IRS Finalizes Rules on Treatment of Partnership Special Enforcement Matters

(Parker Tax Publishing December 2022)

The IRS issued final regulations that except certain partnership-related items (i.e., special enforcement matters) from the centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015, and set forth alternative rules that will apply to the examination of excepted items by the IRS. The final regulations also contain amendments to the final regulations under the centralized partnership audit regime published in 2019. T.D. 9969.

Background

The Bipartisan Budget Act of 2015 (BBA) replaced the partnership procedures enacted under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), along with the rules applicable to electing large partnerships, with a centralized partnership audit regime that determines adjustments and, in general, determines, assesses, and collects tax at the partnership level. Subsequently, in the Tax Technical Corrections Act of 2018 (TTCA), Code Sec. 6241(11) was added to address special enforcement matters and the collection of amounts due under the centralized partnership audit regime pursuant to Code Sec. 6241(7). The TTCA also made a number of technical corrections to the centralized partnership audit regime, including adding Code Sec. 6232(f) (regarding the collection of the imputed underpayment and other amounts due from partners of the partnership in the event the amounts are not paid by the partnership). These rules generally apply to returns filed for partnership tax years beginning after December 31, 2017.

Code Sec. 6241(11) provides that, in the case of partnership-related items involving special enforcement matters, the IRS may issue regulations providing that the centralized partnership audit regime (or any portion thereof) does not apply to certain items and that such items are subject to special rules as the IRS determines to be necessary for the effective and efficient enforcement of the Code. For purposes of Code Sec. 6241(11), the term "special enforcement matters" means: (1) a failure to comply with the requirements of Code Sec. 6226(b)(4)(A)(ii) (regarding the requirement for a partnership-partner or S corporation partner to furnish statements or compute and pay an imputed underpayment); (2) assessments under Code Sec. 6851 (relating to termination assessments of income tax) or Code Sec. 6861 (relating to jeopardy assessments of income, estate, gift, and certain excise taxes); (3) criminal investigations; (4) indirect methods of proof of income; (5) foreign partners or partnerships; and (6) other matters that the IRS determines by regulation present special enforcement considerations.

Code Sec. 6221(b) and Reg. Sec. 301.6221(b)-1 provide that certain partnerships with 100 or fewer partners can elect out of the centralized partnership audit regime. Such partnerships are eligible to make an election out if (1) each partner in the partnership is an eligible partner, (2) the election is timely made, and (3) the partnership notifies its partners of the election. An eligible partner includes a C corporation. Generally, a partnership has 100 or fewer partners if the partnership is required to furnish 100 or fewer statements under Code Sec. 6031(b) (i.e., Schedule K-1s) for the tax year. As part of determining whether a partnership has 100 or fewer partners, a special rule in Code Sec. 6221(b)(2)(A) and Reg. Sec. 301.6221(b)-1(b)(2)(ii) requires that a partnership with an S corporation partner must take into account each statement required to be furnished by the S corporation to its shareholders under Code Sec. 6037(b) for the tax year of the S corporation ending with or within the partnership's tax year. A qualified subchapter S subsidiary (QSub) is not considered an S corporation but is instead a wholly owned subsidiary of an S corporation.

In February of 2019, in T.D. 9844, the IRS issued final rules implementing Code Sec. 6221(a), Code Sec. 6222, and Code Sec. 6225 through Code Sec. 6241 (2019 final regulations). In November of 2020, the IRS issued proposed regulations (REG-123652-18) proposing rules to implement Code Sec. 6241(11) dealing with special enforcement matters and to make changes to the 2019 final regulations. Among other issues, the proposed regulations: (1) propose to treat QSubs as ineligible partners for purposes of the provision allowing some partnerships to opt out of the centralized partnership audit regime; (2) propose procedures for adjusting a partnership-related item that is relevant only to a single partner or a small group of partners; (3) clarify how adjustments to items that are not items of income, gain, loss, deduction, or credit (i.e., non-income items) are taken into account (i) in the calculation of the imputed underpayment; (ii) as adjustments that do not result in an imputed underpayment; or (iii) if the partnership elects to push out the adjustments to its reviewed year partners; (4) provide rules that apply where a partnership ceases to exist before partnership adjustments have taken effect; and (5) propose changes to the 2019 final regulations to address the treatment of IRS changes to income taxes, penalties, and additions to tax, etc. of a partnership where such changes are not generally compatible with the centralized partnership audit regime.

On December 9, the IRS published final regulations in T.D. 9969. The final regulations adopt the proposed regulations with revisions in response to practitioners' comments.

Applicability Date of the Final Regulations

The proposed regulations contained a provision that applied the regulations to examinations or investigations beginning after November 20, 2020, the date the proposed regulations were filed with the Federal Register. One practitioner expressed concern that under this proposed rule, the regulations could apply to tax years prior to November 20, 2020, since the regulations were proposed to be applicable to any examinations or investigations beginning after that date. The IRS agreed with this comment. Accordingly, the IRS modified the applicability dates in the final regulations to remove the provision that applied the regulations to examinations or investigations beginning after November 20, 2020, and to clarify that the final regulations apply to tax years ending on or after November 20, 2020, or tax years beginning after December 20, 2018, in the case of the final regulations in Reg. Sec. 301.6241-7(b).

In addition, Prop. Reg. Sec. 301.6241-7(j)(1) provided that the IRS and a partner under examination could agree to apply any provision (except Reg. Sec. 301.6241-7(b)) to tax years prior to the general applicability date. The IRS determined that partnerships should also have the flexibility to agree to apply Reg. Sec. 301.6241-7(g) (chapter 1 taxes and penalties that are the liability of the partnership) prior to the general applicability date as well. According to the IRS, this may be especially beneficial for partnerships in situations where the IRS proposes to reduce a chapter 1 tax or penalty reported by the partnership. Accordingly, Reg. Sec. 301.6241-7(j)(1) provides that the IRS and the partnership may agree to apply Reg. Sec. 301.6241-7(g) for tax years ending prior to November 20, 2020, provided that tax year is otherwise subject to the centralized partnership audit regime.

Adjustments to Non-Income Items

Under Code Sec. 6241(2)(B) and Reg. Sec. 301.6241-1(a)(6)(ii), the term "partnership-related item" includes items or amounts "relating to any transaction with, basis in, or liability of the partnership." Accordingly, the definition of "partnership-related item" includes items that are not items of income, gain, loss, deduction, or credit (non-income items). An adjustment to an item that is a non-income item is not a decrease in an item of income. Therefore, adjustments to a partnership's non-income items are always positive adjustments, are never negative adjustments, and are not netted against any adjustments to a partnership's items of income, gain, loss, deduction, or credit under Code Sec. 702(a). Adjustments to a partnership's non-income items are therefore adjustments that do not result in an imputed underpayment 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.

Under Prop. Reg. Sec. 301.6225-3(b)(8), if an adjustment to a non-income item is an adjustment that does not result in an imputed underpayment, the partnership takes this adjustment into account on its adjustment-year return by adjusting the non-income item consistently with the adjustment, to the extent the non-income item appears on the adjustment-year return without regard to the adjustment. In the proposed regulations, an example was provided in Prop. Reg. Sec. 301.6225-3(d)(3) to demonstrate that, in the case of an adjustment to the basis of an asset, the partnership would adjust its basis in the asset in the adjustment year. A practitioner commented that it was unclear whether the partnership would also have to recognize gain on that adjustment in addition to adjusting the non-income item on the partnership's adjustment year return. In order to avoid confusion, the final regulations modify the example to clarify that the reduction in the basis of the asset only requires the partnership to recognize income or gain in situations where income and gain would be recognized. The IRS also added examples to Reg. Sec. 301.6225-3(d) to demonstrate (1) how adjustments to liabilities are taken into account when they are adjustments that do not result in an imputed underpayment, and (2) to demonstrate how filing an amended return as part of modification applies when there are adjustments to non-income items.

In Prop. Reg. Sec. 301.6225-1(b)(4), the proposed regulations provide rules for treating an adjustment as zero solely for purposes of computing an imputed underpayment in certain situations. In response to a comment that the language of the proposed regulation was unclear, the IRS modified the regulation to clarify that this provision applies to both the IRS and partnerships, and the rule has been broadened further. As modified, Reg. Sec. 301.6225-1(b)(4) provides that if any positive adjustment is related to, or results from, a second positive adjustment, a partnership may treat one of the positive adjustments as zero solely for purposes of computing the imputed underpayment unless the IRS determines that the adjustment should not be treated as zero. With this change, a partnership may treat an adjustment to a non-income item as zero if the adjustment to the non-income item is related to, or results from, another adjustment to a non-income item. However, the IRS noted that this rule does not allow the partnership to treat an adjustment as zero if one adjustment is positive and one is negative. For example, if a partnership changes an ordinary loss to a capital loss, which results in a positive adjustment to ordinary income and a negative adjustment to capital loss, the partnership could not treat the negative adjustment to capital loss as zero for purposes of calculating the imputed underpayment.

One practitioner recommended removing Reg. Sec. 301.6225-1(d)(2)(iii)(B), which provides that an adjustment that cannot be allocated under Code Sec. 704(b) is treated as a positive adjustment or a credit, as appropriate, if the adjustment could result in an increase in an item of income, gain, loss, deduction, or credit. The practitioner stated that this rule addresses the same issue as Reg. Sec. 301.6225-1(b)(4), which provides that an adjustment may be treated as zero for purposes of calculating the imputed underpayment if that adjustment is included within another adjustment and it would not be appropriate to include both adjustments in the calculation. According to the practitioner, both of these provisions address adjustments to non-income items that are taken into account in calculating the imputed underpayment and, therefore, Reg. Sec. 301.6225-1(d)(2)(iii)(B) is duplicative. The IRS responded that Reg. Sec. 301.6225-1(d)(2)(iii)(B) does not serve the same purpose as Reg. Sec. 301.6225-1(b)(4) and that these provisions are therefore not duplicative. However, the IRS agreed that Reg. Sec. 301.6225-1(d)(2)(iii)(B) is duplicative of concepts in other provisions, such as the definition of positive adjustment. Accordingly, the IRS removed Reg. Sec. 301.6225-1(d)(2)(iii)(B).

Partnership Ceases to Exist

Under Code Sec. 6241(7), if a partnership ceases to exist prior to when any adjustments take effect, the former partners of the partnership must take into account the adjustments under regulations prescribed by the IRS. In Prop. Reg. Sec. 301.6241-3, the proposed regulations provided rules implementing Code Sec. 6241(7), and authorized the IRS to prescribe rules for situations where a partnership (or partnership-partner) has ceased to exist before a partnership adjustment taking effect.

One practitioner asked that the final regulations be clarified to provide that a partnership may make an election to push out the adjustments under Code Sec. 6226, request modification of the imputed underpayment under Code Sec. 6225(c), or pay the imputed underpayment even if the partnership has ceased to exist. The IRS adopted this comment, explaining that the rules implementing Code Sec. 6241(7) were never intended to prevent a partnership from making an election to push out the adjustments under Code Sec. 6226, requesting modification of the imputed underpayment under Code Sec. 6225(c), or paying the imputed underpayment. Rather, the IRS said that Code Sec. 6241(7) is a tool the IRS may use in situations where it is unclear whether the partnership will be able to pay any amounts due resulting from the partnership adjustments to protect the ability to collect tax due as a result of the partnership adjustments.

The final regulations therefore add a sentence to the end of Reg. Sec. 301.6241-3(a)(1) which provides that a determination that a partnership has ceased to exist does not prohibit the partnership from requesting to modify the imputed underpayment under Code Sec. 6225(c). In addition, a sentence was added to the end of Reg. Sec. 301.6241-3(b)(3), which provides for limitations on the IRS's ability to determine that a partnership has ceased to exist. The new sentence provides that a determination that a partnership has ceased to exist is not effective if the partnership has made a valid election under Code Sec. 6226 to push out the adjustments or has fully paid all amounts due under the centralized partnership audit regime within ten days of notice and demand for payment.

Under Prop. Reg. Sec. 301.6241-3(d) of the proposed regulations, the former partners of a partnership are the partners from the last tax year for which the partnership filed a return under Code Sec. 6031, the partners from any administrative adjustment request (AAR) filed by the partnership, or the partners from a final determination that is binding on the partnership. Before these proposed changes, the former partners of the partnership were the partners during the adjustment year or, if there are no adjustment year partners, the partners of the partnership during the last tax year for which the partnership filed a return under Code Sec. 6031. The IRS stated in the preamble that it has decided not to finalize the proposed changes to Reg. Sec. 301.6241-3(d).

Special Enforcement Provisions

Prop. Reg. Sec. 301.6241-7 implements Code Sec. 6241(11) regarding the treatment of special enforcement matters. A special enforcement rule in Prop. Reg. Sec. 301.6241-7(b) allowed the IRS to make determinations regarding partnership-related items as part of an adjustment to an item that is not a partnership-related item in situations where the treatment of the partnership-related item on the partnership return is based, in whole or in part, on information provided by the person under examination.

Practitioners expressed concern that adjustments made in a partner examination could affect the other partners in the partnership and the partnership itself, and recommended that Prop. Reg. Sec. 301.6241-7(b) be removed in its entirety. The IRS responded by noting that under Prop. Reg. Sec. 301.6241-7(h)(2), determinations about partnership-related items that are made outside of the centralized partnership audit regime are not binding on any person who was not a party to the proceeding. To provide clarity in response to the practitioners' concerns, the IRS modified Reg. Sec. 301.6241-7(h)(2) to clarify that the partnership and the other partners are not bound to any determination regarding a partnership-related item resulting from the partner-level examination, and nothing in Reg. Sec. 301.6241-7 requires the partnership or other partners to adjust their returns. The IRS also modified Reg. Sec. 301.6241-7(h)(2) to provide further explanation of how determinations regarding partnership-related items outside of the centralized partnership audit regime affect others who are not parties to the proceeding.

For a discussion of the centralized partnership audit regime rules, see Parker Tax ¶28,700.

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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