Authored by Mark Heroux
The Bipartisan Budget Act of 2015 enacted the centralized partnership audit regime, which changes how the IRS audits and assesses partnerships for income tax.
Prior to 2015, the IRS conducted audits in accordance with the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under TEFRA, the IRS assesses adjustments of partnership items at the partner level. However, under the centralized partnership audit regime, the IRS will by default assess and collect any understatement of tax, interest and penalties at the partnership level for tax years beginning after Dec. 31, 2017. The Treasury Department recently issued regulations that provide guidance with respect to: electing out of the centralized partnership audit regime; the push-out election which allows partnerships to shift the proposed audit liability to its partners; and coordinating international rules with the centralized partnership audit regime.
Electing out of the centralized partnership audit regime: final regulations
On Jan. 2, 2018, the Treasury Department and the IRS released final regulations on electing out of the centralized partnership audit regime. These final regulations provide the rules governing the time, form and manner for making the push-out election.
A partnership is eligible to elect out of the new partnership audit regime if it meets two requirements:
- the partnership must have 100 or fewer partners during the year; and
- all partners must be “eligible partners” at all times during the tax year.
If a partnership elects out of the regime, then the historic small partnership audit rules govern an IRS exam of the partnership’s tax return. The election is made on an annual basis on the partnership’s timely filed tax return.
Determining whether a partnership is eligible to elect out
100 or fewer partners
The regulations provide that a partnership has 100 or fewer partners for the taxable year if it is required to furnish 100 or fewer statements (Schedules K-1). A partnership must furnish a statement to each person that is a partner in the partnership at any time during the taxable year. For S-corporation partners, a partnership must disclose the required information to each person who was a shareholder of the S-corporation partner at any time during the tax year of the S corporation ending with or within the partnership’s tax year. Pass-through entities, disregarded entities and S-corporation shareholders count toward the total number of partners. The IRS may scrutinize whether two or more partnerships that have elected out should be recast as a constructive or de facto partnership for federal income tax purposes.
Each partner of the partnership must be an individual, a C corporation, an eligible foreign entity, an S corporation or an estate of a deceased partner. Partnerships, trusts, disregarded entities, certain nominees and estates other than the estate of a deceased partner continue to be excluded from the list of eligible partners. However, the IRS may revisit the eligible partner definition in the future.
Making the election
A partnership must elect out of the centralized partnership audit regime on an eligible partnership’s timely filed tax return, including extensions. The election must include each partner’s name, U.S. tax identification number (TIN) and federal tax classification. For partnerships with S-corporation partners, the election must include each shareholder’s name, U.S. TIN and federal tax classification. The election must include an affirmative statement that the partner is an eligible partner.
The partnership must notify its partners within 30 days of making the election. The partnership does not have to provide notice to S-corporation shareholders because they are not partners to the partnership. Once the election out is made, it cannot be revoked without IRS consent.
Foreign partners who are subject to the centralized audit regime must have a U.S. TIN to ensure the partners of the partnership can be easily identified. The IRS and the Treasury Department intend to continue to study this issue in an effort to provide for alternative identification methods for foreign partners so they will not have to obtain a U.S. TIN solely for this purpose.
- A partnership cannot elect out of the centralized audit regime if at least one of its partners is a partnership or a disregarded entity.
- A foreign entity partner must have a U.S. TIN in order for the partnership to make a valid election out of the regime.
- A partnership that elects out should still appoint a partnership representative in case the IRS determines the election out was invalid.
- The IRS declined to place time restrictions on its right to determine whether an election was valid.
- The IRS and the Treasury Department still plan to issue additional regulations addressing other areas under the centralized partnership audit regime such as adjustments to outside basis, capital accounts, and the tax and book bases of partnership property.
The push-out election: shifting the proposed liability to reviewed-year partners
These regulations provide guidance on the so-called “push-out election” as applied to tiered partnerships, i.e., partnerships that have pass-through entities as partners. The regulations also address a host of procedural issues, including judicial review and how to challenge proposed penalty assessments.
Basic mechanics of the push-out election
As an alternative to a partnership-level tax, the partnership can elect to push out the adjustments to its reviewed-year partners. Under the push-out election, the partnership is no longer liable at the entity level for the imputed tax underpayment. The reviewed-year partners must take the adjustments into account at the partner level and report the adjustments on their tax returns for the year in which the push-out election is made.
To be effective, the election must:
- Be made within 45 days of the date the final partnership adjustment is mailed by the IRS. This deadline cannot be extended.
- Be signed by the partnership representative and filed in accordance with all IRS forms, instructions and guidance.
- Include the name, address and correct TIN of the partnership; the taxable year to which the election relates; the imputed underpayment or underpayments to which the election applies; each reviewed year partner’s name, address and TIN; and a copy of the final partnership adjustment.
Further, the partnership must furnish statements to the reviewed-year partners and file those statements with the IRS. These statements must include detailed information and be provided separately from any other statements required to be filed, such as Schedules K-1.
The partnership does not need to consult with reviewed-year partners regarding the decision to make the election. Once the partnership makes the push-out election, the partners are bound by the election and become responsible for reporting these adjustments on their own tax returns. The partnership is free to make the push-out election with respect to some adjustments but not others.
Once the election is made for a given adjustment, it can only be revoked with the consent of the IRS.
Application of the push-out election to tiered pass-through entities
The Bipartisan Budget Act does not address how the push-out election applies when an audited partnership has partners that are pass-through entities. Pass-through partners include partnerships, S corporations, certain trusts and decedents’ estates. Prior to issuance of the proposed regulations, it was not known whether these pass-through entities would be liable for imputed underpayments.
Under the proposed regulations, the pass-through partner is given the option to either pay the entity-level tax or push the adjustments through to its own partners, shareholders or beneficiaries. The procedural requirements by which a pass-through partner pushes out adjustments to its partners largely mirror the procedural requirements for the first-tier partnership, e.g., calculate the imputed underpayment and issue statements to the partners and the IRS. The due date for a pass-through partner to push out its adjustment is the due date of the pass-through partner’s income tax return, including extensions.
The IRS will collect the tax from a noncompliant pass-through partner that fails to either choose to pay the tax or push the adjustments through to the next tier of partners.
- Procedural issues
The proposed regulations also address a variety of procedural requirements. For instance, the proposed regulations establish a process under which partners can challenge penalties for circumstances unique to the partner, i.e., partner-level defenses. The regulations do not establish specifically what may constitute a partner-level defense, but a partner-level defense may include, for instance, reliance on a tax professional at the partner level.
The proposed regulations also establish a process for judicial review of partnership adjustments. In short, a partnership must make a deposit of the imputed underpayment, file a claim for refund, and then, six months after the claim for refund the partnership can file suit in a United States District Court or the United States Court of Federal Claims.
Partnerships should decide whether to amend their partnership agreements to include provisions regarding whether to require, prohibit or permit the partnership to make the push-out election in the event of an imputed underpayment. When deciding whether and how to update partnership agreements, some of the many considerations partnerships might wish to consider include:
- Whether to prioritize certainty or flexibility. Will certainty regarding the treatment of all adjustments help or hinder a partnership’s efforts to attract new partners? Does the partnership want the flexibility to consider each adjustment individually?
- Whether to wait for additional guidance regarding how additional aspects of the election will function. For example, there is no guidance at this juncture regarding whether capital account and outside basis adjustments must be made in the reviewed year or the adjustment year. Depending on the situation, either result could have a distortive effect.
- Whether to accept the additional complexity and administrative burdens, which grow with every additional partner, which the push-out election creates.
- Whether the top-tier partners in a tiered pass-through organization structure are sensitive regarding the tiered disclosures.
Partnerships will wish to take these and many other considerations into account before reaching a decision regarding how to address push-out elections, both first-tier and second-tier, in their partnership agreements.
The centralized partnership audit regime: new proposed regulations on international taxation
Proposed regulations provide guidance on some international tax rules under the centralized partnership audit regime. While the centralized partnership audit regime applies to income taxes, these proposed regulations address how the centralized partnership audit regime correlates with certain other types of taxes; more specifically,
- coordinating the centralized partnership audit regime with withholding on payments to non-U.S. persons and under the Foreign Account Tax Compliance Act (FATCA);
- the withholding tax rules for payments to foreign persons and entities when the partnership pushes out the liability for an understatement to its partners;
- reporting items that affect the foreign tax credit calculation at the partner level and computing the imputed underpayment for an adjustment to creditable foreign tax expenditures (CFTE); and
- various other international tax-related issues.
Coordinating the centralized partnership audit regime with withholding on payments to non-U.S. persons and under FATCA
The proposed regulations coordinate the centralized partnership audit regime with the withholding requirements on payments of income allocable to foreign persons as well as the U.S. withholding agent requirement to withhold tax on certain payments made to foreign financial institutions and nonfinancial foreign entities under FATCA. Withholding may arise when a partnership has a foreign partner that is allocated U.S. source income subject to withholding. The partnership is subject to paying the withholding as well as paying an income tax for any additional taxes arising from an income tax audit adjustment. These rules were created primarily to ensure that the tax is collected only once with respect to the same adjustment.
If withholding audits occur first and withholding is collected from the partnership as a result, then the issues resulting in the withholding adjustment are disregarded in any future IRS examination under the centralized partnership audit regime. Alternatively, if an audit under the centralized partnership audit regime occurred first and the partnership paid an imputed underpayment including an adjustment subject to the certain withholding requirement, then the partnership is considered to have satisfied the withholding liability.
Push-out effect on foreign partners
As mentioned above, partnerships under the centralized partnership audit regime are allowed to push out adjustments to its reviewed-year partners rather than pay an imputed underpayment at the partnership level. The partnership must provide notice to each partner that includes information regarding the partner’s allocable share of the adjustment, assessed penalties and any additional taxes. The proposed regulations require the partnership to pay the withholding tax and file all the appropriate withholding returns required using Form 1042 or Form 8805 prior to furnishing the required statement. This withholding tax requirement is not pushed out to the partners and instead must be fulfilled by the partnership.
The proposed regulations also require a reviewed-year partner who is subject to withholding and receives this statement to file a return for the reporting year. In the return, the partner must report the additional tax along with its share of the penalties, interest and addition to tax. The IRS is considering ways to alleviate the filing obligations for foreign partners when a partnership pushes out its adjustments. One potential solution is to allow the partnership to elect to pay the share of the penalties, interest and additional taxes on behalf of the partner who would have been subject to withholding. This could relieve the partner from any filing obligations that would arise from the required statement.
U.S. foreign tax credits
Generally, a taxpayer may claim a foreign tax credit (FTC) for income, war profits and excess profits taxes paid or accrued during the tax year to any foreign country. Partnerships are not eligible to claim an FTC, but each partner can take its distributable share of the creditable foreign taxes paid or accrued by the partnership. This amount is known as the CFTE.
Although any adjustments to a partnership’s foreign taxes paid or accrued are determined at the partnership level under the centralized partnership audit regime, the resulting CFTEs are claimed by each partner; thus, the preamble to the proposed regulations recognizes that this may result in an increase in CFTEs but no corresponding decrease to the imputed underpayment. The centralized partnership audit regime also provides special groupings and subgroupings of CFTEs in order to prevent netting of CFTEs between partners or between the separate categories of a single partner. The groupings are “preferences, restrictions, limitations or conventions” for netting purposes. Subgrouping foreign and U.S. income is essential to determine if there is a foreign tax credit offset because netting such income at the partnership level could understate the underpayment of the tax.
The proposed regulations stress that these special procedural rules apply to FTCs because of the credits’ effects on preventing double taxation and that the credits are often used inappropriately. Section 905 requires taxpayers to notify the IRS if (1) a foreign tax for which credit was claimed is refunded; (2) an accrued tax remains unpaid after two years; or (3) if the amount of taxes paid differs than the amount of taxes accrued. The Treasury Department wants to preserve the long-standing FTC rules while implementing the centralized audit regime and is still seeking ways to accomplish both.
Numerous issues could arise when a partnership has a controlled foreign corporation (CFC) or a passive foreign investment company as a direct partner. For example, a CFC partner may not have a U.S. tax liability with respect to the given adjustment at the partnership level, but the centralized partnership audit regime adjustment may increase the CFC’s subpart F income that is included in income of a U.S. shareholder of the CFC. Treasury has requested comments on how the reporting obligations of foreign entities should be modified to ensure that statements issued are reflected on the returns of the U.S. owners of the foreign entities.
More unresolved issues
Treasury states that it is still figuring out how to approach certain major issues and have requested comments on the following:
- How to govern foreign corporations in the new centralized partnership audit regime
- How reporting obligations concerning foreign entities should be modified to ensure that statements issued are reflected on U.S. owners’ returns
- How to deal with treaty issues that arise when an imputed underpayment is assessed on a partnership with a foreign partner
- How to create an efficient filing system when a foreign partner receives a statement requiring the partner to file to report and pay push out adjustments, while the foreign partner would otherwise qualify for a filing exception
- How to simplify the information-reporting requirements when dealing with FTCs, and how to minimize compliance burdens and costs
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
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