Over 5 years ago, then President Obama ushered in sweeping changes to the method and manner in which partnerships are audited and partnership tax is assessed and collected through his signing of H.R. 1314, the Bipartisan Budget Act of 2015 (“BBA”). Although the provisions of the BBA are extremely complex and relatively untested, the IRS continues to add additional clarity and color on many of its provisions through the publication and release of final and proposed regulations. On November 24, 2020, the IRS published in the Federal Register additional proposed regulations under the BBA relating to, among other things, “special enforcement matters.” See REG-123652-18.
Section 6241(11)
The BBA partnership rules are housed in subchapter C of chapter 63 of the Internal Revenue Code. Among its many provisions is Section 6241(11), which relates to “special enforcement matters.” For these purposes, special enforcement matters means, among other things, termination and jeopardy assessments, criminal investigations, and “other matters that the Secretary determines by regulation present special enforcement considerations.”
Election Out and QSubs
The BBA partnership audit rules do not apply to all partnerships. Under Section 6221(b) and the governing regulations, a partnership may “elect out” of the rules if it has 100 or fewer partners for the tax year, each partner in the partnership is an eligible partner, the election out is timely and properly made, and the partnership properly notifies its partners of the election.
Generally, eligible partners include individuals, C corporations, certain foreign entities that would be treated as C corporations if domestic, S corporations, and estates of deceased persons. However, prior regulations have been explicit that an eligible partner does not include a “disregarded entity.” The proposed regulations clarify that a disregarded entity is “a wholly-owned entity disregarded as separate from its owner for Federal income tax purposes.” Accordingly, a disregarded entity would include a grantor trust and a qualified REIT subsidiary.
But one question prior to issuance of the proposed regulations was whether a qualified subchapter S subsidiary (“QSub”)[1]was an eligible partner or alternatively a disregarded entity. The proposed regulations firmly remove any ambiguity:
Under § 301.6221(b)-1(b)(3)(ii), partnerships that have disregarded entities as partners may not elect out of the centralized partnership audit regime. QSubs are treated similarly to disregarded entities for most purposes under the Code in that both QSubs and disregarded entities do not file income tax returns but instead report their items of income and loss on the returns of the person who wholly owns the entity. Thus, . . . the Treasury Department and the IRS have determined that 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 would enable a partnership to elect out in situations where there are over 100 ultimate taxpayers, thereby frustrating 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 Treasury Department and the IRS have determined it is necessary for the proposed regulations to address such a special enforcement concern by treating QSus as ineligible partners for purposes of section 6221. Accordingly, proposed § 301.6221(b)-1(b)(3)(ii)(G) provides that a QSub is not an eligible partner for purposes of making an election out of the centralized partnership audit regime under section 6221(b). Therefore, if a QSub is a partner in a partnership and required to be furnished a statement by the partnership under section 6031(b), that partnership will not be eligible to make an election under section 6221(b) to elect out of the centralized partnership audit regime.
Partnership-Related Item Components of Non-Partnership Related Items
The hallmark of the BBA partnership audit rules is that all adjustments to partnership-related items must be determined at the partnership level. Section 6241(2)(B) defines a partnership-related item broadly as any item or amount with respect to the partnership which is relevant in determining the tax liability of any person under chapter 1, including any distributive share of such an item or amount. Congress’ goal in mandating these partnership-level adjustments was to ensure efficiency in determining partnership-level adjustments.
However, the proposed regulations recognize that this may not always be the case. Specifically, the Treasury Department and the IRS jointly determined that special enforcement considerations are presented where the partnership’s treatment of a partnership-related item on its return or books and records is based in whole, or in part, on information provided by another person. According to the Treasury Department and the IRS, it would be more efficient for the IRS and the person (generally, the partner) to make partnership-related item adjustments during a partner examination as opposed to opening a separate partnership-level examination. Thus, the proposed regulations permit the IRS to examine and adjust that partnership-related item in an examination of the person who provided the information. The proposed regulations indicate that the IRS intends to use this method in cases where 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 or that impact the partnership as a whole.
Termination and Jeopardy Assessments
Section 6241(11)(B)(ii) defines a “special enforcement matter” to include termination and jeopardy assessments under Sections 6851 and 6861, respectively. In termination and jeopardy assessment situations, the IRS makes an immediate assessment against a taxpayer to collect tax where the collection of tax is in jeopardy. Thus, under the proposed regulations, the IRS may adjust any partnership-related item with respect to a partner or indirect partner for which an assessment of income tax is made under Section 6851 or Section 6861. The IRS is not required to comply with the BBA partnership rules in these instances.
Criminal Investigations
Section 6241(11)(B)(iii) also defines a “special enforcement matter” to include criminal investigations. Under the proposed regulations, the IRS may adjust any partnership-related item with respect to any partner or indirect partner for any tax year of a partner or indirect partner for which such partner is under criminal investigation. Again, the IRS is not required in these circumstances to comply with the BBA partnership rules.
Controlled Partnerships and the SOL
Under the Internal Revenue Code, the general rule, particularly outside the BBA partnership audit rules, is that the partner of a partnership reports the items of partnership income, gain, loss, deduction, and credit on his or her tax return and pays the corresponding tax liability, if any. That is, the partnership does not pay the tax itself.
Under the BBA partnership rules, the IRS is generally precluded from making adjustments to partnership-related items, with some exceptions, after the later of the date which is 3 years after the latest of: (1) the date on which the partnership return for such tax year was filed; (2) the return due date for the tax year; or (3) the date on which the partnership filed an administrative adjustment request (“AAR”) with respect to such year. Because a partner almost always has a separate statute of limitations with respect to his or her individual income tax return, it is generally the rule that the BBA statute of limitations may expire prior to the statute of limitations applicable to the partner.
In instances where this occurs and where the partnership is controlled by a single or small number of individuals, the IRS may disregard the BBA partnership rules to make an assessment directly against the individuals:
Specifically, the Treasury Department and the IRS have determined that special enforcement considerations are presented when the period of limitations on making adjustments to the partnership has expired for a taxable year but a controlling partner’s period of limitations on assessment of chapter 1 tax has not expired or where the partner has voluntarily agreed to extend the period of limitation. When examining a partner that has control of a partnership through multiple tiered entities it may not be evident that an adjustment to an item on the controlling partner’s return requires an adjustment to a partnership-related item until the controlling partner’s interest is finally traced to a partnership. It may not be possible for this tracing to be completed before the period of limitations to make adjustments to the partnership has expired. In these circumstances, it is necessary for the effective and efficient enforcement of the Code to make adjustments or determinations regarding partnership-related items at the partner level during an examination of the controlling partner who has an open period to assess chapter 1 tax with respect to that item or amount. The same principles apply with respect to a partner who has consented to extend the period of limitations.
To determine if a direct or indirect partner has control for these purposes, the proposed regulations incorporate the rules under Sections 267(b) and 707(b).
Summary
The new proposed regulations provide some additional clarity regarding special enforcement matters but also setup several traps for the unwary tax professional. Accordingly, tax professionals would be wise to fully understand their scope and ramifications, particularly if the above provisions are put in final form as a final regulation.
Moreover, there is little doubt that the IRS will focus more on BBA partnership rule audits and examinations in 2021 and later years. To assist our clients and other tax professionals, we have developed a website fully devoted to the BBA partnership rules.
Representation in Tax Audits & Appeals
Need assistance in managing the audit process? Freeman Law’s team of attorneys and dual-credentialed attorney-CPAs regularly represents taxpayers before the IRS and Texas Comptroller. Our team also provides tax return-related representations and helps taxpayers navigate state tax laws. Our Firm offers value-driven services and provides practical solutions to complex issues. Schedule a consultation or call (214) 984-3000 to discuss our tax representation services.
[1] A QSub is defined in the Code as any domestic corporation that is not an ineligible corporation (as defined in Section 1361(b)(2)) if 100% of the stock of such corporation is held by an S corporation and the S corporation makes an election to treat it as a QSub.
