Audit Procedures for Pass-Through Entities (Portfolio 624)

Tax Management Portfolio, Audit Procedures for Pass-Through Entities, No. 624, analyzes in detail the statutory rules of §6221–§6234 governing the audits of “TEFRA partnerships.” The Portfolio also considers briefly the analogous provisions governing the audit procedures for “subchapter S items” (former §6241–former §6245), before their repeal in 1996, and the provisions governing electing large partnerships (§6240–§6255), enacted in 1997.

Partners are generally required to file their returns consistently with the partnership return or provide notice of any variation to the IRS. Audits are conducted at the entity level and are limited to “partnership items” and related penalties. The IRS deals primarily with the Tax Matters Partner (TMP), who in turn has the duty under §6223(g) to keep the other partners informed of all administrative and judicial proceedings.

After the audit is completed, the IRS notifies the TMP of the proposed adjustments in a notice of final partnership administrative adjustment (FPAA). Certain classes of partners are given the right to participate in both administrative and judicial proceedings. There are special rules which apply to partners with a less than 1% interest in a large partnership, and other rules which apply to indirect partners, that is, the ultimate taxpayers when the partner is itself a pass-through entity. At the conclusion of the partnership proceeding, the IRS applies the partnership determination to each partner's tax liability by means of a computational procedure. The IRS may then also issue an “affected item notice of deficiency” to raise substantive issues on the partner's return related to the partnership determination.

The TMP of a TEFRA partnership also has the ability, in certain circumstances, to file amended partnership returns that will apply to all partners. This amended return, called an Administrative Adjustment Request (AAR), differs in several significant respects from non-TEFRA claims for refund. Specific procedural rules govern the filing, processing, and litigation concerning an AAR.