Tougher rules under the centralized partnership audit regulations

Caleb Egli, Adam Silva
| 1/12/2023
Tougher rules under the centralized partnership audit regulations
In summary
  • Regulations related to partnership audit regulations were finalized in December 2022.
  • The final regulations make some changes to the rules under the Bipartisan Budget Act of 2015 (BBA).

On Dec. 9, the U.S. Department of the Treasury and the IRS finalized regulations that were proposed on Nov. 24, 2020, related to the centralized partnership audit regime enacted by the BBA. The BBA generally is applicable to partnership taxable years beginning on or after Jan. 1, 2018. The final regulations, which did adopt many of the comments to the proposed regulations, include the following changes to the BBA rules.

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No election out of the BBA for partnerships with qualified S-corporation subsidiary (QSub) partners

Partnerships are subject to the BBA unless they properly elect out of the regime. Partnerships with 100 or fewer eligible partners may elect out of the BBA. Generally, pass-through entities, such as partnerships, disregarded entities, and grantor trusts, are not eligible partnerships. For an S-corporation partner, the S corporation and each of its shareholders are counted to determine if the 100 or fewer threshold is met.

The final regulations provide that a QSub is not an eligible partner. The rule is effective for taxable years ending on or after Nov. 20, 2020. Given that the effective date for the regulation is retroactive, partnerships with QSub partners that elected out of the BBA for taxable years ending on or after Nov. 20, 2020, should consult with their tax advisers.

Crowe observation

Notice 2019-06 originally proposed that partnerships with QSub partners could elect out of the BBA except that the number of QSub and S-corporation shareholders would be counted to determine if the 100 or fewer threshold was met. That rule was changed when proposed regulations were published.

Special enforcement rules

Under the BBA, the IRS generally is not allowed to audit a partner with respect to a partnership-related item, but instead must audit the partnership. The definition of a partnership-related item is very broad and includes any item in the partnership’s books and records as well as any item on the partnership return and schedules, such as the Schedule K-1, “Partner’s Share of Income, Deductions, Credits, Etc.” A partnership-related item does not include the partner’s basis in its partnership interest.

The BBA includes a provision allowing the IRS to “turn off” the BBA rules in the case of a special enforcement matter and instead audit the partner to make adjustments and collect tax with respect to partnership-related items. The statute lists special enforcement matters, such as criminal proceedings and bankruptcy, and provides authority for special enforcement matters to be set forth in regulations.

The final regulations provide rules for the special enforcement matters described in the statute. They also add special enforcement matters that were not set forth in the statute, including:

  • The IRS may audit any direct or indirect partner that is related to the partnership under IRC Section 267(b) or Section 707 instead of the partnership with respect to partnership-related items if the statute of limitations to audit the partnership has expired and the direct or indirect partner’s statute of limitations is open.
  • The IRS may adjust a partnership-related item in an examination of a person other than the partnership if the adjustment to the partnership-related item is made as part of, or underlying, an adjustment to an item that is not a partnership-related item of the person being examined and the treatment of the partnership-related item is based in whole or in part on the information provided by the person under examination. The regulations include the example of adjusting the basis of property contributed to a partnership by a person being examined with respect to gain or loss on the sale of an interest in the partnership.

Crowe observation

Though the BBA regime has very rigorous rules set forth in statute and regulations, the special enforcement matters added by the regulations appear to give the IRS wide discretion to decide whether it is more advantageous for the government to audit the partner or the partnership without significant guardrails.

Looking ahead

The final regulations create rules that are more favorable to the IRS when examining partnerships and their direct and indirect partners. One significant change prevents certain partnerships from electing out of the BBA regime, thereby broadening the scope of partnerships the IRS will be able to audit within the confines of the BBA. Another change allows the IRS to audit items emanating from a partnership at the partner level, outside of the BBA. Given the complexity of the BBA regime, taxpayers should consider engaging a qualified tax adviser to represent them in examinations regarding partnership issues.

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Caleb Egli Headshot
Caleb Egli
Managing Director, Washington National Tax
people
Adam Silva