November 26, 2022

Volume XII, Number 330


November 23, 2022

Subscribe to Latest Legal News and Analysis

Prescriptions of the Blue Book on the New Partnership Audit Rules

In November 2015, the Bipartisan Budget Act of 2015 (the Act) instituted a new regime for federal tax audits of entities treated as partnerships for US federal income tax purposes (the New Audit Rules) effective 2018.  Our more in-depth discussion of these changes can be found here. In March 2016, the Joint Committee on Taxation released its “General Explanation of Tax Legislation Enacted in 2015” (the Blue Book), which provides some background and explanation with respect to the New Audit Rules. This article discusses certain of the highlights of the Blue Book explanation.

As brief background on the New Audit Rules for partnerships:

  • They apply to taxable years beginning after 2017.

  • Certain partnerships can elect out of the New Audit Rules altogether for a given taxable year (the Small Partnership Election Out), with the result that any adjustments to such a partnership’s items can be made only at the partner level.

    • This election may be made only by partnerships with 100 or fewer partners, each of which is an individual, a C corporation (including a foreign entity that would be required to be treated as a C corporation if it were a domestic entity), an S corporation or an estate of a deceased partner.

  • The New Audit Rules impose entity-level liability for income taxes, penalties and interest on partnerships in respect of Internal Revenue Service (IRS) audit adjustments, absent election of an alternative regime under which the tax liability is imposed at the partner level (the Push-out Election).

  • Absent a Push-out Election, any tax deficiency arising from a partnership-level adjustment with respect to a partnership tax year (a reviewed year) is calculated using the maximum statutory income tax rate and is assessed against and collected from the partnership in the year that such audit or any judicial review is completed (the adjustment year), together with any related penalties and interest.

    • However, if one or more partners file tax returns for the reviewed year that take the audit adjustments into account and pay the associated taxes, the imputed partnership underpayment amount is determined without regard to the portion of the adjustments so taken into account.

    • If the partnership is able to demonstrate that a portion of the imputed underpayment is allocable to a partner that would not owe tax by reason of its status as a tax-exempt entity, or can demonstrate that reduced corporate, capital gain or qualified dividend rates apply, for example, procedures are to be developed to determine a more accurate imputed underpayment amount.

  • The “tax matters partner” is replaced with a “partnership representative” with an expanded role.

    • The partnership representative (not required to be a partner) has sole authority to act on behalf of the partnership in an audit proceeding, and can bind both the partnership and the partners by its actions in the audit.

    • Partners neither have rights to participate in partnership audits or related judicial proceedings, nor standing to bring a judicial action if the partnership representative does not challenge an assessment.

  • The statute of limitations for partnership adjustments will be calculated solely with reference to the date the partnership filed its return.

Highlights of the Blue Book Explanation

Under principles of statutory construction, legislative history is relevant only if the statutory language is ambiguous. If the Blue Book explanation supports other relevant pre-enactment legislative history, then a court is likely to find it persuasive; if other pre-enactment legislative history is absent, then the court may disregard the Blue Book explanation or find it persuasive only to the extent it supports its conclusion. See US v. Woods, 571 U.S. 310 (2013) discussed by us in depth here. With that by way of background, highlights of the Blue Book are as follows: 

  • To the surprise of many practitioners, although the Blue Book indicates that disregarded entity (DRE) partners should be “looked through” for purposes of the Small Partnership Election Out, it states this shall be as provided via regulations or other future guidance.  In addition, it states such guidance should require that the DRE and its owner each be counted towards the 100 member limit. 

  • The Blue Book adopts a similar stance as regards trusts, including grantor trusts.

  • The Blue Book implies that an upper tier partnership that is a partner in a lower tier partnership that has made a Push-out Election would not be able to make a further Push-Out Election to pass the adjustment on to its partners.

  • The Blue Book explains that, upon a partnership’s payment of a partnership level tax, both the partnership and the partners would have a corresponding basis reduction.  It states that any payments of contractual indemnities entered into between the partners and partnership with respect to the payment of partnership level taxes would be non-deductible. 

  • The Blue Book notes that, if a partnership ceases to exist before a partnership adjustment is made (including via a section 708(b)(1)(A) termination, but not a section 708(b)(1)(b) “technical termination”), the adjustment is taken into account by the former partners of the partnership.  For these purposes, a partnership that has no significant income, revenue, assets or activities may be treated as ceasing to exist.

Small Partnership Election Out

The Blue Book provides that, for purposes of determining eligibility for the Small Partnership Election Out, a foreign entity partner that has elected to be treated as a corporation under the check-the-box rules under section 7701 would be considered a qualifying C corporation.  It also provides that a C corporation partner that is a regulated investment company (RIC) or real estate investment trust (REIT) would not prevent the partnership from electing out. 

The Blue Book states that, under regulations or other guidance, a DRE partner, such as a domestic limited liability company with only one member, although not one of the types of partners enumerated as permitted partners for the Small Partnership Election Out, may be a permitted partner for such election if owned by a permitted partner. An example is provided in which both the disregarded entity and its member are treated as partners for purposes of the 100 partner limitation.  In light of the fact that the section 7701 regulations provide that DREs are to be disregarded for all federal tax purposes, it is not clear why regulatory or other guidance is required to conclude the use of a DRE is permissible or, further, why a DRE “takes up a spot” for purposes of the 100 partner rule. 

The Blue Book states guidance to be issued may provide similar rules for partners that are trusts, adds that such guidance should require the partnership to disclose the identity of the trustee of the trust and each person deemed to be an owner of the trust and mandates that each such person be counted for purposes of the 100 partner limitation. The Blue Book also indicates that similar guidance may be provided for grantor trust partners, a former grantor trust that continues in existence for the two-year period following the death of the deemed owner or a trust receiving property from a decedent’s estate for a two-year period.

Lastly, the Blue Book indicates that forthcoming guidance may provide rules permitting the Small Partnership Election Out to be made by a partnership with one or more direct or indirect partners that themselves are partnerships. All direct and indirect partners of this first partnership taken together must not exceed 100 persons and must be disclosed

Partnership Adjustments

In determining the imputed underpayment amount of a partnership, the Blue Book states that netting of items of income, gain, loss or deduction is required to “take into account applicable limitations, restrictions and special rules under present law.”  The Blue Book also provides examples of this netting in scenarios where the partnership has ordinary deductions and income, as well as capital gain and loss and tax credits.

In addition, the Blue Book provides an example of the determination of the imputed underpayment amount of the partnership where an adjustment reallocates depreciation and interest deductions from partner A to partner B. The imputed underpayment amount is calculated without decreasing the income allocable to partner B by the depreciation and interest deductions reallocated from partner A to partner B, with the result that the adjustment is an increase in income equal to the full amount of reallocated deductions, subject to tax at the highest rate of federal income tax.  The example concludes by stating that “the partnership may implement procedures for modifying the imputed underpayment as so determined.”

The Blue Book also provides an example of how a partner’s distributive share of partnership items is determined when the partnership uses the procedures to modify the tax rate assumed applicable to the underpayment: where a partner’s distributive share differs among items, then the portion of the underpayment to which that partner’s lower tax rate applies is determined by the partner’s distributive share on a hypothetical liquidation of the partnership for fair market value.

Finally, the Blue Book notes that, pending the issuance of regulations or other guidance addressing the manner in which modifications to an imputed underpayment amount may be made, “it is anticipated that partnerships will furnish to the Secretary the necessary documentation, data and calculations to determine the amount of the reduction of the imputed underpayment with a reasonably high degree of accuracy.”

Push-Out Election

The Blue Book explains that upon a final court decision, dismissal of the case or settlement with respect to a notice of final partnership adjustment, a partnership will implement the Push-out Election by furnishing statements to the reviewed year partners showing each partner’s share of the adjustments as finally determined.  In the absence of guidance relating to the time and manner of furnishing the partner statements relating to a Push-out Election, the statements are to be furnished to the IRS and all partners “within a reasonable period following the last day on which to make the election.”  The date that the statement is so furnished is the date it is mailed for this purpose. The statement must include the name and taxpayer identification number of the recipient partner.  The Blue Book indicates that the US Department of Treasury (Treasury) may also require the address of the recipient partner and the date the statement is mailed.  Finally, the Blue Book notes that as part of any settlement, the Treasury might permit revocation of a previously made Push-out Election so that the partnership may pay the tax at the partnership level.

Among the more significant points enunciated by the Blue Book with respect to the Push-out Election rules is the treatment of tiered partnerships and other tiered entities.  It states that, in the case of tiered partnerships, a partnership that receives a Push-out Election statement from the audited partnership is treated similarly to an individual who received such a statement.  The recipient partnership, therefore, takes into account the aggregate of the adjustment amounts for its taxable year including the end of the reviewed year, plus any adjustments to tax attributes in subsequent years, and the recipient partnership pays the tax attributable to such adjustments, calculated as if it were an individual.  The Blue Book explanation notes that the partners of the recipient partnership may have entered into indemnification agreements with respect to the risk of tax liability of reviewed year partners being borne economically by partners in the year the statements are furnished.  It notes that, because a payment of tax by a partnership under the centralized system is nondeductible, payments under an indemnification or similar agreement with respect to the tax are also nondeductible. The Blue Book seems to be implying that the immediate upper tier partnership is not entitled to make a further Push-out Election.

Lastly, the Blue Book provides that a RIC or REIT partner that receives a statement from a partnership may wish to make a deficiency dividend under section 860 with respect to the reviewed year. Additional guidance is expected to be issued with respect to these partners.

Partnership Administrative Adjustment Requests

The Blue Book states that, in the case of tiered partnerships, a partnership’s partners that are themselves partnerships may choose to file an administrative adjustment request with respect to their distributive shares of an adjustment. These partners and indirect partners that are themselves partnerships “may choose to coordinate the filing of administrative adjustment requests as a group to the extent permitted by the Secretary.”

Other Items

Among the other matters addressed by the Blue Book explanation is a discussion of some of the procedural aspects of the New Audit Rules, including as regards the period of limitations on assessment and the interplay of a Push-out Election with the rules for contesting a partnership adjustment.  The Blue Book explanation also addresses new section 6241(4) (disallowing deductions for any payment required to be made under the New Audit Rules) and section 6241(7) (providing that if a partnership ceases to exist before a partnership adjustment is made such adjustment is taken into account by the former partners of the partnership).  As to the former, the Blue Book explains that a basis adjustment (reduction) under section 705(a)(2)(B) to a partner’s basis in its partnership interest must be made to reflect the nondeductible payment by the partnership of the tax.  As to the latter, the Blue Book clarifies that a technical termination of a partnership under section 708(b)(1)(B)(sale or exchange of 50 percent or more of total capital and profits of partnership) is ignored in determining whether a partnership ceases to exist while a section 708(b)(1)(A) termination (discontinuation of partnership business) is treated as a cessation of the partnership.  An example of a section 708(b)(1)(A) termination is a partnership becoming a single member entity. The Blue Book states that the Treasury may, under regulations to be issued, treat a partnership that has no significant income, revenue, assets or activities at the time the partnership adjustment takes effect as having ceased to exist.  This could prove significant as a mechanism for addressing liabilities under the New Audit Rules of a partnership lacking material assets—if the partnership is deemed not to exist the audit adjustment would have to be taken into account by the (former) partners.


The Blue Book explanation contains a number of prescriptions for guidance to come.  As noted, some areas practitioners may have viewed as fairly non-controversial have been identified as among the topics to be addressed by regulation or other guidance. Timely issuance of that guidance should be a priority, and taxpayers and practitioners will have to be on the lookout for it.

© 2022 McDermott Will & EmeryNational Law Review, Volume VI, Number 131

About this Author

Gary Karch, Tax Attorney, McDermott Law Firm

Gary C. Karch is a partner in the law firm of McDermott Will & Emery LLP and is based in the Firm’s Chicago office. Gary focuses his practice on the federal income tax aspects of structuring and implementing partnership and limited liability company transactions, including acquisitions, investments, joint ventures and restructurings.

312 984 7543
Kevin Spencer, McDermott Will & Emery LLP , Tax Litigation Attorney

Kevin Spencer focuses his practice on tax controversy issues. Kevin represents clients in complicated tax disputes in court and before the Internal Revenue Service (IRS) at the IRS Appeals and Examination divisions.


In addition to his tax controversy practice, Kevin has broad experience advising clients on various tax issues, including tax accounting, employment and reasonable compensation, civil and criminal tax penalties, IRS procedures, reportable transactions and tax shelters, renewable energy, state and local tax, and private client matters. After earning his Master of...