Background in brief - Partnership audits and the current regime
In 2015, Congress adopted new centralized partnership audit rules in the Bipartisan Budget Act of 2015 (BBA), which was later amended by the Tax Technical Corrections Act of 2018 and followed by a series of proposed and final regulations, resulting in the current “BBA Regime”. Generally, under the BBA Regime, audit adjustments are assessed to, and collected directly from, the audited partnership, and any adjustments (including imputed underpayments) are imposed in the year in which the audit is finalized as opposed to the year that is audited. This may result in a partner bearing the cost of adjustments related to a year in which the partner was not a member of the partnership, although partnership operative documents in practice can provide a true-up mechanic to equitably allocate the tax burden between former and current partners. Further, partnerships must designate a “partnership representative” to interface with the IRS in the context of a partnership audit, and make decisions and take actions to bind the partnership and its partners in connection therewith. Eligible partnerships may make an election (“Push-Out Election”) to opt out of this default regime and pass through adjustments to partners, who are in turn required to pay any tax owed. The BBA Regime contains several other mechanics which are beyond the scope of this brief overview, but these mechanics generally seek to streamline and centralize partnership audits.
The 2022 Partnership Audit Regulations
Adjustments to non-income items
Under the BBA Regime, the term “partnership-related item” generally includes (i) any item or amount that is shown on a partnership’s returns (or required to be maintained in the partnership’s books and records) that is relevant to determine the tax of any other person, (ii) any partner’s distributive share of such amount, or (iii) any imputed underpayment under the BBA Regime. The definition of “partnership-related item” therefore includes items that are not items of income, gain, loss, deduction, or credit (non-income items).
The Proposed Regulations contained rules regarding how to make adjustments in respect of non-income items into account on the adjustment-year return if they are adjustments that do not result in an imputed underpayment (i.e., in situations where a net-negative adjustment to a credit, or an item treated as a credit, reduces the imputed underpayment to zero or less than zero). Commentators argued that this could result in double taxation if a non-income item were adjusted at both the partnership level under the general centralized regime and at the partner level where a special enforcement provision was utilized. Treasury and the IRS explained that the BBA Regime already provides rules that, in practice, should provide for relief from potential double taxation, and that the BBA Regime does not contain any provision that would require a partnership to recognize gain in an adjustment year if a partnership adjusts a non-income item as a result of taking into account adjustments that do not cause (or, presumably, increase) an imputed underpayment. Treasury and the IRS therefore declined to remove the rules in Prop. Reg. § 301.6225-3(b)(8).
Treasury and the IRS also declined the request that non-income items be excluded completely (or always treated as zero) from the calculation of the imputed underpayment. The preamble to the 2022 Partnership Audit Regulations specifies that the imputed underpayment under the BBA Regime is an entity-level liability of the partnership alone computed by reference to any adjustments made to partnership-related items, regardless of whether those adjustments would have actually resulted in a tax liability to any particular partner. This is not meant to determine the exact amount of the tax liability of the partners of the partnership, and Treasury and the IRS pointed out that the existing rules allow the partnership to mitigate any inconsistency that may result with the computation of the imputed underpayment by requesting to modify the imputed underpayment or making a “Push-Out Election” under section 6221(b) for eligible partnerships with less than 100 partners.
Special enforcement rules
The most significant change introduced in the 2022 Partnership Audit Regulations relates to section 6241(11), which expressly allows Treasury to promulgate regulations related to “special enforcement matters” and pursuant to which Treasury may provide for special rules or exclusion from the general centralized regime. Among other items, “special enforcement matters” include a situation in which an adjustment proposed by the IRS during the examination of a person other than the partnership would require an adjustment to a “partnership-related item”.
Under the Proposed Regulations, the IRS could make determinations of partnership-related items as part of an adjustment to a non-partnership-related item. Commentators expressed concern that in such situation, an adjustment to a non-partnership-related item at the partner level could lead to an adjustment of a partnership-related item at the partnership level and, thus, lead to an adjustment of a partnership-related item at the partner level — in other words, an adjustment to a non-partnership-related item for one partner could indirectly cause an adjustment to a partnership-related item for another partner. In response, Treasury and the IRS amended the applicable provision to provide that a partnership and other partners are not bound to any determination regarding a partnership-related item resulting from a partner-level examination to which they are not a party.
In addition, Treasury and the IRS clarified that the following conditions must be met for the IRS to adjust partnership-related items outside of the BBA Regime as a part of an adjustment to a non-partnership-related item:
- A person other than the partnership must be under exam.
- The IRS must propose a non-partnership-related item adjustment.
- A partnership-related item must be a component of the adjustment to the non-partnership item.
- Determinations about that partnership-related item must be needed in order to adjust the item that is not a partnership-related item.
- The treatment on the partnership’s return of the partnership-related item that is the component of the item that is not a partnership-related item being adjusted must be based, in whole or in part, on information provided by the person under examination from that person’s own books and records.
The 2022 Partnership Audit Regulations specify that the special enforcement rules are effective for taxable years beginning after 20 December 2018. Going forward, partnerships may consider including a provision in their operating agreement requiring a partner to notify the partnership or the other partners of any examination involving any of the special enforcement provisions.
The 2022 Partnership Audit Regulations also modified previous proposed regulations to provide that if any positive adjustment relates to or results from any second positive adjustment, a partnership may treat one of the positive adjustments as zero solely for purposes of computing the imputed underpayment. This change, combined with a previous mechanic that allows partnerships to request modification of an imputed underpayment to more closely approximate the amount of tax that would have been paid had the partnership item been properly reported in the year under audit, should generally afford partnerships greater ability to alleviate differences caused by the imposition of an imputed payment in the year of finalization, rather than the year audited.
Put differently, this is an example of the IRS adopting a simplified government-friendly approach but allowing partnerships the ability to propose counter-amounts to best approximate reality and tax due under then-current law.
In addition to the above items, Treasury and the IRS also made certain other changes and addressed certain comments. For example, Treasury and the IRS addressed comments relating to certain applicable dates of prior proposed notices and regulations, stating that the administrative burden placed on the IRS in not being able to utilize final procedure rules as soon as possible would outweigh giving partnerships additional time to implement changes to account for the rules of general substance previously announced.
In short, the changes introduced by the 2022 Partnership Audit Regulations seek to further centralize and streamline partnership audit procedural and administrative matters. However, the tradeoff in this zero-sum game is that taxpayers are subject to increasingly complex requirements, several of which may pose new considerations in structuring partnerships and partnership-related business ventures going forward. Taxpayers are urged to consult with experienced tax professionals to ensure they understand the pertinent aspects of these changes, and the BBA Regime more generally.