August 8, 2016
On August 4, 2016, the Internal Revenue Service (the "IRS") issued temporary and proposed regulations (the "Temporary Regulations") addressing the mechanics for electing to apply the new partnership audit rules (the "New Rules") before those rules become mandatory for tax years beginning after December 31, 2017.[1] The Temporary Regulations are effective beginning August 5, 2016.
Brief Background on the New Rules
Partnerships, unlike corporations, are not subject to income tax. Instead, the partners are taxed on their distributive shares of the partnership’s income. Under the law currently in effect (the so-called "TEFRA rules"), when the IRS audits a partnership, it adjusts the partners’ distributive shares of taxable income for the year under audit, and it is the responsibility of the partners to pay any resulting tax liability. (Certain partnerships with not more than 10 partners are not subject to the TEFRA rules.)
The Bipartisan Budget Act of 2015 (the "BBA") dramatically overhauled the partnership audit rules. Under the BBA, as under the TEFRA rules, the IRS generally will continue to audit most partnerships at the partnership level; however, unlike the TEFRA rules, under the BBA the IRS will adjust and collect any additional tax at the partnership level. Thus, if an audit results in additional tax, the partnership itself generally will be required to pay that tax unless the partnership elects to "pass through" or "push out" the liability to its partners. The New Rules are complex and viewed by the tax community as containing many conceptual and technical shortcomings that, we hope, will be addressed in subsequent guidance. For more detail on the BBA, please see our Client Alert of November 12, 2015.[2]
Election to Be Subject to the New Rules Earlier than 2018
The New Rules are effective for tax years beginning after December 31, 2017. Nevertheless, partnerships may elect to apply the New Rules to any tax year beginning after November 2, 2015 and before December 31, 2017. The Temporary Regulations provide the time, form, and manner of making this election. Specifically, the Temporary Regulations provide a general rule, a special rule, and miscellaneous related rules.
General rule–election after written notice from IRS. Under the general rule, a partnership may elect to apply the New Rules within 30 days after the date of written notification from the IRS that a return of the partnership for an "eligible taxable year" has been selected for examination.[3] This written notice is referred to as a "notice of selection for examination."[4]
We expect very few partnerships will elect to have the New Rules apply in advance of January 1, 2018.
Special rule–election before receipt of written notice from IRS. Beginning on January 1, 2018, a partnership also will be able to elect to have the New Rules apply to an eligible year even if the partnership has not received a notice of selection for examination from the IRS. Electing in would permit the partnership to file an administrative adjustment request under new section 6227 (an "AAR").
It should be noted, however, that a partnership should not attempt to make an election under the special rule before January 1, 2018 otherwise the election will be treated either as an AAR by the partnership under the TEFRA rules, or, if the partnership is not subject to the TEFRA rules, as an amended return of partnership income. In either case, the partnership taxable year with respect to which the election was prematurely attempted will not be an eligible taxable year. As a result, if the return for that year is later selected for examination, the partnership will not be able to elect into the New Rules.[5]
Miscellaneous rules.
Required Election Representations. When the partnership makes the election, it must provide a statement that includes representations that (i) the partnership is not insolvent and does not reasonably anticipate becoming insolvent, (ii) the partnership is not currently and does not reasonably anticipate becoming subject to a bankruptcy petition under title 11 of the United States Code,[6]and (iii) the partnership has sufficient assets, and reasonably anticipates having sufficient assets, to pay the potential imputed underpayment that may be determined during the partnership examination.
Limitations on Effectiveness of Election. There are several situations in which an election will not be effective:
Issuance of Notice of Administrative Proceeding. Upon receiving a partnership’s notice of an election under the general rule, the IRS will mail a notice of administrative proceeding to the partnership.[7] The Temporary Regulations make clear, however, that the IRS will not mail this notice for at least 30 days following receipt of the election. According to the preamble to the Temporary Regulations, "[d]uring the period of at least 30 days after the IRS receives a valid election and before the IRS mails the notice of an administrative proceeding, the partnership may file an AAR under section 6227 as amended by the BBA."[8]
The Treasury Department and the IRS intend to issue additional guidance regarding AARs before January 1, 2018.
Conclusion
A partnership that receives a notice that the IRS intends to audit the partnership for a taxable year beginning after November 2, 2015 and before January 1, 2018, should consider whether to opt into the New Rules. Because of the relatively short 30-day window in which to make an election to apple the New Rules, partnerships and their tax advisors should prepare for a potential audit by determining ahead of time whether they would make the election.
[1] Temp. Treas. Reg. § 1.301.9100-22T; 26 CFR 301.9100-22T; T.D. 9780. Unless indicated otherwise, all "section" references are to the Internal Revenue Code of 1986, as amended (the "Code"), and all "Treas. Reg. §" references are to the Treasury regulations promulgated under the Code.
[2] Available at: http://www.gibsondunn.com/publications/Pages/President-Obama-Signs-Bipartisan-Budget-Act-2015-Sweeping-Aside-Rules-That-Have-Governed-Tax-Audits-Partnerships-Since-1982.aspx.
[3] An "eligible tax year" is generally any tax year beginning after November 2, 2015, and before December 31, 2017.
[4] Temp. Treas. Reg. § 301.9100-22T(b).
[5] Temp. Treas. Reg. § 301.9100-22T(d)(2). This result seems somewhat punitive and it is not clear why the IRS and the Treasury Department adopted this approach
[6] Note, however, that these representations do not appear to limit the right of the partnership to file a petition under chapter 11 of the United States Code, and any such limitation would likely be unenforceable. It is unclear what recourse would exist for the IRS if, subsequent to making the election, the partnership actually files a petition under chapter 7 or 11 of the United States Code.
[7] Temp. Treas. Reg. § 301.9100-22T(b)(2)(iii).
[8] It appears that this rule is intended to be taxpayer-friendly, presumably on the assumption that a partnership may prefer to file an AAR rather than receive a notice of administrative proceeding.
The following Gibson Dunn lawyers assisted in the preparation of this client alert: Eric Sloan, James Jennings, Jeff Trinklein, Romina Weiss, Michael Rosenthal, Nina Xue, and Kathryn Kelly.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the Tax Practice Group, or any of the following:
Art Pasternak - Co-Chair, Washington, D.C. (+1 202-955-8582, [email protected])
Jeffrey M. Trinklein - Co-Chair, London/New York (+44 (0)20 7071 4224 / +1 212-351-2344), [email protected])
Brian W. Kniesly – New York (+1 212-351-2379, [email protected])
David B. Rosenauer - New York (+1 212-351-3853, [email protected])
Michael A. Rosenthal – New York (+1 212-351-3969,[email protected])
Eric B. Sloan – New York (+1 212-351-2340, [email protected])
Romina Weiss - New York (+1 212-351-3929, [email protected])
Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, [email protected])
Dora Arash – Los Angeles (+1 213-229-7134, [email protected])
Hatef Behnia – Los Angeles (+1 213-229-7534, [email protected])
Paul S. Issler – Los Angeles (+1 213-229-7763, [email protected])
Scott Knutson – Orange County (+1 949-451-3961, [email protected])
David Sinak – Dallas (+1 214-698-3107, [email protected])
© 2016 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.