IRS Final Partnership Audit Regulations On Electing Out

IRS Final Partnership Audit Regulations On Electing Out

Tax Reform has taken the spotlight but there is no doubt that accountants will have their hands full and business litigation resulting from tax issues will rise.

On December 29, 2017, the Department of the Treasury-Internal Revenue Service issued final regulations on electing out of the centralized partnership audit rules (CPAR). The preface to the final regulations contains a summary of public comments and a response from the IRS. Electing out under IRC 6221 (b) would require the IRS to assess each partner as had been the rule prior to the change in the law. Not only does CPAR mark a dramatic change in the tax landscape, but also the tax bill must be paid by the partnership as currently constituted when the bill is issued. Stated another way, a current partner may indirectly bear a tax, interest, and penalty for a prior year in which he was not a partner. One can see how electing out under IRC 6221(b) is useful if not desirable especially in drafting operating and partnership agreements.

IRS Response to Public Comments

Treasury, or the IRS if you prefer, responded in the negative to most comments. IRS said no to a request to permit a partnership to look-through a disregarded entity (DRE) that was a partner to determine the partnership’s eligibility to elect out. IRS responded in the negative to a pre-filing procedure that would pre-qualify partnerships for the election.   IRS stated that it did not want to limit the statute of limitations and its opportunity to audit the eligibility to elect out.

Married persons and couples in community property states cannot be combined and count as one partner. Thus, a couple where each is a partner and receives a K-1 will be counted separately. In a community property state, spouse A may own an interest and spouse B subsequently acquires an interest, which becomes community property by operation of law. Notwithstanding local law, the interests are separate for CPAR purposes and count as two for purposes of the 100 partner rule. Subsequent guidance may be issued based on the experience with the CPAR. Tax-exempts did not do well. An exempt-organization organization as a corporation is an eligible partner while an exempt organization organized as a trust is an ineligible partner. The statements of the IRS indicate that it is not will to modify the definition in the statute of who is (or is not) an eligible partner.

Nominees are a concern and the ability of the IRS to cast one is as a nominee is important to IRS. Also important to the IRS is its ability to consolidate two partnerships into one primarily for the purpose of imposing CPAR. Consider if partnership A is divided into two partnerships, one consisting of eligible partners that allows the partnership to elect out and a second partnership of ineligible partners subject to CPAR. The administrative goal would be to reconstitute the two into one. Thus, current doctrines of consolidated partnership and de facto partnerships will receive new application.

Commentators have asked for the ability to revoke an election out without IRS consent and, as one would expect, the request was denied as a burden on tax administration. Another comment that was rejected was requiring IRS to give notice of a rejection within 180 days of receipt of an election out.

Foreign partners may not, necessarily, have an EIN and have submitted a W-8 for withholding purposes. The request that a W-8, in lieu of an EIN, be satisfactory evidence for an election out by a partnership is insufficient. One may recall that correct identifying information for all partners is mandatory for a valid election out. Now, foreign partners must have an EIN for in order for the partnership to make a proper election out. One can imagine this will not be well received.

More on IRC 6221

IRC 6221 requires that a proper election out is that the partnership must give its partners notice of the election within 30 days of making it. Accountants take note of the potential for liability if it assumes this responsibility. Some commentators believed S corporation shareholders should be treated as indirect partners, a TEFRA concept. IRS noted TEFRA was repealed by the statute creating CPAR, eliminating the concept of direct and indirect partners. The definition remaining in the code has direct partners.

Commentators hoped for a “checkbox” type of notice, perhaps on the K-1, to partners that would satisfy the rule; however, no short-cut as provided. Finally, if IRS notifies the partnership of a defective election under Treas. Reg. 301-6221(b)(1)(e)(2), the IRS comments that nothing prevents the taxpayer from working with the IRS to correct the election.

Tax Reform has captured the attention of the media and the public; however, CPAR will result in conflict between and among partners, partnerships, and accountants. The first battles will result from the partnership and operating agreements not being updated to address the issues.

If you have any questions or if you would like to discuss the matter further, please contact me, James McDonough, at 201-806-3364.