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Jamie C. Yesnowitz
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On Sept, 23, 2018, California enacted legislation requiring partnerships that are issued a federal audit adjustment to report each change or correction to the California Franchise Tax Board (FTB) within six months after the final federal determination.1
If the federal change or correction increases the amount of California tax payable, partnerships rather than partners generally are required to pay the tax due. California is substantially conforming to the new federal partnership audit provisions enacted by the Bipartisan Budget Act of 2015 that apply to tax years beginning after Dec. 31, 2017. 2
Application of federal elections to California
Historically, under federal law, partnership audit adjustments were applied at the partner level. Pursuant to a recent federal change, audit adjustments are now applied at the partnership level, though partnerships may elect to pass these adjustments to the partners.3
This election, along with other federal elections made under these new rules, generally applies to California tax, and a separate election is not allowed.4
However, the enacted California law provides two significant exceptions in which the partnership is not bound by its federal election. First, a unitary partner whose distributive share would properly be included in the partner’s business income on its original return is treated as having filed an amended return. 5
Second, a partnership may file a request with the FTB to make an election different from its federal election under the new rules. 6
If the partnership makes a federal election to pass an adjustment to the partners under IRC Sec. 6226,7
the partnership must file an amended California nonresident group return for all nonresident direct partners and pay the additional amount of tax that would have been due if the federal adjustments had been properly reported.8
Subject to the FTB’s approval, an audited partnership or tiered partner may enter into an alternative agreement on any issue resulting from a federal audit adjustment, amended federal return or administrative adjustment. 9
A designated partnership representative makes elections on the partnership’s behalf for both federal tax and state tax purposes.10
Under California law, a partnership’s state partnership representative is its federal partnership representative unless the partnership designates another person as its state partnership representative. 11
The FTB is authorized to establish procedures for designating a separate state partnership representative.12
Imposition of tax on partnership
If the federal change or correction increases the amount of California tax that is payable, tax is imposed on the partnership in lieu of the taxes owed by direct and indirect partners.13
In computing the tax, the following must be excluded: (i) the distributive share of adjustments made to a tax-exempt partner that is not unrelated business taxable income; and (ii) the distributive share of adjustments made to a partner that had previously filed an amended return and paid any additional state tax. 14
The calculation of the partnership’s tax is dependent upon the type of partner that owns a partnership interest. For corporate or tax-exempt partners, the total distributive share of the federal adjustments is apportioned and multiplied by the highest marginal corporation franchise or income tax rate for the reviewed year.15
For tiered partners, nonresident individual partners, or nonresident fiduciary partners, the total distributive share of the federal adjustments that is California source income is multiplied by the highest marginal personal income tax rate for the reviewed year.16
For resident partners, resident fiduciary partners, or any other partners, the total distributive share is multiplied by the highest marginal personal income tax rate for the reviewed year.17
The total tax that is imposed equals the sum of these three amounts.18
Penalties and interest will be imposed from the original due date of the partnership return for the reviewed year.19
If a partnership’s report of the California tax changes from the adjustment results in an overstatement of California taxable or net income, the statute addresses the treatment of the adjustment.20
If the original adjustments were passed through to the partners, the revised adjustment must be passed through to the partners. If tax on the adjustments was originally paid by the partnership, the partnership may amend the return to claim a refund of the overpayment. However, a partnership may not claim an overpayment for amounts not actually paid by the partnership.
Tiered and indirect partners
and indirect partners of an audited partnership are subject to the applicable election, reporting and payment requirements for audited partnerships and their direct partners as discussed above.22
Also, tiered partners and indirect partners must make all required reports and payments within 90 days after the time for filing statements to tiered partners and their partners under IRC Sec. 6226.
Publicly traded partnerships
For purposes of the reporting requirements, a publicly traded partnership23
is only required to report its direct partners’ distributive share of a federal adjustment to the FTB.24
A publicly traded partnership is deemed to have made a federal election to pass the adjustment to the partners under IRC Sec. 6226 unless the publicly traded partnership files a request with the FTB to make an election different than the federal election.
The Bipartisan Budget Act of 2015 included new partnership audit and assessment procedures that dramatically increase the payment and reporting responsibilities for partnerships for tax years beginning after Dec. 31, 2017.25
The new procedures are designed to shift the burden for actually assessing tax after a partnership-level adjustment from the Internal Revenue Service to the partnership and partners. A federal partnership audit that produces an adjustment may change corresponding state tax liability, and often poses to be problematic for several reasons. For example, the identity of the partners in the partnership may change between the tax year in which the adjustment occurs, and the tax year in which liability is finally fixed. In addition, while states have not had much opportunity to react to the new federal rules, a lack of uniformity in this area could make things extremely unwieldy for multistate partnerships and their partners.
Several other states, including Arizona,26
have also adopted the new federal partnership audit provisions and other states are considering similar legislation. The adoption of the federal approach by other states has been endorsed by a number of business and governmental groups,29
and would advance uniformity and ease the administrative burden for partnerships that operate in multiple states, as well as their partners.
Partnerships designate a representative to make election decisions on their behalf for both federal tax and state tax purposes. As noted above, California law allows partnerships to designate a state partnership representative that differs from their federal partnership representative. This may produce interesting results if a partnership’s federal representative makes elections or decisions that conflict with the elections or decisions made for the same partnership by a different state partnership representative.
The legislation adopts the partnership audit provisions in effect on Jan. 1, 2018, but California generally adopts the IRC as in effect on Jan. 1, 2015, for corporate and personal income tax purposes.30
Thus, the adoption of the new partnership audit provisions is not consistent with California’s general adoption of the IRC.
Partnerships subject to the new procedures in California should notify the FTB of federal changes or corrections within six months of each final federal determination. As discussed above, if the change or correction increases the tax payable to California, the partnership generally must directly pay the tax due. Partnerships that fail to meet these requirements may be subject to applicable interest and penalties. Because corporate partners may have a tax obligation, the new procedures could have an ASC 740 effect on some taxpayers.
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