New procedures were enacted for federal audits of partnerships that will likely impact states’ existing collection of state taxes on federal adjustments. With many state tax issues involved, the AICPA is working with several organizations to develop draft model state legislation for reporting federal tax changes to the states, including the new partnership audit process.
New federal rules
Starting with tax years beginning on and after Jan. 1, 2018, many partnerships will be subject to the new audit regime, which was enacted by Congress as part of the Bipartisan Budget Act (BBA) of 2015 (P.L. 114-74) to enhance the ability of the Internal Revenue Service (IRS) to audit partnerships. In June 2017, the IRS issued proposed regulations (REG-136118-15) to provide further guidance on the implementation of the new audit procedures. The AICPA submitted comments to the IRS in Oct. 2016, June 2017, and Aug. 2017 and testified at the Sept. 18, 2017 IRS hearing.
State tax issues
As discussed in the March 2017 The Tax Adviser article, “State Challenges with the New Federal Partnership Audit Rules,” there are many state tax issues related to the new federal partnership audit procedures.
Of concern to the AICPA and other organizations is that not all states will respond in the same way with how to address the new federal procedures, which will contribute to additional complexity in resolving audit matters when dealing with a partnership operating in multiple states.
States are starting to consider their own legislation, which would cause substantial variances across the nation. Arizona, however, is the only state to have enacted legislation. One concern is that states attempting to adopt legislation similar to the new federal process could be constitutionally suspect. States, unlike taxes imposed at the federal level, have to be concerned with issues such as a partner’s state residency and making sure any tax is fairly apportioned. This will mean any new state laws related to adjustments from federal partnership audits will likely have to differ from the federal process in some ways, which is likely to impose significant administrative burdens on taxpayers and their representatives.
Numerous additional concerns exist at the state level. For example, partnerships and their partners will need to consider whether nexus existed in a particular state for the reviewed year versus the adjustment year. Resident/nonresident considerations may arise when individual partners move from one state to another between the reviewed year and the adjustment year. In addition, statute of limitations considerations for partners in overpayment situations to claim refunds are likely to exist. Additional concerns, also raised by state tax administrators, relate to the increased compliance burden of filing amended returns and obtaining enough detailed information from the federal audit to make proper adjustments at the state level.
Recent state activity
Many states are starting to address these issues.
To date, Arizona is the only state that has enacted legislation to address the federal changes. S.B. 1288 was signed into law on May 11, 2016. Arizona’s legislation provides some insight on how states might address these issues, but it does not comprehensively address federal changes and will need to address additional items such as tiered partnerships (presumably through its administrative regulatory process). Arizona likely will need to amend its enacted law to reflect the final IRS regulations as well as any statute changes in the possible technical corrections bill (which AICPA commented on in Nov. 2016) if it is ultimately enacted.
Four states (GA, MN, MO, and MT) considered legislation this year, with Georgia enacting a bill that was revised to exclude the partnership audits provision that was in the original bill. The other states did not move forward with the legislation.1 All the proposals had different approaches and were not as comprehensive as the draft model statute discussed later in this article.
AICPA efforts on state tax issues
To study, analyze, and provide possible recommendations to assist the state CPA societies regarding state tax partnership audit issues, the AICPA formed a State Partnership Audits Task Force, which is made up of members with expertise in state tax and partnership tax issues. Its most recent efforts are highlighted below:
- A joint task force was formed with the AICPA, the Council on State Taxation (COST), Tax Executives Institute (TEI), the American Bar Association (ABA) Tax Section’s State and Local Tax Committee, and the Institute for Professionals in Taxation (IPT) that is working in conjunction with the Multistate Tax Commission (MTC). A draft model bill, Uniform Statute and Regulations for Reporting Adjustments to Federal Taxable Income and Federal Partnership Audit Adjustments, was developed along with a presentation to the MTC Partnership Informational Project for consideration by the MTC Uniformity Committee at its Aug. 3, 2017 meeting. The MTC Uniformity Committee is using this draft model bill as its draft starting point. The draft model bill is still a work in progress.
- An MTC issue list was developed and the multi-organization task force developed a comprehensive list of issues related to the impending changes and a checklist for partnership conformity. In addition, the MTC developed a comparison of the MTC issue list to the proposed Montana legislation.
The AICPA supports efforts by state CPA societies that want to work with policymakers for a fair, reasonable, and administrable state partnership audit process that minimize the complexities and burdens to taxpayers and state tax authorities alike.
To assist in this effort, in March 2017, the AICPA developed and shared with the state CPA societies an AICPA Position Paper on State Conformity to Federal Partnership Audit Rules and a one-page summary on the issue. While waiting until the federal rules are further clarified, state CPA societies should start analyzing the impact of the new federal rules on their current state partnership audit rules and developing potential options to address these issues. To assist in this process, the AICPA provided recommendations that state CPA societies may want to consider as they work with their state legislatures and tax authorities.
In addition, in March 2017, the AICPA developed and shared with the state CPA societies and the MTC a related issue paper, AICPA Position Paper on RAR (Revenue Agent’s Report) – Reporting to State Tax Authorities of Federal Tax Examination Adjustments and their Effect on State Tax Liability, and a one-page summary on the issue. Currently, there is no consistent method for reporting federal tax examination adjustments and their effect on state tax liability to state tax authorities. States have not adopted a uniform notification period for reporting federal adjustments. This RAR issue is especially relevant due to the likelihood that states will consider changes related to the reporting of federal audit adjustments to accommodate the new federal partnership audit rules.
The AICPA presented the AICPA RAR paper to the MTC Uniformity Committee at its meeting on March 8, 2017. The AICPA encourages state CPA societies to work with policymakers to adopt guidelines and procedures to provide taxpayers with certainty and consistency. The AICPA supports the draft updated proposed Model Uniform (RAR) Statute for Reporting Adjustments to Federal Taxable Income that was submitted by the multi-organization task force to the MTC at its Dec. 14, 2016 meeting. The updated model RAR bill has now been incorporated into the draft model bill on partnership audits and RAR issues.
Draft state model legislation
The draft state model legislation is titled, Model Uniform Statute and Regulation for Reporting Adjustments to Federal Taxable Income and Federal Partnership Audits Adjustments.
The draft model legislation was designed to provide states with a uniform, simplified method to apply the results of a partnership audit conducted by the IRS under the new federal rules in effect for taxable years beginning Jan. 1, 2018.
The draft model bill is designed to work irrespective of which options are selected by a partnership within the new federal process.
The draft model legislation is a work in progress. As of September 27, 2017, it contains sections on:
- Reporting adjustments to federal taxable income (general rule and partnership-level audits)
- Assessments of additional state tax, interest, and penalties arising from adjustments to federal taxable income
- Estimated state tax payments during the course of a federal audit
- Claims for refund or credits of state tax arising from federal adjustments made by the IRS
- Scope of adjustments and extensions of time
- Effective date
What practitioners should do now
The federal changes are expected to increase the audit rates for partnerships dramatically. The new federal procedures revised the prior federal audit process extensively and will now have as the default the assessment and collection of tax at the partnership level unless certain elections and information filings are met. Partners should review and consider possible revisions to their partnership operating agreements. Once the federal issues are clarified further, the issues at the state level will need to be addressed.
Because the new federal rules generally apply to partnership returns filed after 2018, careful planning starting today will help mitigate any unfavorable consequences resulting from these changes. The AICPA has created a partnership audits resource center to help practitioners discuss these changes with their clients and avoid any unintended consequences that might occur under the new process. One of the tools available to Tax Section members is a draft client letter template on the new partnership audit changes. Further details regarding the draft model state legislation will be in the December 2017 and March 2018 The Tax Adviser. The AICPA will continue to keep members updated on developments and resources regarding partnership audits.
 See Georgia (House Bill 283 and then a revised substitute House Bill 283 that did not contain the partnership audits provision that was in the original bill), Minnesota (HF 1227), Missouri (SB 521), and Montana (House Bill No. 47). In all those states, the state CPA societies were engaged in discussions on the bills and assisted with efforts to delay action until there is federal clarity.