Current developments in partners and partnerships.

• Author: Burton, Hughlene A.

This article reviews and analyzes recent law changes as well as rulings and decisions involving partnerships. The discussion covers developments in the determination of partners and partnerships, gain on disposal of partnership interests, partnership audits, and basis adjustments. During the period of this update (Nov. 1, 2016, through Oct. 31, 2017), the Treasury Department and the IRS worked to provide guidance for taxpayers on numerous changes that had been made to Subchapter K over the past few years. The courts and the IRS issued various rulings that addressed partnership operations and allocations.

Regulations project

Executive Order 13789 directed the secretary of the Treasury to review significant tax regulations issued on or after Jan. 1, 2016, and submit a report identifying regulations that impose an undue financial burden on taxpayers, add undue complexity to the federal tax law, or exceed the IRS's statutory authority. Notice 2017-38 identified two partnership regulations that either impose an undue financial burden on taxpayers or add undue complexity to the federal tax law: the temporary regulations under Sec. 752 regarding "bottom-dollar payment obligations" and the temporary and final regulations under Sec. 707 regarding a partner's share of liabilities for disguised-sale purposes. (1) There have been some objections from taxpayers and practitioners to both of these regulations. On Oct. 2, 2017, Treasury issued a "Second Report to the President on Identifying and Reducing Tax Regulatory Burdens." In it, Treasury and the IRS stated that, upon further review, they believe the Sec. 752 regulations relating to bottom-dollar payment obligations should be retained and that they do not plan to propose substantial changes to those regulations. However, Treasury and the IRS stated that they were considering whether the temporary regulations under Sec. 707 should be revoked, with the prior regulations reinstated.

Audit issues

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) (2) enacted "unified audit rules" to simplify IRS audits of large partnerships. Under TEFRA, determinations of partnership tax items generally were made at the partnership level. Any adjustments to partnership tax items would then flow through to the partnership's partners, and the IRS would assess deficiencies against and collect them from the applicable partners. Two issues that arose frequently under TEFRA concerned partnerships' items of income and the statute of limitation for the partners and the partnership.

In an effort to streamline the audit process for large partnerships, Congress enacted Section 1101 of the Bipartisan Budget Act of 2015 (BBA), (3) which amended in its entirety Sec. 6221. The revised section instituted new procedures for auditing partnerships, affecting issues including determining and assessing deficiencies, who pays the assessed deficiency, and how much tax must be paid. The BBA procedures replace the unified audit rules as well as the electing large partnership regime. The IRS issued proposed regulations implementing the new partnership audit regime in June 2017. (4)

Under the BBA, which applies to partnership tax years beginning after Dec. 31, 2017 (earlier elections to apply the new procedures were allowed), (5) partnership items generally will be determined in an audit of the partnership at the partnership level. The audit can adjust a partnership's income, gain, loss, deduction, or credit, or any partner's distributive share of these items.

A key part of the new law is that the partnership will pay the tax at the highest individual tax rate. A partnership will pay an imputed underpayment when the audit adjustment(s) result in an increase to income or a decrease to deductions. The payment is borne by the current partners. Adjustments that do not result in an underpayment of tax must be taken into account in the adjustment year. This requirement allows the current partners to benefit from the partnership-favorable audit adjustment related to the reviewed year. It was not clear from the BBA if partners from the reviewed year would be able to receive a refund for the reviewed year if there is a net partnership-favorable IRS audit adjustment. The proposed regulations made it clear that review year partners could claim a refund if the audit adjustments resulted in a decrease in Chapter 1 taxes. (6)

Partners will not be subject to joint and several liability for any partnership tax liability. Partnerships will have the option to lower their tax liability if they can prove that the total tax liability would be lower if the adjustments were calculated on a partner-level basis. In addition, partnerships with 100 or fewer partners can elect out of this section if each of their partners is either an individual, a C corporation, any foreign entity that would be treated as a C corporation if it were domestic, an S corporation, or an estate of a deceased partner. Elections out of the regime must be made each tax year. Under this scenario, a partnership could be subject to different audit regimes in different years. If the BBA rules do not apply, the IRS would audit each partner separately in separate proceedings.

Any penalties applying to a tax underpayment will be determined at the partnership level. Interest may be determined at either the partnership or the partner level. However, the interest rate is increased by 2% if the partnership elects for partners from the reviewed year to pay. (7)

In December 2017, the IRS issued proposed regulations (REG-120232-17) addressing how passthrough partners and tiered partnership structures take adjustments into account.

This year, there were not as many TEFRA issues as in the past. However, Russian Recovery Fund (8) dealt with the statute of limitation. In this case, the taxpayer, Russian Recovery Fund (RRF), which was a partnership, reported on its 2000 tax return a large loss on foreign currency transactions. This loss was allocated to the RRF's direct and indirect partners in 2000. One of the taxpayer's direct partners, FFIP, which was also a partnership, reported a substantial amount of the 2000 loss allocated to it from RRF on its 2001 tax return, thereby allocating the loss to its individual partners in 2001.

The IRS audited the 2001 return for FFIP in 2005 and did not make any adjustments. Later that year, the IRS issued a final partnership adjustment agreement (FPAA) to RRF disallowing the 2000 loss, which in turn disallowed the loss to its direct and indirect partners. The taxpayer filed suit in the Court of Federal Claims disputing whether the FPAA was timely issued and whether it suspended the limitation period for adjustments and assessments of the partnership's indirect individual partners' tax returns. The court determined that if the 2000 losses from RRF could be traced to the individuals' tax returns, the IRS could assess the additional taxes, as the FPAA validly suspended the statute of limitation for the indirect partners. (9)

RRF appealed to the Federal Circuit and argued that the attempt to collect tax from the indirect partners was time-barred because the IRS did not issue an FPAA to the direct partner for 2001 and later years. According to RRF's argument, the FPAA applied only to its 2000 return because an FPAA cannot apply to two partnerships or to two years. The Federal Circuit rejected both these arguments and held that the Court of Federal Claims had correctly determined that losses claimed by the individual indirect partners on their 2001 tax returns were attributable to the loss claimed by RRF on its 2000 tax return, for which the statute of limitation was suspended by the FPAA.

Congress created the role of a tax matters partner (TMP) to increase the efficiency of partnership taxation. Under TEFRA, the TMP served as the partnership's central representative before the IRS and the courts. (10) As the central representative of the partnership, the TMP possessed important powers and responsibilities, including (1) keeping all partners informed of the status of the administrative or judicial proceedings involving the adjustment of partnership items; (2) having priority in choosing the forum in which the partnership will seek judicial review; and (3) binding other partners to the terms of a settlement the partnership reaches with the IRS.

This role came up as an issue in Cambridge Partners. (11) In this case, the operation of two limited partnerships was taken over by...