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Wiley Rein Tax Lawyer Michael Grace Raises Concerns That Final IRS Regulations Do Not Respect Disregarded Entities Under New Partnership Audit Rules
Michael J. Grace, consulting counsel in Wiley Rein’s Tax and Corporate Practices, has raised concerns that recently released final tax regulations do not allow partnerships having “disregarded entity” partners to elect out of the IRS’ Centralized Partnership Audit Regime. Mr. Grace was quoted in a January 2 Law360 on the final regulations, which were published in the Federal Register of January 2, 2018: 83 FR 24.
Centralized Partnership Audit Regime
Historically, the IRS has audited partnerships at the entity level. But then the agency has had to try to collect any resulting “deficiency” from the partners themselves.
In order to reduce administrative burdens on the IRS, the Bipartisan Budget Act of 2015 added to the Internal Revenue Code a Centralized Partnership Audit Regime (CPAR). Under these new rules, the IRS will continue to audit partnerships at the entity level. But the IRS, subject to exceptions, generally will also collect any deficiency from a partnership itself. The IRS no longer will have to “chase down” partners for its money.
In general, the CPAR applies for partnership tax years beginning after December 31, 2017. For example, for the many partnerships that use the calendar year as their tax year, the new rules first apply for the tax year consisting of calendar year 2018.
Ability to Elect Out
In general, partnerships having no more than 100 partners all of whom are “eligible partners” may elect out of the CPAR. If a partnership elects out, then the IRS must both audit and collect deficiencies at the partner level.
Eligible partners include individuals and corporations but, under the final regulations, not disregarded entities.
A “disregarded entity” is a legal entity of which one person (individual, corporation, etc.) owns 100%. Although respected as a separate legal entity for corporate and other non-tax legal purposes, the entity is disregarded (transparent) for most tax purposes. The entity itself does not file income tax returns. The owner reports all the entity’s tax-relevant items on the owner’s income tax returns.
Disregarded entities generally include limited liability companies (LLCs) having a sole member, often referred to as “single-member LLCs.”
Assume, for example, that a partnership has 100 individuals as partners all of whom own their partnership interests directly. The partnership may elect out of the CPAR. If, instead, even one partner owns any interest through a single-member LLC, then the partnership may not elect out of the new rules.
Mr. Grace’s Critique
According to Mr. Grace, the final regulations’ refusal to recognize disregarded entities as eligible partners contradicts commonly used and accepted structuring of legal entities to conduct businesses and make investments. He also finds the regulations’ position unnecessary to protect the IRS’ interests.
“My own opinion is I don’t think it was necessary for the final regulations to take that approach,” Mr. Grace told Law 360. “I think the IRS could have adequately protected itself without drawing such a bright line.” In his commentary to Law360, Mr. Grace suggested that the IRS can easily protect itself by requiring the partnership to provide information such as a disregarded entity owner’s name, address and other identifying data.
Mr. Grace also predicted that the U.S. Treasury Department and IRS likely will not change their position unless people “keep haranguing them about it.”
Mr. Grace also analyzed the CPAR in a bylined article, “New Partnership Auditing Procedures: Practical Responses and Drafting Strategies,” published in Bloomberg BNA’s 57 Tax Management Memorandum on September 19, 2016.