IRS increases focus on partnership audits

| 12/10/2020
IRS increases focus on partnership audits

In 2021 the IRS plans to begin an initiative to audit large partnerships using the powerful centralized partnership audit tools Congress gave the agency when it enacted the Bipartisan Budget Act of 2015 (BBA). The BBA generally applies to partnership taxable years beginning on or after Jan. 1, 2018. The IRS said that it will use data analytics as part of its partnership audit selection and issue identification processes similar to the Large Corporate Compliance audit procedures used for large corporation audits. This initiative is in addition to other IRS initiatives that focus on wealthy individuals and related pass-through entities.

As part of this increased focus on partnership audits, the U.S. Department of the Treasury and the IRS published proposed regulations on Nov. 24, 2020, to refine some of the existing rules and implement the special enforcement provisions added to the BBA by the Tax Technical Corrections Act of 2018 (TTCA). Following are highlights of the proposed regulations.

Qualified S-corporation subsidiaries (QSubs)

The proposed regulations provide that partnerships that have QSub partners may not elect out of the BBA, reversing an earlier IRS notice indicating that the IRS intended to publish proposed regulations to allow certain small partnerships to elect out of the BBA even if they have a QSub partner. This provision is proposed to be applicable on Nov. 20, 2020.

Treatment of partnerships that cease to exist

The proposed regulations modify rules that allow the IRS to require former partners to take BBA adjustments into account if the partnership ceases to exist before the adjustments take effect. Under the current regulations, a partnership generally ceases to exist before the adjustments take effect if, before the partnership fully pays the amount due resulting from the BBA audit (the imputed underpayment), the partnership terminates under IRC Section 708(b)(1) or the IRS determines that the amount is uncollectible because the partnership does not have the ability to pay it.

The proposed regulations would allow the IRS to require former partners to take the adjustments into account if the partnership terminates or cannot pay the imputed underpayment when the adjustments are finally determined; there is a settlement with the IRS; or for adjustments appearing on an administrative adjustment request (AAR) when the AAR is filed, regardless of whether the partnership has already fully paid the imputed underpayment or whether the partnership has sufficient assets to pay the imputed underpayment.

In addition, the proposed regulations change the definition of former partners. Under the current regulations, former partners are the adjustment year partners (generally the partners for the year the adjustments are finally determined) or, if there are no partners in the adjustment year, the partners for the year the final return is filed. Under the proposed regulations, former partners would be the partners for the year the last partnership return or AAR is filed or “the most recent persons determined to be partners of the partnership in a final determination (for example, a defaulted notice of final partnership adjustment, final court decision, or settlement agreement) binding upon the partnership.”

These changes are proposed to apply to IRS cease-to-exist determinations made after Nov. 20, 2020.

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Special enforcement matters

Prior to amendments made by the TTCA, the IRS had to open a BBA partnership audit to adjust any partnership-related item, including items allocated to a particular partner. The TTCA amended the BBA to add IRC Section 6241(11) to allow the IRS to adjust certain partnership-related items outside of a BBA audit in the case of a special enforcement matter identified in regulations. This authority is significant because it allows the IRS to turn the BBA off and adjust a partnership-related item in an audit of a direct or indirect partner without having to audit the entire partnership.

The proposed regulations identify the following special enforcement areas:

  • Controlled partnerships and extensions of the partner’s period of limitations. This rule generally would allow the IRS to use a controlling direct or indirect partner’s period of limitations on assessment, rather than the period of limitations that applies to the partnership, to adjust partnership-related items. A direct or indirect partner is deemed to have control if the partner is related to the partnership under Section 267(b) or Section 707(b).
  • Partnership-related items underlying nonpartnership-related items. Under this rule, the IRS could adjust a partnership-related item at the partner level rather than having to audit the partnership if adjustment of a partnership-related item is part of or underlying a nonpartnership-related item of the partner and the partnership’s treatment of the item is based on information provided by the partner.
  • Termination and jeopardy assessments.
  • Criminal investigations.
  • Indirect methods of proof of income.
  • Penalties and taxes imposed on the partnership under Chapter 1.

Generally, the special enforcement provisions are proposed to be applicable to partnership taxable years ending after Nov. 20, 2020, or any examination or investigation begun after Nov. 20, 2020. The rule for partnership-related items underlying nonpartnership-related items is proposed to apply to partnership taxable years ending after Dec. 20, 2018, or any examination or investigation begun after Dec. 20, 2018. The proposed regulations provide that these provisions can apply earlier if the IRS and the taxpayer agree.

Looking ahead

These changes generally are proposed to be effective in 2020, which means that they would have retroactive effect if finalized without a change to the effective date. Partnerships with QSub partners that planned to elect out of the BBA for 2020 should consult with their tax advisers to evaluate how these proposed changes could affect them. Partners of partnerships currently under BBA audit should consider whether one of the factors that would cause the partnership to cease to exist might arise and, if so, how the cease-to-exist rules could affect them. Partners and partnerships also should be aware of how the special enforcement provisions could affect them, especially the rule that would allow the IRS to audit partnership-related items outside of a BBA audit in the case of underlying nonpartnership-related items, because those rules could apply to taxable years and examinations that began after Dec. 20, 2018.

Update: On Dec. 8, 2020, the IRS released two practice units – one on allocation of partnership liabilities and another on recourse and nonrecourse liabilities. These practice units give further insight into issues the IRS will be focusing on during partnership examinations.

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Rochelle Hodes
Rochelle Hodes
Principal, Washington National Tax