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US Inbound: Partnership audit regime raises complexities


The Tax Act of 2015 set forth a new centralised partnership audit regime that goes into effect for partnership tax years beginning on and after January 1 2018. A number of issues raised by the new partnership rules affect foreign partners.


Jim Fuller

David Forst

Regulations were proposed, withdrawn, and re-proposed again in essentially the same form.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 Section 1446.

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 ( and David Forst (

Fenwick & West


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