State challenges with the new federal partnership audit rules.

• Author: Sherr, Eileen Reichenberg

A big surprise to many tax practitioners at the end of 2015 was the enactment by Congress of new partnership audit rules in the Bipartisan Budget Act (BBA) of 2015, (1) which President Barack Obama signed into law on Nov. 2, 2015. As summarized more clearly in many articles, (2) the new partnership audit rules radically expand the IRS's powers in dealing with audits of partnerships.

While the IRS has long had authority to audit partnerships, until the BBA was enacted, it could only assess and collect tax from partners individually. The new rules, when fully implemented and applicable to all partnerships for audits of tax years beginning on or after Jan. 1, 2018, will allow the IRS to assess and collect tax from the partnership itself. Partnerships that receive an IRS audit notice can elect into the new regime now. (3) Moreover, when the law is fully implemented, a partnership can pay an assessment directly or elect to "push out" the assessment to its partners.

A fundamental change, though, is the empowerment of the new "partnership representative" as the sole representative of the partnership in binding the partnership and its partners to all federal audit determinations and elections under the new regime. How partnerships will control the authority of the partnership representative and how a partnership representative will be indemnified for his or her actions will need to be addressed and will likely create tensions between the partners and the partnership representatives. This issue, hopefully, can be resolved through amendments to partnership agreements.

Many tax practitioners, and notably IRS Commissioner John Koskinen, have questioned whether, and how, the new partnership audit rules will work. No doubt, legislative technical corrections will be required, as well as new regulations and IRS procedural guidance and audit training for IRS auditors. (4) One objective of the new rules was to reduce the complexity of partnership audits and allow for the more efficient collection of federal income taxes. However, as tax authorities and practitioners peel back the new rules, they have discovered myriad significant questions that will have to be addressed. None of those questions are more complex than those affecting the area of state and local tax.

It is unlikely that Congress gave serious consideration to the state tax impact when it enacted the new rules. Although states generally rely on the Internal Revenue Code, at least in part, to determine their own state taxable income base, they generally rely on their own audit, assessment, and collection procedures. Thus, when the new federal partnership audit rides are fully implemented, nearly all of the states will have to take some legislative action to conform to them.

On the other hand, due to the information-sharing arrangements that the states have with the IRS, as the Service gears up to manage and resolve more partnership audits, the states may be inundated with partnership audit information. Many of them already recognize they are not fully prepared to deal with the increased volume. Moreover, just as there are 50 states, there are 50 ways they could choose to conform. Without some uniformity in critical areas, the "simple" federal reform of the partnership audit rules could result in an administrative nightmare at the state level not only for taxpayers but also for the states that will have to administer the information they will receive from the IRS.

For CPAs, the consequences are both professional and personal. As tax advisers to their clients, many of whom do business as partnerships, they need to understand the implications of the new rules not only to assist in the preparation of returns but to advise clients on their responsibilities and obligations. Likewise, many CPA firms are organized as partnerships, so CPAs will be directly affected by the rules.

The good news is that state taxing...