The New Bba Centralized Partnership Audit Rules and Bankruptcy: a Shotgun Wedding Without Any Marital Bliss

• Publication year: 2019
• Author: A. Lavar Taylor

The New BBA Centralized Partnership Audit Rules and Bankruptcy: A Shotgun Wedding Without Any Marital Bliss

A. Lavar Taylor

A. Lavar Taylor is the founder of the Law Offices of A. Lavar Taylor, LLP (www.Taylorlaw.com), which specializes in civil and criminal tax controversies. He has been named as one of "The Best Lawyers in America" in tax law and is a frequent speaker at Tax and Bankruptcy

I. Introduction

Bankruptcy and taxes. Taxes and bankruptcy. These two topics go together like peas and carrots. Except that tax professionals don't like peas, and bankruptcy professionals don't like carrots.

It appears to be a metaphysical certainty that Congress, when it enacted the new Centralized Partnership Audit Regime ("CPAR") rules contained in §§ 6221 through 6241 of the Internal Revenue Code in 2015, forgot that it had enacted the Bankruptcy Code almost forty years earlier. These new CPAR rules have replaced the so-called TEFRA partnership audit rules,¹ and are generally effective for tax years starting after December 31, 2017. Thus, in 2019 we have entered the very first tax return filing season in which the CPAR rules potentially may apply to all tax partnerships, which can include not only "real" partnerships but also multi-member limited liability companies that have elected to be treated as partnerships for income tax purposes.

The CPAR statutory scheme is in many places completely incompatible with the Bankruptcy Code, despite the fact that a Technical Corrections Act was passed in 2018. Yet, these two statutory schemes must co-exist. Hence the subtitle: A Shotgun Wedding without Any Marital Bliss.

Bankruptcy practitioners and trustees would be unwise to attempt to thoroughly understand the new CPAR rules on their own. Indeed, even most tax practitioners will likely never truly understand these new rules. While the statutory provisions are not lengthy, the regulations implementing those provisions consume hundreds of pages.² Rather than attempt to explain comprehensively all of these rules and regulations—an impossible task in a short article—this article provides an examination of several key aspects of the new CPAR rules that should be of interest to bankruptcy practitioners and trustees, along with questions as to how each of these key aspects might interact with the Bankruptcy Code.

II. Bankruptcy Practitioners and Trustees Must First Determine Whether the New CPAR Rules Apply to a Tax Partnership or to a Partner in a Tax Partnership

The first step in figuring out whether there is a need to deal with the new CPAR rules is to determine whether an entity that is in bankruptcy (or is contemplating filing bankruptcy) is a tax partnership that is governed by the new CPAR rules. In addition, where any person or entity is in bankruptcy, or is contemplating filing bankruptcy, it is necessary to determine whether that person or entity has an ownership interest in, or other connection with, an entity that is a tax partnership governed by the new CPAR rules. This creates a whole new area of required due diligence for bankruptcy practitioners and trustees.

By default, all partnerships are governed by the CPAR rules for tax years beginning after December 31, 2017.³ However, certain partnerships are eligible to elect out of the CPAR rules. Such an election is done on annual basis.

[Page 17]

First, partnerships that furnish/file 100 or fewer Form K-1s in a given tax year may be eligible to elect out of the new CPAR rules.⁴ This "100 or fewer Form K-1s" rule is not straightforward, however. For example, when a partnership with one or more Subchapter S corporation partners makes this election, the partnership must count all of the S-corporation shareholders for purposes of the "100 or fewer Form K-1s" threshold.⁵ If the partnership does not satisfy this "100 or fewer Form K-1s" requirement in a given year, the partnership is subject to the new CPAR rules for that year.

Second, to be eligible to elect out of the new CPAR rules, each partner of the partnership must be "an individual, a C corporation, any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner."⁶ Thus, for example, if a grantor trust is a partner in a particular year, the partnership may not elect out of the new CPAR rules for that year. This provision has generated a great deal of heartburn for estate planners, who often rely on grantor trusts as an estate planning tool.

Assuming that the partnership is eligible to elect out of the CPAR rules for a given year, certain procedural requirements must be met for the election to be valid. First, the election must be included with a timely filed partnership return for the election year.⁷ Failure to timely file the election with respect to any year means that the partnership will be governed by the CPAR rules for that year.⁸ Second, all current partners must be notified of the election.⁹

If a partnership makes a valid, timely election out of the CPAR rules for a given year, any adjustments made to the partnership's tax return as the result of an audit of that return will affect only the partners of the partnership. And, once a valid election out has been made, the IRS cannot assess additional taxes against the partners of the partnership without (1) auditing the tax returns of the partners individually and (2) proposing any additional taxes owed prior to the expiration of the statute of limitations on assessment for each partner individually. These are the same rules that applied prior to the enactment of the TEFRA partnership provisions in 1982.

Because elections out of the CPAR rules are made on an annual basis, the due diligence that needs to be done by bankruptcy practitioners and trustees is significant. Merely determining that there was or was not an election out for only one tax year out of many to which the CPAR rules might apply is not sufficient.

III. If the CPAR Rules Apply, Bankruptcy Practitioners and Trustees Need to Understand the Procedural Rules and Which Parties May Be Liable for Any Additional Tax Owed as the Result of an Audit of the Partnership's Tax Return(s)

The CPAR rules have turned the tax world upside down. These rules, left unchanged, will turn the bankruptcy world both upside down and inside out.

A. Who Can Be Liable for Taxes Owed as the Result of Adjustments to a Partnership's Tax Returns

Under the new CPAR rules, it is possible that, in the event of an IRS audit of the partnership's tax return, taxes could be owed by any of the following parties:

1. The partnership itself may be liable for taxes based on adjustments made to the partnership's tax return(s) for the year(s) under audit. The taxes, however, would be owed by the partnership for the tax year in which the adjustments at issue in any administrative or judicial proceeding involving the partnership's tax returns for earlier years become "final"¹⁰ For example, assume that the IRS audits a partnership's tax returns for 2019 and 2020 and proposes increases in the partnership's net income of $1 million for each of these years. If these proposed adjustments are upheld in court, and the court decision becomes final in the year 2026, the partnership could be liable for tax on this $2 million of additional income in the year 2026. This result could occur even though all of the income, deductions, and credits of the partnership shown on the original 2019 and 2020 partnership tax returns flowed through to the partners of the partnership in those years.

How is the amount of tax owed by the partnership computed? The answer can be complicated. For now, just assume that tax may be computed at the highest possible tax rates of the partners.

2. The partners of the partnership in the year in which the dispute regarding the proposed adjustments to the partnership's tax return(s) for earlier tax years becomes final may be liable for taxes owed as the result of adjustments to the partnership's tax return(s) for those earlier years.¹¹

Thus, for example, take the scenario in 1) above, where the IRS proposes adjustments to the partnership's 2019 and 2010 tax returns and the court decision upholding these adjustments becomes final in 2026. If the partnership is liable in the year 2026 for the tax on the adjustments to the partnership's tax returns for 2019 and 2020 and the partnership fails to pay the taxes that are owed, the IRS may assess the taxes owed by the partnership for the year 2026, on a...