More partnerships than first thought were affected by significant changes in how partnerships (including multi-member LLCs) are treated for federal income tax purposes in 2018. Because of the Bipartisan Budget Act of 2015, the IRS is now able to audit some “big”
partnerships rather than just the individual members and impose an income tax, interest, and penalty assessments against the partnership as a whole.
IRS partnership audits have started, and some “super auditors” are now ready to begin their training.
From IRS representatives, we also heard that a surprising number of smaller partnerships did not use their annual right to opt-out of the comprehensive partnership audit regime (CPAR). As a result, they are now obligated to follow the new audit regulations, whether they like it or not.
Because partnerships are pass-through businesses with owner-level tax obligations and are not regarded as taxpayers under state law, most state laws do not permit the direct assessment of partnerships. With the implementation of the CPAR, states now have three options:
(1) pass legislation giving them the authority to independently audit and assess specific partnerships;
(2) substantially comply with the new federal CPAR and wait for the IRS to provide information on recent audits of partnerships with ties to that state; or
(3) do nothing and allow what could be sizable sums of state tax revenue to go uncollected.
A number of these organizations decided to negotiate a model statute that could be adopted by every state that imposes a net income tax because professional and business trade associations were worried that their partnership clients/members might be subject to multiple states audits in addition to a thorough IRS audit.
This model was developed over about two years at meetings involving representatives of the Multistate Tax Commission (MTC), the AICPA, the Council on State Taxation (COST), the ABA Tax Section*, and the Tax Executives Institute, the Institute for Professionals in Taxation, and other organizations.
In January 2019, the MTC approved and the other organizations quickly supported the MTC Model Statute. Fortunately, the model statute essentially supports the second choice, enabling only the IRS to perform partnership audits and then handing along the audit material to the states to proceed with their own assessments.
The Model Statute is important in that it addresses reporting federal audit changes for all taxpayers, not only partnerships, even though numerous states have passed versions that solely apply to partnerships.
With the addition of more revenue agents as a result of the Inflation Reduction Act of 2022, the model is intended to give states a standard, straightforward mechanism to apply the findings of IRS partnership audits, which may rise significantly.
However, the Model Statute offers taxpayers and their partnership representatives several state-level options that may differ from their federal choice.
Choosing to “push out” the obligation for the assessment to individuals who were partners during the audit period for federal tax purposes while choosing, on a state-by-state basis, whether to have the partnership itself pay the apportioned amount of the assessment is a suitable example.
To create its own version of the Model Statute, the Alabama Department of Revenue (ADOR) and the Alabama State Bar Tax Section collaborated on a project abandoned more than a year ago.
The Alabama Society of CPAs and the State Bar Tax Section will likely work together on this project again, and the ADOR recently stated that it plans to restart it. The ADOR will then polish its draft in preparation for possible submission in the Spring 2023 legislative session.
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We anticipate that several additional states, including Alabama, will take the idea under consideration in their upcoming legislative sessions in light of the anticipated rise in IRS partnership audits, the Inflation Reduction Act of 2022’s approval by President Biden, and the fact that the vast majority of states with individual income taxes have already adopted all or significant portions of the Model Statute.
All partnerships (including multi-member LLCs) should also use this opportunity to have their tax advisors evaluate their organizational forms and make any required adjustments to ensure compliance with the CPAR and related state legislation.
Here is where you may get the AICPA’s viewpoint on the Model Statute. You may find a thorough history of the Model Statute here, along with several helpful connected articles.
