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Centralized Partnership Audit Regime – What Me Worry?

By:  Cameron L. Hess[1]

Overview.

It’s fitting tribute that Mad Magazine’s final publication ending the use of the sarcastic catch-phrase “What me worry?” came just before the issuance of the Treasury’s February 27, 2019 final regulations for the Centralized Partnership Audit (CPA) regime. February 27, 2019 final regulations supersede prior draft and final regulations, but leave in place certain final regulations released August 9, 2018, including those particular to partnership representative designation.[2]

These final regulations leave a back-fold page filled with undisclosed problems,[3] but are intended to provide directions to following the CPA regime enacted in 2015 (with further changes March 2018[4]) effective for partnership tax returns filed having for fiscal (or calendar) years beginning after December 31, 2017[5]  

In replacing former TEFRA partnership audit examination rules,[6]  the CPA regime did not simply shift the audit examiner’s work to partnership representative and add simplified tax collection, but strengthened of the Service’s authority through several key provisions.

Basics of CPA Regime

Because CPA regime is complex, this article highlights a portion of the CPA regime as covered in final regulations, and then goes into several concerns.  Not covered are the implications in bankruptcy, to which the Business Law Section Magazine has published a fairly interesting article.  

The Imputed Underpayment

The CPA regime’s coverage applies to those partnerships previously under TEFRA examination, with certain modifications in coverage.[7]  The concept as to partnership has not changed, whether a joint venture, partnership, LLC or other pass-through entity, nor that it is generally a pass-through entity.  

The most distinct feature of the CPA regime is its new default rule, applicable to partnership audit examinations.  Absent a contrary election, an auditor’s identified partnership adjustment items will result in an additional tax liability due by the partnership entity itself, and not its partners.[8]  However, the tax burden may fall upon the partnership as of the year of the assessment, which impacting the existing partners as of the year of the assessment, and not the year under examination.

In addition, this new assessment, known as an “imputed underpayment” will in a majority of cases likely triggers a far greater tax liability than would have been assessed under TEFRA provisions, because, except for a few allowed modifications, the tax rate imposed on the partnership, is determined at the highest Chapter 1 or 11 income tax rate.[9]

In addition, the rules for determining the aggregate total adjustments to be made to partnership items, and the resultant liability is to be based on only those groups of items found during the examination to result in net positive item adjustments identified by the Service.[10]  Grouped items that are found to have a net negative amount (i.e., that might actually reduce liability for taxes) must be disregarded by the examiner in determining the additional tax due.[11]   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 set-off an offsetting decrease in an earlier or later year.  As another example, positive items, subject to tax, may include simply 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 developing the groupings themselves.  Nowhere is an audit examiner instructed by regulations to follow Section 704(b), in setting out categories of items to be netted.  Thus it is possible that an examiner may combine or separate similar items into different groups, to determine a greater net positive adjustment and to disregard a greater net negative adjustment grouping.[12]  The actual process, itself, is complex, containing more formulations than certainty.[13]  

The extent to which audit examiners may permissibly disregard offsetting adjustments may incentivize examiners to be less likely to compromise as to proposed adjustments.[14]

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),[15] but the term is slightly different from its predecessor as there are several procedural changes.

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.[16]    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 auditor.  This involves changes to the procedures audit examiners used to undertake to make partner level adjustments and assessments that the audit examiner 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.[17]  The audit examiner may accept or reject each of the modification requests.[18]   While informal discussions with the legal division indicate that discretion should not be an issue, examiners interpreting the regulations may not come uniformly to the same conclusion as to the scope of their discretion.

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

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, i.e., 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.[19]  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. [20]

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 interests) with respect to the reviewed year.   

Under final regulations, the Service’s examiner may reject a push-out election without notice, appeal or opportunity to correct.[21]  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” at a standard which 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, appears to be no guidance which provides for a 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 a compliant suit for refund. 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 effective to set aside.

The effect of the push-out election for the reporting year, i.e., the year within which the partner statement was issued under Treas. Reg. 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—, 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.[22]   Referred to as “correction amounts,”[23]  the regulations do reference negative adjustments – i.e., the consequence of these adjustments that the result 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 (2%) higher than the general underpayment rate had the tax been paid by the partnership.[24]

Push-up Election.  In addition, 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 audit examiner’s report, including all related items is reported to the Service.  No new matters may be asserted. 

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

With respect to negative adjustments, they are not forgotten, but are allowed to be deducted against partnership income in the “adjustment year” that is the year when the determination becomes final.[25]

Discussion – CPA Regime Issues

The CPA Regime raises several issues of concern.   

Electing Out.  First, many practitioners may be caught unaware as to how difficult it is to elect out of the CPA regime.  

The basic rule is that qualifying partnerships (consisting of not more than 100 individuals, S Corporations, and C Corporations) may elect out of the CPA Regime.[26]   However, the signing partner in filing a tax return must now “prove” by declaration and statements that the partnership actually qualifies to elect out.[27]  

Previously, those filing under TEFRA did not undertake due diligence, and assumed that owners were qualified to elect out.  However, under prior law and current law, trusts, including revocable trusts and legal entities, including LLCs, could not be owners and could not elect out. 

The effect is that preparers and return signers must exercise extraordinary caution as they are signing under perjury that all partners qualify.  Failure to undertake diligence may result in preparer and negligence penalties.

 Recommendation:  Practitioners may consider providing for two items in The Partnership Agreement:  First, the agreement might state that it is limited to ownership by qualified partners, prohibiting a trust, LLC, partnership or corporation (other than a permitted S Corporation) from being an owner.  However, partners might not accept the draconian consequences of only allowing qualified partners.  Second, the Partnership Agreement, may identify with whom the decision to elect out rests – and how the making (or not making) of an election will be enforced.  For example, the agreement may state: The Partnership Representative will have sole authority to determine whether the partners are qualified to allow the partnership to elect out of the CPA Regime.  Unless designated in writing delivered to the Tax Representative by January 31st of each year from the General Partner or a majority vote of the partners, the Partnership Representative will decide whether the partnership, if qualified, may elect out of CPA regime, whereupon making that election, proper notice will be given to all of the partners.  A Partnership Representative is not required to elect out if the representative cannot determine that all partners are qualified for the entire year and may rely on any reasonable representations received from partnership staff and partners. 

Partnership Representative Authority.  The CPA regime changes who may serve as a representative; it allows someone other than a partner to serve in that capacity.  The CPA regime is far more absolute than TEFRA, and clarifies that the designated “partnership representative”  is the only person with whom the IRS will contact (besides the partnership)[28], deal with[29], and rely upon as to elections during the examination process.[30]  Accordingly, the selection of a representative is critical.[31]  And, such person must have a US address, phone number, and be available to meet in the US.  No other person – other than the representative (or his attorney in fact), can sign, consent or settle any matter.

This may result in a ton of problems.  A hired professional must be careful with respect to taking instructions, and may want a written agreement from the partnership that he looks solely to the partnership representative.  If the partnership representative and the general partner don’t agree, an engagement should cover how this is addressed, including possibly a right to withdraw as counsel.[32] 

Absent an approved “push-out” election (or push-up election), the partnership is responsible for the final tax bill based on the final determination of the “imputed underpayment.” [33]  Accordingly, the partnership should be clear as to the duties of the partnership representative, and whether consent is required of others to take any position, including the push-out election.  The representative may wish to be indemnified or held harmless from any claim that the representative acted inappropriately, where the representative acts in accordance with his or her authority.

No Amended Partnership Returns?  To avoid additional problems, it is a terrible idea to have partnership file a return early in the year, before it is ready to do so, even if it is to help its partners to file their returns by April 15 each year.  This is because a partnership that has not elected out of the CPA regime may no longer file an amended return in order to correct previous errors on an earlier prepared return, not even for an inadvertent mistake made by the tax preparer who electronically filed a draft return by mistake.  Under the CPA regime, once the return has been filed, the partnership may only make changes by filing an Administrative Adjustment Request (AAR)[34]

The AAR is very different from the original (or an amended) tax return in several respects.  The procedures to make corrections and gain approval will be far more costly.  The representative will have a greater burden of work to undertake that will be somewhat analogous to those undertaken during an audit examination process.  This includes the previously described assessment process, wherein any assessment of a partnership level tax will likely be greater than prior law.  

In addition, explaining the impact of the CPA Regime to partners will be not only confusing, but involve possible confrontational issues as to who bears liability for corrections.  There may be some difficulty in explaining the complications of the process to partners.[35]   It also remains to be clarified with future guidance whether a push-up election may be made with an AAR.  

Modification Issues.  As previously discussed, a partner may request a modification during the examination process, for amended returns, but it involves certain levels of cooperation between the partnership representative and the partners.  Generally, the representative is the only person who may request a modification for a taxpayer.  There are several issues that arise with modifications. 

Return Privacy and Service Misplaced Amended Returns.  To protect partner tax return privacy rights, there is a procedure for modification requests based on an amended personal income tax return for affected partners, but it may not always work effectively.  Procedurally, the amended returns are filed directly with the Service.  The representative is only required to deliver to the examiner an affidavit, signed under penalty of perjury, stating that all of the amended returns required to be filed for a modification have been filed, and that the full amount of tax, penalties, additions, and interest have been paid.[36]   However, amended returns prepared by a partner are not always filed as instructed or findable by an audit examiner.  Examiners face the problem that some returns are misplaced or transferred (buried) for months or years in one of several IRS processing or review departments.  This may result in rejection of modifications properly filed with little recourse.

Examiner Discretion.  Another concern is that regulations state that the audit examiner has discretion on several areas, wherein not all examiners will construe this power the same way.  On rejected matters, going to court to show an abuse can be costly proposition.[37]  

This level of discretion for examiners may involve a number of areas of dispute.[38]  And, it is questionable whether giving examiners discretion in some areas goes beyond what the law contemplated.[39] 

 Recommendation.  Absent guidance in regulations, the Service should issue internal procedures or a revenue procedure to address areas of discretion, including acceptance of modifications.   
 Example.  In an audit examination, the auditor proposes to reclassify $500,000 of the business interest expense for an LLC engaged in home construction.  The auditor proposes to reclassify interest expense, in part as investment interest expense (for the land to-be developed), and another portion that should have been capitalized (then deducted as cost of home sales).  While the entire interest expense on closer examination of the facts should be entirely deductible (there is sufficient investment income) and all homes were sold, the examiner declines to consider the impact.  A $200,000 imputed underpayment will be assessed against the partnership.  The examiner rejects accepting a modification based on the fact that owner amended returns showing the pass-through have zero income tax effect. The IRS Appeals Office may uphold the auditor’s findings on the grounds that the auditor acted within his discretion. The sole remedy is a push-out election and the filing of amended returns by all partners to show there was no actual tax effect. 

Partner Personal Examination of Items.  Audit examiners may make requests that go beyond the scope of the CPA regime.  While the preamble to the final regulations states that the Service should make such requests to a partner and not the partnership if not a partnership item, it is unlikely that this limitation will be enforced and the examiner may use the process to go into items such as a partner’s tax basis for at-risk limitations.[40]

Push-out Election.  Should an examiner unreasonably reject a push-out election, there does not appear to be a right to Tax Court review.  If unreasonably rejected, it creates quite a quagmire to address assessments.  If the partnership must pay the tax, then sue on a claim for refund in federal district court, the cost to challenge the disallowance of the election falls upon the current partners and partnership to be out-of-pocket; and it may take years to redress and push the tax to the original partners.[41]   Due to a lack of Tax Court jurisdiction, Congress needs to address this oversight to allow all proceedings to occur within one courtroom, and before taxes are paid.[42]

Appeal Rights.  If there is a dispute, presently there is no formal guidance as of the time this article was written to allow an administrative appeal before the IRS Appeals Office.  The Service has indicated that it contemplates having an administrative review procedure.  The timing as to filing an appeal remains uncertain.  And, what can be appealed remains uncertain.

Collection.  The Service’s expansion of its collection authority will have substantial concerns. Previously, with respect to assessments against entities, the Service could utilize only certain limited federal and state law provisions to seek enforcement against its owners.  It now appears that if the IRS cannot collect from the partnership on the tax bill, for whatever reason, the Service may now deem the partnership to cease, even if it is still an ongoing concern, and even if the partnership might be able to pay in the future.[43]  Regulations do not specifically identify limited partnerships or LLCs; presumably, the Service may assert that these provisions fully apply to limited partners and LLC members.   

On the other hand, the Service recognizes that assessments on partner income historically has been against its partners, and therefore this provision gives the Service similar authority; however, what is of major concern is that the deemed insolvency entitles the Service to collect from later partners who never held interest in the partnership during the reviewed year, creating difficult exposure issues.[44]  This may also give rise to legal claims for failure to disclose risks to new partners acquiring an interest.

Of greater concern, indeed, is that regulations do not indicate that there is any limit as to the amount by which the Service may seek collection from any one partner.[45]  The Service arguably may assert collection of all taxes from a nominal 1% partner/LLC member.  Regulations also infer that the Service may assert collection against partners as long as the statute of limitations remains open.[46]  

Accordingly, there may be an interest in partners shifting ownership to have intermediate single-member LLCs or other entities in an effort to insulate individuals from collection.  There will be extensive litigation guaranteed in this area.  In fact, regulations under Section 6241 to deem dissolution may have exceeded its statutory authority by deeming ongoing partnerships to have ceased to exist.[47]  And, arguably, collection rights by the Service may be limited by exhaustion of remedies under Section 6901, and state law as identified under Kardash v. Com’r.[48]  Ergo, the Service giving notice of its intent to seek collection after partners may not, in fact, grant any greater actual rights.

Representative.  Granting a representative greater authority is a worry to all partners.  A partnership agreement can impose extensive requirements and liabilities upon a representative for acting and approving without consent. Such provisions would not be binding upon a designated partnership representative who is not actually a partner to the partnership (or a manager in an LLC), and they may require a separate agreement.  Furthermore, placing greater duties upon the representative to be attentive to individual partner expectations could not only place the partnership representative in an adversarial relation with the partners, but increase the likelihood of a conflict of interest between the duties of the representative to take actions before the Service and the duties to the partners themselves.  

For example, because the interest rate will be 200 basis points higher, if a push-out election is made, partners may disagree among themselves as to whether that election is the best choice and represents an appropriate decision.  Minority partners may prefer that the partnership pay the higher tax due to the reduction in costs of representation, but assert that the general partners/managers should be held liable for “excessive” taxes from failure to correctly report on the partnership return.  On the other hand, the majority partners may blame a partnership representative for not making a push-out election and not contesting any imputed underpayment, preferring that each of the partners, including the minority partners pay their share of the imputed underpayment.  There is also an overriding issue as to the partnership/operating language in many limited partnership and LLC agreements that reflects state law and expressly provides that no limited partner or member can be held liable for any obligations or creditors to the partnership/LLC.  If this is a separate contractual provision, then the push-out election would seem to present a potential claim for breach of contract.

Indeed, the procedures before the United States Tax Court may be daunting.   Furthermore, the partnership representative bears a heavy burden to decide whether to address all partner requests for modifications which may require conflicting positions on penalty relief – i.e., whose fault is it. 

Options for Partners & Partnerships

For those facing the new CPA Regime, there are many options.  Obviously, one approach is to take a wait-and-see, wherein one hopes that their clients are not selected for audit examination.  While some partnerships are seemingly low risk, unfortunately, an inexperienced auditor may propose major adjustments by claiming reclassification of expenses into subgroups that normally would have zero actual tax effect, but could result in a substantial imputed underpayment.  

For anyone concerned with the process, here are a few suggestions:

  • Revise the partnership agreement.  One option is to be prepared for an examination under a CPA regime and to revise the partnership agreement that will address questions concerning who should decide as to making elections and to guide representatives on expectations as to which audit matters will require partner notice and at least indirect participation or decision making.  These will vary dramatically, from large partnerships with investors holding small interests, to closely held partnerships where several partners actively render major decisions on partnership’s affairs and reporting.  Regardless of changes to the agreement, partners need to accept that audits may become far more adverse, take more work to fight, and may be too costly (or hard) to fight the amount due, even if an assessment is arbitrary or incorrect, unless the tax amount is substantial.  There should also be some procedures to address tax return privacy issues and other concerns addressed above.
  • Make it easy to elect out.  Some partnerships may want to make sure that they can elect out of the CPA regime.  If an election out is made, the CPA regime will simply not apply.  One option to elect out is to require that all partners be in fact individuals.  And, where there are trust owners, it is possible that the partnership agreements should be restated to show title in individuals, but allow a “pay on death”(POD) designation into one’s respective trust to try to preserve the right to elect out for as long as possible.

For example, no California Probate Code provision currently expressly allows the use of POD designations in the context of transfers of partnership interests.  (By contrast, POD California bank accounts are expressly covered under Probate Code 5301(d) as to their legal effect.)  While POD designations have historically been given priority over other agreements, this is an area ripe for beneficiary disputes where title is held individually, and succession is not covered as a matter of law.  

  • Terminate Partnership.  Another option, if worthwhile is to elect to terminate partnership reporting.  Investments held in a co-tenancy are not required to file as a partnership, but have certain requirements to avoid partnership reporting.  For example, each co-tenant must personally hold title to any realty used in an investment.  While there may be a co-tenancy agreement, caution is urged that neither title nor the terms be sufficiently restricted to deem a partnership to exist as a matter of form.  

On the other hand, few will take up this offer.  First, a judgement creditor can get a claim against a co-tenancy interest, which can have adverse consequences.  Second, this option may not be available where there is any loan financing, without approval of the lender.  

Each member would be a co-tenant.  Each co-tenant gets a simple one-column “total” and “your share” statement.  Each would have to separately report, compute and determine his own share of income/expense and depreciation.  (No K-1 form will be issued.)

Co-tenancies are not legal entities and do not provide the same asset protection – separating risks.  While a lead co-tenant can be appointed, most decisions may/will require unanimous consent. 

Summary

         Given all of the foregoing issues, clients need to be prepared for the new CPA regime.  Tax advisors need to work with all clients to recommend revisions to partnership agreements and strategies, including giving consideration whether to qualify the partnership. Should the ownership be revised to eliminate trust owners, so that it can elect out, or, if eligible, elect out of partnership taxation under a Section 761(a) election or conversion of investment activities into a co-tenancy?  The decision as to what to do (or to do nothing) must be made on a case-by-case basis.  Taking a Rip Van Winkle-like nap, and awakening as to the issues upon commencement of an examination may limit options and result in unanticipated problems during the examination process.


[1] Cameron L. Hess is a transactions and tax partner with Wagner Kirkman Blaine Klomparens & Youmans LLP and Co-Chairs the Corporate and Pass-through Committee of the Tax Section of the California Lawyers Association.  For questions regarding this article or his warped thinking, having read too many Mad Magazines, he may be reached at (916) 920-5286.

[2] Provisions for partnership representative may be found under the final regulations issued August 9, 2018. (Federal Register, Volume 83, No. 154, August 9, 2019.)

[3]For my brother, Mark L. Hess, whose copies I read, and folded the diorama pages to see hidden images, hopefully he’ll forgive me if I wore out any of those pages. 

[4] Consolidated Appropriations Act (P.L 115-141), enacted March 23, 2018

[5] Bipartisan Budget Act of 2015 (BBA), Section 1101 deleted the TEFRA rules and enacted Sections 6621 through 6641. 

[6] BBA Section 1101(a)

[7] This article does not cover the changes in who is covered, but it should be noted that these rules do not apply to S Corporations, except to the extent they hold an interest in a partnership.  Also, while expanding the TEFRA carve-out from less than 10 partners to less than 100 partners, the Service is taking a strict enforcement approach, wherein many partnerships erroneously assumed that they were not subject to TEFRA, and will be subject to the new rules.

[8] Treas. Reg. § 301.6221(a)-1 (2019)

[9] Treas. Reg. § 301.6225–1(b)(iv)

[10] Treas. Reg. § 301.6225-1.

[11] Treas. Reg. § 301.6225-1(c)(2).  “[T]axpayer favorable adjustments are generally disregarded and the highest rate of tax is applied.  This formula may produce an amount that is larger than the cumulative amount of tax the partners would have paid had the partners taken the adjustments into account separately, but it also relieves the IRS of the obligation to account for specific partner facts and circumstances….” (Preamble to Final Regulations, Federal Register, Volume 84, No. 39, page 6472.)

[12] Preamble to Final Regulations, Federal Register, Volume 84, No. 39, page 6480).  Treas. Reg. § 301.6225-1(h).

[13] Treas. Reg. § 301.6225-1.  Under these regulations, adjustments are divided into groupings and subgroupings for purposes of determining adjustments.  Within any subgrouping there is created two sets of adjustments, positive adjustments and negative adjustments.  Negative adjustments are placed in the same subgrouping as positive adjustments if the amounts would have been properly netted at that partnership level.  (Treas. Reg. § 301.6225-1(d)(3))

[14] Treas. Reg. § 301.6225-1(c).

[15] Treas. Reg. § 301.6225-1(a)(3).

[16] Treas. Reg. § 301.6225-2(c)(3); for the extension, see paragraph (iii) at (2)(c)(3)(iii).

[17] Treas. Reg. § 301.6225-2(d).  Modifications include provisions for exempt partners, lower tax rates (i.e., dividend rate, capital gain rate), passive losses of publicly traded partnerships, qualified investment entities, amended returns, closing agreements, tax treaties, and other modifications as requested by the partnership representative.

[18] For example, regulations require that for a reallocation, all partners must submit amended returns to request a modification.  Treas. Reg. § 301.6225-1(d)(2)(ii)(C).  However, the Service may accept a modification where less than all submit amended returns.

[19] Treas. Reg. § 301.6226–1

[20] Treas. Reg. § 301.6226–2(c)(2).

[21] Treas. Reg. § 301.6226–2(d).  The Service may determine an election to be invalid without first notifying the partnership or providing the partnership an opportunity to correct any failure to satisfy all of the provisions of this section and § 301.6226–2.

[22] Treas. Reg. § 301.6226-3(a).

[23] Treas. Reg. § 301.6226–3.

[24] Treas. Reg. § 301.6226-3 refers only to “items as required in the statement” but allow for reductions in later years.  The Preamble, however, refers to all years as being allowed to have a “correction amount” of less than zero, which would require that negative adjustments be included.  (Federal Register, Volume 84, No. 39, page 6511.)

[25] Treas. Reg. § 301.6225-3.

[26] Code Section 6221(b); Treas. Reg. § 301.6221(b)-1. The election out requires that partners be notified within 30-days of election out of these provisions, which may be given in any form.  Presently Schedule B-1 to Form 1065 requires extensive reporting for each partner.

[27] See Schedule B-2 Form 1065.  

[28] Treas. Reg. § 301.6231–1.

[29] “No partner, except a partner that is the partnership representative, or any other person may participate in the partnership proceeding without permission of the IRS.” (Preamble, Federal Register, Volume 84, No. 39, page 6476)

[30] Treas. Reg. § 301.6223-2 (August 9, 2018)

[31] “If the IRS conducts a proceeding with respect to the partnership, that proceeding will include only the IRS, the partnership, and the partnership representative who is acting on behalf of the partnership.” (Preamble, Federal Register, Volume 84, No. 39, page 6476)

[32] In addition, one should not be surprised if an overzealous audit examiner attempts to remove the general partner from an audit examination meeting, a telephone conference or absolutely disregards information provided by that partner in that meeting.  While the purpose of the representative was to clear up issues as to contact and consents, and not to limit the audit examination process, an audit examiner may take the process one-step too far.  A representative may request attendance and participation of anyone to further the audit examination process, and may need to resolve this issue with higher-ups.

[33] Treas. Reg. § 301.6225–1(a)(1).

[34] Treas. Reg. § 301.6227-1.  See also the preamble at Federal Register, page 6521-22.  Apparently, partnerships that have elected out under Section 6221 may still file amended returns.

[35] The consistency regulations fail to cross-reference to the AAR regulations.  Consistency requirements under regulations do cross reference to Section the Partner Statements under 6226, but make no reference to statements under Section 6227.  See Treas. Reg. §301.6222-1.

[36] Treas. Reg. § 301.6225-2(d)(ii)(3)(iii).

[37]Helvering v. Taylor,  293 U.S. 507 (1935.)  In that decision, the court stated “But, where as in this case, the taxpayer’s evidence shows the Commissioner’s determination to be arbitrary and excessive, it may not reasonably be held that he is bound to pay a tax that confessedly he does not owe, unless his evidence was sufficient also to establish the correct amount that lawfully might be charged against him.”

[38] Otherwise, the imputed underpayment will reflect an enhanced, i.e., higher assessment, due to the Services’ disregard of any net negative items in a reported subgroup.  An examiner’s discretion to reject a modification, solely for ease of administration, could result in assessments that are seemingly punitive, sometimes in circumstances where there has been no real underreporting.

[39] With respect to the deductions and matters of compliance, the standard of “discretion” has generally involved whether the Commissioner made a determination inconsistent with the law and regulations.  For example, in Thor Power Tool Co. v. Com’r 439 U.S. 522 (1979), the Service upheld the Service’s determination of limits to reserves for bad debts based upon case law and regulatory standards to clearly reflect income.  In matters of tax collection, the concept of “discretion” such as with respect to offers-in-compromise or installment payment plans, wherein the reviewing officer had discretion to determine whether the taxpayer failed to submit documents after several opportunities or failed to comply with the offer, and therefore should not be allowed remedy.  Kearse v. Com’r, T.C. Memo 2019-53; Robinette v. Com’r, 123 TC no. 5 (2004).

[40] Federal Register, Volume 84, No 39, preamble at page 6472.

[41] Under the preamble the Treasury notes that it refused to adopt acknowledgement as to Tax Court review of imputed underpayments, noting that this is not within the purview of the Treasury.  The Service’s Internal Revenue Memorandum identifies that the grant of the Tax Court is to redetermine whether deficiencies determined by the Commissioner are correct, and such other items as expressly granted, such as collection due process cases.  (https://www.irs.gov/irm/part35/irm_35-001-001)  While regulations expressly acknowledge a right to file a petition, even with an election, the regulations may be interpreted to only address the amount of deficiency:  “Accordingly, a partnership that makes [a push-out] election under this section is not precluded from filing a petition under Section 6234(a).”  (Treas. Reg. 301-6226-1.)

[42]The Tax Court stated that an “Abuse of discretion exists when a determination is arbitrary, capricious, or without sound basis in fact or law.”  Murphy v. Commissioner, 125 T.C. 301, 320 (2005), aff’d, 469 F.3d 27 (1st Cir. 2006).

[43] Treas. Reg. 301.6226–3(b)(1)(ii).

[44] Treas. Reg. § 301.6241-3.

[45] Treas. Reg. § 301.6241-3.

[46] Treas. Reg. § 301.6241-3(b)(3).

[47] Code Section 6241 did not grant authority to the Service to determine when a partnership ceases to exist.  Accordingly, to the extent that the Service asserts positions that extend beyond Section 708 of the Code and common law, there is a position that the provisions that deem active partnerships to cease to exist are invalid.

[48] Kardash v. Com’r  (11th Cir, 2017) 866 F.3d 1249.


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