New Proposed Regulations Turn Off the Centralized Partnership Audit Rules in Certain Cases and Provide Guidance on QSub Partners

Alerts / December 4, 2020

On Nov. 20, 2020, the IRS and Treasury Department released proposed regulations on the centralized partnership audit rules enacted as part of the Bipartisan Budget Act of 2015 (the BBA Rules). The proposed regulations allow the IRS to turn off the BBA Rules for certain “special enforcement matters,” provide guidance on whether a partnership with a qualified Subchapter S Subsidiary (a QSub) partner can elect out of the BBA Rules, and clarify various aspects of existing regulations. Comments on the proposed regulations are requested by Jan. 25, 2021.

Special Enforcement Matters

Although the BBA Rules are relatively new and many unanswered questions remain, partners and partnerships generally expect that the rules will dictate the course of partnership audits. Under the proposed regulations, however, that is not always the case. The BBA Rules may not apply in the following situations:

  • Certain partner audits. The IRS audits a nonpartnership-related item of a partner or other person; in the course of that audit, the IRS adjusts or makes a determination with respect to a partnership-related item; and the treatment of the partnership-related item on the partnership’s return or in its books and records is based on information provided by the partner or other person. This proposal allows the IRS to avoid opening a partnership audit solely to adjust a partner-specific item, such as the basis of a contributed asset.
  • Criminal investigations. A partner or indirect partner is the subject of a termination or jeopardy assessment or under criminal investigation.
  • Indirect method of proof. A deficiency determination for a partner or indirect partner is based on an indirect method of proof, such as the use of bank deposits or net worth to determine the partner’s income.
  • Partner’s statute of limitations remains open. The partnership’s statute of limitations has expired but a partner’s statute of limitations is open and that partner voluntarily agrees to extend the period of limitations to adjust and assess tax attributable to partnership-related items or is deemed to control the partnership because the partner and partnership are related within the meaning of sections 267(b) and 707(b). While this proposal will be welcome news to minority partners accustomed to the IRS-favorable approach to statutes of limitations under the old TEFRA rules, direct and indirect partners under audit should closely review statute extension requests to avoid inadvertently enabling IRS adjustments of partnership items.
  • Partnership is directly liable for tax. The adjustment relates to any tax, penalty or addition to tax that is imposed on a partnership and for which the partnership is liable.

If the IRS adjusts a partnership-related item pursuant to the rules in the proposed regulations, certain notice requirements apply. The adjustment is not binding on the partnership or on any direct or indirect partner that is not a party to the adjustment proceeding. Special rules apply under the proposed regulations to avoid double counting in the event that a partnership-related item is adjusted and taken into account both in a partnership-level proceeding under the BBA Rules and as part of an audit of a person other than the partnership.

QSub Guidance

The proposed regulations provide that a partnership cannot elect out of the BBA Rules if one or more of its partners is QSub. Notably, this position is at odds with Notice 2019-16, which announced that the IRS intended to treat QSubs like S corporations for this purpose (a partnership with an S corporation partner can elect out in certain circumstances). The proposed regulations also clarify that election out is unavailable for partnerships with grantor trust or qualified REIT subsidiary partners.

Effective Dates

The rules in the proposed regulations, if finalized, would apply retroactively. In particular, rules relating to special enforcement matters generally would apply to partnership taxable years ending after, or any IRS exam beginning after, Nov. 20, 2020 (rules for adjustments in connection with an audit of a partner or other person would apply to partnership taxable years beginning after Dec. 20, 2018, or to any IRS exam beginning after Nov. 20, 2020). A partner generally can apply the special enforcement matter rules to earlier tax years if the IRS agrees. Other changes and clarifications generally would apply on Nov. 20, 2020.

Authorship Credit: Morgan W. Holtman and Michelle M. Hervey

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