Update: The president signed the budget legislation into law on Nov. 2, 2015.
Congressional lawmakers have reached agreement on a sweeping budget compromise that will replace the current partnership audit procedures with a new process that dramatically increases the payment and reporting responsibilities for partnerships.
The agreement was brokered by the congressional leaders of both parties in both chambers and the White House. It passed the House on Oct. 28 and the Senate on Oct. 30 and is expected to be signed into law by the president. The deal resolves the most contentious year-end legislative issues by extending government funding and suspending the debt limit for two years.
Congress can now turn to the remaining unfinished items, including highway funding and the tax provisions that expired at the end of 2014. Lawmakers have discussed attaching the extenders to the highway bill or using international tax reform to fund highways, but the prospects for major international tax changes this year are diminishing.
The Bipartisan Budget Act (H.R. 1314) is partially paid for with tax offsets that will do the following:
- Extend pension funding relief through 2020 ($6.5 billion)
Partnership audit procedures
- Increase Pension Benefit Guaranty Corporation premiums ($4 billion)
- Rewrite partnership audit procedures ($9.3 billion)
- Clarify the test for determining when a partnership is valid ($1.9 billion)
The bill would repeal the partnership audit procedures under the Tax Equity and Fiscal Responsibility Act (TEFRA) and the audit procedures for Electing Large Partnerships (ELP) and replace them with a single regime for auditing, making adjustments and collecting assessments at the partnership level.
The legislation builds on a provision included in the tax reform discussion draft from former Ways and Means Committee Chair Dave Camp, R-Mich., and the Partnership Audit Simplification Act of 2015 (H.R. 2821) introduced earlier this year by Reps. Ron Kind, D-Wis., and Jim Renacci, R-Ohio. However, the current version departs significantly from earlier proposals.
The general purpose of the legislation is to make it easier for the IRS to audit partnerships and assess and collect tax after audits. Renacci and Kind claim that a C corporation is 33 times more likely than a similarly sized partnership to face an audit. The IRS argues that examining large partnerships is difficult because adjustments must be made for each partner and sometimes through multiple tiers of partnerships.
Who is covered
The new audit procedures generally apply to all partnerships with more than 100 partners, plus any partnership with a partner that is another partnership, a trust or a tax-exempt entity. Partnerships with 100 or fewer partners could opt out on an annual basis if their partners were limited to individuals, C corporations (including foreign entities that would be considered C corporations if domestic), S corporations and estates of deceased partners. Real estate investment trusts are not excluded as permissible C corporation partners, as in prior proposals. Each shareholder in an S corporation holding a partnership interest would count toward the 100 partner threshold.
Partnerships with 100 or fewer permissible partners who opt out would be subject to the individual audit procedures that currently apply only to partnerships with 10 or fewer partners. These rules require separate audits of each partner. Although the “small partnership” threshold is nominally higher under the new legislation, many types of partners are not allowed, and partnerships must opt out annually to avoid the new rules. Under TEFRA, small partnerships were excluded unless they opted in.
The bill would require partnerships to designate a representative with a role similar to a tax matters partner under TEFRA. The representative could be any partner (or other person) with a substantial presence in the United States. If a partnership did not designate a representative, the IRS would be free to designate anyone it chose. The representative would have the sole authority to act on behalf of the partnership in exam, and the decisions made by the representative would be binding.
Other partners would retain no rights in administrative proceedings and no ability to challenge IRS determinations separately, but would still be able to file inconsistently with the partnership return with notification to the IRS. Partners would also be able to file inconsistently when receiving incorrect information. Otherwise, any underpayment due to inconsistent treatment would be assessed in the same manner as a mathematical or clerical error.
Procedures for assessment and payment
The legislation creates two options for paying tax after a partnership assessment. The general rule uses procedures similar to the ELP rules, in which the partnership itself is responsible for paying the tax. The alternative procedure is more similar to TEFRA, in which adjustments are passed through to partners -- except that the partnership would be responsible for issuing adjustments instead of the IRS. Partners would not be jointly and severally liable for all partnership underpayments as proposed in earlier bills, a significant improvement from earlier drafts.
- Partnership payment procedures: The partnership would generally be required to calculate its additional tax by netting all adjustments of items of income, gain, loss or deduction, and multiplying the net amount by the highest tax rate in effect for the reviewed year. The partnership could reduce this amount by the portion that could be attributed to tax-exempt partners and partners it could demonstrate paid a lower marginal rate, such as the 35% rate for C corporations or the reduced rates for individuals paying capital gains and dividend rates or in lower tax brackets. The partnership could also reduce this amount to the extent partners amend their returns for the tax year, including the end of the reviewed partnership year, to reflect their allocable share of the adjustment. In the case of an adjustment that reallocates the distributive share of any item among partners, the amended return feature would reduce only the imputed underpayment amount if all the affected partners amended their returns to reflect the adjustment.
- Partner payment procedures: The partnership would have the option of passing the adjustment to partners themselves by issuing a “statement” to each partner within 45 days of the adjustment, to reflect each partner’s share of changes to income, gain, loss, deduction or credit. The legislation leaves the details of this alternative payment option up to the IRS. Each partner would then pay any additional tax due as a result of the adjustment. Penalties would be determined at the partnership level, and each partner would be liable for the additional amount. Interest would be assessed at the partner level from the due date of the return for the tax year to which the increase could be attributed.
A partnership could also initiate its own administrative adjustment request (AAR) outside of an audit. If the AAR resulted in an underpayment, the partnership could either pay the additional tax or issue statements to its partners, who would then be required to file amended returns. If the AAR didn’t result in an underpayment, the partnership would issue statements and the partners would be required to amend their returns. A partnership could file an AAR within three years after the later of the date the partnership filed its return or the last day for filing the partnership return for such tax year (determined without regard to extensions).
The legislation would be effective for partnership tax years beginning after Dec. 31, 2017, sooner than earlier versions proposed. The legislation also leaves considerable discretion to the IRS to write rules filling in the details and implementing the procedures. Entities classified as partnerships for tax purposes will have to act quickly to review and amend their partnership or operating agreements to reflect the substantive changes once guidance is issued.
Valid partnership interests
The legislation includes a separate legislative change intended to clarify that Congress did not intend for the family partnership rules in Section 704(e) to provide an alternative test to the generally applicable principles of law for determining whether a person is a partner in a partnership for tax purposes.
The bill appears to be a response to a district court holding in Castle Harbour v. U.S.
(TIFD III-E Inc. v. U.S., 660 F.Supp.2d 367, D. Conn. 2009). The court in Castle Harbou
r ruled that Dutch banks were partners in Castle Harbou
r and their interests should be treated as partnership interests because they owned capital interests in the Castle Harbour
partnership and capital was a material income-producing factor for Castle Harbou
The legislation would clarify the family partnership rules by providing that a person is treated as a partner in a partnership in which capital is a material income-producing factor, whether such interest was obtained by purchase or gift, regardless of whether such interest was acquired from a family member. According to the legislators, the rule is a general rule about who should be recognized as a partner.
The legislation makes several pension changes that together raise more than $8 billion. The legislation increases the Pension Benefit Guaranty Corporation (PBGC) flat rate premiums for single employer pension plans from $64 per participant in 2016 to $69 in 2017, $74 in 2018 and $80 in 2019. They are then re-indexed for inflation. The variable premium rate per $1,000 of unfunded vested benefits increases from $30 in 2016 to $33 in 2017, $37 in 2018 and $41 in 2019, plus any inflation adjustments. The legislation also accelerates the PBGC payment due date by one month for plan years beginning in 2025.
The legislation provides funding relief by extending the narrower range of interest rates used to calculate pension liabilities. Generally, funding obligations are calculated using two-year averages. Recent legislation has limited these interest rates to within 90% and 110% of the 25-year average. Because of low current interest rates, this has effectively raised the interest rate used to value pensions and has lowered pension liabilities. This interest range was scheduled to increase to 85% to 115% in 2018, and then increase annually until reaching 70% to 130% in 2021. The budget bill retains the 90% to 110% range through 2020, increasing the range yearly to reach 70% to 130% in 2024.
In addition, the legislation changes the standards for when a pension can deviate from Treasury mortality tables.
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