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California bill seeks to align partnership audit procedures

The proposed change affects partnership tax returns when the IRS makes changes or corrections during a federal tax audit. The new step requires the partnership to notify the California Franchise Tax Board of the updates. S.B. 274 is on desk of Governor Jerry Brown after passing the Senate.

Another feature of the proposed legislation is that it could shift tax liability to the partnership entity itself and away from individual partners.

How do the federal and state procedures differ?

The IRS conducts most partnerships audits through a centralized system. This means that audits are at the partnership level and adjustments to income, gain or loss is determined at this top level. Additional tax or penalty assessments occur at the partnership level with a partner's distributive share calculated based on this overall amount. A partnership can elect out of the system in certain cases when it meets eligibility criteria.

California law looks at each partner separately. This extends to administrative and judicial proceedings when challenging the outcome of an audit. With the existing procedures and potential for change, it is wise to seek the counsel of a California tax attorney if contacted by the IRS.

What are the pros and cons?

The change could bring consistency and reduce taxpayer confusion. This does create some work for the state, but the analysis attached to the bill suggests it would increase state tax revenue collections

On the opposing side, allowing for an election to impute adjustments at the partnership level goes against the concept of a flow-through entity. It also removes the ability for each partner to separately address issues that might be unique to his or her situation.

What happens in a federal audit generally affects your state tax liability. The proposed change highlights the importance of working with an attorney who understands the interplay between federal and state tax law. 

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