In November of 2015, Congress passed the Bipartisan Budget Act of 2015 created one system to centralize the audit process for partnerships. On January 18, 2017, the IRS issued proposed regulations (REG-136118-15) that will guide how future IRS audits are conducted and how the results of those audits are implemented. Under the new regulations any adjustment to income, deductions, credits, gains or losses resulting from an IRS audit will be made at the partnership level. Because of this, the partnership will have to determine the implications of any additional tax liability and how it will impact its partners. You can read more about the federal implications of these new regulations here – New Partnership IRS Audit Rules–What You Need to Know
Since the Bipartisan Budget Act was passed in 2015 the impact these regulations will have on a partnership’s federal tax filings have become clearer, however, the impact these regulations will have on a partnership’s state returns is far from clear. Historically, most states conform to or opt out of IRS regulations in regards to determining taxable income, but not necessarily administrative procedures, such as partnership audits. For administrative procedures, states typically have their own set of statutes. Currently, how the states will incorporate the new partnership audit rules is still up in the air. However, it is anticipated that the number of IRS partnership audits will increase significantly once the new regulations go into effect so it is inevitable that the states begin to address several issues in regards to how the federal audit will impact the state level.
According to the Multistate Commission, which governs the tax laws for some states, the issues that will need to be addressed by the states include the following:
Role of the partnership representative
As part of the changes to the IRS regulations, the partnership will need to elect a partnership representative. This individual will have the power to act on behalf of both the partnership and its members during an IRS audit. This individual will also have the power to determine how the audit results are applied. State regulations will need to address the following questions – Will states hold the federal representative responsible for state issues as well? Will states allow a different representatives from the designated federal representative when handling both resident and nonresident partner issues? Will the representative be able to act on the partnership’s behalf in regards to other state tax matters outside of an audit?
Calculation of underpayments at the state level
The states will have to provide guidance on how the results of an IRS audit will be calculated at the state level. If it is determined that income was understated at the federal level how will the tax on this additional income be calculated at the state level? At the federal level the partnership representative can decide to apply the adjustment to the tax year under review or to the year the audit is taking place. If the results can potentially be applied to two different tax years how will the states account for the fact that this could mean different members in the partnership, member residencies, partnership state filing requirements, apportionment percentages and tax rates.
State amended returns
Currently, if a partnership is required to file an amended federal return due to an audit adjustment then it may be required to file a state amended return. Some questions that the states will need to address are the following – On an amended return will states require any additional information or disclosures in regards to the results of the audit? If composite returns were originally filed will an individual now be able to opt out of that filing and file their own state return or file an amended composite? Will a state consider other information that may impact the state tax liability if it was not considered at the federal level?
“Push-out” of the final adjustment
As mentioned in #1 above, the new regulations allow the partnership representative to determine how any audit adjustment will be applied. The representative can elect to push-out the final adjustments to the partners in the reviewed year or the adjustments can be applied to the partners in the year the results were presented. If an underpayment adjustment is pushed-out the consequences of any underpayments is no longer the responsibility of the partnership and is instead placed on the individuals who were partners in the reviewed year. What state information will need to be provided to the members in order for them to calculate their underpayment liabilities? What happens if a partner’s residency has changed? How will an individual recognize the adjustment if they originally did not file a state return or filed a composite return? These are all questions that the states will have to address.
These are just a few of the questions that will need to be answered before the new federal audit rules go into effect. As you can see, although the federal regulations have been approved there has been very little guidance from the states on how they will adapt their laws to these new regulations and clearly there are many questions left to be addressed. How the states comply with these new regulations will certainly be something that partnerships should be considering going into the 2018 tax year.
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.