In recent years Tax Executives Institute, Inc. (TEI), has met with various state organizations and revenue departments to encourage standardizing the rules for reporting federal audit adjustments. These efforts have been fruitful but have even greater potential for success with the passage of the Bipartisan Budget Act of 2015 (BBA), which adopts a new federal centralized partnership audit regime. The BBA, which is scheduled to become effective for taxable years beginning after December 31, drastically changes the way partnerships and their partners will be audited and assessed by the Internal Revenue Service (IRS). Because the BBA necessitates amendments to state laws governing the reporting of federal audit adjustments to states, it provides a unique opportunity to achieve greater uniformity for such state legislation.
States Diverge Widely on Reporting of Federal Audit Adjustments
Nearly all states require taxpayers to report changes resulting from federal income tax audits to their state revenue department. Reporting ensures that states can collect the revenues to which they are entitled.
States diverge substantially, however, on the time to report the changes, the specific events or actions triggering the reporting requirement, and the form or format required to report the federal adjustments. For example, states allow between thirty and 180 days from the date of a final adjustment to report federal income tax changes.1 What constitutes a final determination also varies widely among states, with some states requiring reporting as each issue in the federal audit is settled or agreed to (even if other issues in the federal audit continue to be contested) and others requiring reporting only once all issues have been resolved.2 States also allow different methods to report such adjustments, with some states requiring amended state tax returns, others allowing a streamlined report or written notice, and still others waiving the reporting requirement if they have received notice of the adjustment from the IRS or another state.3
These diverse reporting requirements create needless confusion and complexity for multistate taxpayers. Indeed, multistate taxpayers must develop convoluted matrices to track each state’s specific requirements and are often must prioritize reporting federal changes based on the due date, size of the adjustment, and the state’s method of reporting. Taxpayers often have to file supplemental amended returns to correct errors on the returns reporting such adjustments because these returns were filed under short deadlines. The burden of complying with different state rules to report the same information in different formats is thus costly and wasteful for taxpayers and inefficient for states and taxpayers alike.
These diverse reporting requirements create needless confusion and complexity for multistate taxpayers.
TEI’s State and Local Tax Committee authored a policy statement on the Reporting of Federal Adjustments in 2015, and updated it in 2017, to provide recommended guidelines and procedures for state statutes for reporting federal audit adjustments.4 In summary, TEI recommends that:
- taxpayers should be provided at least 180 days to report federal income tax adjustments to state tax authorities;
- the 180-day period should start from the date of a final determination, which shall be deemed to occur when all adjustments made by the IRS became final and all appeal rights under the Internal Revenue Code (IRC) are exhausted or waived for the taxpayer’s taxable year. With respect to entities filing unitary or other types of combined or consolidated returns, the final determination would be based upon the last occurrence of such events for all members of the group;
- states should allow taxpayers to report federal adjustments to the state using a form similar to Federal Form 1120X, which is used to report federal income tax changes5;
- such streamlined reports should be the taxpayer’s means to report additional state tax due, report a claim for a refund or credit of state tax, and make other adjustments (including net operating losses) arising due to changes in the taxpayer’s federal taxable income;
- states should provide taxpayers with the option to notify the state that the adjustments to the taxpayer’s federal taxable income result in a de minimis state tax liability or refund in lieu of filing a report of their federal adjustments;
- prior to the final determination date, taxpayers should be permitted to make estimated payments of state tax that the taxpayer anticipates will be owed as a result of a pending IRS audit. Such payments should be creditable against any tax liability ultimately found to be due to the state and would limit the accrual of interest. Taxpayers should be able to obtain a refund on amounts the taxpayer overpaid; and
- adjustments made after the expiration of the state’s normal statute of limitations for assessments and refunds should be limited to changes arising directly from the IRS’ adjustments to the taxpayer’s federal taxable income unless the taxpayer and the state agree otherwise.
Over the past several years, TEI has discussed these recommendations during liaison meetings with the Multistate Tax Commission (MTC) and the Federation of Tax Administrators (FTA). These efforts have been well received, generally, and as a result of these efforts, South Carolina changed the manner in which taxpayers can report federal adjustments to that state. Specifically, the South Carolina Department of Revenue issued SC Revenue Procedure #16-1 on December 8, 2016,6 which offers corporations the option to report changes resulting from IRS adjustments by submitting a streamlined report and copy of the taxpayer’s federal final determination. The Revenue Procedure attaches an approved sample reporting format that is based upon the model provided in TEI’s policy statement addressing the Reporting of Federal Adjustments.
New Federal Partnership Rules Complicate State Reporting
Although state organizations acknowledge the benefits of uniformity for reporting federal adjustments, the more pressing priority is to determine how states incorporate provisions relating to the BBA’s new partnership audit rules. The states’ need to amend their laws to address the BBA’s provisions presents a new opportunity to advocate for greater uniformity among states for reporting all federal adjustments.
Overview of the New Federal Partnership Rules
Much has been written about the new partnership audit rules.7 This article only summarizes them at a high level. In general, under the current Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) rules,8 the IRS has authority to determine the tax treatment of partnership items at the partnership level. However, a partnership, as a pass-through entity, is not subject to federal income tax. The IRS must thus collect deficiencies from its partners rather than from the partnership. Such collections can be protracted for multi-tiered partnerships, because the adjustments must be pushed through the indirect partner tiers and collected from the ultimate owners of the audited partnership. In some cases, the adjustments are never reported or paid by those indirect partners, and states lack an effective enforcement mechanism.
Under the BBA and subject to certain exceptions, the IRS will audit partnership items at the partnership level and issue a proposed adjustment to the partnership for what is referred to as the “reviewed year.” The reviewed-year partners may file amended returns and pay their share of the tax (the “pay-up” method), and the partnership may submit modifications to the imputed underpayment during a 270-day period. After that period, the IRS issues a notice of final partnership audit adjustment. The partnership then has forty-five days to elect whether the partnership will allocate the adjustments to the reviewed-year partners (a “push-out election”), under which the partnership will prepare an informational statement and the partners will pay the tax on their current-year (“adjustment-year”) returns or the partnership will pay the tax on its adjustment-year return (the “partnership pays” method), in which current-year partners effectively bear the liability. It is estimated that the BBA provisions will increase tax collections by $9.3 billion over ten years by enabling collection at the partnership level.9
The BBA also changes how partnerships are represented. Under TEFRA, partners are represented by a tax matters partner (TMP). The TMP has special rights and authority to represent partners during an IRS audit and related proceedings; however, partners have some rights, including notice of audits and resulting administrative adjustments, the ability to participate in administrative proceedings at the partnership level, and the right to request administrative adjustments and refunds for each partner’s separate tax liability. The IRS generally has three years to adjust partnership items and one year from the date of a properly timed administrative adjustment to assess the partners.
The BBA replaces the TMP with a partnership representative (PR), who has the sole authority to act on behalf of the partnership with the IRS and can bind the partnership and its partners. Under the BBA, partners no longer have a statutory right to participate in the partnership’s audit, receive notice of audit proceedings, challenge the PR’s actions, or challenge the merits of adjustments allocated to the partners under the “push-out” method.
Much remains to be clarified about the BBA’s partnership audit procedures, although some clarifications are expected to be accomplished through a federal technical corrections bill and proposed Department of Treasury regulations. However, all partnership agreements should be updated to reflect the BBA provisions and to determine, prior to a BBA audit and potential liability, how the partnership will address audit adjustments made under the BBA.10
State Implications Arising from the New Federal Partnership Rules
The BBA rules have numerous implications for how partnerships and their partners report audit adjustments to states and who bears liability for the resulting state tax payments. First, state laws do not automatically conform to the BBA; therefore, states will need to affirmatively amend their laws to address the new federal rules. Second, most states do not impose tax upon partnerships. States that do not will need to amend their laws to ensure they receive information regarding federal audit adjustments and are able to assess a state tax liability against the partnership, if necessary. Third, the partnership’s apportionment factors are likely to differ between the reviewed year and adjustment year, complicating any mechanism that would require partnerships to pay additional tax on their adjustment year return. Fourth, states generally impose tax on 100 percent of an individual resident partner’s income and provide a credit for taxes paid to other states. A partner’s state of residence may differ for the reviewed year and the adjustment year, further complicating any mechanism that would require partners to pay additional tax on their adjustment-year return and creating potential disparities in calculating state tax due depending if the partnership or the ultimate partners pay the state tax liability. What’s more, only a few states have clear, detailed procedures regarding partnership audits and taxation.
The MTC thus formed the Partnership Project in 2016 to address whether new state statutes are needed, what states should do to audit and track partnership income, whether withholding statutes are effective for multiple-tiered entities, and how old statutes will intersect with entity-level liability.11 To date, only Arizona has enacted legislation addressing the BBA provisions. California, Georgia, Minnesota, Missouri, and Montana considered legislation during the spring of 2017; however, each of these states opted to delay action while Congress considered the technical corrections bill and the Department of Treasury finalized its proposed regulations. Interestingly, each state considering legislation has taken a different approach when seeking to integrate the BBA provisions at the state level.12
Interested Parties Develop Model Statute to Address Reporting of All Federal Audit Adjustments
The Interested Parties’ Efforts
TEI, in conjunction with the American Bar Association’s State and Local Tax Committee, the Council on State Taxation, the American Institute of CPAs, and the Institute for Professionals in Taxation (collectively, the Interested Parties) have created a working group to address implementing the BBA provisions at the state level. The working group’s primary objectives are to participate in the MTC’s Partnership Project, monitor proposed state legislation, and develop a model statute for reporting federal adjustments. The Interested Parties recognize that consistency, as well as ease of reporting, is essential to implementing the federal partnership audit rules efficiently at the state level.
The MTC adopted a model statute addressing the reporting of federal audit adjustments generally in 2003. In December 2016, the Interested Parties made a presentation at the MTC’s fall meeting and urged the Uniformity Committee to consider updates to the 2003 model statute while the Partnership Project was ongoing. The Interested Parties noted the lack of uniformity among states and discussed problems with current state statutes. The Interested Parties also presented proposed amendments to the MTC’s 2003 model statute (Draft Model Statute) at that meeting.13
Since then, the Interested Parties have met extensively with their membership and constituents to determine the best practices for reporting BBA audit adjustments to the states and incorporated such provisions into the Draft Model Statute. The Interested Parties then presented an updated Draft Model Statute to the MTC during the Partnership Project’s June 2017 conference call and made additional revisions to the Draft Model Statute in July. In August, the MTC’s Uniformity Committee passed a motion to use the Draft Model Statute as its starting point for analyzing the partnership provisions and agreed that the Partnership Project should seek to address uniformity for reporting federal audit adjustments generally. The Interested Parties again updated the Draft Model Statute in September to reflect feedback from states and other parties.
The Interested Parties’ Draft Model Statute
The Draft Model Statute includes several provisions relating to the reporting of federal audit adjustments generally. Specifically, the Draft Model Statute updates the definition of “final determination,” provides taxpayers with at least 180 days to report federal audit adjustments to states, allows taxpayers to provide notice of federal changes via a streamlined model report, provides an exception for de minimis changes to state tax liabilities, and allows taxpayers to make estimated tax payments prior to a federal final determination. These provisions are consistent with TEI’s policy statement governing the Reporting of Federal Changes.
With respect to federal adjustments arising as a result of a BBA audit, the draft model requires a partnership to file a federal adjustments report notifying the state of changes to the partnership’s taxable income apportioned to the state within sixty days of the final determination. At this time, if the partnership has a state imputed underpayment, the partnership must elect to (1) pay the tax liability at the partnership level (partnership pays election); (2) pay the tax on behalf of composite return and withholding partners, issue amended K-1s to all reviewed-year partners, and require all other partners to pay the tax (partners pay general election); or (3) pay the tax on behalf of reviewed-year composite return, withholding, and nonresident partners; issue amended K-1s to all reviewed-year partners; and require all other (resident) partners to pay the tax (partners pay based on residency election).
If the partnership fails to make an election, the partnership is deemed to make a partnership pays election. If the partnership is owed a refund, or is dissolved or becomes insolvent, the partnership must issue amended K-1s to the reviewed-year partners, and such partners must pay the tax or claim a refund. Regardless of which election is made, if the partnership fails to meet its payment obligations, the Draft Model Statute provides states with authority to assess the partners directly for their share of the liability.
The Draft Model Statute also contains extensive provisions addressing the calculation of tax, whether paid by the partnership or the partners, and reporting requirements to advise the states of each partner’s apportioned share of the liability. The partnership or it partners would be required to pay the tax within 180 days from the final determination date, with the exception of tiered partnerships.
Although the BBA currently requires partners that are themselves pass-through entities (tiered partners) to pay any federal income tax liability attributable to the tiered partner, a federal technical corrections bill contemplates that tiered partners will have the option to pay the tax or have the tiered partner’s partners pay the tax. In anticipation of the adoption of this amendment, the Draft Model Statute provides tiered partners a similar option to pay the state tax or issue amended K-1s and have their partners pay the state tax, at each tier of a tiered partnership. These provisions are coupled with various reporting requirements to ensure that states receive the information they need regarding the partners’ liability at each tier. A cutoff date is mandated for the payment of all state tax that mirrors the provisions addressing tiered partnerships in the federal technical corrections bill.
The Draft Model Statute, like the BBA itself, seeks to balance timely, simplified reporting and payment procedures against the current system, which theoretically calculates the “true” tax but is time-consuming and complex and results in states sometimes not collecting the full tax due. The Interested Parties and MTC agree that there is no perfect solution for how partnerships and their partners report adjustments arising from BBA audits to states, given how the BBA potentially shifts liability from partners to the partnerships and given the complexities of state tax residency and apportionment.
For example, if the partnership opts to pay the tax liability arising from a BBA audit, the state would receive all of its tax within 180 days based upon the partnership’s entity-level apportionment formula. However, this amount might more or less than the amount that would have been received if the partners paid the tax, could take the state substantially longer to collect, and could result in some tax being uncollected if the liability is pushed out to partners through all of the tiers of a multi-tiered partnership.
Other concerns relate to information reporting requirements, as states only have jurisdiction over entities that conduct business within their state. As a result, the state may not receive notice of federal audit adjustments that should be paid by a resident partner if the partnership does not conduct business in that state. The lack of such information will hinder states’ ability to enforce collection of tax due from partners.
The Interested Parties are continuing discussions with the MTC, as well as state revenue departments, and will continue participating in the MTC’s Partnership Project. The Interested Parties anticipate further refinements to the September 2017 version of the Draft Model Statute to address additional comments from all stakeholders and constituents. The Interested Parties will also continue to monitor any changes made through a technical corrections bill or Treasury regulations and adapt the Draft Model Statute to such changes as necessary. The Interested Parties hope to have a model statute by the 2018 legislative session, enabling states to enact consistent provisions for reporting BBA and other federal audit adjustments and ensuring that such provisions are acceptable to states and taxpayers alike.
Pilar Mata is tax counsel at the Tax Executives Institute.
- Council on State Taxation, 2016 Scorecard on Tax Appeals and Procedural Requirements (COST Scorecard), available at www.cost.org/WorkArea/DownloadAsset.aspx?id=94726.
- COST Scorecard; see also Bloomberg BNA, 2016 Survey of State Tax Departments, Reportable Adjustments (BNA Survey), Vol. 23, No. 4 at 334-335.
- COST Scorecard; BNA Survey at 336-338.
- Available at www.tei.org/sites/default/files/advocacy_pdfs/2017.01.23%20-%20SALT%20Policy%20-%20Reporting%20Federal%20Changes%20-%20Updated%20with%20Template%20-%20FINAL.pdf.
- TEI’s State and Local Tax Committee developed a model streamlined report for reporting federal adjustments to the states, which is attached to the Reporting Federal Changes policy statement.
- Available at https://dor.sc.gov/resources-site/lawandpolicy/Advisory%20Opinions/RP16-1.pdf.
- See, e.g., Bruce P. Ely et al., “MTC, Business Groups Respond to Federal Partnership Audit Rules,” State Tax Notes, Jan. 9, 2017, p. 215; Carol Kulish Harvey et al., ‘‘New Partnership Audit Rules—What We Know So Far, Part 1,’’ Tax Notes, Aug. 8, 2016, p. 829; and Harvey et al., ‘‘New Partnership Audit Rules—What We Know So Far, Part 2,’’ Tax Notes, Aug. 15, 2016, p. 991.
- The TEFRA rules apply to partnerships with over ten partners or with pass-throughs as partners. Large partnerships with more than 100 partners can elect to have the large partnership rules apply to their audits and adjustment; relatively few partnerships make this election. For partnerships with ten or fewer partners that have not elected the TEFRA audit rules, the tax treatment of partnership items is determined at the partner level.
- See, e.g., Bruce P. Ely et al., “MTC, Business Groups Respond to Federal Partnership Audit Rules,” State Tax Notes, Jan. 9, 2017, p. 215.
- The MTC’s Partnership Project webpage contains a robust collection of statutes, regulations, presentations, and documents related to the issues discussed in this article. See www.mtc.gov/Uniformity/Project-Teams/Partnership-Informational-Project.
- See Ariz. 2016 HB 1288; Ga. 2017 HB 283; Minn. 2017 HB 1227, and SB 1218; Mo. 2017 SB 521; Mont. 2017 HB 47. California deferred action following a legislative study.
- For more details, see www.tei.org/advocacy/liaison-meetings/tei-urges-multistate-tax-commission-update-its-model-statute-governing.