In 2012 I wrote an article for State Tax Notes discussing whether states are adequately auditing real estate partnerships. A key source in that story was Jerry Curnutt, a former partnership industry specialist for the IRS. Curnutt told me the problem was that some real estate partnerships improperly report (or do not report) taxable gain after the disposition of property secured by nonrecourse loans.
Curnutt said he identified the problem in his role at the IRS using key pieces of data from the IRS Business Master File. He suggested that because states have access to the Business Master File, they too could use the same data to identify partnerships and audit them. Since retiring from the IRS, Curnutt has taken that idea to states, but they have shown no interest in exploring his method for identifying noncompliant partnerships. If auditing these partnerships could result in millions of dollars of additional tax revenue, the obvious question is: Are states knowingly leaving millions of dollars of tax revenue on the table?
I suggested that the answer to that question is a qualified maybe. Although states have difficulty auditing partnerships, and in particular large partnerships, they have been stepping up enforcement efforts and have made progress in that area, though not in the exact manner that Curnutt prescribes. Curnutt's method is not the only way of locating partnerships that have failed to properly report taxable gain, and it may not be the most efficient way in every state. State taxation of partnerships is complex and nuanced. There is no uniform solution.
States have long had difficulty auditing partnerships. Subchapter K rules are complex, and many state auditors lack the necessary training in those complexities. For federal tax purposes, an entity classified as a partnership pays no income tax, but passes its income through to its partners. Although a partnership is not a taxable entity, it must compute and characterize the amount of income that passes through to its partners. A partnership computes its income like an individual's, except that the partnership is not permitted to take some deductions that an individual may take.
Partnerships are required to file an information return with the IRS (Form 1065, "U.S. Return of Partnership Income"), which sets forth profits and losses and provides a means for the IRS to verify whether partners are properly reporting their income. The partners may receive a Schedule K-1 from the partnership detailing their distributed shares of their income, expense, gain, loss, and credits. The partners would report those items on their individual or corporate income tax returns and pay tax accordingly. Calculating the distributive share that each partner receives can be complex, but partners generally receive a share based on the allocations specified in the partnership agreement.
The first question in looking at how a partnership is taxed at the state level is whether the state conforms to the federal tax classification of the partnership as a passthrough entity. In general, most state income tax statutes do conform to the federal classification of entities. However, federal conformity is rarely uncomplicated, and the classification of entities is no different. Even if states conform to the federal classification of entities, they may add entity-level state income taxes or fees, non-income entity-level taxes, withholding and estimated tax obligations, partner consent conditions, and composite filing requirements.
Noncompliance in the states may stem from taxpayer confusion regarding nonresident income tax withholding requirements. States impose a variety of rules regarding when partnerships are required to withhold tax from nonresident partners and what the filing requirements are for both resident and nonresident partners. The problem is the lack of uniformity among states creates a compliance nightmare.
The difficulty in compliance is exacerbated for partnerships in a multitiered structure. With such a structure, close attention must be paid to the level at which nonresident withholding is required. Is the final taxpayer required to withhold, or is it the taxpayer before that final taxpayer? Or, as in New Jersey, is tax required to be withheld several times up the chain? Making the wrong determination can start a compliance nightmare for the taxpayers involved. There can be significant penalties for noncompliance with withholding requirements and nonfiling of nonresident returns. This is a very confusing area of state tax law, and one that often trips up even sophisticated taxpayers.
But Curnutt recently raised an interesting point (and one that I’m now researching): Although the New York Department of Taxation and Finance indicated that it has hundreds of open field audit cases of partnerships that have allegedly failed to properly report taxable gain, not one audit of a real estate tax partnership has reached the New York State Division of Tax Appeals. In other words, if Curnutt is correct, every audit of a real estate partnership has resolved itself during audit. Is that possible? Or is New York simply not aggressively auditing real estate partnerships?