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February 16, 2017 Practice Point

SALT Committee Update on Partnership Audit Rules, Work with MTC and States

By Bruce P. Ely and William T. Thistle, II, Bradley Arant Boult Cummings LLP, Birmingham, AL (Co-Chairs of the SALT Committee’s Task Force on the State Implications of the New Federal Partnership Audit Rules)

Partnership tax aficionados will recall that Congress passed the Bipartisan Budget Act of 2015 (the BBA)1 as amended by the PATH Act of 2015, in record time.  That law established a new partnership audit and assessment regime and repealed prospectively the current TEFRA partnership audit rules.2  Even though more than a year has passed, much remains unknown—both at the federal and the state level.  In fact, none other than the Commissioner of Internal Revenue, John Koskinen, recently remarked that “the statute has turned out to be more complicated, rather than less.”3

The federal rules will take effect on a widespread basis for tax years beginning after December 31, 2017.  In the meantime, state legislatures, state departments of revenue (DORs) and the Multistate Tax Commission (MTC) are analyzing the federal rules to address the conformity issues in a reasoned and hopefully uniform way, with input from the business and tax practitioner communities.  This article provides an update on how the new partnership audit regime is being addressed at the state level so far and discusses some helpful options. 


There have been numerous articles and seminar presentations explaining how, and why, the new partnership audit rules came about.  We only set the stage here and defer to others for the details behind the federal legislation.  In November 2015, Congress passed the BBA, at the last minute tacking on draft legislative language repealing the existing TEFRA rules.5   Within the legislation are new rules tailored to combat the growing problem—from the perspective of the IRS and the General Accounting Office (GAO)—of auditing the ever-increasing number of so-called “large” partnerships, i.e., those with more than 100 partners.  As the number of partnerships—in particular, the number of large partnerships—has exploded over the past decade, sourcing of income has become a problem for revenue officials before and during the audit process.  The new regime is designed to alter the burden of sifting through myriad assortments of partnership structures,6 saving time and expense for IRS revenue agents who the GAO notes are often not conversant with the intricacies of Subchapter K.

Arizona and Recommendations Going Forward

Following enactment of the BBA, the Arizona legislature rushed to conform the state’s tax audit procedures to the new federal rules as part of their periodic effort to conform their state income tax to the corresponding federal income tax rules.  This was accomplished in large part by engrafting the new federal procedures into Arizona’s existing tax code, with certain material differences.

As outlined by various authors,7 Arizona’s initial attempt at drafting conforming rules has highlighted various problems and provided a useful case study for those of us reviewing other states’ income tax statutes and assessment procedures for future revisions.  For example, consider the scenario in which a partnership doing business in Arizona is determined to have an imputed underpayment of federal income taxes for a prior year.  Assuming the partnership elects at the federal level to “push-out” the final adjustments to its reviewed-year partners, those partners (and former partners) will be required to take their share of any adjustments into their current (adjustment) year federal returns, with no amendment to the prior, reviewed-year returns required.  This aspect differs from the new regime set forth by Arizona, which presently requires reviewed-year partners, irrespective of federal level treatment, to file amended state returns for the reviewed year.  Such a lack of conformity between state and federal rules creates not only significant administrative difficulties but also due process concerns, given the all too likely scenario of a reviewed-year partner who sold all or part of his or her partnership interest after the reviewed year and is assessed Arizona income tax relating to the reviewed year due to adjustments at the federal level.  The same issue arises in the case of a partner who was an Arizona resident during the reviewed year but has since moved out of state and now has no nexus with Arizona other than the partnership interest.

To compound the problem, Arizona’s new rules also introduce timing issues through mismatching notice and filing deadlines.  This raises the specter of a partnership that chooses to push-out Arizona adjustment items, but isn’t required to provide notice of these adjustments to reviewed-year partners until after the statute of limitations for the original filings by these partners has expired.  In sum, one modification to the machine’s components has created a cascading effect for all running processes.

Seeking to correct the problems in the new Arizona law and to prevent similar drafting issues with other states, a number of groups have taken the initiative to suggest various ways in which the states can craft their partnership audit rules to coexist with the new federal regime in a fairer and more administrable way.  In particular, the MTC staff and its partnership work group have been active in promoting open dialogue to explore all available avenues to achieving consistent legislation as each state tackles implementation of new partnership audit rules.8   As part of those efforts, the MTC staff, with input from the SALT Committee’s Task Force on the State Implications of the New Federal Partnership Audit Rules (the Task Force)9 and others, posted on the MTC’s website a very helpful list of the material state conformity issues.  It is uncertain whether the MTC will issue a blanket set of recommendations for all member states levying a net income-based tax or will proceed to work individually with state legislatures through proposing or at least editing individualized conformity legislation.  Perhaps “both” is the likely answer.

In hopes of furthering the discourse, the Task Force partnered with the Council On State Taxation, Tax Executives Institute, Inc., and the American Institute of CPAs.  These groups collectively submitted an informal set of recommendations to the MTC staff and their partnership work group.  The Task Force and its partners believe these recommendations will aid the states in designing partnership audit rules that not only operate smoothly with the new federal regime, but also serve to promote the most beneficial operational outcomes for taxpayers.10   These unofficial recommendations have not yet been vetted by the ABA Tax Section leadership, so at this point they constitute only our members’ personal views. 

As an initial matter, the Task Force urged the MTC and the states to take a go-slow approach and to monitor the progress of the pending Tax Technical Corrections Act of 2016, H.R. 6439, S.3506 (introduced Dec. 6, 2016), which makes several material and helpful changes to the audit rules.  Also, all parties are anxiously awaiting guidance from Treasury11 .  Second, the Task Force proposed that any state conformity statute or any proposed MTC model statute provide that the designation of an individual or entity as the partnership representative (PR) for IRS audit purposes should be accepted by the states.  We recognize that circumstances exist where a sub-PR may be appointed to handle a particular state or perhaps group of states, and we recommended that the sub-PR’s selection be honored by the respective states as well. 

Regarding the new “push-out” election under section 6226, the Task Force recommended that states and the MTC offer partnerships the opportunity to elect to remain liable for any underpayment of state income taxes, interest and penalties, irrespective of which election is made (or by default, not made) for federal tax purposes.12   The rationale here is simply a cost-benefit calculation: while adjustment items elected to be “pushed-out” at the federal level may be significant in terms of dollar amounts, state-level items for one or more states may not be, thereby making it more cost-effective for the partnership to “pay-up” at the state level rather than expending resources on calculating and providing notice of each reviewed-year partner’s share of state-level adjustments.  That also allows the states to look to only one entity–the partnership itself–for payment.  Along those lines, the Task Force also recommended states consider developing composite adjustment returns for all partners, including residents and nonresidents, of the reviewed year, even if original composite returns were not filed.

The Task Force also recognized the need for most states to amend their existing statutes, since in most states partnerships are not currently treated as taxable entities and therefore are incapable of being assessed tax, other than perhaps under a composite return or nonresident partner withholding statute.  Further, should a partnership pay any state income tax deficiency, the state conformity statute should provide that adjustment (current) year partners receive credit against their state income tax liability for the payment.  Based on our non-scientific review, it’s likely that most if not substantially all state nonresident partner withholding statutes must be amended to take into account this new scenario. 

The Task Force also believes that now is an opportune time to amend each state’s federal audit adjustment reporting rules, commonly known as revenue agent’s report (RAR) statutes, to bring them into conformity with the federal rules and promote much-needed uniformity among the states.13   The Task Force, in conjunction with its partners, recently submitted to the MTC’s Uniformity Committee a draft RAR statute patterned in part after the MTC’s model uniform RAR statute issued August 1, 2003. While the MTC’s model statute contains a number of beneficial components and is a good starting point, the Task Force believes there are some important changes needed—e.g., adopting a uniform 180-day period in which to file either amended state returns or a streamlined multi-year report, and limiting the state assessment (and the scope of the state DOR audit) to only those tax items in the federal audit that directly affect the taxpayer’s state income tax liability.

Another of the Task Force’s recommendations is that any state conformity statute should provide a mechanism (similar to the provision in section 6225) for a partnership to reduce its state income tax liability by proving that lower tax rates are applicable to the state share of the imputed underpayment—e.g., by showing that a partner is a tax-exempt entity under state law, is subject to a lower state tax rate, or is not subject to a state’s income tax regime at all (such as an insurance company or a financial institution, in many states). 

Finally, the Task Force recommendations note the existence of due process concerns in several circumstances, including the scenario in which a reviewed-year partner is no longer a resident of a particular state to which the partnership is liable for RAR adjustments when the partnership makes a “push-out” election under section 6226.  Similar issues arise with a partnership that was doing business in or otherwise taxable by a state during the reviewed year (or more) but was not doing business in or otherwise taxable in that state during the adjustment year, or vice versa.  Of course, any MTC model or state conformity statute should be designed to avoid violating any constitutional provisions, specifically the Commerce and Due Process Clauses.  For example, the Task Force stressed that if a reviewed-year partner is required to file an amended state return for each reviewed year, the partnership’s apportionment factor in effect during each reviewed year should be applied, not the currently applicable (adjustment year) factor.


President Trump campaigned on a platform of increased infrastructure spending along with federal budget reduction, so it is likely that addressing ambiguities within the new federal partnership audit framework may not qualify as a legislative priority for the Trump Administration.  It’s clear, however, that a thorough technical corrections bill14 and administrative guidance are needed to ensure that this projected $9.3 billion revenue-raiser will work effectively. 

Nonetheless, the new federal audit regime has arrived and the effective date clock is ticking.  It is the authors’ hope that the states and the MTC will take a measured and transparent approach to crafting their own partnership audit and RAR reporting rules–after legislative corrections have been made to the BBA and detailed guidance issued by Treasury.  Doing so would go a long way toward ensuring that the transition to the new audit regime by multistate partnerships, their partners, and the states is as seamless as possible.

1 Bipartisan Budget Act of 2015, Pub. L. No. 114-74, 129 Stat. 584 (to be codified as amended at IRC §§ 6221–6241) (2015).

2 The current audit rules were enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324, and are typically referenced, using the legislation’s acronym, as the TEFRA rules.

3 Laura Davidson & Colleen Murphy, Koskinen Skeptical of New Audit Regime for Partnerships, 221 DTR G-1 (BNA Nov. 16, 2016).

4 For a more comprehensive review of the new federal partnership audit rules, see Fred F. Murray, New Partnership Audit Rules Require Action Now in Respect to Partnership Agreements, LLC & Partnership Rep., 17 (ABA October 2016); Jennifer McLoughlin, New Federal Take on Partnership Audits: A Primer, 236 DTR H-1 (BNA Dec. 7, 2016).

5 See supra n. 2.

6 Many partnerships are now limited liability companies (LLCs). All references in this article to partnerships or partners include LLCs treated as partnerships for federal tax purposes and their members as well, unless the context requires otherwise.

7 For an excellent analysis of Arizona’s new partnership audit regime, see Marianne Evans et al., New Partnership Audit Rules Create State Tax Issues, 81 State Tax Notes 955 (Sept. 19, 2016).  Despite calls to take a wait-and-see approach, the Montana Department of Revenue pre-filed its own conformity bill, H.47, and is seeking comments.  The SALT Committee Task Force has been asked to provide informal drafting suggestions consistent with its recommendations to the MTC, as discussed infra note 9 and accompanying text.

8 For more information about the MTC partnership work group, and their efforts in this regard, please visit their helpful website.

9 The Task Force is chaired by authors Bruce Ely and Will Thistle and consists of the following additional members: John Barrie, Dan De Jong, Nikki Dobay, Julia Flanagan, Karl Frieden, Erica Horn, Willie Kolarik, Kelvin Lawrence, Pilar Mata, Alysse McLoughlin, Kelley Miller, Fred Nicely, Kyle Wingfield, and Steve Wlodychak.

10 The Task Force produced a memorandum discussing the state implications of the federal partnership audit rules on September 16, 2016. For additional coverage, see Amy Hamilton, MTC Outlines Reporting Issues Raised by New IRS Partnership Audit Regime, 2016 STT 199-1 (Oct. 14, 2016); and Amy Hamilton, MTC Partnership Audits Work Group to Delve into Federal Push-Out Election, 2016 STT 222-3 (Nov. 16, 2016). 

11 In light of President Trump’s new Executive Order requiring agencies to eliminate two regulations before proposing a new one, it is unclear when Treasury will be able to issue such guidance.

12 For prior coverage, see Amy Hamilton, States Advised to Depart From IRS Partnership Audit Regime’s ‘Push-Out’ Election, 2016 STT 188-1 (Sept. 28, 2016). 

13 See Amy Hamilton, Practitioners Seek Comprehensive Revision of Model State RAR Statute, 2016 STT 212-2 (Nov. 2, 2016).

14 Andrew Velarde, New Bill May Require Reproposal of Partnership Regs, 2016 TNT 237-3 (Dec. 9, 2016).