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.

Is A Zero-Return Partnership A Valid Tax Filing?

 

I remember when they were called Chief Counsel Advices. IRS employees – think revenue agents or officers in the field – would reach out to their employer – the IRS – for guidance on an issue.

I am looking at something called a Chief Counsel Email.

Everything changes.

It caught my eye because I was talking with a CPA last week on the very same issue.

And the IRS position is initially disturbing.

Let’s go over this.

A revenue agent (commonly called an auditor) wanted to know if an initial partnership return showing partner information but zeros for activity would constitute a valid tax return.

COMMENT: I have seen this situation many times, including last week. Someone obtains a federal EIN, putting the entity on the IRS radar. The entity then goes on to do … nothing. It never starts or starts a year or two later. Meanwhile the entity is on the IRS Christmas card list. Fail to file a return and the IRS may send a letter asking why you did not file. In response, practitioners usually file an initial return but show zeros as activity because… well because there has been no activity.

Here is the Email:

We agree with the RA’s memo that the initial return showing ownership information, but containing all 0s would most likely be considered invalid under application of the Beard test.

Not good.

To be fair, however, I do not think that it is difficult to work with this Email.

Let’s first talk about Beard.

Beard was a tax protestor.

He found himself in Tax Court over his 1981 return. He received a Form W-2, which he reported on the form 1040. He then inserted a line he described as “Non-taxable receipts” and subtracted his W-2. The result was that he owed – according to him – no taxes and was entitled to a full refund of his withholding.

The IRS wanted tax, of course, and also wanted penalties for failure to file a return. He filed something, but tampering with the forms voided the filing.

Beard responded that he obviously filed a return. The IRS was out of line saying that he had not.

The issue before the Court was: what is a tax return?

The Court presented a four-part test:

1. Does it purport to be a tax return?
2. Is it signed under penalties of perjury?
3. Does it include enough information to calculate a tax?
4. Does it represent an honest effort to satisfy the tax laws?

Beard – a protestor – missed the third test by altering the form.

Here was the Court on the fourth test:

The tampered form here is a conspicuous protest against the payment of tax, intended to deceive respondent’s return-processing personnel into refunding the withheld tax. Since such intentional tampering could go undetected in computer processing, respondent was forced to develop and institute special procedures for handling such submissions. The critical requirement that there must be an honest and reasonable attempt to satisfy the requirements of the Federal income tax law is clearly not met."

Back to our Email.

Numerous tax court decisions have found that a return (typically a 1040) containing all zeros, even if filed on an official IRS form, does not constitute a valid tax return.”

True, but …

However, these are all in the tax protestor context and other cases have held that a zero return may be valid if there is reason to believe that it is an accurate reflection of the taxpayer’s activity.”

Got it.

I will start including a schedule or attachment to the partnership tax return stating the following:

XXX Partnership/LLLC was formed on XX/XX/XX and no business operations occurred during its initial tax year ending XX/XX/20XX.”

Easy.

But it is a trap for a non-tax specialist.

This time we discussed CCA 2026030612260600 a/k/a Chief Counsel Email 202634014.

 

An Ugly Case Over An Ugly Penalty

 

You know that the IRS pays especial attention to foreign transactions of U.S. citizens. We are to report foreign bank accounts, for example, should they exceed a certain balance.

Did you know that you may also have to report gifts made to you by individuals (and entities) overseas and exceeding certain threshold amounts?

That may come as a surprise, as we anticipate gifts to be tax free (and unreported) by the recipient. To the extent we pay attention to this area of tax, it is the donor - not the donee - who reports a gift. It is even possible to have a tax (the gift tax) if one cumulatively gifts “too much” over a lifetime.

Let’s be candid here: this is not a risk you or I have to sweat.

What got me thinking about it is a recent case coming out of California. Ms. Huang litigated over IRS penalties for her failure to timely report gifts from her overseas parents. She used TurboTax to prepare her taxes, and TurboTax advised her incorrectly about the gifts. She believes she has reasonable cause for abatement of those penalties.

I agree with her.

I also think this area of tax law is a mess.

Let’s go over this – briefly.

First, there are two considerations with foreign gifts:

·       Disclosure

·       Taxation

It is unlikely that there will be a tax, but it is likely that you must report the gift. There is even a specialized form for this – Form 3520: 

Trust me, one can have a long career in public accounting and never see this form.

The filing threshold varies depending on the donor:

Gifts From Foreign Individuals

·       The threshold is $100,000. Not surprisingly, multiple gifts from the same person (say mom) must be added together.

o   BTW, if mom gets creative and arranges to transfer more than $100 grand via various family members, there is a related party rule that will combine all those donors into one person – and put you over the $100,000 threshold.

o   Once required to file, each gift of $5 thousand or more is to be separately identified and described.

o   There may be excellent reasons for the multiple gifts. There are numerous countries which impose restrictions on outbound currency transfers. South Korea, for example, places a limit of $50,000 (USD).

Gifts From Foreign Corporations or Partnerships

·       The reporting threshold is greatly reduced if a business entity is involved – to $19,570.

·       In addition to the usual gift information, one is also to provide the name, address, and tax identification number (if such exists) for the entity.

Inheritances

The IRS takes the position that an inheritance is comparable to a gift. If one inherits from a nonresident, the inheritance might be reportable on Form 3520.

EXAMPLE: Carlos is a lawful permanent resident of the U.S. His uncle – a nonresident alien - passes away, leaving Carlos a house in a foreign country. While the residence is outside the U.S., Carlos is a U.S. permanent resident and should file a Form 3520.

Let’s change the example a little bit:

EXAMPLE: Carlos’ uncle was also a lawful permanent resident of the United States, even though he lived for substantial periods outside the U.S. The inheritance now is from one “US person for tax purposes” to another, and there is no need to file Form 3520.

  The penalties for not filing a 3520 can be onerous.

·       5% of the gift amount for each month a failure to file exists. In the spirit of not bayoneting the dead, the IRS will (fortunately) stop counting once you get to 25%.

·       If the IRS contacts you before you contact them, the penalty changes. It then becomes $10,000 for each month you fail to file Form 3520 after request.

·       Penalties will apply even if you filed a 3520, if the IRS believes that the return is incomplete or incorrect.

·       BTW this penalty can chase you unto death – and beyond. There are cases where the IRS has demanded penalties from the estates of deceased individuals.

So, what happened to Ms. Huang?

Her name is Jiaxing Huang, and in 2015 and 2016 her parents gifted substantial sums to help her relocate to the U.S. and purchase a home. Ms. Huang, like millions of others, used TurboTax to prepare her taxes for those years. She asked - and TurboTax informed her - that donors, not donees, are required to report gifts. Based on that feedback, she did not file Form 3520 for those years.

COMMENT: TurboTax was correct, IF one was talking about gifts from a U.S citizen or lawful permanent resident to another. It was not correct in specialized circumstances – such as that of Ms. Huang’s.

A couple of years later she learned of her filing obligations. Trying to play by the rules, she immediately filed Form 3520 for 2015 and 2016. She was late, of course, but she filed before the IRS ever contacted her – or had any reason to suspect that she was even required to file.

The IRS responded – here is a (too) common reason people hate the IRS – with penalties exceeding $91 grand.

COMMENT: The IRS churns these letters automatically. They do not go by human eyes. I propose – as a small improvement – that the someone at the IRS review these letters and related files before sending out such onerous penalties. I understand workforce limitations, but let’s be blunt: HOW MANY NOTICES CAN THERE BE?

Ms. Huang submitted an abatement request based on reasonable cause.

The IRS denied the request. They then withheld her 2019 ($280) and 2022 ($7,859) tax refunds.

Of course.

She appealed the denial of abatement within the IRS itself.

COMMENT: She was trying.

She instead learned that her penalty had jumped to over $153 grand. With interest she was topping $190 grand.

This was so egregious that even the IRS backed down. Appeals reduced the penalty to slightly over $36 grand.

Ms. Huang paid it.

COMMENT: No!!!!!

Two weeks later she filed a Claim for Refund.

COMMENT: Yes!!!!!

Her grounds? Abatement of the penalties – as well as the 2019 and 2022 tax refunds the IRS intercepted.

Let’s take a moment to explain why Ms. Huang paid the penalty.

In many if not most areas of tax law, one can bring suit without paying the tax (or penalty or whatever). That is one of the attractions of the Tax Court: you can get a hearing before sending the IRS a nickel. Not all areas of tax law are like this, however. An area that is not? You guessed it: Form 3520 penalties.

COMMENT: If you think about it, this is one way to keep people from bringing suit. How many can afford to pay the tax (or penalty or whatever) AND pay a tax attorney to litigate? It’s a nice scam you have there, Agent Smith.

The government did its usual: an immediate motion to dismiss the complaint. They even offered four reasons why the Court should dismiss.

The Court agreed with the government on three of the reasons.

It did not agree with the fourth: whether Ms. Huang’s reliance on tax software such as TurboTax under these circumstances could constitute reasonable cause.

Ms. Huang will have her day in Court.

But at what cost to her.

And why – when the IRS is hemorrhaging employees and losing budget allocations it likely should not have received in the first place – are they wasting their time here? The facts are unattractive. Ms. Huang is not a protestor or scofflaw. She tried. She got it wrong, but she tried. There is no win condition here for the government.

Our case this time was Jiaxing Huang v United States, Case No 24-cv-06298-RS, No District California.