The IRS and Treasury published final regulations (T.D. 9829) on Jan. 2, 2018, that provide guidance on electing out of the new centralized partnership audit regime introduced by the Bipartisan Budget Act (BBA) of 2015, P.L. 114-74. It is important that partners, partnerships, and their representatives be aware of the rules in the final regulations regarding the process to elect out of the new audit rules, as the BBA regime overhauls the way partnerships are audited and how any resulting tax liability is computed, assessed, and collected.
The IRS generally conducted partnership audits in accordance with the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) before Congress enacted the BBA in November 2015. TEFRA did not provide a statutory mechanism for collecting tax at the entity level; instead, the IRS generally had to seek payment of underpaid tax directly from the partners who would have owed that tax had the partnership properly reported its items on its original return. The BBA brought in a new regime to allow for assessment and collection of tax at the partnership level. Along with it are a number of other changes to the partnership audit process. Beginning Dec. 31, 2017, these new rules are generally effective for most partnerships.
Under Sec. 6221(b), certain partnerships are eligible to annually elect out of the BBA. The IRS would generally make any adjustment relating to the partnership’s return in an audit of a partner, not an audit of the partnership, if a partnership makes a valid election under Sec. 6221(b). The partnership would also generally not owe any taxes, interest, or penalties. Treasury and the IRS published proposed regulations on June 14, 2017, that provide guidance on the applicable BBA procedures, as well as procedures for electing out of the new regime.
Final regulations on electing out
T.D. 9829 addresses the election out of the BBA rules that is provided by Sec. 6221(b) and not any of the other BBA rules. The final regulations adopt the proposed regulations (REG-136118-15) with a few minor revisions and clarifications in response to comments received.
Sec. 6221(b) states that a partnership is eligible to elect out of the BBA regime if: (1) it has 100 or fewer partners during the year, and (2) all its partners are “eligible partners” at all times during the tax year. The final regulations provide that a partnership has 100 or fewer partners during the year if the partnership is required to furnish 100 or fewer statements under Sec. 6031(b) during the tax year for which the partnership makes the election. However, when a partner is an S corporation, a special rule applies. Under this rule, any statements the S corporation partner is required to furnish under Sec. 6037(b) are treated as statements the partnership is required to furnish for the relevant tax year.
Generally, the final regulations declined to adopt any recommendations that statements furnished to certain types of partners (e.g., statements furnished to passthrough entities and disregarded entities, as well as to spouses) should not be taken into account in determining whether the partnership met the requirement of furnishing 100 or fewer statements.
The final regulations define an eligible partner as any person who is an individual, C corporation, “eligible foreign entity,” S corporation, or an estate of a deceased partner. Furthermore, they define an eligible foreign entity as a foreign entity that is a per se corporation under Regs. Sec. 301.7701-2 or an association taxable as a corporation (either by default or due to an election under Regs. Sec. 301.7701-3). An S corporation is an eligible partner even if it has a shareholder who holds an interest directly and would not be an eligible partner himself or herself.
The IRS decided not to expand the definition of eligible partner to include persons or entities other than those in the statute even though it has received numerous comments requesting it to exercise its discretionary authority to do so. As a result, an eligible partner does not include partnerships, trusts, disregarded entities, nominees or other similar persons that hold an interest on behalf of another person, foreign entities that are not eligible foreign entities, and estates that are not estates of a deceased partner. However, the preamble to the final regulations does indicate that the IRS may revisit the definition of an eligible partner after it gains further experience with the new centralized partnership audit regime.
Making the election
The final regulations set forth the time, form, and manner to make a valid election out of the partnership audit regime for a particular tax year. The partnership must make the election on a timely filed partnership return (including extensions) for the tax year to which the election relates. In addition, the partnership must provide the following information: name, correct U.S. taxpayer identification number (TIN), and federal tax classification of each partner and each shareholder of a partner that is an S corporation. Thus, each partner — foreign or domestic — must have a valid U.S. TIN.
A partnership electing out of the regime must notify each of its partners of the election within 30 days — in a manner elected by the partnership. Additional guidance is expected when the IRS issues forms and instructions relating to the filing of an election out of the BBA rules under Sec. 6221(b).
Key takeaways regarding election out eligibility
The major highlight in the final regulations is that a partnership will not be eligible to elect out of the new partnership regime if it has a partner that is itself a partnership or a disregarded entity, such as a disregarded single-member limited liability company (LLC) or a grantor trust. It is also important to note that all eligible foreign partners — even those with no U.S. filing requirements — must apply for and obtain a valid U.S. TIN for the partnership to file a valid election out of the BBA rules under Sec. 6221(b). In addition, a partnership that is interested in electing out of the BBA rules and is eligible to make this election may want to consider restricting the number, type of partners, and the ability of its partners to change tax status. The partnership will also have to substantiate the tax status of its partners (and shareholders of partners that are S corporations) to make this election.
The IRS needs to make assessments against all of the partners in separate partner-level proceedings if a partnership elects out of the BBA rules. Thus, if a partnership proceeds to make the election out, its partners should confirm that they will have sufficient access to the partnership’s books and records if they need to substantiate the amounts allocated by the partnership in an IRS audit — as stated above. A more crucial aspect is the fact that if a partnership makes a valid election out, the applicable statute of limitation for assessment of tax will be determined at the partner level and is further determined separately for each partner.