The IRS Large Business and International Division and Small Business/Self-Employed Division issued an Internal Guidance Memorandum to IRS personnel regarding interim field examination procedures under the partnership audit rules that were enacted as part of the Bipartisan Budget Act of 2015 (the BBA rules).[1]

The memorandum, the PDF of which is 66 pages long, contains provisions that are to be used until the Internal Revenue Manual is formally updated for the program.  The memorandum contains the following sections:

• Delinquent Return and Substitute for Return (SFR)

• Compliance Assurance Process (CAP)

• Partnerships in Bankruptcy and Cease to Exist

• BBA Scope — Adjustments at the Partnership Level

• Planning the Examination

• Executing the Examination

• Resolving the Examination

• Report Writing

• Case Disposition Procedures

While the document outlines procedures agents are to use in exams, it does contain some interesting reminders about the BBA regime and some of the IRS’s views of how the law operates.

Overview Section

The memorandum, in the Overview Section, reminds IRS employees that the partnership representative is the sole party authorized to act on behalf of the partnership:

A partnership must designate a partnership representative. The partnership representative has sole authority to act on behalf of the partnership. Partners are bound by the decisions made by the partnership representative. Direct and indirect partners have no participation rights during the examination. (emphasis added)[2]

The overview also indicates how the IRS will approach partnership level math errors:

The BBA regime also provides that if an adjustment is identified on account of a mathematical or clerical error appearing on the partnership return, the IRS may make an adjustment to correct the error and may assess the partnership an imputed underpayment resulting from that adjustment. The notice to the partnership of the adjustment on the basis of correcting the error is not considered a notice of final partnership adjustment under section 6231(a)(3). [3]

For large taxpayers involved in the Compliance Assurance Process[4] the memo notes that since the process takes place before a return is filed, the CAP process is not subject to the BBA regime rules.[5]

Bankrupt Partnerships and Partnerships No Longer in Existence

If a partnership is currently involved in a Title 11 bankruptcy case the IRS cannot make the adjustment assessment or make collections during the case.  But the IRS can take the following actions while the case is before the Bankruptcy Court:

• A BBA examination,

• The mailing of any notice with respect to a BBA examination,

• The issuance of a Notice of Administrative Proceeding (NAP), Notice of Partnership Proposed Adjustment Package (NOPPA), and Notice of Final Partnership Adjustment (FPA),

• A demand for tax returns,

• The assessment of any tax and imputed underpayment, or

• The issuance of notice and demand for payment.[6]

The final regulations indicated that if a partnership no longer exists, the IRS would look to the partners to pay any assessment.  The memo indicates the IRS will deem the partnership to cease to exist in the following cases:

A partnership ceases to exist if the IRS makes a determination that such partnership (including partnership-partner):

A. Terminates within the meaning of § 708(b)(1), or

B. Does not have the ability to pay, in full, any amount due (not collectible).[7]

Partnership Related Items (PRIs) and Partner Only Items

The memo notes that the BBA regime applies to any partnership-related item (PRI), and not to items shown on another party’s return that results after the application of the IRC to a PRI based on a specific taxpayer’s facts and circumstances.[8]  Of course, figuring out the dividing line between those “in the partnership” and “outside the partnership” items was a troubling issue in the prior TEFRA regime, and it is reasonable to expect the same will be true in the BBA regime.

The memo does provide a list of items the IRS deems to be examples of PRIs:

• The character, timing, source, and amount of the partnership’s income, gain, loss, deductions, and credits;

• The character, timing, and source of the partnership’s activities;

• The character, timing, source, value, and amount of any contributions to, and distributions from, the partnership;

• The partnership’s basis in its assets, the character and type of the assets, and the value (or revaluation) of the assets;

• The amount and character of partnership liabilities and any changes to those liabilities from the preceding tax year;

• The category, timing, and amount of the partnership’s creditable expenditures;

• Any item or amount resulting from a partnership termination;

• Any item or amount relating to an election under section 754; and

• Partnership allocations and any special allocations.[9]

As well, the IRS provides a shorter list of items it deems not PRIs:

• A deduction shown on the return of a partner that results after applying (correctly or incorrectly) a limitation under the Code (such as section 170(b)) at the partner level to a partnership-related item based on the partner’s facts and circumstances, and

• A partner’s adjusted basis in his/her partnership interest (outside basis).[10]

The memo also notes that components of a partner’s basis may be PRI.[11]

The BBA regime only applies to taxes imposed under Chapter 1 of Subtitle A of the IRC—that is, Income Taxes.  The memo notes that specifically this means the BBA exam does not cover the following partnership related taxes:

• Chapter 2 (Tax on Self-Employment Income — “SECA”)

• Chapter 2A (Unearned Income Medicare Contribution — “NIIT”)

• Chapter 3 (Withholding of Tax on Nonresident Aliens and Foreign Corporations)

• Chapter 4 (Taxes to Enforce Reporting on Certain Foreign Accounts)[12]

The memo notes that a special quirk applies to Chapter 2 (Self-Employment) and Chapter 2A (Net Investment Income Tax) with regard to the statute of limitations on assessments.  IRC §6501(c)(12) provides the following special rule that extends the statute in certain cases for these taxes that are impacted by partnership level adjustments:

(12) Certain taxes attributable to partnership adjustments

In the case of any partnership adjustment determined under subchapter C of chapter 63, the period for assessment of any tax imposed under chapter 2 or 2A which is attributable to such adjustment shall not expire before the date that is 1 year after—

(A) in the case of an adjustment pursuant to the decision of a court in a proceeding brought under section 6234, such decision becomes final, or

(B) in any other case, 90 days after the date on which the notice of the final partnership adjustment is mailed under section 6231.[13]

The IRS warns its employees that this rule may not apply if the partnership did not report any self-employment income or income subject to net investment income tax on the original return:

If a partnership improperly classifies income, or does not classify income at all, as subject to SECA or NIIT on its originally filed return, there is a risk that section 6501(c)(12) will not apply to the assessment of any tax imposed under chapter 2 or 2A which is attributable to partnership adjustments determined under the BBA regime. In this case, you must protect partners’ section 6501(a) statutes to assess SECA or NIIT related to both their originally reported distributive share and/or to their distributive share of adjustments to PRIs you make at the BBA partnership level. Example — your sole adjustment is to increase net earnings from self-employment on line 14 of Schedule K-1 from zero to equal to ordinary income on line 1 of Schedule K-1.[14]

The memo goes on to provide details of how the agent is to handle the complexities of this situation,[15] concluding with a series of examples of both partner-level audits and partnership-level audits on these issues.

Example 1 - Partner-Level audit[16]

An examiner is auditing the Form 1040 of an individual taxpayer. Taxpayer is a partner in a partnership that is subject to the BBA regime. The partnership issued a Schedule K-1 to the partner reporting $100,000 of ordinary income on line 1 and $100,000 of income subject to SECA on line 14 of Schedule K. The partner did not report the income as subject to SECA. The examiner determines, as part of the individual’s audit, a chapter 2 deficiency of $3,800 ($100,000 X 3.8% maximum Medicare rate). BBA doesn’t apply to taxes under chapter 2 and the inconsistent reporting rules under section 6222 can’t be used to assess non-chapter 1 taxes. The examiner is not required to open an audit of the BBA partnership because there’s no adjustments to PRI.

Example 2 - Partner-Level audit[17]

An examiner is auditing the Form 1040 of an individual taxpayer. That taxpayer is a partner in a partnership that is subject to the BBA. The partnership issued a Schedule K-1 to the partner reporting $100,000 of section 1231 gain on line 10 of schedule K from the sale of assets used in one of its trade or business activities. The partner did not report the income as subject to NIIT. The examiner determines, as part of the individual’s audit, that the partner was a passive investor in the BBA partnership and its activities. As such the examiner determines a chapter 2A deficiency of $3,800. This adjustment and assessment is made in a proceeding outside of the BBA regime; the examiner is not required to open an audit of the partnership under the BBA regime because the partner’s failure to include this income as NIIT is exclusively a partner level issue.

Example 3 - Partner-Level audit[18]

An examiner is auditing the Form 1040 of an individual taxpayer. That taxpayer is a partner in a partnership that is subject to the BBA. The partnership issued a Schedule K-1 to the partner reporting $100,000 of ordinary income on line 1 and $0 of income subject to SECA on line 14 of Schedule K. The partner did not report the income as subject to SECA. Examiner reviews the partnership’s other partners and notes that all its partners took similar positions with respect to SECA that they, as partners, were not subject to SECA. The examiner may open the partnership for examination and follow dual procedures. Primarily the examiner will make a $100,000 PRI adjustment to line 14 of Schedule K-1 and compute an IU[19] of $37,000. The examiner is required to utilize BBA PCS linking procedures to have the CPF issue substantially similar SNDs for SECA tax to all the partnerships’ partners and protect the partners’ 6501(a) statutes; these SNDs will state that the partner is subject to SECA on their distributive share of income from the BBA partnership because (state reason; i.e., The IRS has determined that your interest in the BBA partnership is not a limited partnership interest for purposes of Chapter 2 SECA) and this $3,800 ($100,000 X 3.8% maximum Medicare rate) assessment of SECA will be made at the partner level.

Example 1 - PartnerSHIP-Level audit[20]

An examiner is auditing the Form 1065 of a partnership subject to the BBA. The partnership has 10 equal individual partners. The partnership reported $1,000,000 of ordinary income on schedule K, line 1 and reported that $0 of that income as subject to SECA on schedule K, line 14. The examiner determines that the partnership should have reported the entire $1,000,000 on line 14 of Schedule K as subject to SECA. There is no other adjustments to a PRI. Under dual procedures, primarily, this PRI adjustment will result in an IU. Secondarily, the $1,000,000 adjustment to line 14 must be taken into account for purposes of determining the partners’ SECA tax obligations. The IRS may adjust and assess each partners’ SECA tax liabilities on their individual returns. Since each partner is an equal partner, each partners’ income subject to SECA will be increased by $100,000 or 10% of the increase to line 14 of Schedule K-1. The IRS will issue a SND stating that the partner is subject to SECA on their distributive share of income from the BBA partnership and assess $3,800 ($100,000 X 3.8% maximum Medicare rate) to each partner for their SECA tax related to an adjustment made to the BBA partnership. The examiner must follow the BBA linkage procedures and protect the partners’ section 6501(a) statutes.

The memo also discusses the interaction with Chapter 3 and 4 withholding taxes and procedures to deal with such taxes which generally are outside of the BBA regime.[21] As with the SEC and NII issues, the memo contains examples of such situations arising in a Chapter 3 or 4 audit.

Example A – Chapter 3 or 4 Audits[22]

An examiner is auditing Form 1042 filed by a partnership subject to the BBA regime. The partnership has 2 equal partners, one is a US citizen and one is a non-resident alien who is a resident of another country. The partnership earned $200 of US source royalty income and reported $100 on each partner’s Schedule K-1. The partnership withheld $15 from the foreign partner. The examiner proposes a rate adjustment and determines that the partnership should have withheld $30 from the foreign partner. As such the examiner determines a chapter 3 deficiency of $15. This adjustment and assessment is made in a proceeding outside of the BBA because the tax imposed on the partnership for its failure to withhold on that income, however, is not a tax imposed by chapter 1. Rather, it is a tax imposed by chapter 3, which is not covered by the BBA. Even though the examiner is auditing the partnership’s Form 1042, the examiner is not required to open an audit of the BBA partnership’s Form 1065.

Example B – Chapter 3 or 4 Audits[23]

An examiner is auditing Form 1065 filed by a partnership subject to the BBA. The partnership has 2 equal partners, one is a US citizen and one is a nonresident alien who is a resident of another country. The partnership earned $200,000 of US source royalty income and reported $100,000 on each partner's Schedule K-1. The examiner notes that the partnership properly withheld $30,000 from the foreign partner. The examiner determines, as part of the Form 1065 audit, that the partnership should have reported $400,000 of US source royalty income and proposes a base adjustment. The imputed underpayment is $74,000, calculated as the $200,000 adjustment to royalty income subject to chapter 1 income tax times the maximum individual rate of 37%. The examiner notes that the partnership should have withheld an additional $30,000 from the foreign partner. In this instance, the $37,000 imputed underpayment attributable to the foreign partner's $100,000 allocable share of the adjustment satisfies the partnership's requirement to withhold chapter 3 tax; if the partnership elects to push out the partnership adjustment, the partnership must remit $30,000 of chapter 3 withholding on behalf of the foreign partner's $100,000 allocable share of the adjustment.

Example C – Chapter 3 or 4 Audits[24]

Similar facts in example B except that the examiner is auditing Form 1042 (instead of Form 1065) and discovers the under-reported royalty. The examiner may determine, assess, and collect chapter 3 tax attributable to an adjustment to a partnership-related item (increase the partnership’s royalty income) without conducting a BBA examination. The examiner’s assessment will be limited to $30,000 (not the $74,000 imputed underpayment), the chapter 3 withholding attributable to the foreign partner. This adjustment and assessment is made in a proceeding outside of the BBA because the tax imposed on the partnership for its failure to withhold on that income, however, is not a tax imposed by chapter 1. Rather, it is a tax imposed by chapter 3, which is not covered by the BBA. Even though the examiner is auditing the partnership’s Form 1042, the examiner is not required to open an audit of the BBA partnership’s Form 1065.

Electing Out of the BBA Regime

The memo has provisions that examining agents will use when facing a partnership that made an election out of the BBA regime for one or more years under exam.  First, the memorandum directs the agent to see if a timely election was made.  The memo notes the following:

A. Non-filers can’t elect out because there was no return filed. The election can’t be made on a substitute for return (SFR). The SFR will be subject to the centralized partnership audit regime.

B. Similarly, a constructive or de facto partnership would be subject to the centralized partnership audit regime because it would not have made a timely election.[25]

Assuming the election was timely, the memo next goes on to direct the examining agent to determine if the partnership was eligible to make the election.  The memo provides:

1. There are two criteria that a partnership must meet to be eligible to elect out of the BBA:

A. The partnership may only have partners each of whom is an individual, a C corporation, an estate of a deceased partner, or an S Corporation, and

B. The partnership is required to furnish 100 or fewer Schedule K-1s.

2. If either one of these requirements is not met, the partnership is not eligible to elect out and is automatically subject to the BBA regime.[26]

An interesting provision is found in the discussion of S corporation shareholders, with the memo noting:

S Corporations may have shareholders (such as QSSTs and/or ESBTs) that would otherwise be ineligible if they were direct partners. The type of shareholders doesn't factor into the determination of eligible partners.

Note: Partnerships that have Q-Sub(s) as a partner are not permitted to elect out.[27]

A similar analysis is provided by the memo with regard to beneficiaries of a decedent’s estate:

An estate of a deceased partner filing Form 1041 may issue Schedule K-1s to its beneficiaries. Similar to S Corporations, an estate may have beneficiaries that would otherwise be ineligible if they were direct partners. The type of beneficiaries doesn't factor into the determination of eligible partners.[28]

The memo reminds agents that having the following types of entities as a partner during the year under examination would automatically render the election invalid:

• A partnership or limited liability company

• Any type of trust, even a grantor trust

• A foreign entity that would not be treated as a C Corporation if it were a domestic entity

• A disregarded entity for federal tax purposes

• An estate of an individual other than a deceased partner or

• A nominee.[29]

As well, the memo notes that “[i]f any of the partners are LLC whose type of entity is reported as a corporation, IDRS must be researched to verify the filing status of the LLC as a corporation and not a pass-through entity.”[30]

The memo also notes the 100 K-1 limitation and some quirks there.  First, the memo makes clear the limit is based on the number of K-1s required to be issued for a year, not the number actually issued.  So a partnership that failed to issue one or more K-1s would have to add those required but not issued K-1s to the number actually filed to determine the 100 K-1 limit.[31]

For an S corporation partner, the 100 K-1 count includes both the K-1 issued to the corporation and each K-1 issued by the S corporation to its shareholders:

Because S corporations are allowable partners and issue Schedule K-1s to their shareholders, in the determination of whether the partnership has furnished 100 or fewer Schedule K-1s, the Schedule K-1 furnished to the S corporation partner counts as one Schedule K-1 while all of the Schedule K-1s required to be furnished to the shareholders of the S corporation partner count as additional Schedule K-1s.[32]

The memo provides the following example of counting K-1s for an S corporation partner.

Example – S Corporation K-1s

For example, the partnership PS has two partners, S1 and S2, each of which is an S corporation. S1 has 20 shareholders and S2 has 35 shareholders. Solely for purposes of determining eligibility to elect out, partnership PS is deemed to be required to furnish 57 Schedule K-1s, consisting of S1 and S1’s 20 shareholders (21 total) and S2 and S2’s shareholders (36) for a total count of 57

But the same rule does not apply to eligible estates:

With regard to a partner that is an estate of a deceased partner, the estate may file Form 1041 and furnish Schedule K-1s to its beneficiaries. For purposes of determining the number of Schedule K-1s required to be furnished by the partnership, any Schedule K-1s furnish by the estate are NOT taken into account for purposes of determining whether the partnership has furnished 100 or fewer K-1 statements.[33]

Multiple Revocations of the Partnership Representative

The memo discusses how the IRS should respond to multiple revocations of a partnership representative (PR) within a 90 day period.  Under the final BBA regime regulations, the IRS may, but is not required to, treat such a multiple revocation as having the effect of the partnership having no PR designation in place.  In such a case, the IRS has the authority to appoint a PR for the partnership.

The memo provides the agent with the following guidance in this situation:

1. The IRS’s goal is to conduct effective and efficient examinations. Multiple revocations within a relatively short timeframe can have a negative impact on achieving this goal.

A. If you receive two revocations within a 90-day period, you may (but are not required to) determine that the second revocation (the “current” revocation) results in no PR designation in effect.

i. Do not send out Letter 6053 responding to the current revocation if you contemplate determining that no PR designation in effect.

B. If you and your manager understand the reasons for multiple revocations within the 90-day period based on facts and circumstances, you may accept the current revocation (if valid) and confirm the latest PR of record. You will send Letters 6053, 6007 and 6008.

2. If you do determine there’s no PR designation in effect, you must provide notice within 90 days of receiving the current revocation to indicate that there is no designation in effect. Otherwise, you can’t later determine that no designation is in effect because of these multiple revocations. You will send Letters 6053 and 6007 only.

A. Although there is no set time to designate a new PR after you’ve declared there’s no designation in effect, you must select a new PR with reasonable due diligence while balancing the need to continue the examination in an efficient and effective manner. For factors to consider when designating a PR, see below, “Service’s Selection of a PR”.

3. Once you have selected a PR, the partnership cannot revoke the PR without the permission of the IRS. Permission is granted if the partnership submits a Form 8979 and the IRS accepts the submittal as valid.[34]

Powers of Attorney

The memo notes that a partnership cannot use a Form 2848 to appoint a partnership representative.  However, the form can be used to appoint a party to represent the partnership representative who is acting on behalf of the partnership.

The memo provides the following information related to the use of powers of attorney in BBA regime cases:

1. Form 2848, Power of Attorney and Declaration of Representative, is used to authorize an individual to represent a PR who is acting on behalf of the partnership under the centralized partnership audit regime. Refer to IRM 4.11.55 for POA rights and responsibilities.

A. A power of attorney (including a Form 2848, Power of Attorney) may not be used to designate a partnership representative.

2. The PR or DI (for an EPR) of record must sign the Form 2848 and the authorized individual must be eligible to practice before the IRS.

3. You must contact the BBA POC if you receive a Form 2848 because instructions for Form 2848 may change.

4. For matters unrelated to the centralized partnership audit regime, a separate Form 2848 must be signed by a partner that has authority to do so under state law. For dissolved partnerships, see 26 CFR 601.503(c)(6).

Note: Any statute extension (Form 872-M) should be signed by the PR or DI (for an EPR).[35]

Grouping of Adjustments

The memorandum contains a detailed discussion of the grouping of adjustments at the partnership level and how they will be taken into account.[36]  What may be even more useful to practitioners are a pair of examples of how the grouping options work.  They are relatively simple and, in real life, things will get much more complicated.  But they can help advisers understand the existence of separate groups and how that will impact the exam.

Example 1 - Groupings[37]

The AB Partnership’s 2019 return is under examination. Form 1065, page 1 consists of gross receipts of $1,000 and COGS of $250 for a net ordinary business income of $750 from a single activity. The $750 of net ordinary business income was included on Schedule K, line 1. The revenue agent proposes to increase gross receipts by $100 and increase COGS by $30. The $100 increase in gross receipts represents a positive adjustment while the increase in COGS represents a negative adjustment. Both of these adjustments are placed in the residual grouping since neither is properly classified as a reallocation, credit or creditable expenditure grouping. Since one of the adjustments is negative, subgrouping is required. The agent verified that AB Partnership netted the gross receipts and COGS as a single partnership-related item on Schedule K, line 1, and therefore, the negative adjustment for COGS will be subgrouped with the positive gross receipts adjustment. After netting these adjustments, the result is a net positive adjustment of $70 in the Schedule K, line 1 subgroup as well as a net positive adjustment in the residual grouping. The $70 will be included in the total netted partnership adjustment for purposes of computing the imputed underpayment.

Example 2 - Groupings[38]

The facts are the same as example 1 above, except the partnership’s operations included two distinct activities (“Activity A” and “Activity B”). The net income from each activity were separately stated on a statement attached to Form 1065. The audit adjustment to gross receipts of $100 (increase) was identified as being related to Activity “A” while the adjustment to COGS of $30 (increase) was identified as being related to Activity “B.” Again, both the positive adjustment to gross receipts of $100 and the negative adjustment of $30 to COGS are placed in the residual grouping. Since the separate net income from each activity are required to be separately stated on line 1 of Schedules K/K-1 (via an attached schedule), those amounts were not treated as a single partnership-related item for purposes of section 702(a) and were not allocated as a single item on the filed tax return as was proper. Therefore, each adjustment must be placed into a separate subgroup within the residual grouping. The two subgroups (within the residual grouping) could be identified as “Schedule K, line 1, Activity A” and “Schedule K, line 1, Activity B” or similar. Under the netting rules, netting adjustments across subgroups is not permitted and the positive $100 adjustment and the negative $30 adjustment may not be netted. Thus, the residual grouping contains a net positive adjustment of $100 (netting rules only allow positive adjustments to be added together in each grouping to arrive at a net positive adjustment). This amount will be included in the total net partnership adjustment for purposes of computing the imputed underpayment. The net negative adjustment of $30 is an adjustment that does not result in an imputed underpayment and must be included on the partnership’s tax return for the year in which such adjustment becomes final.

We have summarized only a few key items discussed in this document.  Until the document is replaced by the updates made to the Internal Revenue Manual, advisers working with BBA regime issues will find the memo useful to help understand what would occur in a BBA exam or to deal with one should an examination notice arrive in the mail.

[1] LB&I-04-1019-010, October 31, 2019, released to public November 28, 2019, https://www.irs.gov/pub/foia/ig/spder/lbi-04-1019-010.pdf

[2] LB&I-04-1019-010, p. 7

[3] LB&I-04-1019-010, p. 7

[4] https://www.irs.gov/businesses/corporations/compliance-assurance-process-cap-frequently-asked-questions-faqs

[5] LB&I-04-1019-010, p. 8

[6] LB&I-04-1019-010, p. 8

[7] LB&I-04-1019-010, p. 9

[8] LB&I-04-1019-010, p. 9

[9] LB&I-04-1019-010, pp. 9-10

[10] LB&I-04-1019-010, p. 10

[11] LB&I-04-1019-010, p. 10

[12] LB&I-04-1019-010, p. 10

[13] IRC §6501(c)(12)

[14] LB&I-04-1019-010, p. 11

[15] LB&I-04-1019-010, pp. 11-14

[16] LB&I-04-1019-010, p. 14

[17] LB&I-04-1019-010, p. 14

[18] LB&I-04-1019-010, pp. 14-15

[19] Imputed underpayment

[20] LB&I-04-1019-010, p. 15

[21] LB&I-04-1019-010, pp. 15-16

[22] LB&I-04-1019-010, p. 16

[23] LB&I-04-1019-010, pp. 16-17

[24] LB&I-04-1019-010, p. 17

[25] LB&I-04-1019-010, p. 20

[26] LB&I-04-1019-010, p. 20

[27] LB&I-04-1019-010, p. 21

[28] LB&I-04-1019-010, p. 21

[29] LB&I-04-1019-010, p. 21

[30] LB&I-04-1019-010, p. 21

[31] LB&I-04-1019-010, p. 22

[32] LB&I-04-1019-010, p. 22

[33] LB&I-04-1019-010, p. 22

[34] LB&I-04-1019-010, p. 27

[35] LB&I-04-1019-010, pp. 38-39

[36] LB&I-04-1019-010, pp. 50-59

[37] LB&I-04-1019-010, pp. 58-59

[38] LB&I-04-1019-010, p. 59