IRS Finalizes Rules on Opting Out of Centralized Partnership Audit Rules

(Parker Tax Publishing January 2018)

The IRS issued a final regulation on who can elect out of the centralized partnership audit regime and the manner in which such election must be made. In the final rule, the IRS declined to expand the types of taxpayers eligible to make the opt-out election even though Congress authorized it to do so, saying that such an expansion would increase the IRS's burden with respect to auditing such taxpayers. T.D. 9829.

Background

In 1982, Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). TEFRA included unified partnership audit procedures aimed at separating the determination of partnership items from the determination of nonpartnership items. For tax years beginning before 2018, the unified TEFRA audit procedures apply to most partnerships that have 10 or more partners. There is an exception to TEFRA for, and special audit procedures apply to, certain small partnerships and electing large partnerships (ELPs).

For tax years beginning after 2017, and earlier tax years if elected, the TEFRA and ELP audit procedures no longer apply. The Bipartisan Budget Act of 2015 repealed the TEFRA and ELP audit procedures and replaced them with a single set of rules for auditing partnerships and their partners at the partnership level.

Under this streamlined audit approach, the IRS examines the partnership's items of income, gain, loss, deduction, credit and partners' distributive shares for a particular year of the partnership (i.e., the "reviewed year"). Any adjustments are taken into account by the partnership, and not the individual partners, in the year that the audit or any judicial review is completed (i.e., the "adjustment year"). Partners are not subject to joint and several liability for any liability determined at the partnership level.

As an alternative to taking an adjustment into account at the partnership level, a partnership can issue adjusted information returns (i.e., adjusted Form K-1s) to the reviewed year partners, in which case those partners would take the adjustment into account on their individual returns in the adjustment year through a simplified amended-return process. The practical effect of this rule is that partnerships generally will no longer issue amended Form K-1s after the partnership return is filed, but instead will use the adjusted Form K-1 process for prior year adjustments.

Opting Out of the Post-2017 Partnership Audit Rules

Under Code Sec. 6221(b)(1), partnerships with 100 or fewer qualifying partners can opt out of the post-2017 partnership audit rules in which the partnership is responsible for underpayments of tax. In such cases, the partnership and partners will be audited under the general rules applicable to individual taxpayers. In order to qualify for this opt-out provision, Code Sec. 6221(b)(1)(C) provides that the partners must be either individuals, C corporations, a foreign entity that would be treated as a C corporation if it were a domestic entity, an S corporation, or an estate of a deceased partner. The election must be made with a timely filed return for the tax year for which it is to be effective and must disclose the name and taxpayer identification number of each partner in the partnership, and each partner must be notified of the election.

A number of situations were not addressed in the opt-out legislation, such as (1) the determination of the number of partners of the partnership for purposes of determining whether the partnership has 100 or fewer partners; (2) the determination of what partners constitute eligible partners for purposes of determining whether the partnership is eligible to make the election; and (3) the mechanics of making the election under Code Sec. 6221(b).

The IRS has now issued Reg. Sec. 301.6221(b)-1, which provides some guidance in these areas.

Determining the Number of Partners

In determining if a partnership has 100 or fewer partners for the tax year, the final regulation provides that a partnership has 100 or fewer partners for the tax year if it is required to furnish 100 or fewer statements under Code Sec. 6031(b). Thus, spouses count as two partners and not one. The IRS noted that, if two individuals are partners in a partnership, the partnership is required to furnish a statement under Code Sec. 6031(b) to each of those individuals, regardless of whether they are married to one another.

In addition, the IRS rejected a comment that the regulation expressly state that one spouse's community property interest is not taken into account for purposes of determining the number of statements the partnership is required to furnish under Code Sec. 6031(b). According to the IRS, creating a specific rule potentially at odds with the existing rules under Code Sec. 6031(b) could result in confusion regarding the proper operation of existing Code Sec. 6031(b) rules and such a rule was not necessary for implementation of Code Sec. 6221(b).

Observation: The IRS said that, as it gains experience with the centralized partnership audit regime, it may consider issuing sub-regulatory guidance covering elections under Code Sec. 6221(b) in the context of constructive and de facto partnerships.

Determining "Eligible" Partners

Under Code Sec. 6221(b)(2)(C), the IRS is authorized to prescribe rules similar to the rules for S corporation partners with respect to other types of persons not specifically described as eligible partners under Code Sec. 6221(b)(1)(C). Practitioners had asked the IRS to expand the rules in a number of ways, suggesting that partnerships, disregarded entities, trusts (including tax-exempt trusts, revocable trusts, charitable remainder trusts, grantor trusts, and nongrantor trusts), individual retirement accounts, nominees, qualified pension plans, profit-sharing plans, and stock bonus plans should be considered eligible partners for purposes of making an opt-out election under Code Sec. 6221(b).

The IRS rejected these comments because, it said, broadening the scope of the election out provisions to include additional types of partners or partnership structures would increase the administrative burden on the IRS since those structures and partners would need to be audited under the deficiency procedures. The IRS dismissed suggestions that the authority granted in Code Sec. 6221(b)(2)(C) signified a congressional expectation that the IRS would expand the list of eligible partners under Code Sec. 6221(b)(1)(C).

Making the Election to Opt-Out

The final regulation provides that the election to opt out of the centralized partnership audit regime must be made on an eligible partnership's timely filed return, including extensions, for the tax year to which the election applies, and, once made cannot be revoked without the consent of the IRS. Additionally, the election must include each partner's name, correct U.S. taxpayer identification number (TIN), and federal tax classification. If the election is being made by a partnership that has an S corporation as a partner, the regulation provides that the election must also include each S corporation shareholder's name, correct U.S. TIN, and federal tax classification.

The regulation also provides that the election must include an affirmative statement that the partner is an eligible partner and any other information required by the IRS in forms, instructions, or other guidance. If a partnership makes an election under Code Sec. 6221(b), the partnership must notify its partners of the election within 30 days of making the election. If the IRS determines that a purported election by a partnership is invalid, the IRS will notify the partnership in writing, and the provisions of the centralized partnership audit regime will apply to the partnership.

For a discussion of the election to opt out of the centralized partnership audit rules, see Parker Tax ¶28,710.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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