IRS and Treasury Issue Proposed Regulations on Centralized Partnership Audits

By: Jerald David August

This post is the third of a Three Part Series of K&F Business and International Tax Developments Posts on the Proposed Regulations to the New Partnership Audit Regime which legislation is due to go into effect for all unincorporated entities treated as partnerships, in general, for taxable years beginning after December 31, 2017. Part One, which was posted on February 17, 2017, summarized the legislation which enacted the new partnership audit rules as part of The Bipartisan Budget Act of 2015, Pub. L. No. 114-74, Act §1101 (the “Budget Act”) which was signed into law on November 2, 2015, (as modified by Protecting Americans from Tax Hikes Act of 2015, Pub. L. No. 114-113 (the “PATH Act”)). The Proposed Regulations were issued on January 18, 2017 (REG-136118-15).

In a Memorandum from Reince Priebus, Assistant to the President and Chief of Staff, issued on January 20, 2017 to all Heads of Executive Departments and Agencies on behalf of President Trump, a regulatory freeze on the issuance of new regulations was announced to take effect immediately. In particular, proposed regulations that had neither been published in the federal register or had been waiting for their effective date, were immediately withdrawn for review and approval of the department or agency head appointed or designated by the President. Therefore, the Proposed Regulations to the partnership audit rules issued just two days earlier, were technically withdrawn on January, 20, 2017. See “White House Memo Puts Freeze on All New and Pending Regs”, Tax Notes, Jan. 20, 2017. In a recent announcement made on March 3 by Ms. Hodes, attorney-adviser, Treasury Office of Tax Legislative Counsel, in addressing the Federal Bar Association Section on Taxation, practitioners were urged not to assume the IRS will be unprepared for January 1, 2018, the deadline for the commencement of the new partnership audit regime.

Introduction

For a summary of the Partnership Audit legislation and the audit provisions applicable to partnerships under current law, the TEFRA entity audit level rules, refer back to this blog’s post of February 2, 2017.[1] Part II summarized

the rules under the Proposed Regulations on the “imputed underpayment rules” and modifications. This Part Three, addresses the important “push-out election” made by the partnership representative to the reviewed year partners and other procedural rules, including the new administrative adjustment request provision. A criticism of the new legislation follows in the form of an Editorial Comment at the end of this Post.  The comments are drawn primarily from the Preamble to the Proposed Regulations and other articles that have been written by Jerry August and cited in footnote 1.

Preamble to Proposed Regulations: Explanation of the “Push-Out Election” Under Section 6226(b) And Other Important Procedural Rules Under the New BBA Legislation on Centralized Audits of Partnership

1. Alternative to Payment of the Imputed Underpayment: The so-called “Push-Out” Election

     a. In General. Prop. Reg. § 301.6226-1(a) provides that a partnership may, as part of the centralized audit provisions, elect, through its partnership representative, to “push out” the adjustments that had comprised the determined “imputed underpayment” amount to its reviewed year partners, in accordance with their distributive shares of partnership income, loss, deduction or credit, in lieu of requiring the partnership to pay the imputed underpayment amount under §6225.  Where a partnership makes a valid election in accordance with Prop. Reg. § 301.6226-1, the partnership avoids liability in full with respect to the imputed underpayment amount. Many partnership agreements will undoubtedly be drafted to require the partnership representative to “push-out” all imputed underpayments arising out of an IRS audit.

     b. “Push-Out Election”. A partnership may make an election under this section with respect to one or more imputed underpayments identified in an FPA. For example, where the FPA includes a general imputed underpayment and one or more specific imputed underpayments, the partnership may make an election with respect to any or all of the imputed underpayments. This is part of the multiple imputed underpayment rules set out in the proposed rule-making.

     c. Impact on Reviewed Year Partners. Prop. Reg. § 301.6226-1(b)(1) provides that where a partnership makes a valid election in accordance with Prop. Reg.  § 301.6226-1, the reviewed year partners of the partnership are liable for tax, penalties, additions to tax, and additional amounts, as well interest on such amounts, after taking into account their share of the partnership adjustments determined in the FPA. Any modifications approved by the IRS under Prop. Reg.  § 301.6225-2 are also reported to the reviewed year partners. In addition, the proposed regulations state, under Prop. Reg. §301.6226-1(b)(2), that for adjustments that do not result in an imputed underpayment in certain instances such adjustments may nevertheless be included in the reviewed year partners' share of the partnership adjustments reported to the reviewed year partners of the partnership.

Under Prop. Reg. § 301.6226-1(c), a “push-out” election under 6226 is not valid unless the partnership complies with all the provisions for making the election, including the obligation to issue statements to the reviewed year partners and file all such statements electronically with the IRS. See Prop. Regs. §§301.6226-1, 301.6226-2.  It is important to understand that once made, a “push-out” election by the partnership may only be revoked with the consent of the IRS.

     d. Defective Push-Out Election. Under the proposed regulations, where the IRS determinates that a push-out election is invalid or otherwise defective, it must notify the partnership and the partnership representative within 30 days of the determination of such defective election and set forth the ground or grounds for its invalidity.  Prop. Reg. §301.6226-1. The impact of an invalid “push-out” election is obvious. The result is that the aggregate imputed underpayment is pushed back to the partnership which again becomes primarily liable for the imputed underpayment as well as additions to tax in the form of penalties and interest. See §6233.  

2. Applicable Rules for Making the “Push-Out” Election.

     a. Time for Making Push-Out Election. The partnership must make the “push-out” election within 45 days of the date that the FPA was mailed to the partnership by the IRS. Prop. Reg. §301.6226-1(c)(3). At present there is no provision for extending the time to make the election although presumably the IRS may consent to give the partnership an extension. The push-out election is required to be signed by the partnership representative and filed in accordance with published guidance. Prop. Reg. §301.6226-1(c)(4)(ii) provides, in this regard, that the election must include the name, address, and correct taxpayer identification number (TIN) of the partnership, the taxable year to which the election relates, the imputed underpayment(s) to which the election applies (if there is more than one imputed underpayment in the FPA), each reviewed year partner's name, address, and correct TIN, and any other information required under forms, instructions, and other guidance. A copy of the FPA to which the push-out election relates must also be attached to the election.

     b. Consequence of Push-Out Election to Partners. As a formal partnership action under §6223, all reviewed year partners (for each year under review) are bound by the election and each reviewed year partner must take the adjustments on the statement into account in accordance with § 6226(b) and report and pay additional chapter 1 tax (if any) per Prop. Reg. § 301.6226-3. A reviewed year partner may therefore not treat items reflected on a statement described in Prop. Reg. § 301.6226-2 inconsistently with how those items are treated on the statement that the partnership files with the IRS. There is no recourse on the part of a reviewed partner to file an “inconsistency statement” as with the filing of form 1065. See Prop. Reg. §301.6222-1(c)(2).  

     c. Issuance of Statements to Review Year Partners. As mentioned, the proposed regulations (Prop. Reg. §301.6226-2(a)) require that where a partnership makes a “push-out” election, it must furnish statements to the reviewed year partners with respect to the partner's share of the adjustments and file those statements with the IRS in the time, form, and manner prescribed. This push-out statement requirement and filing is separate from any other statements required to be filed with the IRS and furnished to the partners for the taxable year, including any Schedules K-1, Partner's Share of Income, Deductions, Credits, etc. The partnership must furnish separate statements for each reviewed year at issue and cannot combine multiple reviewed years (if any) and reflect the total of such adjustments by the issuance of a single statement.

     d. Time For Issuance of Push-Out Election Statements to Partners.  Push-out election statements must be sent by the partnership representative (or its agent) to reviewed year partners no later than 60 days after the date the partnership adjustments are finally determined and reflected in the FPA. More specifically, the partnership adjustments are finally determined upon the later of the expiration of the time to file a petition under §6234 or, if a petition is filed under § 6234, the date when the court's decision becomes final. Accordingly, if an FPA is mailed on June 30, 2020, and no petition is filed by the partnership, the partnership adjustments set out in the FPA are finally determined on September 28, 2020 (at the conclusion of the 90-day petition period under section 6234).  Again, reviewed year partners cannot file inconsistently with any statements furnished by the partnership with respect to the “push-out” assessment amount allocable to the review year partner. Special procedural rules apply with respect to “errors” in the computation of the push-out statements. See Prop. Reg. §301.6226-2(d).  The proposed regulations contain examples of the notification of the “push-out” rule.

     e. Contents of Push-Out Statements to Reviewed Year Partners. The proposed regulations set forth information required to be included to the reviewed year partners.  Such information includes: (i) the reviewed year partner's share of items originally reported to the partner (taking into account any adjustments made under §6227); (ii) the reviewed year partner's share of the partnership adjustments and any penalties, additions to tax, or additional amounts; (iii) modifications attributable to the reviewed year partner; (iv) the reviewed year partner's share of any amounts attributable to adjustments to the partnership's tax attributes in any intervening year (per Prop. Reg. § 301.6226-3) resulting from the partnership adjustments allocable to the partner; (v) the reviewed year partner's safe harbor amount and interest safe harbor amount (if applicable), as determined in accordance with proposed § 301.6226-2(g); (vi) the date the statement is furnished to the partner; (vii) the partnership taxable year to which the adjustments relate; and (viii) any other information required by the forms, instructions, or other guidance prescribed by the IRS. See Prop. Reg. § 301.6226-2(e).

     f. More On Push-Out Elections and The Required Reporting  For The Reviewed Partner's Share of Adjustments and Other Amounts. Per Prop. Reg. § 301.6226-2(f), a reviewed year partner's share of adjustments required to be taken into account must be reported to the reviewed year partner in the same manner as originally reported on the return filed by the partnership for the reviewed year. If the adjusted item was not reflected in the partnership's reviewed year return, the adjustment must be reported in accordance with the rules that apply with respect to partnership allocations, including under the partnership agreement. However, if the adjustments, as finally determined, are allocated to a specific partner or in a specific manner, the partner's share of the adjustment must follow how the adjustment is allocated in that final determination. So we have some complexity here. See Prop. Reg. § 301.6226-2(f)(1). In all cases, adjustments taken into account on any amended returns or closing agreements that are approved during the modification process per Prop. Reg. § 301.6225-2(d)(2) and that are disregarded in determining the imputed underpayment are ignored for purposes of determining the reviewed year partners' share of the adjustments. However, these modifications are listed separately on the statements provided to the reviewed year partners.  With respect to modifications that are ignored for purposes of reporting the adjustments to the reviewed year partners, any reviewed year partner that previously took into account the same adjustment will not be taxed a second time with respect to that adjustment. An example is set forth in Prop. Reg. § 301.6226-3(g).

     g. Additions to Tax Attributable to a Push-Out Election. Penalties, additions to tax, or additional amounts are reported to the reviewed year partners in the same proportion as each partner's share of the adjustments to which the penalties relate, unless the penalty, addition to tax, or additional amount is specifically allocated to a specific partner(s) or in a specific manner by a final court decision or in the FPA, if no petition is filed. Where a penalty is determined with respect to a specific item or items, such penalty is reported to the reviewed year partners in the same manner as the adjustments to that specific item or items, unless otherwise provided in the FPA or a final court decision.  Where a penalty, addition to tax, or additional amount does not relate to a specific adjustment, each reviewed year partner's share of the penalty, addition to tax, or additional amount is determined in accordance with how such items would have been allocated under rules that apply with respect to partnership allocations, including under the partnership agreement, unless it is allocated to a specific partner in a specific manner in a final determination of the adjustments, in which case it is allocated in accordance with the final determination.

     h. Computation of Tax Resulting From Push-Out Election: Taking The Adjustments Into Account. Pursuant to Prop. Reg. § 301.6226-3, a reviewed year partner furnished a push-out statement is required to pay any additional chapter 1 tax (additional current year tax) for the partner's taxable year which includes the date the statement was furnished to the partner in accordance with Prop. Reg. § 301.6226-2 (the reporting year) which is determined taking into account the adjustments reflected in the statement. The additional reporting year tax is either the aggregate of the adjustment amounts, as determined in Prop. Reg. § 301.6226-3(b), or, if an election is made under proposed § Prop. Reg. §301.6226-3(c), the so-called “safe harbor” amount. Additions to tax in the form of penalties and interest are also required to be assessed and paid. Prop. Reg. §301.6226-3(d). The aggregate of the adjustment amounts is the aggregate of the correction amounts determined under Prop. Reg. § 301.6226-3(b) to-wit: (i) one with respect to the partner's taxable year which includes the reviewed year of the partnership (first affected year); and (ii) a second correction amount for the partner's taxable years after the first affected year and before the reporting year (intervening years). These correction amounts cannot be less than zero, and any amount below zero after applying the rules in Prop. Reg. § 301.6226-3(b) does not reduce any correction amount, any tax in the reporting year, or any other amount. The rules in this area are complex and must be fully understood. This will occur with respect to allocating and reducing interim year net operating losses of the reviewed year partner or other tax attributes.

     i.  Election to Pay the Safe Harbor Amount. Under Prop. Reg. § 301.6226-3(c), a partner furnished a push-out election statement may elect to pay the safe harbor amount (or the interest safe harbor amount, in the case of certain individuals) shown on the statement in lieu of the additional reporting year tax. This safe-harbor election is made on the partner's return for the reporting year. If a partner is furnished multiple statements per Prop. Reg. § 301.6226-2, the partner may elect to pay the safe harbor amount with respect to some or all of the statements. For instance, if the IRS examined two partnership taxable years in the same administrative proceeding, and a push-out election under § 6226 was made by the partnership with respect to all imputed underpayments for both years, the partnership would be required to furnish separate partners and to calculate separate safe harbor amounts for each year. A reviewed year partner could elect to pay the safe harbor amount for one taxable year, but not the other taxable year. If a partner elects to pay the safe harbor amount, the partner must report the safe harbor amount on the partner's timely-filed return (excluding extensions) for the partner's reporting year. If the partner fails to do so, the partner may not utilize the safe harbor amount, but instead must compute the additional reporting year tax under Prop. Reg. § 301.6226-3(b) as if no election under Prop. Reg. § 301.6226-3(c) had been made. Applicable computation rules to compute the safe harbor amount and interest safe harbor amount are contained in the regulations. See Prop. Reg. §301.6226-2(g).

     j. Binding Nature of Push-Out Election. The election under  §6226 which is within the sole authority of the partnership representative, which does not have to be a partner, and may even be appointed by the IRS, is a partnership election which is binding on the partners. §6223(b). While reviewed year partners can avoid the computation under §6226(b) by filing an amended return (or entering into a closing agreement) and paying the tax and interest due in accordance with §6225(c)(2) during the modification phase of the audit, not all partners are willing or able to amend their returns for the relevant year. Therefore,  partners are granted the option to pay a simplified safe harbor amount in lieu of computing the correction amounts described per Prop. Reg. §301.6226-3(b) and a simplified interest safe harbor amount for certain individuals in lieu of computing the interest on the safe harbor amount under Prop. Reg. § 301.6226-3(d)(2). Any reviewed year partner may elect to pay the safe harbor amount, including reviewed year partners that are partnership-partners or S corporation partners.

     k. Liability for Interest Under Push-Out Election. Reviewed year partners are further liable for interest on any correction amount for the first affected year and any intervening years See Prop. Reg. § 301.6226-3(d)(1). If a partner elects to pay the safe harbor amount, a reviewed year partner that is an individual may also elect to pay the interest safe harbor amount. For all other partners and individuals that do not elect the safe harbor amount, interest applies under Prop. Reg. § 301.6226-3(d)(2). Interest on the correction amounts and the safe harbor amount is determined at the partner level. The interest rate is the underpayment rate per §6621(a)(1) except that when determining that rate, five percentage points are used instead of three percentage points, with the result that the underpayment rate for purposes of §6226 is the federal short-term rate plus five percentage points. A reviewed year partner is liable for interest on any correction amount from the first affected year and any intervening years from the due date of the return (without extension) for the applicable tax year (that is, the year to which the additional tax is attributable) until the correction amount is paid. For purposes of calculating interest, the safe harbor amount and any penalties, additions to tax, or additional amounts are attributable to adjustments taken into account for the first affected year.

     l. Qualified Investment Entities (QIEs): Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs). The proposed regulations under the push-out election rules are coordinated with the deficiency dividend procedures under §860 for partners that are RICs and REITs. In general, §860 allows RICs and REITs to be relieved from the payment of a deficiency in (or to receive a credit or refund of) certain taxes including, among certain others, taxes imposed by §§852(b)(1) and (3), 857(b)(1) or (3), and, where the entity flunks the distribution requirements of §852(a)(1)(A) or §857(a)(1), as applicable, the corporate income tax. Details of this part of the regulations are not covered in this post. See Prop. Regs. §§301.6226-2(h), -3(b)(4).  

     m.  Foreign partners and Certain U.S. Partners. The proposed regulations reserve the issuance of rules applicable to push-out statements made to foreign partners, including foreign entities, or certain domestic partners. In general, certain amounts received by a partnership that are allocable to a foreign partner may be subject to withholding under chapter 3 of subtitle A of the Code (chapter 3), and certain amounts allocable to a foreign or domestic partner may be subject to withholding under chapter 4 of subtitle A of the Code (chapter 4). To the extent that amounts are withheld by the partnership or other withholding agent under chapter 3 or 4, and remitted to the IRS, such amounts are creditable by the foreign partner or domestic partner to offset the chapter 1 tax that the partner otherwise would owe in the absence of the withholding. The purpose of chapter 3 withholding is to ensure compliance by foreign persons with respect to income subject to tax under chapter 1, by requiring the partnership (or other withholding agent) to withhold and remit the tax that would normally be paid by the foreign person on payments or income allocated to the foreign person. The purpose of chapter 4 (FACTA) withholding is to ensure that information reporting about U.S. persons that use certain offshore financial accounts or passive foreign entities is available to the IRS to enhance tax compliance. The withholding imposed under chapter 4 may be imposed on certain foreign financial institutions, account holders of a financial account, or passive non-financial foreign entities with substantial U.S. owners, to incentivize the information required under chapter 4 to be reported and available to the IRS. Additional comments on this area of the proposed regulations are being sought by the Treasury and the Service. In particular, comments are requested on: (i) how the partnership should satisfy its reporting obligations under chapters 3 and 4 in the reporting year with respect to income allocable to a foreign partner or domestic partner; (ii) whether the partnership should be required to obtain new documentation from partners to support a lower withholding rate or whether the partnership should be able to rely on documentation obtained with respect to the reviewed year; and (iii) how the rules under chapters 3 and 4 should apply when a statement described in Prop. Reg. § 301.6226-2 includes additional income allocable to a foreign partner that is an intermediary or flow-through entity.

     n. Section 6226 Push-Out Election and Section 6234 Petition for Readjustment.  Section 6226(a) provides that the push-out election must be made within 45 days of the date the FPA is mailed. Section 6234(a) provides that the partnership may petition for readjustment within 90 days of the date the FPA is mailed. The proposed regulations  provide that a push-out election may be made within the 45 day rule under §6226 without cutting off the partnership’s right to challenge the adjustments in court  under the 90 day rule in §6234. See Prop. Reg. §301.6226-1(e). The proposed regulations provide that while the election under §6226 must be filed within 45 days of the date the FPA is mailed, the filing and furnishing of the statements, is not required until 60 days after the adjustments are finally determined. Prop. Reg. § 301.6226-2(b). In this situation, the partnership adjustments become finally determined upon the later of the expiration of the time to file a petition under §6234 or, if a petition is filed under §6234, the date when the court's decision becomes final. Accordingly, a partnership can make an election under section 6226, petition for readjustment, and then file and furnish statements once the adjustments are finally determined. If, after going to court, a partnership that filed the election within the 45-day period determines that it no longer wishes to have §6226 apply, the partnership can request IRS consent to revoke the election 

3. Treatment of Pass-through Partners: Multiple Tiered Partnership Rules. In response to comments made pursuant to IRS Notice 2016-23 issued last year requesting guidance on a number of subjects under the BBA partnership audit rules, there were suggestions made that a pass-through partner who receives a statement described in Prop. Reg. § 301.6226-2 should be able to flow through the adjustments to its owners instead of paying tax on the adjustments at the first tier. Under this approach, the adjustments would flow through the tiers until a partner that is not a pass-through partner receives the adjustment. The proposed regulations reserve on this issue.  Per §6226(a)(2), where a partnership makes a "push-out” election instead of making payment of the imputed underpayment, the partnership is required to furnish statements to "each partner of the partnership for the reviewed year." Under §6226(b), a reviewed year partner's tax imposed by chapter 1 for the reporting year is increased by the aggregate of the correction amounts for the first affected year and any intervening years. Section 7701(a)(2) defines "partner" as a member in a partnership (that is, a direct partner). Therefore, §6226(b) requires the partnership's direct partners from the reviewed year to take into account the adjustments. Neither §7701(a)(2) nor §6226 distinguish direct partners that are themselves pass-through entities, and direct partners that are not pass-through entities, such as individuals and C corporations.

     a. In General. As previously noted, a partnership making a push-out election must do so no later than  45 days after the FPA is mailed to the partnership, and the partnership must furnish and file statements reflecting the reviewed year partners' shares of the adjustments. Then, §6226(b) provides that each direct partner's chapter 1 tax for the taxable year including the date the statement is furnished (reporting year) is increased by an amount that represents the tax that should have been paid by the partner if in the reviewed year the items adjusted were correctly reported on the partnership's return and taken into account by the direct partner.

     b. Bluebook Explanation to the BBA. In the case of a partnership that is itself a partner, the General Explanation of Tax Legislation Enacted for 2015 (Bluebook) explained that the partnership-partner "pays the tax attributable to adjustments with respect to the [first affected year] and the intervening years, calculated as if it were an individual . . . for the taxable year . . . ." JCS-1-16 at 70. To account for the fact that partnerships are not liable for chapter 1 tax, the Bluebook provides that, "a partnership that receives a statement from the audited partnership is treated similarly to an individual who receives a statement from the audited partnership." Id. (omitting footnote providing "[s]ection 703, which states that 'the taxable income of a partnership shall be computed in the same manner as in the case of an individual . . . .'"). In consideration of the fact that direct partnership-partners must pay the tax, the Bluebook further states that the audited partnership, the partnership receiving the statement under section 6226, and that partnership's partners "may have entered into indemnification agreements under the partnership agreement with respect to the risk of tax liability of reviewed year partners being borne economically by partners in the year that includes the date of the statement. Because the payment of tax by a partnership under the centralized system is nondeductible, payments under an indemnification or similar agreement with respect to the tax are nondeductible."

     c. Technical Corrections to the BBA Announced. In December 2016, both the House and the Senate introduced bipartisan technical corrections that would resolve this issue by providing that a partner that is a partnership or S corporation may elect to either pay an imputed underpayment under rules similar to section 6225 or flow the adjustments through the tiers. See Tax Technical Corrections Act of 2016 (H.R. 6439, 114th Cong. (2016)); Tax Technical Corrections Act of 2016 (“TCA”) (S. 3506, 114th Cong. (2016)). As a result, the proposed regulations reserve this issue. See Prop. Reg. § 301.6226-2(e).

          1. Moving Up the Tiers Permitted For Push-Out Elections. The TCA would allow a partnership or S corporation to flow adjustments through the tiers presents significant administrative concerns. The Treasury and Service note that this reform may cause much administrative complexities, challenges and inefficiencies.

          2. Multiple Tiers and Tax Collection Problems. Another significant concern stated in the Preamble as to the TCA’s allowance of multiple tiered push-out elections is the collection of tax. Indeed, it is noted that the BBA presents a bifurcated process where the tax is determined and later assessed and collected through a self-reporting process by the partners. The process of flowing adjustments to the reviewed year partners occurs after the audit/litigation is concluded. The assessment process under BBA, whereby the partners are required to calculate the tax, interest and penalties and report them on their next filed return, presents a challenge because of the passage of time. Even compliant taxpayers, who receive statements in the middle of the tax year may not understand their significance, and may not know exactly how to utilize this information. This would necessitate additional compliance resources by the IRS to check the adjustment year reporting to verify that the adjustments were indeed correctly reported by every tier and by all direct and indirect partners.

          3. Associated Costs. The costs involved in administering these processes will limit the overall number of audits that can be undertaken, which in turn will limit the IRS's ability to meaningfully address tax noncompliance for this segment of taxpayers, as well as limit the overall revenue collection from these entities, including, for example, as partners die, dissolve, become insolvent, or are not able to be located due to the passage of time.

          4. Application to Direct Partner That is An Estate, Trust or Foreign Entity. The Treasury is concerned with the adoption of the TCA in instances where a direct partner in the partnership that is an estate or trust, or a foreign entity, such as a foreign trust or foreign corporation that may not be liable for U.S. federal income tax with respect to one or more adjustments, but an owner of the direct partner is, or could be, liable for tax with respect to such amount. For instance, if a direct partner in the audited partnership is a controlled foreign corporation, the foreign corporation as a direct partner may not have a U.S. tax liability with respect to a given adjustment; however, the adjustment may impact the tax liability of its U.S. shareholder(s). The tax effects on the U.S. shareholder(s) may arise in the first affected year, an intervening year, or some subsequent year, depending on the specific facts and circumstances.

4. Push-Out Rules Continued: Adjustments to Tax Basis, Capital Accounts, Partnership Asset Basis, etc. Section 6226(b)(3) requires that any tax attribute which would have been affected if the partnership adjustments were taken into account for the reviewed year, be appropriately adjusted for the amount by which the tax imposed under chapter 1 would increase for any intervening year. As with §6225, however, §6226 does not expressly state that tax attributes affected by reason of a partnership adjustment should be adjusted for all purposes, and not just for purposes of taking the adjustments into account to calculate the additional reporting year tax, and that the adjustments to tax those attributes should continue to have effect after the adjustment year. The Preamble states that it is appropriate to adjust the adjustment year partners' outside bases and capital accounts and a partnership's basis and book value in property when one of those tax attributes is affected by reason of a partnership adjustment. But a different approach may be needed for push-out elections. The purpose of the partnership adjustments is to create a new, accurate starting point for later taxable years; therefore, it is required to adjust the adjustment year partners' outside bases and capital accounts despite the fact that it is the reviewed year partners who pay additional tax under section 6226. Providing mechanical rules to govern the adjustments to adjustment year partners' outside bases and capital accounts and a partnership's basis and book value in property raise a myriad of technical issues on which the Treasury Department and the IRS request comments. This is certainly going to be a controversial aspect of the rule-making.

5. Administrative Adjustment Requests

     a. Procedure for Filing Administrative Adjustment Request. Prop. Reg. § 301.6227-1(a) sets out the general rules for filing an administrative adjustment request (AAR). Per §6227(a), Prop. Reg. § 301.6227-1(a) provides that a partnership may file an AAR with respect to one or more items of income, gain, loss, deduction, or credit of the partnership and any partner's distributive share thereof for any partnership taxable year. Prop. Reg. § 301.6227-1(a) requires a partnership to determine whether the adjustments requested in the AAR result in an imputed underpayment for the reviewed year. If the requested adjustments result in an imputed underpayment, Prop. Reg. § 301.6227-1(a) provides that the partnership takes the adjustments into account under Prop. Reg. § 301.6227-2(b), which requires the partnership to pay the imputed underpayment unless the partnership makes an election under Prop. Reg. § 301.6227-2(c), in which case the reviewed year partners take the adjustments into account in accordance with Prop. Reg. § 301.6227-3, which provides rules similar to section 6226. Under Prop. Reg. § 301.6227-1(a), if the adjustments do not result in an imputed underpayment, the reviewed year partners must take the adjustments into account. Prop. Reg. § 301.6227-3.

     b. Partnership Representative Makes the Call. Prop. Reg. § 301.6227-1(a) confirms that only a partnership may file an AAR and that a partner may not file an AAR unless the partner is doing so in his or her capacity as partnership representative for the partnership. Additionally, in certain cases, a partner that is itself a partnership subject to subchapter C of chapter 63 (that is, the partnership has not elected out of the centralized partnership regime under §6221(b)) may file an AAR in response to the filing of an AAR by the partnership of which it is a partner. See Prop. Reg. § 301.6227-3(c) for the rules regarding certain partnership-partners filing AARs.  Prop. Reg. § 301.6227-1(a) clarifies that a partnership may not file an AAR solely to provide the partnership an opportunity to change a designation of the partnership representative.

     c. Partnership Return Filing Required. Prop. Reg.  § 301.6227-1(b) provides that an AAR may only be filed by a partnership for a partnership taxable year for which a partnership return has been filed. In general, a partnership may not file an AAR with respect to a partnership taxable year more than three years after the later of the date the partnership return for such partnership taxable year was filed or the last day for filing such partnership return determined without regard to extensions. In addition, the proposed regulations provide that an AAR may not be filed with respect to a partnership taxable year after a notice of administrative proceeding with respect to such taxable year has been mailed by the IRS under § 6231.

     d. Coordination with Foreign Tax Credits. The proposed regulations reserve provision with respect to rules on integrating the AAR rules with §905(c) when  the AAR includes an adjustment to the amount of creditable foreign tax incurred by the partnership.

     e. AAR Procedural Filing Requirements. See Prop. Reg. §301.6227-1(c)(1). A valid AAR must include the information set forth in the regulations including the adjustments requested and grounds for making the changes. When mailed the partnership must notify each reviewed year partner by forwarding a copy of the AAR filed with the IRS. See Prop. Regs. §§301.6227-1(c), -1(d), -1(e)(2).

In filing the AAR, the partnership and all partners are bound by the actions taken. Prop. Reg. §301.6227-1(f) provides, that a partner's share of the adjustments requested in an AAR  are binding on the partner. Under Prop. Reg. § 301.6227-1(f), a partner must treat the adjustments on the partner's return consistently with how the adjustments are treated on the statement that the partnership files with the IRS. See Prop. Reg.  § 301.6222-1(c)(2) (regarding items the treatment of which a partner is bound to under §6223).

The IRS may, within the period provided under §6235, conduct a proceeding with respect to the partnership for the taxable year to which the AAR relates and adjust items subject to subchapter C of chapter 63, including the items adjusted in the AAR. In the case of an AAR, the Service may make adjustments with respect to the partnership taxable year to which the AAR pertains within three years from the date the AAR is filed. Prop. Reg. § 301.6227-1(g) provides the IRS may re-determine adjustments requested in an AAR, including modifications applied by the partnership to the imputed underpayment. If the partnership adjustments determined by the IRS increase any imputed underpayment, the additional amount is assessed in the same manner and subject to the same restrictions as any other imputed underpayment.

     f. AAR Adjustment Requests Resulting In An Imputed Underpayment.

          i. Partnership Pays the Imputed Underpayment. Per Prop. Reg. § 301.6227-2(b)(1) when adjustments requested in an AAR result in an imputed underpayment, the partnership must pay the imputed underpayment (as reduced by modifications meeting the requirements of proposed § 301.6227-2(a)(2)(ii)) at the time the partnership files the AAR, unless the partnership makes the election under proposed § 301.6227-2(c) to have its reviewed year partners take such adjustments into account. The partnership's payment of the imputed underpayment is treated as a nondeductible expenditure under section 705(a)(2)(B) in accordance with Prop. Reg.  § 301.6241-4. See Prop. Reg. §301.6227-2(b)(7)(penalties and interest on imputed underpayment resulting from AAR). See §6233(a)(3). Interest on an imputed underpayment is determined under chapter 67 for the period beginning on the date after the due date of the partnership return for the reviewed year (determined without regard to extension) and ending on the earlier of the date payment of the imputed underpayment is made with the AAR, or the due date of the partnership return for the adjustment year. §6233(a)(3).

          ii. Election to Have the Reviewed Year Partners Take the Adjustments into Account. Prop. Reg. § 301.6227-2(c) allows a partner to elect to effectively push-out the adjustments requested in an AAR that result in an imputed underpayment in lieu of the partnership paying that imputed underpayment. In such event, the partnership is no longer required to pay the imputed underpayment resulting from the adjustments requested in the AAR. Rather, each reviewed year partner must take into account its share of such adjustments. Prop. Reg. §301.6227-3.

     g. Adjustments Requested in AAR Not Resulting In Imputed Underpayment. In such event, the reviewed year partners must take into account their shares of such adjustments in accordance with Prop. Reg. § 301.6227-3. Prop. Reg. § 301.6227-2(d) provides that in that situation the partnership must furnish statements to the reviewed year partners and file a copy of those statements with the IRS in accordance with Prop. Reg. § 301.6227-1.

     h. AARs and Review Year Partner Adjustments/Liability. Reviewed year partners take adjustments requested in an AAR filed by the partnership into account in two circumstances: (1) the adjustments requested in the AAR result in an imputed underpayment and the partnership elects under Prop. Reg. § 301.6227-2(c) to have its reviewed year partners take the adjustments into account, or (2) the adjustments requested in the AAR do not result in an imputed underpayment per Prop. Reg. §301.6227-2(d). See Prop.Reg. §301.6227-3.  Under Prop. Reg. § 301.6227-3(b), the reviewed year partner must pay any amount of tax, penalties, additions to tax, additional amounts, and interest that results from taking into account such adjustments in accordance with Prop.Reg. § 301.6226-3, except that, the rules under proposed § 301.6226-3(c) (allowing the reviewed year partner to elect to pay a safe harbor amount), Prop. Reg. § 301.6226-3(d)(2) (regarding interest on the safe harbor amount), and Prop. Reg. § 301.6226-3(d)(4) (regarding the increased rate of interest) do not apply. Other special rules apply.

     i. Refund Attributable to AAR Final Adjustments. Prop. Reg. § 301.6227-3(b)(2) allows the reviewed year partner to claim a refund where the partnership incorrectly allocated items from the partnership in the reviewed year and provides that when a partner (other than a pass-through partner) takes into account adjustments requested in an AAR, and those adjustments result in a decrease in tax, the partner may use that decrease to reduce the partner's chapter 1 tax for the taxable year which includes the date the statement was furnished to the partner (reporting year), and may make a claim for refund of any overpayment that results. The reduction is treated in a manner similar to a refundable credit under §6401(b). See also Prop. Reg. § 301.6227-3(b)(3) provide examples to illustrate the operation of these rules.

The Treasury Department and the IRS intend in future guidance to cross reference Prop. Reg. § 301.6226-4 for rules regarding adjustments to partners' outside bases and capital accounts and a partnership's basis and book value in property when reviewed year partners take adjustments requested in an AAR filed by the partnership into account.

Editorial Comment.

Ok, let’s stop here! There’s more to the proposed regulations unfortunately as they do suffer from being long-winded and complex. As detailed and complex as they are, the challenge for the Treasury and that of the Service in issuing these proposed regulations was difficult, i.e., trying to fill in all the gaps and spaces that arguably a rather poorly thought out piece of tax legislation provided. The regulations gallantly try to rescue a statute that is not imposes a partnership level assessment of prior years’ partners’ taxes but muddies the water further by announcing procedures, sub-procedures, a new lexicon of terms, and the draconian imposition of a partnership representative, meet the new “tax czar”, who can bind all partners, both direct and indirect, in any partnership audit or other proceeding. The challenge that the Treasury and IRS face in issuing regulations in such instances is imposing and daunting. The proposed regulations will ultimately only be understandable to a few. Most will trod through them when and as necessity requires, but it is a formidable bog that must be traversed. There are many traps for the unwary.  It is, in this writer’s sole opinion, an area that is worthy of rethinking and possible repealing. The former rules were far from perfect, but the new centralized partnership audit rules clearly miss their intended mark.  

So, when you combine the three posts on this development together and try to understand the new rules and interpreted by the proposed regulations as a whole, it is easy to recognize that something went amuck when this new law was enacted. Partnerships subject to income tax for taxes not paid in prior years by their partners? Really? That’s what Congress wanted obviously, it passed the law and was signed into law by President Obama. But there’s one or two exit doors available to prevent partnerships from paying the taxes of partners, most notably the partners from prior years’ returns who may not be partners in the year the partnership gets audited let alone the audit is completed through litigation perhaps. Well, exit door number one, is to elect out of the mess each year provided the partners are qualified and the partnership representative makes a timely election-out. Yes, that’s true but not always, especially if your partnership has a grantor trust or trust as a partner. In other words you may have one or more non-qualified partners, even if your partnership has only 2 members let alone the required less than 100. There’s the second door to exist from the mess of having the partnership pay partners’ taxes and that is the push-out election. Well, a well-done and timely filed push-out election saves the partnership from liability but wreaks havoc on the reviewed year partners to have to accept the partnership representative’s settlement of tax issues that might have otherwise been challenged. The multiple adjustment rules, payment safe harbors, interim tax attribute adjustments, interest adjustments, etc. make leaving through the second exist a complex enterprise.

When the “tax czar”, i.e., the partnership representative, decides to settle out with the IRS and push-out the additional tax, penalties and interest to the partners for the reviewed year it is binding on such review year partners. Clients will undoubtedly ask, “are you kidding, I have no recourse to challenge?”. Each of us will have to explain to our client that it has to right to participate in the audit, appeal or trial with respect to an IRS audit of the partnership seeking to impose additional taxes for prior years’ partnership returns. Each of us will have the privilege of further explaining to our clients that there is indeed no right to participate or even be informed of what’s going on. Well, why wasn’t the partnership agreement filled with detailed procedures and notice requirements to be imposed on the partnership representative? The simple truth that makes this new legislation regrettable is no partner, regardless of his percentage interest in the partnership has any right to participate. You are bound by the partnership representative, always. That’s not fair let alone being good tax policy. It is not going to be well received at the grass roots level. Perhaps one could support this legislation only for large funds and funds of funds where the participating members have on a very small capital interest in the deal, say 1% or even 5.1%. Yes, perhaps this is OK. But we already had in place an electing partnership rule for large partnerships. Didn’t someone think to tell the Congress of §771 thru §779. Ah, but only a very few made that election, we need a new machine the Commissioner of Internal Revenue Service said to collect much more from these large funds of funds, hedge funds, large partnerships, etc.

So, these three posts describe in some detail the myriad of rules under the proposed regulations which are going to have to be understood by tax professionals, business lawyers, even estate planners. These advisors will have to explain what may otherwise be unexplainable to their clients. Partnership agreements must be entirely revamped to accommodate these rules. The government doesn’t want to spend much time auditing, it just wants to collect tax. Any problems with the statute and regulations that work unfairness at the partner level are to be resolved under the partnership agreement. That is what the government wanted in the new law and Congress obliged just with two resolutions and the President’s stroke of his pen. Still, the new partnership centralized audit rules is not good tax policy. It arguably subverts the general understanding of  why persons enter into a partnership to conduct business or investment activity. The expectation has always been that each partner would be  allocated and ultimately receive its share of profits (and bear the economic burden of its share of loss) and further agree to pay federal income tax but only on its share of partnership profit.  But not now. No, beginning in 2018 the partnership will pay the tax for prior years’ underpayments in tax attributable to partnership audit adjustments, plus penalties and interest.  No, the partnership will pay the tax unless the partnership representative decides otherwise.  In such instances newly admitted partners will indirectly bear the unpaid taxes of prior years’ partners who get off from paying tax on one or more corrected items as a result of an audit.

If the legislation is not repealed, and right now it does not appear that many are entertaining that thought, then a whole new world of complexity will shower all over our tax-thinking heads beginning next year. Perhaps there’s more time to learn the hundreds of new rules and their applications since audits under the “new rules” will await another year or two to get under way.

I would welcome comments on your thoughts of the new BBA. Please feel free to disagree.

Jerry August,

Kostelanetz & Fink, LLP


[1] For more in-depth treatment of the subject see, in general, August, “The New Partnership Audit Rules: Guidance Needed”, J. Corp. Tax’n (Jan/Feb 2017); August “The Case for Repealing the TEFRA Partnership Audit Rules”, Practical Tax Lawyer(February, 2017); August, “Repeal of the TEFRA Entity Level Audit Rules”, Journal of Tax Practice & Procedure, (August/September 2016); August and Cuff, “The TEFRA Partnership Audit Rules Repeal: Partnership and Partner Impacts”, ALI-CLE Video Webcast (7/17/2016); August, “The Good The Bad, and Possibly the Ugly in the New Audit Rules: Congress Rescues the IRS From Its Inability to Audit Large Partnerships”, Business Entities (WG&L) (May/June 2016); August, “Entity-Level Audit Rules Continue to Pose challenges for Partners”, Parts 1 and 2, Business Entities (WG&L) (Nov./Dec. 2014) (July/Aug. 2015). Section 1101, Pub. L. No. 114-74, the Bipartisan Budget Act of 2015. Section 1101 repeals the current rules governing partnership audits with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level. On the new audit provisions generally, see New York State Bar Association, Tax Section, Report No. 1347, “Report on the Partnership Audit Rules of the Bipartisan Budget Act of 2015” (May 25, 2016).


"Disclaimer of Use and Reliance: The information contained in this blog is intended solely for informational purposes and the benefit of the readers of this blog. Accordingly, the information does not constitute the rendering of legal advice and may not be relied upon by the reader in addressing or otherwise taking a position on one or more specific tax issues or related legal matter for his or her own benefit or the for the benefit of a client or other person.” ©Jerald David August for Kostelanetz & Fink, LLP”

Part One, "IRS And Treasury Issues Needed Guidance On Centralized Partnership Audits: Proposed Regulations Issued"

Part Two, "IRS And Treasury Issues Needed Guidance On Centralized Partnership Audits: Proposed Regulations Issued"