Partnership Audits And BBA Graffiti

 

I am reading two amicus briefs filed with the Tax Court concerning a partnership audit.

I see that the IRS wants approximately $84 million in tax and $17 million in penalties.

Let’s talk about partnership audits this time. The issue here is caused by the IRS audit process itself.

Before 1982 the IRS would audit partnerships and – if there were adjustments – would also have to audit the partners separately. While not an issue with small partnerships, it was a significant issue with larger partnerships. Take a partnership with headquarters in Atlanta, for example. The partnership audit team might come from Georgia, but the partner audits might require IRS personnel from other states.  

Enter new rules with the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. The partnership would designate a representative to deal with the IRS. There was one audit to bind the partnership and partners, a single judicial review of that audit and a unified limitations period for all. Just the presence of the partnership representative (tax matters partner or “TMP”) was enormous, as this required only one audit team. The IRS did not need to chase the partners for approval. The day to day was also streamlined, as the IRS did not need to notify any non-TMPs of ongoing audit activities.

But while the partnership was binding the partners, the IRS still had to coordinate the amended partner returns. As partnerships (and now LLCs) became larger and more popular, this became an increasingly formidable task.

Knowing this, what would you change to make partnership audits easier?

I would have the partnership itself pay any additional tax resulting from the audit. The partners could settle up as they wish, but the IRS would have moved on.

For the most part, that is the new system - the Bipartisan Budget Act (BBA) centralized audit regime - effective after December 31, 2017.

There are limited exceptions to the BBA regime. For example, a partnership can opt-out of BBA if it has less than 100 partners and every partner is an individual, the estate of an individual, a C or an S corporation. This seems a large exception, but is not. For example, a trust - even a grantor trust - will disallow an opt-out. A disregarded entity (almost every Schedule C is a disregarded entity these days) will also disallow an opt-out.

Fail to opt-out and you are working under BBA rules.

COMMENT: Even if you are in BBA, you can still elect to have the partners rather than the partnership pay tax on any adjustments. This is called a “push-out” election. Mind you, you are still in BBA, but you are electing to use an escape hatch.

BTW the above means that we have two audit regimes (BBA and non-BBA) functioning simultaneously out there. A partnership tax practitioner has to know and be able to work with both.

We will discuss BBA audits only from this point on.

There is an issue with the partnership paying tax on any audit adjustments.

Here is an example:

• You incorrectly reported a $2,000 asset as being placed in service by 12/31/XX.
• This resulted in an incorrect depreciation deduction of $500.
• Self-employment income was understated by $500.
• Qualified Business Income was understated by $500.
• QBI unadjusted asset basis after acquisition was overstated by $2,000.
• You inadvertently understated ending recourse liabilities by $400.

In the old days, the accounting would be straightforward. Say you had two 50:50 partners. The accountant would go back to the original tax returns, substitute the amended numbers for the original numbers and recalculate the tax. The accountant would do this for each partner, and the effect of the audit was the sum of the two changes in final tax.

Intuitive.

However, BBA does not have a tax return like the above. BBA works off the partnership return, which is an information return and does not separately calculate taxable income or arrive at a final tax.

Let’s look at our simple example. What is the change in BBA income from the above?

• $500
• $500 + $2,000
• $500 + $2,000 + $400
• $500 + $2,000 + $400 + ($500 times 20%)
• Something else?

You see the problem: the audit adjustments are divorced from a tax return. You can talk your self into knots over what to include and what to exclude.

So, the BBA created the concept of an Imputed Underpayment (IU). Think of it as a subtotal to which we will apply a tax rate.

Start by separating the adjustments into customary tax pools; income, gain, deduction, loss, and credit.

BBA adds one more pool: non-income items. This pool is the genesis of our problems.

Next separate your adjustments between positive (increase taxable income) and negative adjustments.

Positive adjustments are always included. Negative adjustments are allowed when both the positive and negative adjustments would be reported on the same line of a Schedule K-1. The effect, of course, is to leave many a negative adjustment on the table.

Let’s next look at Reg 301.6225-1(d)(2)(iii):

Got it: gobbledygook.

The hook here is that the customary tax pools (income, gain, deduction, loss, credit) can have both positive and negative sides.

The new BBA pool however – the non-income item – is always positive. The IRS arrives at this conclusion by looking at (d)(2)(ii) above. Since it does not subtract from income, the non-income item is not a negative adjustment. Since it is not negative, (d)(iii) means it must be positive.

Once we are done with positive and negatives, we crunch everything together to arrive at a sum called the Imputed Underpayment (“IU”).

We multiply the IU by the maximum tax rate to arrive at tax due from the BBA audit.

You can see the possible danger from non-income items. Land in this pool – voluntarily or involuntarily – and you can be in trouble. Items in the pool might be indirectly used in calculating tax (say QBI UBIA, for example), but not be directly involved in any tax calculation. You are still paying BBA tax on the pool, however.

Seems to me that someone who could put you in this pool potentially has the power to bankrupt you.

With the above as background, let’s briefly look at the Site Solar Fedok Fund III LLC case.

Site Solar is an Oklahoma partnership that owns, operates, and leases mobile solar generators. It reported a loss of approximately $68 million on its 2018 tax return. It also claimed energy credits on the solar equipment.

The IRS audited the 2018 tax return. It determined that approximately $80 million in depreciable assets were not actually placed in service by December 31, 2018. The IRS reduced depreciation by approximately $63 million. Since assets were not placed in service, the IRS also reduced the solar energy credit by approximately $24 million.

Stopping there and being very liberal with the numbers, we might say that a tentative IU is $104 million ($80 million plus $24 million).

The IRS calculated the IU to be $227 million.

Which translated into tax of approximately $84 million and penalties of $17 million.

How did we get from $104 million to $227 million?

Beats me.

Granted, there are rules to avoid double-counting, more specifically the “subsume rule” of Reg 301.6225-1(b)(4):

COMMENT: The subsume rule is far from perfect. Say for example that the IRS reclassifies an ordinary loss to a capital loss. The ordinary loss is a positive adjustment. The capital loss is a negative adjustment. They will not offset, as they appear on different lines of Schedule K-1. The partnership can wind up with tax due when its taxable income did not change a jot.

Treasury has explicitly stated that an IU is not intended to be the amount of tax that the partners would have owed. It instead is an entity-level calculation, disregarding whether any adjustments would have resulted in an actual tax liability to an actual partner.

Huh?

Maybe we need to regard that last point a bit more, folks. This otherwise is just scribbling numbers on a wall – BBA graffiti if you will.

I understand how this ended up in Court.

The taxpayer had no choice.

Our case this time was Site Solar Fedok Fund III, LLC v Commissioner, U.S. Tax Court Docket 19733-23.

Deducting Business Interest From Personal Credit Cards

The case caught my eye because it involves a very common fact pattern:

A small business owner obtains credit cards in his/her personal name and uses it/them for business purchases and activities.

Question: Can the business deduct the interest on the credit cards?

I doubt that there is a tax practitioner out there that hasn’t deducted this, but a recent case points out minimum requirements in case the IRS challenges the deduction.

Let’s look at C.A. Simmons, TC Memo 2026-34.

I admit that I was expecting some technical dive into the interest deduction, but this case is not that. It is a reminder that one has to get to first base before being able to reach home plate. Strike out and the rest is meaningless.

Cathryn Simmons and her sister owned a specialty store (called Stuff) in Kansas City, Missouri. They had sold handmade and small-batch goods since 1996. As is too common, Stuff struggled to obtain credit in its own name, so the sisters used personal credit cards and loans to finance the business. They used QuickBooks for their accounting, and they did try to segregate the credit cards between those used for business and those used personally.  

COMMENT: I suspect most clients I have advised can remember my standard sermon:

·      Establish a separate business account. Business deposits and expenses go through the business account. Personal expenses do not. I understand that the bank is going to charge for a business account, and it might be cheaper to lean into a personal account. Do not do that. You already incurred that expense when you started the business.

·      I understand that you might not be able to get a credit card in the business name and may have to use a personal card. Use one card for business and the rest for personal. Do not intermingle the two.

·      If you are using a personal card, I might have the business recognize it as a loan from you. We will formalize it with a note, mention an interest rate and make some reference to repayment. Do not be surprised if the interest rate on the note is the same as the credit card.

·      Keep records of all business deposits and expenses. At a minimum, buy an expanding file and file the paperwork by month. When we finish the tax return for the year, combine the return and its paperwork into a file or folder for the year, and hold onto it.

Back to Stuff.

The IRS looked at the 2017 business return and 2017 and 2019 personal returns. They expanded the business audit to include cost of goods sold, advertising, vehicle expenses, travel, meals and entertainment, charitable and promotion, and interest. We will discuss only the interest deduction today.

Stuff field a partnership return, and each sister’s share of the 2017 business profit was less than $3 grand.

There was a little chop with the interest deduction because it included both interest on the credit cards and interest on the personal loans. I point it out because the Court says the following about the personal loans:

As an initial matter, … fails to establish that the purported interest amounts Stuff paid to her and her sister arose from Stuff’s own indebtedness. The record contains promissory notes … but no ‘loan papers’ establishing Stuff’s indebtedness to the sisters.”

… we cannot conclude from these payments and the sisters’ testimony that Stuff had an actual legal obligation to pay interest to them.”

I get it but … harsh. I suppose Stuff was not following the terms of the promissory notes. We would - of course - redraft the terms of the notes. This is low hanging fruit.

What about the credit cards?

Ms. Simmons likewise fails to demonstrate that Stuff was entitled to deduct the credit card interest and finance charges recorded on its QuickBooks account. The evidence shows that Ms. Simmons obtained and used credit cards in her own name to finance Stuff’s business expenses given its inability to obtain credit on its own. Ms. Simmons fails to show that any credit card interest and finance charges constituted Stuff’s own indebtedness rather than her personal indebtedness, and thus no deduction is appropriate.”

Stop. I am having a problem here, as I am quite aware of Reg 1.163-8T.

Seems to me that if (1) I trace a business expense from the credit card statement to (2) the QuickBooks, I have at least a good chance of meeting the requirement that “debt is allocated by tracing the disbursements of the debt proceeds to specific expenditures.”

Back to the Court:

Assuming arguendo that credit cards opened by Ms. Simmons constituted an indebtedness of Stuff, the records before us would not substantiate the amounts claimed. Although the sisters testified that they used the six designated credit cards exclusively for Stuff’s expenses, they failed to establish the amounts and business purposes of the underlying expenditures that resulted in the interest and finance charges at issue.”

They failed to establish the amounts and business purposes …?

I believe two things happened here:

(1)  Stuff could not document a lot of expenses. On quick review, I see the IRS disallowing almost $13 grand of vehicle expenses, $22 grand of charitable and promotion expenses, and so on.

(2)  If those expenses ran through the credit cards, then I understand an allocable portion of the interest being disallowed.

However, the Court just nixed the interest deduction altogether.

Seems to me that some of the credit card interest – that allocable to deductions allowed – should be deductible. I presume the accounting was not clean enough to do a side calculation. The IRS will rarely play forensic, and the Tax Court certainly will not.

The Court did reemphasize that it wanted to see linkage between the business activity and the credit cards, but that has been the rule since I have been practicing. There is nothing new here. Somebody just forgot to get on first base.