Proposed Regs Cover Wide Array of Partnership Special Enforcement Matters

(Parker Tax Publishing December 2020)

The IRS issued proposed regulations dealing with special enforcement matters relating to partnerships subject to the centralized partnership audit regime. The regulations, among other changes, (1) propose to treat qualified subchapter S corporation subsidiaries (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 in various calculations and adjustments; (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. REG-123652-18.

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. 6241(11) (regarding the treatment of special enforcement matters) and 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. Following the issuance of T.D. 9844, the IRS issued Notice 2019-6, in which it announced its intention to propose regulations regarding two matters that it said presented special enforcement considerations for purposes of the centralized partnership audit regime. The first matter concerned situations in which an adjustment during an audit of a person other than the partnership required a change to a partnership-related item. The second matter concerned situations where a QSub is a partner in a partnership.

Last week, in REG-123652-18, the IRS issued those proposed regulations. The regulations propose the rules discussed in Notice 2019-6 and provide additional rules regarding special enforcement matters under Code Sec. 6241(11) while also proposing several changes to the final regulations in T.D. 9844.

Among other issues, these 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.

QSubs and the Election Out of the Centralized Partnership Audit Regime

According to the IRS, partnership structures with QSubs as partners present special enforcement concerns because allowing a partnership with a QSub partner to elect out of the centralized partnership audit regime could enable a partnership to elect out in situations where there are over 100 ultimate taxpayers. For example, in contrast to S corporations, if a QSub is an eligible partner for purposes of the election out of the centralized partnership audit regime, the special rules for S corporations under Code Sec. 6221(b)(2)(A) and Reg. Sec. 301.6221(b)-1(b)(2)(ii) would not apply to the QSub partner because it is not an S corporation. Therefore, in a situation where a partnership that has a QSub as a partner and 99 other individual partners for purposes of Code Sec. 6031(b), the stock of the S corporation that wholly owns the stock of the QSub could be owned by well over 100 ultimate taxpayers who satisfy the requirements of Code Sec. 1361(b)(1)(A) (limiting the number of shareholders of an S corporation to 100) by reason of Code Sec. 1361(c)(1) (treating members of a family as one shareholder for purposes of Code Sec. 1361(b)(1)(A)). Allowing such a partnership to elect out of the centralized partnership regime, the IRS said, would clearly frustrate the efficiencies the regime was intended to create.

To make clear to taxpayers that a QSub cannot be used to facilitate the election out of the centralized partnership audit regime by a partnership with greater than 100 ultimate taxpayers, the proposed regulations treat QSubs as ineligible partners for purposes of allowing a partnership to elect out of the centralized partnership audit regime.

Adjustments Relating to a Single Partner or a Small Group of Partners

Code Sec. 6221(a) requires that any adjustment to a partnership-related item must be determined at the partnership level under the centralized partnership audit regime, except to the extent otherwise provided in subchapter C of chapter 63 of the Code (i.e., Code Sec. 6221 through Code Sec. 6241). Under Code Sec. 6241(2)(B), a partnership-related item is defined as any item or amount with respect to the partnership which is relevant in determining any person's income tax liability, including any distributive share of such an item or amount.

The IRS has determined that special enforcement considerations are presented where the partnership's treatment of a partnership-related item on its return or in its books and records is based in whole, or in part, on information provided by a person other than the partnership. In these circumstances, it is more efficient for the IRS and the partner if the IRS makes an adjustment to a partnership-related item during an examination of the partner rather than opening a separate examination of the partnership to first adjust the partnership-related item at issue in the examination of the partner. It also is likely, the IRS noted, that the partnership is not in the best position to substantiate the information upon which the partnership's treatment of that partnership-related item is based and may not have detailed or adequate records regarding the information. According to the IRS, in situations in which the number of partners potentially impacted by an adjustment is limited, adjusting the partnership-related items in direct examinations of those partners does not raise inefficiency or inconsistency concerns that the centralized partnership audit regime is designed to alleviate. As a result, the IRS said that it may be a more efficient use of both IRS and taxpayer resources to examine and adjust that partnership-related item in an audit of the person who provided this information. The IRS said that it anticipates making these adjustments in cases in which the adjustments are likely only relevant to a single partner or a small group of partners and are unlikely to involve items that are allocable to all partners generally or that impact the partnership as a whole.

Therefore, Prop. Reg. Sec. 301.6241-7(b) provides that the IRS may determine that subchapter C of chapter 63 does not apply to an adjustment or determination of a partnership-related item if an adjustment or determination of that partnership-related item is part of, or underlies, an adjustment to a non-partnership-related item during an examination of a person other than the partnership. However, this rule only applies if the treatment of the partnership-related item on the return of the partnership (or in its books and records) is based in whole or in part on information provided by the person under examination. Accordingly, if the IRS determines that subchapter C of chapter 63 (of a portion thereof) does not apply, the IRS may adjust, or make determinations regarding, partnership-related items that underlie, or are part of adjustments or determinations regarding a non-partnership-related item of the person under examination.

Observation: For partnerships, this special rule alleviates the need to open an audit of the partnership under the centralized partnership audit procedures solely to adjust the partnership-related items based on information provided by the partner who is already independently under audit. This relieves the partnership from having to expend resources during an audit for items related primarily to the partner who provided the information. Additionally, this rule allows those partners whose non-partnership-related items are being adjusted during an audit of their return to more fully control and participate in any adjustments or determinations that need to be made to partnership-related items that underlie or affect the non-partnership-related item that is being adjusted.

Example: ABC Partnership is subject to the centralized partnership audit regime, has no liabilities, and is a calendar-year taxpayer as are all its partners. On June 1, 2018, Al acquires an interest in ABC by contributing Asset 1 to ABC. ABC claims a basis in Asset 1 of $50 equal to Al's purported adjusted basis in Asset 1. There is no activity in ABC that gives rise to any other partnership-related items between June 1, 2018, and June 2, 2019. On June 2, 2019, Al sells his interest in ABC to Bob for $100 in cash and reports a gain of $50. The IRS audits Al and determines that his adjusted basis in Asset 1 immediately before the contribution should have been $30 instead of the $50. As a result, Al's basis in Asset 1 immediately before the contribution is reduced from $50 to $30 and his adjusted basis in his interest in ABC is reduced from $50 to $30. Because Al's adjusted basis in his ABC partnership interest is reduced to $30, the total gain from the sale of his interest in ABC is increased to $70. The amount of ABC's adjusted basis in Asset 1 is based on information provided by Al to ABC; the adjustment to Al's pre-contribution adjusted basis in Asset 1, which is a non-partnership-related item, results in an adjustment to the adjusted basis of the property (that is, Asset 1) transferred to ABC in the contribution, which is a partnership-related item; and the contribution underlies the adjustment to Al's basis in his interest in ABC, which is a nonpartnership-related item. As a result, the IRS may determine that the rules of subchapter C of chapter 63 do not apply to the contribution and may adjust, during an audit of Al, the contribution as it relates to the adjusted basis in Asset 1 transferred in the contribution.

Adjustments to Items That Are Not Items of Income, Gain Loss, Deduction, or Credit

The regulations under Code Sec. 6225 do not expressly explain how adjustments to items that are not items of income, gain, loss, deduction, or credit (collectively referred to as "non-income items") are taken into account (1) in the calculation of the imputed underpayment as defined in Reg. Sec. 301.6225-1(f)); (2) as adjustments that do not result in an imputed underpayment; or (3) if the partnership elects to push out the adjustments to its reviewed year partners. Examples of non-income items include the partnership's assets, liabilities, and capital accounts. Accordingly, the proposed regulation provide changes to the final regulations to clarify the treatment of adjustments to non-income items.

For example, under Reg. Sec. 301.6225-1(b)(4), the IRS may treat an adjustment as zero solely for purposes of calculating an imputed underpayment if that adjustment is reflected in one or more partnership adjustments. If appropriate, the IRS could treat an adjustment to a non-income item as zero solely for purposes of calculating the imputed underpayment if the effect of the adjustment is already reflected in an adjustment to an item of income, gain, loss, deduction, or credit. However, this authority is only provided to the IRS. Accordingly, Prop. Reg. Sec. 301.6225-1(b)(4) provides that, generally, an adjustment to a non-income item that is related to, or results from, an adjustment to an item of income, gain, loss, deduction, or credit is treated as zero as part of the calculation of an imputed underpayment unless the IRS determines that the adjustment should be included in the imputed underpayment. This proposed addition not only clarifies the rule in Reg. Sec. 301.6225-1(b)(4) but also extends the rule in that provision to persons other than the IRS. Consequently, when filing an administrative adjustment request (AAR), a partnership may treat an adjustment to a non-income item as zero if the adjustment is related to, and the effect is reflected in, an adjustment to an item of income, gain, loss, deduction, or credit unless the IRS determines that the adjustment should be included in the calculation of the imputed underpayment.

Partnership Ceases to Exist

The proposed regulations also address Code Sec. 6241(7), which provides that if a partnership ceases to exist prior to the partnership adjustments taking effect, the adjustments are taken into account by the former partners of the partnership. Code Sec. 6232(f) provides rules that allow the IRS to assess a former partner for that partner's proportionate share of any amounts owed by the partnership under the centralized partnership audit regime.

Code Sec. 6232(f) expressly provides for rules that govern the use of Code Sec. 6232(f) in situations when a partnership has ceased to exist. Accordingly, the IRS said that it would be inconsistent with the intent of Congress to define when the adjustments take effect in a way that precludes the use of Code Sec. 6232(f) when a partnership has ceased to exist. Therefore, Prop. Reg. Sec. 301.6241-3 provides that a partnership adjustment takes effect (1) when the adjustments become finally determined; (2) when the partnership and IRS enter into a settlement agreement regarding the adjustment; or, (3) for adjustments reflected in an AAR, when the AAR is filed. If a partnership ceases to exist before the adjustments take effect, the former partners of the partnership must take the adjustments into account. Prop. Reg. 301.6241-3(d) modifies the definition of "former partners" to be partners of the partnership during the last tax year for which a partnership return or AAR was filed or the most recent persons determined to be the partners of the partnership in a final determination.

IRS Adjustments to Income Taxes, Penalties, and Similar Amounts:

If the IRS adjusts a partnership's income taxes (i.e., chapter 1 taxes), penalties, additions to tax, or similar amounts utilizing the centralized partnership audit regime, there must be a mechanism for including these amounts in the imputed underpayment and accounting for these amounts if the partnership elects to push out the adjustments to partners under Code Sec. 6226. In addition, there must also be a mechanism to account for any adjustments to a previously determined imputed underpayment. Accordingly, the proposed regulations provide for the calculation of the imputed underpayment during an IRS examination and for adjustments to the imputed underpayment as calculated by the partnership.

Prop. Reg. Sec. 301.6225-1 modifies the final regulations to provide a mechanism for including the partnership's income taxes, penalties, additions to tax, or additional amounts, as well as any adjustment to a previously determined imputed underpayment (chapter 1 liabilities), in the calculation of the imputed underpayment. Under Prop. Reg. Sec. 301.6225-1(c)(3), any adjustments to the partnership's chapter 1 liabilities are placed in a credit grouping and treated similarly to credit adjustments for purposes of calculating the imputed underpayment. Adjustments to these amounts are placed into this credit grouping because, similar to credits, they change the amount the partnership owes on a dollar-per-dollar basis.

Observation: According to the IRS, multiplying the adjustments to chapter 1 liabilities by a tax rate after the amount has been calculated would be inappropriate because, like credits, these amounts increase or decrease the amount owed on a dollar-per-dollar basis. If these chapter 1 liabilities were included with the other partnership adjustments, they would be multiplied by a tax rate, which would inappropriately reduce the amount of the partnership's chapter 1 liabilities. Thus, the IRS said, treating adjustments to chapter 1 liabilities similarly to credit adjustments allows for appropriate increases or decreases to the imputed underpayment.

Prop. Reg. Sec. 301.6225-1(d)(2)(ii) provides that a decrease in a chapter 1 liability is treated as a negative adjustment. In general, net positive adjustments are used to calculate the imputed underpayment, and net negative adjustments are adjustments that do not result in an imputed underpayment. An exception to that rule is the treatment of credit adjustments. Both net positive and net negative adjustments to credits may be included in the calculation of the imputed underpayment to increase or decrease the imputed underpayment amount after the tax rate is applied to other adjustments. If a net negative adjustment applied to the imputed underpayment reduces the amount of the imputed underpayment to zero or below zero, the imputed underpayment adjustments are treated as adjustments that do not result in an imputed underpayment under Reg. Sec. 301.6225-1(f)(1)(ii). These adjustments would then be taken into account by the partnership on the adjustment year return pursuant to Reg. Sec. 301.6225-3 or by the reviewed year partners pursuant to Reg. Sec. 301.6226-3.

The IRS noted that this rule does not operate well when the adjustment that has reduced the imputed underpayment below zero is a net negative adjustment to chapter 1 liabilities because the chapter 1 liabilities at issue are adjustments to the liability of the partnership, not the partners, and they are thus neither properly allocated to the partners after they are reported on the partnership's next filed return nor properly pushed out to the partners under Code Sec. 6226. These amounts could be used to offset another chapter 1 liability of the partnership, but partnerships may not have those types of items on their returns each year because partnerships are often not liable for income tax. Treating these amounts similarly to other adjustments could result in an amount reported on the partnership's return that would not result in an overpayment to the partnership and for which there may not be an item to offset in the adjustment year. Accordingly, for partnerships to take advantage of a net negative adjustment to these chapter 1 liabilities, a special rule is required.

As a result, Prop. Reg. Sec. 301.6225-1(e)(3)(ii), along with Prop. Reg. Sec. 301.6225-1(f)(1)(ii) and Prop. Reg. Sec. 301.6225-1(f)(3), provides two special rules for the treatment of a net negative adjustment to chapter 1 liabilities. Under the first rule, a net negative adjustment to a credit is normally treated as an adjustment that does not result in an imputed underpayment unless the IRS makes a determination to have it offset the imputed underpayment. Under Prop. Reg. Sec. 301.6225-1(e)(3)(ii), a net negative adjustment to one of the chapter 1 liabilities is not an adjustment described in Prop. Reg. Sec. 301.6225-1(f).

The second rule creates an exception which provides that if the calculation of the imputed underpayment under Reg. Sec. 301.6225-1(b)(1) results in a number that is zero or less than zero, the partnership adjustments associated with that calculation are treated as adjustments that do not result in an imputed underpayment.

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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