Legislative update: “Budget deal” includes tax provisions

Budget agreement includes tax provisions

Late last night, the White House and congressional leadership reached an agreement that would suspend the limit on public debt (the “debt ceiling”) through March 15, 2017, and increase defense and discretionary spending for fiscal years 2016 and 2017 above the levels set by the Budget Control Act of 2011. Revenue offsets in the agreement (the “Bipartisan Budget Act of 2015”) include two partnership tax provisions described further below:

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  • Changes to the rules for partnership audits and adjustments
  • Amendments to Code sections 704(e) and 761(b) relating to the determination of who is a partner in a partnership

The agreement also would make certain changes to pension funding, including amending section 430(h)(3) of the Code (relating to mortality tables).

Documents

Read a discussion draft version of the statutory language [PDF 351 KB] and a section-by-section summary [PDF 152 KB] of the agreement.

Changes to rules for partnership audits and adjustments

Effective for returns filed for partnership tax years beginning after 2017, the agreement would repeal the unified audit rules established by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the special rules for electing large partnerships (ELPs) and would replace them with a single system of centralized audit, adjustment, and collection of tax for all partnerships, except for certain eligible partnerships that elect out of the centralized regime for a tax year. 

The agreement would allow a partnership to elect out of the new regime for a tax year only if: (1) the partnership is required to furnish 100 or fewer statements under section 6031(b) (i.e., schedules K-1) with respect to its partners for the tax year; (2) each of its partners is an individual, a decedent's estate, a C corporation, an S corporation, or a foreign entity that would be treated as a C corporation if it were domestic; and (3) certain procedural requirements are met relating to the election out.  Certain special rules, however, would apply for a partnership with S corporation partners to elect out.  Further, Treasury could issue guidance allowing partnerships with partners other than those listed to elect out.

Very generally, if the new audit regime applies, the IRS would audit items of income, gain, loss, deduction, or credit of the partnership (and any partner’s distributive share thereof) at the partnership level.  According to the section-by-section analysis [emphasis added]:

 

Any adjustments would be taken into account by the partnership (not the individual partners) in the year that the audit or any judicial review is completed (the “adjustment year”). Partners would not be subject to joint and several liability for any liability determined at the partnership level. Partnerships would have the option of demonstrating that the adjustment would be lower if it were based on certain partner-level information from the reviewed year rather than imputed amounts determined solely on the partnership’s information in such year. This information could include amended returns of partners opting to file, the tax rates applicable to specific types of partners (e.g., individuals, corporations, tax-exempt organizations), and the type of income subject to the adjustment (e.g., ordinary income, dividends, capital gains). As an alternative to taking the adjustment into account at the partnership level, a partnership would be permitted to issue adjusted information returns (i.e., adjusted Form K-1s) to the reviewed year partners, in which case those partners would take the adjustment into account on their individual returns in the adjustment year through a simplified amended-return process. As a result, partnerships generally would no longer issue amended Form K-1s after the partnership return is filed, but instead would use the adjusted Form K-1 process.

A partnership would also have the option of initiating an adjustment for a reviewed year, such as when it believes additional payment is due or an overpayment was made, with the adjustment taken into account in the adjustment year. The partnership generally would be permitted to take the adjustment into account at the partnership level or issue adjusted information returns to each reviewed-year partner.

 

In addition, the agreement provides for a partnership to designate a partner, or other person, to be its partnership representative that can act on behalf of the partnership with the IRS and that can bind the partnership and all partners to any decision in a proceeding with respect to the partnership.

KPMG observation

Tax professionals currently are reviewing the details of the partnership audit reform provisions. Initial impressions indicate that the provisions are similar in many respects to those included in the “Tax Reform Act of 2014,” as introduced by former Chairman of the House Ways and Means Committee, Dave Camp, in December 2014 (the “Camp Bill”), and H.R. 2821, the “Partnership Audit Simplification Act of 2015,” as introduced earlier this year by Reps. Renacci and Kind.  However, the audit reform provisions in the agreement reflect some significant modifications.  For example:

  • Unlike the previous proposals, the agreement would not make all persons that were partners during either the reviewed year or the adjustment year jointly and severally liable for any imputed underpayment.  This addresses a significant concern that had been raised with the previous proposals.
  • Previous proposals generally did not allow partnerships to demonstrate that an adjustment would be lower if it were based on certain partner-level information from the reviewed year and did not permit partnerships to issue adjusted information returns (i.e., adjusted K-1s) to the reviewed-year partners.  
  • Although the audit reform provisions in the agreement would apply to a broad universe of partnerships, they appear to allow somewhat more partnerships to elect out of the regime.

Amendment to Code sections 704 and 761

The budget agreement would strike section 704(e)(1) and change the heading of section 704(e) to “Partnership Interests Created by Gift” (instead of “Family Partnerships”).  It also would add a new sentence to the end of section 761(b) providing that, in the case of a capital interest in a partnership in which capital is a material income-producing factor, whether a person is a partner with respect to such interest will be determined without regard to whether such interest was derived by gift from any other person. These amendments would be effective for partnership tax years beginning after December 31, 2015. The section-by-section explanation of the agreement explains that:

 

The provision would clarify that Congress did not intend for the family partnership rules to provide an alternative test for whether a person is a partner in a partnership.  The determination of whether the owner of a capital interest is a partner would be made under the generally applicable rules defining a partnership and a partner. In addition, the family partnership rules would be clarified to provide 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 and regardless of whether such interest was acquired from a family member. The rule, therefore, is a general rule about who should be recognized as a partner.

KPMG observation

An initial impression is that this provision appears similar to a proposal that was included in the Camp Bill last year. This provision appears to be intended to clarify legislatively that the argument made by the taxpayer in the Castle Harbor case (TIFD III-E v. United States) regarding who is treated as a partner for federal income tax purposes under 704(e) is not valid. TIFD III-E v. United States, 459 F3d 220 (2d Cir. 2006), rev’g and remanding 342 F. Supp. 2d 94 (D. Conn 2004).

What's next?

The House and the Senate are expected to vote on the bipartisan agreement later this week.  Assuming the agreement passes both the House and the Senate, it will then go to the president for his signature.  Given that the administration was involved in negotiating the agreement, it would be expected that the president will sign the legislation if it passes the House and Senate.

Possible additional tax legislation later this year?

The agreement does not address highway spending—the authorization for which expires soon. A highway bill could be a vehicle for tax legislation (e.g., tax revenue could be used to offset the costs of highway spending).  

In addition, the agreement does not address the so-called “extenders”—i.e., the more than 50 tax provisions that expired for most taxpayers at the end of 2014. It is not certain at this time when and how Congress will address the expired provisions.

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