES: The 2018 Partnership Audit and Collection Rules Under Proposed Regulations and Technical Corrections in the Consolidated Appropriations Act, 2018—Part III, TAXES-The Tax Magazine (May, 2018), in which the author discusses several complex matters related to the BBA but not finally resolved.
59 See I.R.C. § 6221(b) as in effect for partnership tax years starting after 12/31/2017.
60 See I.R.C. § 6221(b)(1)(B) as in effect for partnership tax years starting after 12/31/2017, I.R.C. § 6031(b), and Treas. Reg. § 301.6221(b)-1(b)(2).
61 See I.R.C. § 6221(b)(1)(C), as in effect for partnership tax years starting after 12/31/2017 and Treas. Reg. § 301.6221(b)-1(b)(3).
62 See § 475.083, RSMo Supp. 2017, and Treas. Reg. § 301.6221(b)-1(b)(3)(ii)(E).
63 See Treas. Reg. § 301.6221(b)-1(b)(3)(ii)(B).
64 See I.R.C. § 6225(c), as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6225-2.
65 See I.R.C. § 6225(c)(2)(A), as in effect for partnership tax years starting after 12/31/2017, Treas. Reg. § 301.6225-2(b)(2)(i), and Proposed Reg. § 301.6225-2(d)(2).
66 See I.R.C. § 6225(c)(2)(B), as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6225-2(d)(2)(x). Under that regulation, technically the partnership provides the IRS with the information on behalf of each partner.
67 See I.R.C. § 6225(c)(4), as in effect for partnership tax years starting after 12/31/2017, Treas. Reg. § 301.6225-2(b)(3), and Treas. Reg. § 301.6225-2(d)(4).
68 I.R.C. § 6225(c)(7), as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6225-2(c)(3).
69 See generally I.R.C. § 6226, as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6226-1.
70 See I.R.C. § 6226(a) and (b), as in effect for partnership tax years starting after 12/31/2017, Treas. Reg. § 301.6226-1(b), and Treas. Reg. § 301.6226-3.See also I.R.C. § 6226(b(4) and Treas. Reg. § 301.6226-3(e) for rules on push-outs for partners that are themselves pass-thru entities, i.e., partnerships or S corporations, so-called tiered arrangements.
71 See I.R.C. § 6226(a), as in effect for partnership tax years starting after 12/31/2017, Treas. Reg. § 301.6226-1(c)(2) and Treas. Reg. § 301.6226-2. For purposes of determining when partnership adjustments become final for the 60-day period to send statements, partnership adjustments become final at the later of the date on which the time to file a court petition expires or the court decision becomes final, Treas. Reg. § 301.6226-2(b)(1).
72 See I.R.C. § 6226(b), as in effect for partnership tax years starting after 12/31/2017, and Treas. Reg. § 301.6226-3.
73 See I.R.C. § 6226(c), as in effect for partnership tax years starting after 12/31/2017, Treas. Reg. § 301.6226-3(c) (calculation of interest), and Treas. Reg. § 301.6226-3(d) (calculation of penalties and assertion of partner level defenses after payment of penalties). Note that payment of the penalty and claim for a refund are first required before the penalty will be abated. Treas. Reg. § 301.6226-3(d)(3).
74 See I.R.C. § 6222, I.R.C. § 6223, and I.R.C. § 6226(d), as in effect for partnership tax years starting after 12/31/2017; Treas. Reg. § 301.6226-1(e); and Treas. Reg. § 301.6223-2, as to the binding nature of the statements on the reviewed year partners and the sole right of the partnership representative to contest the IRS’ determinations. See also Treas. Reg. § 301.6226-1(f) affirming the right of the partnership, through the partnership representative, to contest the FPA under I.R.C. § 6234, even after an election out.
75 See Treas. Reg. § 301.6223-1(e)(2).