The IRS loves consistency in partnerships

The Internal Revenue Service has been steadily ramping up its enforcement of partnership tax compliance. The Bipartisan Budget Act of 2015 streamlined the framework for auditing of partnership tax returns and made it easier for the IRS to assess any resulting tax. The IRS also announced implementation of the Large Partnership Compliance Pilot Program, designed to identify the largest partnership cases and develop improved methods of identifying and assessing the compliance risks. 

Additionally, the IRS made a large hiring push for revenue agents and tax law specialists, and stated that it plans to increase the number of partnership audits by 50% in the 2021 fiscal year. Furthermore, the recent Inflation Reduction Act of 2022 provided significant additional funding for the IRS to increase enforcement efforts.

An entity that is treated as a partnership for U.S. federal tax purposes is not itself subject to U.S. federal income tax. Each partner on its separate tax return takes into account the distributive share of the partnership’s income, gain, loss, deductions and credits. In other words, partners are liable for their share of the income tax and can deduct their share of losses (subject to limitations) in their separate individual capacities.

A question sometimes arises whether a partner in a partnership can report an item of income or loss from the partnership in a manner that is inconsistent with the way the partnership reports the item. The general answer is no, because U.S. federal tax law, specifically Section 6222, requires a partner, on its return, to treat any partnership-related item in a manner which is consistent with the treatment of such item on the partnership return that was actually filed. Consistent treatment includes, among other things, treating the amount, timing and characterization of items consistently. 

If a partner violates the consistency requirement (without filing a notice described below), the main consequence is that the IRS can adjust the inconsistent items and determine any underpayment of tax resulting from the adjustment. Then, the IRS can assess and collect the underpayments of taxes using an expedited procedure for mathematical and clerical errors. The Computational Adjustment procedure dispenses with the regular procedure for the taxpayer to contest the tax liability by filing a request for abatement or by filing a petition with the tax court. Instead, the partner subject to Computational Adjustment would have to pay the asserted tax liability, and the only avenue of contesting it would be suing for refund in a U.S. District Court or the U.S. Court of Federal Claims.

A partner who files a tax return inconsistently with the partnership tax return can avoid the threat of Computational Adjustment by filing with the tax return IRS Form 8082, “Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR).” Filing Form 8082 does not mean that the IRS will accept the inconsistent tax treatment. The items disclosed on Form 8082 as inconsistent would avoid being subject to Computational Adjustment, but the IRS still has the option of adjusting those items by conducting regular partner-level or partnership-level audits.

Application to indirect partners

Since it is common to have multiple tiers of partnerships in business structures, the consistency regulations provide a rule for indirect partners. As illustrated in the diagram below, an indirect partner is a partner who holds an interest in the “source partnership” through another intermediate partnership.

An indirect partner who files a tax return consistently with the tax return of the source partnership will satisfy the consistency requirement, regardless of whether the indirect partner files consistently with the pass-through partner. If an indirect partner files a tax return inconsistently with the tax return of the source partnership, such a partner can avoid Computational Adjustments if either the indirect partner or the pass-through partner notifies the IRS of the inconsistency by attaching the IRS Form 8082 to its tax return.

Foreign partnerships and partnership that do not file tax returns

If a partnership is required to file a tax return and does not file it, then a partner’s treatment of items relating to that partnership is per se inconsistent. This rule applies to both U.S. and foreign (non-U.S.) partnerships, but it creates a particular concern for partners in foreign partnerships because many foreign partnerships do not file U.S. tax returns.

For purposes of the consistency rules, the term “partnership” is defined as any partnership required to file a return under Section 6031(a). A foreign partnership, however, is required to file a U.S. partnership tax return under Section 6031(a) only if it has (i) gross income that is effectively connected with a U.S. trade or business or (ii) income from sources within the United States. Thus, although the regulations do not expressly address this issue, arguably the consistency rules only apply to U.S. partners in foreign partnerships that are required to file U.S. tax returns and do not apply to U.S. partners in foreign partnerships that are not required to file U.S. tax returns. If a partner has a small, noncontrolling interest in a foreign partnership, it is not clear how the partner is supposed to determine whether the foreign partnership has a U.S. tax filing obligation. U.S. partners with a significant interest in a foreign partnership (generally, an interest of 10% or more) are usually required to file an informational return on IRS Form 8865, “Return of U.S. Persons With Respect to Certain Foreign Partnerships.” Presumably, those partners have sufficient leverage over the partnership to obtain the information required for the Form 8865. To the extent possible, the partner investing a foreign partnership should ensure that the partnership agreement provides the right to obtain all of the information reasonably necessary for the partner to file the U.S. income tax returns.

Partnership tax return is inconsistent with the Schedule K-1 supplied to the partner

In some cases, the information supplied by a partnership to its partner is not consistent with the information included on the partnership’s tax return. This can happen either because of a mistake or because the tax return is filed at a later date when more accurate information is available.

The regulations emphasize that a partner must treat the item consistently with the tax return filed by the partnership, not just with the Schedule K-1 or other information supplied by the partnership to the partner. The regulations provide an example where the partner receives a K-1 showing $15,000 of loss allocated to the partner, but the partnership’s actually filed tax return shows only $5,000 of loss allocated to such partner. The example concludes that the partner reporting $15,000 loss (based on the Schedule K-1) would not satisfy the consistent reporting requirement.

The regulations, however, provide a procedure to avoid Computational Adjustment for a partner who files consistently with the information supplied by the partnerships. The partner would first receive a notice from the IRS, alerting the partner about the inconsistency (Letter 6202, Notice of Partner’s Inconsistency). Within 60 days of receiving such a notice from the IRS, the partner can elect to be treated retroactively as having given proper notice of inconsistent treatment, which is equivalent to timely filing a Form 8082 as described above. The IRS can still audit and assess the partner or the partnership, but would have to use the regular procedures instead of using Computational Adjustment.

The centralized partnership audit regime enacted by the BBA generally provides that the IRS may assess and collect the underpayments of taxes from the partnership itself. The partnership, however, can elect to “push out” the liability to the partners and former partners. The regulations provide that the tax returns of the partners to whom the liability was “pushed out” will not be treated as having been filed consistently. Thus, the IRS can assess and collect the “pushed out” liability through the simplified Computational Adjustment.

Key takeaways

As the IRS is increasing its scrutiny of partnerships, taxpayers holding interests in a partnership should be aware of the fairly strict consistency requirements. Furthermore, because filing inconsistent tax returns may lead to an audit of the partnership and other partners, the partnership agreement may incorporate either a contractual obligation for the partners to file consistently, or an obligation to notify the partnership of an inconsistent tax filing. Finally, a partner who has a significant interest in a partnership may wish to negotiate for some control over “push out” elections made by the partnership representative under the BBA. 

As with other partnership tax issues, the rules are complex, contain many exceptions, and are subject to change.