Centralized Partnership Audit Regime—what Me Worry?

• Publication year: 2020
• Author: By Cameron L. Hess

Centralized Partnership Audit Regime—What Me Worry?

By Cameron L. Hess¹

I. OVERVIEW

Legislatively enacted in 2015, Congress delayed the effective date of the Centralized Partnership Audit (CPA) regime to partnership tax returns having fiscal (or calendar) years beginning after December 31, 2017 to help the Treasury Department to adopt guidelines, and, presumably, give the taxpayer community time to adjust to those guidelines.²

The result was the replacement of the former Tax Equity and Fiscal Responsibility Act (TEFRA) partnership audit examination rules.³ Implemented are revised audit examination procedures that, in a simplistic sense, shift major portions of the audit examiner's work to the partnership representative. More precisely, the CPA regime simplifies the Internal Revenue Service's (the Service) assessment and collection of tax from proposed partnership audit adjustments. Key provisions, which include March 2018-year legislative changes⁴ and changes in response to practitioner comments, are outlined below, but for some will be a new ball game. Arguably, resolving some issues representatives will encounter during audit may unfortunately prove insurmountable.

II. BASICS OF CPA REGIME

The CPA regime is very complex and therefore, the highlights in this article are not intended to be exhaustive as to all the changes.

A. The Imputed Underpayment

A distinct feature under the CPA regime and its regulations is a new provision as to who bears the burden of any tax adjustment, known as the default rule. Under the default rule, absent a contrary election, partnership adjustment items will, in fact, result in an additional tax liability to be borne directly by partnership itself, and not its partners.⁵

This new assessment, known as an "imputed underpayment" usually triggers a greater tax liability than under the former law. And, it is usually greater than what would otherwise have been assessed against each of the partners. For example, except for a few allowed modifications, the tax rate is required to be determined at the highest Chapter 1 income tax rate.

In addition, in picking up the total adjustments made to partnership items, the liability will only reflect the total of all net positive item adjustments identified by the Service.⁶ Grouped items that have a net negative amount (that would otherwise decrease applicable taxes) will be disregarded.⁷ For example, if there is simply a timing issue as to an item of income or deduction between tax years, there will be an adjustment to increase the tax for the audited year, without a setoff for an offsetting decrease in an earlier or later year. As another example, positive items subject to tax may arise from a reallocation of income among partners wherein only the increases are considered and any counterbalancing reductions to other partners will be disregarded.

One uncertainty with the final regulations will be the extent to which the examiner's discretion in determining groupings of net positive adjustment items will affect the total amount assessed. A revenue agent is not necessarily required to follow Internal Revenue Code (Code) section 704(b), in setting out categories of items to be netted to determine a net positive or net negative adjustment, the latter of which may be disregarded.⁸ The actual process is complex.⁹

The extent to which revenue agents may permissibly disregard offsetting adjustments may incentivize them to be less likely to compromise as to proposed adjustments.¹⁰

B. Walking the Adjustment Pathway

There are several new or changed procedural steps with respect to an examination. Findings will still be part of a Notice of Proposed Partnership Adjustment (NOPPA),¹¹but the term is slightly different from its predecessor as there are several procedural changes.

1. Modifications

A new process was created due to the concept of an imputed underpayment. Because of the effect of the imputed underpayment, partnerships are granted a 270 day period (which may be further extended by the Service, if requested), following the audit examiners initial findings to allow the partnership representative to request modifications.¹² The function of permitting modifications, is not to directly dispute any of the partnership adjustment items. Rather, it is a right to request that the imputed underpayment reflect certain items beyond the determination by the revenue agent. This involves changes to revenue agent procedures used to make partner level adjustments and assessments, that the revenue agent will no longer be required to undertake. For example, it may be that the resultant tax should be less than the resultant tax computed at the highest Chapter 1 tax rate-due to capital gains treatment or the partner being a nonprofit organization, not subject to tax. There are many different types of modifications, a few of which include: i) allowing partners to submit amended returns, ii) closing agreements, and iii) other items.¹³ The revenue agent may accept or reject each of the modification requests.¹⁴ While informal discussions with the legal division indicate that discretion should not be an issue, revenue agents interpreting the regulations may not come uniformly to the same conclusion as to the scope of their discretion.

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Once the modification requests are determined, the revenue agent will then issue a notice of final partnership adjustment. This notice is similar as before insofar as it generally closes the examiner's determination of the adjustments but differs as the tax amount due remains to be addressed at a partnership level or through the push-out at a partner level.

C. Pushing Out the Tax

The final partnership adjustment will generally represent the items upon which the partnership is required to determine its additional tax bill, for example, the imputed underpayment amount. However, upon receipt of this notice, the partnership representative may then, under section 6226 of the Code, request that the Service allow the partnership to elect to "push-out" the assessment to the original partners for the reviewed year.¹⁵ To be effective, the push-out election must be made, whether or not the partnership intends to challenge the adjustments, within 45 days of the date the final partnership adjustment is mailed by the IRS.¹⁶

The original partners for the reviewed year may differ from those partners who held interests at the time the notice is issued. As a result, a push-out election provides direct relief to later partners who were not partners or held a lesser interest with respect to the reviewed year.

Under final regulations, the revenue agent may reject a push-out election without notice, appeal or opportunity to correct.¹⁷ This absolute rejection right is intended be reserved for circumstances where a partnership representative failed to identify and provide sufficient information to collect upon the original partners, requiring current addresses and shares of the imputed underpayment. However, the grant of an absolute right by the Service to itself may result in an increase in arbitrary decisions, and a standard of "absolute compliance" may turn out to be impossible. For example, any perceived "defect" as to a single partner may cause the push-out election to be rejected. Furthermore, there appears to be no guidance which provides for judicial review. Absent a clearly stated Tax Court jurisdictional right, action might only arise as to the erroneously rejected election, after payment by the partnership and only pursuant to claim for refund procedures. This provision vastly increases the legal costs of challenging an improper rejection, and the likelihood that an arbitrary Service rejection of an election will be cost prohibitive to set aside.

The effect of the push-out election for the reporting year, for example, the year within which the partner statement was issued under Treasury Regulation section 301.6226-2, differs from former law. These items are considered increases to income and result in tax for the adjustment year—the year in which the determination is final, and, hence, being assessed on returns filed years later—which may have unexpected consequences. It requires that a notice be sent to each of the partners, wherein the partners pay tax based on the notice or compute the effect of the additional adjustments on the adjustment year.¹⁸ Referred to as "correction amounts,"¹⁹ the regulations do reference negative adjustments. For example, the consequence of these adjustments on the first affected year or any intervening year may be less than zero, and therefore some partners may see refunds. Any taxes assessed will bear interest that is two percent higher than the general underpayment rate had the tax been paid by the partnership.²⁰

1. Push-up Election

There is also an additional election that may be made, but it is made by the partners, not the partnership. A partner may elect to "push-up" where there is not a push-out election. This allows a partner to accept his/her or its share of tax as if a push-out election was made as to just that electing partner. The partnership is relieved as to that partner's share. On the push-up election, the general underpayment of interest rate applies.

The push-up election is not done by way of an amended return, but a statement filed by the electing partner where only adjustments identified on the revenue agent's report, including all related items, is reported to the Service. No new matters may be asserted.

2. Tax Court Rights

The notice of final partnership adjustment triggers the 90 day right for the partnership to file a petition with the United States Tax Court.

With respect to negative adjustments, they are not forgotten, but can be deducted against partnership income in the "adjustment year" that is the year when the determination becomes final.²¹

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III. DISCUSSION—CPA REGIME ISSUES

The CPA Regime raises several issues of concern.

A. Electing Out

Many practitioners may be caught unaware as to how difficult it...