Introduction
Federal tax law treats partnerships as conduits for tax reporting purposes. Under this reporting concept, the partnership files a tax return (IRS Form 1065) each year and issues information returns (IRS Schedules K-1) to its partners. The partners then report those items and pay taxes on their respective shares of income, deductions, and credits from the partnership.
Generally, this system of reporting works well. However, problems may occur if a partner wants to treat an item differently than the manner in which that item was reported by the partnership. Although federal tax law permits partners to claim inconsistent reporting positions, special filing procedures located within a centralized partnership audit regime must be followed at the partner level. In addition, partners must consult governing partnership agreements to determine whether they are contractually prohibited from reporting an item inconsistently.
History Of Partnership Audit Procedures
Historically, the IRS has had difficulties auditing partnership tax returns. Prior to 1982, the agency was required to examine each and every partner of a partnership if it wanted to make adjustments related to the flow-through items of a partnership. Because this was time-consuming and inefficient, Congress changed the partnership audit rules in 1982 through enactment of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under TEFRA, the IRS could conduct a centralized audit of the partnership and effectively pass through the adjustments to the partners.
But TEFRA proved imperfect. According to a Government Accountability Office (GAO) report, the IRS examined far fewer large partnerships as compared to similar large corporations. Moreover, the GAO report noted that even if the agency examined a large partnership under the TEFRA procedures, the IRS rarely proposed partnership adjustments at all. The GAO report served as a catalyst for Congress to revisit the TEFRA audit procedures for partnerships.
Shortly after the GAO report, Congress phased out TEFRA through its passage of the Bipartisan Budget Act of 2015 (BBA). Similar to TEFRA, the new BBA rules allow the IRS to conduct centralized examinations of certain partnerships. However, unlike TEFRA, the BBA authorizes the agency to make assessments of tax directly against the partnership unless the partnership takes action to have the tax paid by the partners.
Not all partnerships are subject to the BBA centralized partnership audit rules. Rather, certain partnerships may elect out of the BBA each year unless they have ineligible partners (e.g., partnership partners).
Partnership And Partner Tax Reporting
Buried within the BBA are rules related to consistent reporting. Under these rules, a partner must generally report consistently with the manner in which the partnership reported the item on its tax return. Accordingly, if a partner receives an IRS Schedule K-1, Partner’s Share of Current Year Income, Deductions, and Credits, and Other Items, and reports an item differently from the information return, the IRS may adjust the partner’s return to treat the item consistently with that of the partnership. In addition, the agency may make these adjustments through summary assessment procedures.
Example.
Michael is a partner in Partnership, LLC, a BBA partnership. Michael receives a Schedule K-1 that reports $100,000 of ordinary flow-through income. If Michael reports only $50,000 of partnership income on his individual income tax return, the IRS may make a summary assessment against Michael to correct the error. In this instance, the agency is not required to issue a Notice of Deficiency to Michael.
The summary assessment rules apply unless the partner properly alerts the IRS of its intention to take an inconsistent reporting position. Partners do this through filing IRS Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, with their own tax returns. If these procedures are followed, the IRS may not make a summary assessment; rather, the agency must open an examination of the partner at the partner level or the partnership at the partnership level (or both).
Example.
Same facts as above with Michael and Partnership, LLC, except that Michael files a Form 8082, notifying the IRS of his intent to omit $50,000 of partnership flow-through income. In this instance, the IRS may not use its summary assessment procedures to correct the omission. Rather, the agency must open an examination of Michael’s return or Partnership, LLC’s return. If the agency chooses to make an adjustment, it must issue a Notice of Deficiency to Michael or Notice of Final Partnership Adjustment (FPA) to Partnership, LLC.
Relevant Considerations In Claiming An Inconsistent Position
Partners who want to claim a different reporting position from the partnership must do so carefully. First, as discussed above, these partners should ensure that their tax professionals properly file a Form 8082 with their return. This filing precludes the IRS from using summary assessment procedures. It also prevents the agency from imposing civil penalties applicable to taking an inconsistent position without filing the Form 8082.
In addition to these tax-reporting rules, partners in these situations should review their partnership agreements to ensure that they are contractually permitted to claim an inconsistent reporting position. Just because the BBA permits the filing does not mean that the partnership has authorized it. Indeed, many agreements recognize the increased risks of audit if a partner files a Form 8082—therefore, it is common for these agreements to contain provisions prohibiting partners from taking inconsistent positions or, at a minimum, contain requirements that the partner notify the partnership of such action. Partners who fail to comply with the provisions of a governing partnership agreement run the risk of a breach of contract lawsuit.
Summary
Partners in BBA partnerships have the flexibility to treat partnership items differently from how those items were reported by the partnership. Prior to going this route, however, partners should make sure that they comply with: (i) the BBA rules in claiming an inconsistent position; and (ii) the terms of any governing partnership agreement.
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