Regulations were proposed, withdrawn, and re-proposed again
in essentially the same form.
Under the new rules all adjustments and items relating to a
partnership are determined at the partnership level. Further,
any Chapter 1 tax (and penalties and interest) resulting from
an adjustment to items under the centralised partnership audit
regime is assessed and collected at the partnership level.
Therefore, unless an exception applies, if a partnership
adjustment results in an imputed underpayment, the partnership
must pay the imputed underpayment in the adjustment year.
The statute (Section 6226) permits certain partnerships to
elect out of the rule requiring the partnership to pay an
adjustment and to shift the responsibility to the partners.
Many recent partnership agreements express a preference that
this election be made.
Section 6221 also permits a complete election-out from the
new rules if certain criteria are met. The election must be
made on a timely filed partnership tax return for the year to
which the election relates.
There could be uncertainty in respect of both the
partnership's and a foreign partner's liability if the
partnership has not fully withheld tax on ECI allocated to a
foreign partner under Inland Revenue Code (IRC) Section 1446.
Under longstanding rules, the foreign partner, of course, is
liable for tax on any ECI allocated to it, and the partnership
is liable as well to the extent it fails to withhold under IRC
The new rules add extra layers of complexity to this
situation. For example, if the Internal Revenue Service (IRS)
increases the partnership's ECI amount (resulting in under
withholding by the partnership in the year under audit) and a
partnership makes a Section 6226 election, how must both the
foreign partner and the partnership take the adjustment into
account? How, and on whom, are penalties calculated?
The new rules raise other issues as well. They require a
partner on its individual return to report items consistently
with the partnership's treatment. Penalties can apply if the
partner does not make such consistent reporting.
One significant, and potentially dangerous, area involves
so-called "de facto" partnerships. The IRS sometimes asserts,
often in a cross border situation, that a business arrangement
is "in fact" a partnership for US tax purposes even if there is
no partnership agreement or a legal entity that is commercially
treated as a partnership. The parties, therefore, might not
think that they have a partnership. In FSAs 1999-1230,
for example, the transaction involved the construction of a
paper mill in the US. In FSA 200144015 and ILM
200606035 the transaction involved the distribution of
products by a US entity for a foreign enterprise.
While IRS examiners are not always successful in making
these assertions, as shown in these rulings, there can be a
number of consequences of partnership treatment if upheld. The
US "partner" could be effectively a § 1446 withholding
agent. Partnership elections will not have been made. Now we
can add to the list consequences under the centralised
partnership new audit rules.
Jim Fuller (firstname.lastname@example.org)
and David Forst (email@example.com)
Fenwick & West