Getting states on board: A model for partnership tax audits
The rules have changed for IRS examinations and adjustments of partnership returns at the federal level, but are the states following suit? We’ll find out how model legislation issued by the Multistate Tax Commission, developed in collaboration with the AICPA and other stakeholders, is being adopted across the United States, harmonizing state laws with the new federal ones and bringing some uniformity to what otherwise are widely differing treatments of partnerships and their partners.
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Play the episode below or read the edited transcript:
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To comment on this podcast or to suggest an idea for another podcast, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com.
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Transcript:
Paul Bonner: Hello, and welcome to the Journal of Accountancy podcast. Our guest today is Eileen Sherr, CPA, CGMA, a senior manager in the AICPA’s Tax Policy and Advocacy team. She joins me from the AICPA’s Washington office. Hi, Eileen and thanks for speaking with us.
Eileen Sherr: Hello.
Bonner: My name is Paul Bonner. I am a senior editor of the JofA, and I’ve asked Eileen to bring us the latest on some important developments in the still relatively new regime by which the IRS audits the returns filed by partnerships and in many or most cases adjusts the income tax paid or owed by their partners. However, the corresponding procedures for state taxing authorities are still far from being coordinated with these federal changes, much less uniform among states. Isn’t that right, Eileen?
Sherr: Definitely.
Bonner: Maybe first you could tell us about your involvement and your role in bringing this issue to the fore.
Sherr: Sure. I’m the senior manager to the AICPA State and Local Tax Technical Resource Panel. As part of that panel, we have a task force, the AICPA State Partnership Audits Task Force. And that’s been working pretty much since the new federal rules have been enacted in 2015 as part of the Bipartisan Budget Act, the BBA, where Congress decided to change the regime for partnerships from what used to be the TEFRA regime, where IRS would have to go assess and collect from the partners directly in the partnership. And, obviously, with these big partnerships, that was very cumbersome for the IRS as well as the partners to deal with. And so the new BBA rules, the new partnership audit regime rules, for federal purposes, now the IRS would assess and collect at the partnership level. Of course, there’s an election to push out to the partners the adjustment. So, there’s an option within the new federal rules for that.
Also, the new federal rules now provide for a federal partnership representative, which used to be the tax matters partner. Now the partnership has to designate, when they file the return, that there’s a partnership representative that will be able to bind the partnership and negotiate with the IRS for the audit. They have that permission and authority. So those are some of the changes. There’s also, besides the pushout election, you can elect out of the regime for certain partnerships. And there’s lots of other rules that the IRS has come up with to implement the new rules.
Bonner: Right. Now, with respect to the states, what effect does that have?
Sherr: Sure. So, right now, in order for a state to be able to collect their share of the liabilities flowing from an IRS audit, they will need to enact legislation because most of their assessment and collection rules are separate from the Internal Revenue Code. So, if a state just conforms to the Internal Revenue Code, that will just mean that their state-level audits are the same way that the federal audits are being done. But it doesn’t necessarily mean that the state can collect based on the adjustment that’s made at the federal level and then the state gets their portion of those liabilities.
So, we’ve worked with various different organizations and, mostly, the Multistate Tax Commission, the MTC, to develop a model act at the state level that would help the states to be able to collect. A reasonable method that included practitioners, taxpayers, and the state departments of revenue were involved in developing it so that we could reach a compromise of a reasonable method that would work, and it would be clear that they’re going to assess it on the review-year partners, not on the adjustment year. So the year that’s under audit would be what the states are looking at, because of different residency and allocation and apportionment and nexus rules. There’s state consequences that the Congress did not have to consider at the federal level that the states are going to need to consider at the state level.
Bonner: And tax practitioners have to consider, ad nauseam, probably.
Sherr: Yes.
Bonner: So, we’re calling this the new federal partnership audit regime, but if it was enacted in 2015, why are we still calling it new?
Sherr: Oh, it is new, because it is just being implemented now. Basically, its effective date that Congress passed is for taxable years beginning Jan. 1, 2018. So, it was the 2018 tax returns that all these rules started having to take place on. And then they were filed in 2019, those tax returns. And then now, in 2020, the IRS will probably be starting to audit those 2018 tax returns.
One of the reasons that these rules were enacted was so that IRS is likely to increase their audits of partnerships. Compared to other types of businesses — corporations — their audits were lower, relatively. And there’s a lot of big partnerships out there now, and so IRS wanted to be able to audit it more efficiently. And so there’s probably going to be an uptick in the number of audits we’re going to see of partnerships now.
Bonner: I see. Well, it’s good that the AICPA is involved in this issue, as it requires coordination across so many jurisdictions, doesn’t it? How and why did the AICPA get interested in it, and what’s at stake for CPAs?
Sherr: Sure. Well, this is a profession issue, we think. There’s a lot of CPA firms that are partnerships; they’re structured that way. And, obviously, they have a lot of clients that are partnerships as well. So, we think it’s going to affect the profession, and we want to eliminate a lot of the inconsistent requirements across the states, as well as some complications and burdens and compliance challenges that would happen if every state enacted something different that didn’t really work. So, we thought a simplified, unified approach was good to try to get throughout the states so that the CPA firms, as well as their clients, will have an easier and more administrable time with facing these kinds of state assessments based on the IRS audit.
Bonner: I see. So how has the AICPA done this?
Sherr: We have been very active right from the start. First of all, we worked at the federal level working with Congress. We suggested some technical corrections right away in 2016, and Congress enacted many of them. So, we were very effective there. As well as, we did try to get a delay in the effective date because it was taking IRS quite a while to come out with the guidance and the forms and all that stuff. So, we asked for it; unfortunately, we didn’t get the delay. So, it did take effect for the 2018 returns.
We also were very active with commenting to IRS and Treasury on the regulations that they were issuing and suggestions we had. We started back in 2016 suggesting comments on the general issues. And then, starting in 2017, we testified and submitted comments again. And then in 2018 on the tax attributes. And then we proposed in this last set of regulations, which were all-encompassing, we were active with the hearing, testifying at the hearing, even, on that one. So, we’re still in dialogue with the IRS on these issues.
Bonner: And when you say “we,” who do you mean?
Sherr: The AICPA.
Bonner: Members?
Sherr: Within the tax advocacy group, we have a Partnership TRP, technical resource panel. And they’re primarily helping draft and in dialogue with IRS on the federal level.
Bonner: These are CPA volunteers who give of their expertise and time to advocate for these changes, aren’t they?
Sherr: Yes. We have 10 members on the technical resource panel, and, yes, the chair came and did the testimony at the IRS hearing.
Bonner: So, I understand that state CPA societies also are involved, as they should be. I suppose they have a stake in this, being closer to their state capitals, right?
Sherr: Right. And they’re the ones that advocate at the state level. They’re the ones that do the lobbying at the state level. The AICPA has a state legislative and regulatory group that I’m working closely with. And our State and Local Tax Technical Resource Panel is, also — we’re providing resources and trying to educate the state societies. Obviously, we’re very active working with the other state tax organizations to come up with the model and work with MTC. And then we provide the resources and the suggestions for the state societies to consider when they work with their departments of revenue and their state legislators. So, they’re the ones working directly on their various state legislative matters.
Bonner: Well, we’ve touched briefly on why this should matter for states. What are some of the additional considerations why they would want to enact this model legislation?
Sherr: Sure. Well, first of all, like I said, they need to enact legislation in order to collect their share of the liabilities coming from an IRS audit. So, because they don’t automatically have a mechanism, a lot of states do not tax partnerships. And those that do may not tax the partners or on the partnership income. So, they’re going to need to develop rules and methods for dealing with this new situation where the partnership’s the one under the audit and getting the adjustments at the federal level.
Also, they’re going to need to deal with the allocation and apportionment issues and the nexus issues. Like, if a partner moves out of state between the time the return was filed and the time afterwards, can the state go after that partner or not? So, there’s definitely a lot built into the MTC model statute that has these kind of considerations and will be very helpful for the states and the state societies to use as a starting point for when they’re drafting their legislation.
And when we developed the legislation, the model act, the departments of revenue were at the table and helping with drafting, and they realized — one of the provisions in it is the main default, for federal purposes, is that the partnership pays and you can elect to push out to the partners. The states thought that would be a little bit too challenging, and they thought it would be easier to administer if they kept it the way it’s always been in many of their states, with the partners filing amended returns. So, they wanted to make that the default, which we ended up doing with the model act. And there’s an election for the partnership to pay. So, it was a little bit flipped. And, actually, California preferred the federal approach, so they went with that.
But we think as long as there’s lots of options and flexibility built into the model to allow various parties to do what’s best for their own situation, that would be better. Also built into the model is, we have an option that you don’t have to do exactly as you did with the federal. So, if you decided to push out at the federal level, you can opt to have the partnership pay at a state where there’s just little bit of liability involved, and it’s just easier than having all the partners deal with it at the state level. So, there’s options —
Bonner: There are menu options.
Sherr: — within the model. Lots of options.
Bonner: Yeah. Which states like, to have their options, I’m sure.
Sherr: And taxpayers. Good for everybody.
Bonner: And taxpayers, right. Yeah. It provides a clear definition of “final determination.” When is final really final? I guess we all wonder that, don’t we?
Sherr: Yes. And that is a very important point that’s in this bill. It’s basically when all your options for appeals are drained. You’ve exhausted all of them at the federal level, that’s the final time when you — that’s the start of the clock for the — and we had 180 days that you have to report to the state. And interest will still accrue until you actually pay the amount, so the states aren’t losing any money in the process. But it gives time, and everybody would be consistent with when the clock starts.
And one other thing I want to point out in the model is, in addition to dealing with the new federal regime for partnerships, it also covers what we call RAR, revenue agent report. Just all reporting of federal adjustments from the IRS audits will now be covered in the model act. So, it really makes a lot more consistency throughout the states for all tax returns, all types of taxpayers, not just partnerships. I think it’s a good time to fix those.
Bonner: This provision caught my eye, “An equal statute of limitation even if no return is filed.” Now, under federal law, if no return is filed, there is no statute of limitation, but there could be one for the states, which intrigues me. What is that all about?
Sherr: Basically, it cuts off when the taxpayer and the state can still look at different things in the return, and once you’ve reached the end, that is it. And it also should only be limited to what was in that actual audit, in the IRS audit; they can’t start looking at other things.
Bonner: That sounds like an important protection.
Sherr: Yes. And it would be a six-year maximum period for the tax assessment.
Bonner: That sounds like a reasonable limitation.
Sherr: And, of course, if there’s fraud, then it would be changed, but —
Bonner: Yes. No statute of limitation on fraud either, under federal law.
Sherr: Yeah. And also, one other thing I just want to point out. Within the model, we had a mutual-agreement provision that if the partnership representative and the state agreed on a different type of method of reporting or payment, then as long as both of them agree, and they’re both fine with it, it gives some flexibility that they could come up with a different way to deal with it.
Bonner: Another feature that caught my eye is that you can have a different state-level tax partnership representative than your partnership representative at the federal level, which seems to me it could be handy if say you’re a California business that have most of your sales in, say, Maryland. And wouldn’t it be nice if you had your state partnership representative in Maryland where they could not have to travel across the country to talk with the tax representatives?
Sherr: Exactly. And we thought that we could even have it at different state representatives for each state. You could have one person that’s the federal representative continue to be the main person. But we thought it was best if the federal representative could designate a state person and that could be the primary person to work with the state.
Bonner: More options and flexibility there. I like that. So why is it important for the states to adopt this model in 2020 if they haven’t done so already?
Sherr: Like I said, it’s just starting to take effect at the federal level now in 2020 that you’re going to start seeing some audits under the new regime. And the states, if they want to collect their share of what’s coming out of the IRS audit, then they’re going to need to enact legislation to be able to do that. We don’t think that there’s mechanisms right now built in to deal with all these new types of rules and how to get it. So, it’s important for the states to consider it. And it’s important for the taxpayers and practitioners that the states do this because they’re going to be operating and it’s going to be very confusing and challenging if all states do it all differently or they’re not able to deal with it once these audits start happening.
Bonner: Or they’re still looking for that TEFRA tax matters partner and can’t find it.
Sherr: Exactly. And to deal with all the new rules, all the elections and things like that.
Bonner: Yeah. I understand that the model legislation has been out for about a year now. I have a copy of it here. It’s a very reasonable size of number of pages. And it is available on the MTC website. So, have many states adopted it so far?
Sherr: Only five states have really followed the model. And Georgia’s is the best example I would suggest people look at. Theirs really closely followed the model act, and it was enacted in 2018. California did a good job, also in 2018, but it’s a little bit different. And then Ohio, Oregon, and West Virginia have also adopted it this past year to a general extent. So those states are good, and they’re ready to move ahead in this area.
There’s been four other states that have dealt with partnership audits, but I don’t think very effectively. And I think they’re probably going to have to go back and amend the legislation that they enacted. Arizona was the first, back in 2016, to do it. But that was before all the technical corrections, before all the IRS guidance. We’ve already talked with the state society there, and they’re aware that they need to make some fixes to their legislation. Rhode Island and Maine passed it last year, their legislation. But it’s missing the pushout election in some of the places and other fixes. And we’re already talking to the Rhode Island Society of CPAs there about their legislation. And the last thing is Hawaii. They passed it a while ago, and their legislation really only talks about state partnership audits. It doesn’t really talk about the state collecting based on the adjustment at the federal level. So, they’re probably going to need to amend their statutes.
Bonner: I should say at this point that you are the author of an article in The Tax Adviser for March that discusses this: “Why States Should Adopt the MTC Model for Federal Partnership Audits.” And it includes two handy-dandy U.S. maps showing all these states and their various statuses, which I think is cool.
Sherr: Yes! And did you know that — we haven’t added that in, but there’s a few states now in 2020 that have already introduced legislation. Virginia just did, and it follows the model act, which is good. Missouri also follows the MTC model act. And we think a lot more states are going to be considering it coming forward. We think Alabama, Delaware, Indiana, maybe Louisiana and Kentucky, Maryland, Michigan, Minnesota — those M’s — and New York and South Dakota are — and I will mention Minnesota’s had two versions of the bill in prior years. One of the versions the state society was pushing that had the model act. And another that the department of revenue was pushing. So, they’re going to maybe come to a meeting of the minds this year. We’ll have to see or not. So, that’s been interesting to watch that.
Bonner: Okay. We will stay tuned for that. I will be able on our podcast to provide some links to the more information that you helpfully provided, and we’ll share those with our listeners as well if they go to the main podcast webpage. With that, we will say thank you very much for telling us about these changes and the changes to come.
Sherr: Great! I’ve enjoyed talking to you.
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