This post is part of a Three Part Series of K&F Business and International Tax Developments Posts on the New Proposed Regulations to the New Partnership Audit Regime which is due to go into effect for all unincorporated entities treated as partnerships for taxable years beginning after December 31, 2017. Part One, which was posted on February 17, 2017, summarized the legislation which enacted the new partnership audit rules as part of The Bipartisan Budget Act of 2015, Pub. L. No. 114-74, Act §1101 (the “Budget Act”) which was signed into law on November 2, 2015, (as modified by Protecting Americans from Tax Hikes Act of 2015, Pub. L. No. 114-113 (the “PATH Act”)). The Proposed Regulations were issued on January 18, 2017 (REG-136118-15).
In a Memorandum from Reince Priebus, Assistant to the President and Chief of Staff, issued on January 20, 2017 to all Heads of Executive Departments and Agencies on behalf of President Trump, a regulatory freeze on the issuance of new regulations was announced to take effect immediately. In particular, proposed regulations that had neither been published in the federal register or had been waiting for their effective date, were immediately withdrawn for review and approval of the department or agency head appointed or designated by the President. Therefore, the Proposed Regulations to the partnership audit rules issued just two days earlier, were technically withdrawn on January, 20, 2017. See “White House Memo Puts Freeze on All New and Pending Regs”, Tax Notes, Jan. 20, 2017. In a recent announcement made on March 3 by Ms. Hodes, attorney-adviser, Treasury Office of Tax Legislative Counsel, in addressing the Federal Bar Association Section on Taxation, practitioners were urged not to assume the IRS will be unprepared for January 1, 2018, the deadline for the commencement of the new partnership audit regime.
For a summary of the Partnership Audit legislation and the audit provisions applicable to partnerships under current law, the TEFRA entity audit level audit rules, refer back to this blog’s post of February 2, 2017.
This post, Part II, of a three part series, will summarize the Proposed Regulations’ rules on the “imputed underpayment rules” and modifications. Part Three, which will be issued shortly, will address the “push-out election” and other procedural rules. The comments will be drawn from the Preamble to the Proposed Regulations and other articles that have been written by Jerry August and cited in footnote 1.
Preamble to Proposed Regulations: Explanation of Provisions on Imputed Underpayments and Modifications.
1. Imputed Underpayment and Modifications of Imputed Underpayments
a. Section 6225, as amended by the Budget Act, sets the broad framework for the partnership adjustments made by the IRS under the new centralized partnership audit regime and the determination of any resulting imputed underpayment. The assessment made against the partnership is for the “imputed underpayment amount”. The imputed underpayment concept is new and one of the most controversial and complex aspect of the new partnership audit rules. For the first time, a partnership can be held directly liable for the payment of assessments in income tax attributable to underpayments sourced from adjustments to prior years’ returns. In many instances, the partners or LLC members who would otherwise be individually assessed and required to make payment of the tax, will no longer be a partner or member of the limited liability company and may therefore fall outside of the assessment process unless an exception is set forth in the new rules or there is a clawback obligation contained in the partnership agreement. Indeed, the new partnership audit rules pose a set of potential adverse outcomes that must be addressed, at least in concept, at the organization state of organizing a partnership or LLC as well as to partnerships already in place. The centralized partnership audit regime limits the burden on the IRS in both the examination of partnerships and the judicial process -- changes that were designed to increase the ability of the IRS to audit large partnerships.
b. The New Operative Term: “The Imputed Underpayment”. Under the centralized partnership audit regime, the IRS generally will no longer be required to determine each partner's share of the adjustments made to partnership items unless the partnership has “elected-out” for that particular year, or, there are partner level modifications that can be provided to the government during the audit process. In contrast to prior law, under the default rules of §6225, the partnership is liable for the imputed underpayment for each particular year under review based on the adjustments made at the partnership level. Unfortunately, the imputed underpayment calculation may, for some partnerships where there are required allocations of income or loss which are not made properly or omitted, overstate the amount of tax due had the partnership and partners reported the partnership adjustments properly.
c. In General. Section 6225(a)(1) provides that in the case of any adjustment by the Secretary in the amount of any item of income, gain, loss, deduction, or credit of the partnership, or any partner's distributive share thereof, the partnership is required to pay any imputed underpayment with respect to such adjustment in the adjustment year as provided in §6232. Except for an adjustment to an item of credit, which is required to be treated (and taken into account) as a separately stated item, an adjustment not resulting in an imputed underpayment must be taken into account as a reduction in non-separately stated income or as an increase in non-separately stated loss (whichever is appropriate) in accordance with See §§ 702(a)(1)-(8), and, in particular, §702(a)(8). See also §§6225(a)(2)(A)-(B).
d. Net Aggregate Taxable Income or Loss Adjustment. An imputed underpayment with respect to a partnership adjustment for the partnership's reviewed year is determined in accordance with §6225(b). Under that section, adjustments to similar items of income, gain, loss, or deduction are netted with each other, treating any net increase or decrease in loss as a decrease or increase, respectively, in income. See §§6225(b)(1)(A)-(B). The net amount is then multiplied by the highest rate of tax in effect for the reviewed year under section 1 (individual rates) or section 11 (corporate rates). §6225(b)(1)(A). The product is then increased or decreased, as the case may be, by any adjustments to items of credit. §6225(c).
e. “One-Way Upward” Adjustments. Some Unfairness is Present in the New Regime. Section 6225(b)(2) provides that in the case of an adjustment that reallocates the distributive share of an item from one partner to another, such adjustment shall be taken into account when determining the imputed underpayment by disregarding any decrease in any item of income or gain and any increase in an item of deduction, loss, or credit. This could occur, for example, as the result of not properly allocating tax items on the original partnership return, such as built-in gain under §704(c) to a particular sale or distribution of partnership asset to a partner where the subject property was contributed to the partnership or as the result of a “reverse book-up” procedure.
2. Calculation of the Imputed Underpayment. Under the Proposed Regulations, the imputed underpayment is calculated by multiplying the total net partnership adjustments by the highest rate of federal income tax in effect for the reviewed year (per Prop. Reg. § 301.6241-1(a)(8)) under section 1 or 11. The product of such amount is then increased or decreased by any adjustment made to the partnership's credits. If there is a net positive adjustment, the resulting amount is the imputed underpayment, and, if it results in a net non-positive amount, the result is an adjustment that does not result in an imputed underpayment. See Prop. Reg. § 301.6225-1(c)(2). Under Prop. Reg. §301.6225-1(c)(3), the total netting partnership adjustment is the sum of all net positive adjustments in the “residual grouping” plus the sum of all net positive adjustments in the “reallocation grouping”.
3. Grouping and Netting of Adjustments. Under Prop. Reg. § 301.6225-1(d), adjustments are grouped together and within each grouping, adjusted items may be further divided into subgroupings depending on their character or to account for preferences, sources, categories, limitations, or other restrictions under Title 26 (for example, adjustments to short-term capital gain will generally be in a different subgrouping from adjustments to long-term capital gain). The rules and their applications are quite complex. See Prop. Reg. § 301.6225-1(d)(1). Prop. Reg. § 301.6225-1(d)(2)(i) provides for three types of groupings, and that the adjustments are divided in order into those groupings. This is the most complex part of the proposed regulations at least from a computational standpoint. Yet, unless the final regulations get it “right”, there could be traps for the unwary on mismatching the characterization of income and loss so that the net amount still results in a positive adjustment and becomes part of an imputed underpayment when on an overall basis there is no income if true netting rules are applied. There is the potential therefore for the coin flip to be “heads the government wins, or tails, the partnership loses”.
a. Reallocation Grouping. As to reallocation groupings, the proposed regulation provide that where any adjustment that reallocates an item from one or more partners to one or more other partners is treated as two adjustments. The first adjustment is a decrease in the amount of the items allocated by the partnership on its return to one or more partners. The second adjustment is an increase in the amount of the items allocated by the IRS to the other partner(s). Each adjustment is grouped in its own reallocation subgrouping to prevent the two adjustments from netting to zero. After application of the netting rules under Prop. Reg. § 301.6225-1(d)(3), any net non-positive adjustment is disregarded in the calculation of the imputed underpayment under Prop. Reg. § 301.6225- 1(d)(3)(ii)(A). An adjustment that results in a net non-positive adjustment is an adjustment that does not result in an imputed underpayment because the reallocation of an item among partners is one of the circumstances described in Prop. Reg. § 301.6225-1(c)(2). The credit grouping described in Prop. Reg. § 301.6225-1(d)(2)(iii) includes all adjustments to items that the partnership claimed or could have claimed as a credit on the partnership's return.
b. Residual Grouping. The third grouping is the residual grouping, which is described in Prop. Reg. § 301.6225-1(d)(2)(v). The residual grouping includes all other adjustments, which are grouped according to character (for instance, ordinary or capital income or loss) and other limitations under the Code. The adjustments of a particular partnership may warrant further subgroupings for other items (for instance, long-term capital versus short-term capital). An adjustment that recharacterizes the character of an item is treated as two separate adjustments, one adjustment decreasing the amount of the item as reported by the partnership and a second adjustment increasing the amount of the item as recharacterized by the IRS. Each adjustment is grouped separately with similar items.
c. Netting Groupings and Subgrouping Results. Prop. Reg. § 301.6225-1(d)(3) describes the rules for netting items after separating the items into their groupings and subgroupings. First, Prop. Reg. § 301.6225-2(d)(3)(i) provides that the IRS will net items within the same grouping or subgrouping. For instance, all ordinary adjustments (assuming no other restrictions under the Code) are netted against each other, regardless of whether such adjustments were part of related transactions or whether they were increases or decreases to income, but none of the ordinary adjustments are netted against the adjustments in the capital subgrouping. Adjustments in the capital subgrouping are netted against each other within that subgrouping. Adjustments from one taxable year may not be netted against adjustments from another taxable year, even if they would otherwise be part of the same subgrouping. See Prop. Reg. § 301.62251-1(c)(4). Once adjustments within each subgrouping have been netted, each grouping or subgrouping will have either a net positive adjustment (as defined in Prop. Reg. § 301.6225-1(d)(3)(ii)(B)) or a net non-positive adjustment (as defined in Prop. Reg.§ 301.6225-1(d)(3)(ii)(C)). As previously mentioned, any netted amount that is a net non-positive adjustment in the reallocation grouping or the residual grouping is an adjustment that does not result in an imputed underpayment under Prop. Reg. § 301.6225-1(c)(2). See also Prop. Reg. §301.6225-3. Any net nonpositive adjustment is disregarded for the remaining purpose of calculating the imputed underpayment. See Prop. Reg. § 301.6225-1(c)(2) (which lists this netting step as another circumstance in which net non-positive adjustments are adjustments that do not result in an imputed underpayment) and § 301.6225- 1(d)(3)(ii)(A). This again could result in a “whipsaw” outcome against the partnership.
d. Exception to Not Recognizing Net Negative Adjustments. The exception to this rule under Prop. Reg. § 301.6225-1(d)(3)(ii)(A) (regarding disregarding net nonpositive adjustments) is set forth with respect to the credit grouping because adjustments to credits are applied to the total netted partnership adjustment after the rate is applied as described in Prop. Reg. § 301.6225-1(c)(1). If the net credits reduce the amount calculated under Prop. Reg. § 301.6225-1(c)(1) to zero or less than zero, the partnership adjustments resulting in the total netted partnership adjustment and the adjustments to credits taken into account in calculating the zero or less than zero amount are all partnership adjustments that do not result in an imputed underpayment under proposed § 301.6225-1(c)(2).
e. Multiple Imputed Underpayments. Prop. Reg. § 301.6225-1(e) provides rules for multiple imputed underpayments. Each administrative proceeding that ends with the determination by the IRS of an imputed underpayment will result in a general imputed underpayment. The IRS may determine, in its discretion, a specific imputed underpayment on the basis of certain adjustments allocated to one partner or a group of partners based on the items or adjustments having the same or similar characteristics, based on the group of partners sharing similar characteristics, or based on the partners having participated in the same or similar transactions. There may be multiple specific imputed underpayments depending on the adjustments. For instance, some transactions may not involve all partners, and there may be a reason to place certain adjustments or even entire groupings into a specific imputed underpayment (described in Prop. Reg. § 301.6225- 1(e)(2)(iii)), while other adjustments remain in a general imputed underpayment (described in Prop. Reg. § 301.6225-1(e)(2)(ii)).
i. Illustration. For example, if a partnership intends to elect the alternative to payment of an imputed underpayment (“push-out” election) under §6226, and, based on the appropriate allocable shares, a particular adjustment should be allocated to one partner or group of partners, the IRS could separate that adjustment into a separate imputed underpayment, called a specific imputed underpayment. The partnership could then elect to apply the rules under § 6226 to the specific imputed underpayment for which a single partner or group of partners would be responsible and the partnership could pay the general imputed underpayment at the partnership level.
ii. Flexibility. The option to create multiple imputed underpayments provides flexibility for the partnership, the partners, and the IRS to address fact-specific issues that may arise as part of the administrative proceeding at the partnership level. If the partnership would like to change the number or composition of the imputed underpayments that are listed on the NOPPA, the partnership may request modification under Prop. Reg. § 301.6225-2(d)(6). See Prop. Reg. §301.6225-1(f) for examples.
4. Modifications to the Imputed Underpayment.
a. Purpose of Modification Procedures With Respect to the Imputed Underpayment Amount. To reach the correct amount of tax, the IRS makes one set of adjustments at the partnership level and allows the partnership, through modification, to adjust the imputed underpayment amount down to the correct amount of tax as if the partnership and partners had correctly computed and paid the aggregate tax amount due to implement the most efficient and prompt assessment and collection of tax attributable to the income of the partnership and partners. See Joint Committee Report to BBA, JCS-1-16 @ 65-66.
b. Audit Process in Determining Imputed Underpayment Amount. Prop. Reg. § 301.6225-1(a) provides, in general, that if a partnership adjustment results in an imputed underpayment, the partnership must pay the imputed underpayment in the adjustment year. As per Prop. Reg. §301.6225-1(a)(3), the partnership adjustments and any imputed underpayment resulting from such adjustments are set forth in a NOPPA mailed to the partnership and partnership representative. The partnership may request modification with respect to an imputed underpayment set forth in the NOPPA under the procedures described in Prop. Reg. § 301.6225-2 as discussed below. As part of the audit process, the IRS may agree to review certain information prior to the issuance of the NOPPA in order to resolve issues in an expedited fashion. This could include “modification” information instead of waiting to the issuance of the NOPPA (and 270 day period). However, once the NOPPA is issued, the modification procedures under Prop. Reg. § 301.6225-2 are the partnership's sole avenue to request changes to an imputed underpayment set forth in the NOPPA.
c. Calculation of the Imputed Underpayment. See discussion above pertaining to the reallocation grouping, credit grouping and residual grouping rules as well as the netting rules and allocation provisions. Note that again that all residual groupings are grouped together according to the character, preferences, restrictions, and other limitations of the item adjusted. Within each grouping, there might be more than one subgrouping based on a partnership's particular adjustments. For instance, within the residual grouping, there might be an ordinary subgrouping as well as a capital income/loss subgrouping. Adjustments that generally affect, or that are affected by, the application of any rules related to preferences, limitations, restrictions, or conventions, will generally be taken into account within their own respective grouping or subgrouping.
d. Characterization of Adjustments. Under Prop. Reg. § 301.6225-1(a)(2) provides that unless the IRS determines otherwise, all applicable preferences, restrictions, limitations, and conventions will be taken into account as if the adjusted item was originally taken into account by the partnership or the partners in the manner most beneficial to the partnership or partners. The Preamble provides an example on this subject. “For instance, if the adjustment is a reduction of qualified research expenses, the IRS may determine the amount of the adjustment as if all partners claimed a credit with respect to their allocable portion of such expenses under section 41, rather than a deduction under section 174. To the extent supported by the facts, the partnership may take steps through the modification procedures set forth in proposed § 301.6225-2 to provide the IRS with information about specific partners and how those partners took items from the partnership into account”. It is presently unclear how the partner level loss limitation provisions will be deemed to apply at the partnership level in arriving at the imputed underpayment amount. Thus, for example, will partnership level capital losses offset ordinary income adjustments on a dollar-for-dollar basis under the netting rule?
e. Modification of Imputed Underpayment: In General. Under §6225(c), a partnership may modify an imputed underpayment under procedures established by the Secretary. Information that is required to be sent to the Service to request a downward modification of the imputed underpayment must be submitted within 270 days following the date of the notice of proposed partnership adjustment (NOPPA) is mailed in accordance with §6231 by the Service. The period for submitting modification requests may be extended with the consent of the Service. §6225(c)(7). Any modification of the imputed underpayment amount shall be made only upon approval of the requested modification by the Service. See §6225(c)(8).
f. Modification Through Partners/Members Filing Amended Returns and Making Payments. Under §6225(c)(2), modification procedures will permit that where one or more partners files amended returns (notwithstanding § 6511) for the taxable year of the partners that includes the end of the reviewed year of the partnership, such returns take into account all adjustments made by the Secretary that are properly allocable to such partners (and for any other taxable year with respect to which a tax attribute is affected by reason of the adjustments made by the Secretary), and payment of any tax due is included with the amended returns, the imputed underpayment will be determined without regard to the portion of the adjustments taken into account in the amended returns. In the case of any adjustment that reallocates the distributive share of any item from one partner to another, a modification described in § 6225(c)(2) will apply only if amended returns are filed by all partners affected by such adjustment.
g. Portion of Imputed Underpayment Attributable to Tax-Exempt Partner or Member. Under §6225(c)(3), modification procedures will provide for determining the imputed underpayment without regard to the portion thereof that the partnership demonstrates is allocable to a partner that would not owe tax by reason of its status as a tax-exempt entity (as defined in section 168(h)(2)). Of course, this requires full consideration of the unrelated business taxable income definition under §511 et seq., and in particular instances, application of the debtfinanced income rules in §514.
h. Demonstration of Lower Rate of Tax on Certain Partnership Items. Under §6225(c)(4), the Proposed Regulations allow the proposed modifications (as properly submitted) to be adjusted by the Service in determining the imputed underpayment by taking into account a rate of tax lower than the highest rate of tax described in § 6225(b)(1)(A)(see §§1, 11, 11(h)) with respect to any portion of an imputed underpayment that the partnership demonstrates is allocable to a partner that is a C corporation or, in the case of a capital gain or qualified dividend, is an individual. In no event can the “lower rate” be less than the highest rate in effect for the reviewed year with respect to the type of income and taxpayer (that is, a C corporation or an individual). For the purposes of the lower rate for capital gains and qualified dividends, an S corporation is treated as an individual. §6225(c)(4)(A). The portion of an imputed underpayment to which the lower rate applies with respect to a partner shall be determined by reference to the partner's distributive share of the items to which the imputed underpayment relates. § 6225(c)(4)(B)(i). If an imputed underpayment is attributable to the adjustment of more than one item, and any partner's distributive share of such items is not the same with respect to all such items, the portion of the imputed underpayment to which the lower rate applies with respect to a partner shall be determined by reference to the amount which would have been the partner's distributive share of net gain or loss if the partnership had sold all of its assets at their fair market value as of the close of the reviewed year of the partnership. §6225(c)(4)(B)(ii).
i. Publicly Traded Partnership (“PTP”) Rule on Modifications. Section 6225(c)(5) provides a PTP, per §469(k)(2), will be allowed to use the modification procedures in computing the imputed underpayment without regard to the portion thereof that the partnership demonstrates is attributable to a net decrease in a specified passive activity loss that is allocable to a specified partner and for the partnership to take such net decrease into account as an adjustment in the adjustment year with respect to the specified partners to which such net decrease relates. See §6225(c)(5)(A). For purposes of §6225(c)(5), the "specified passive activity loss" means, as to any specified partner of such publicly traded partnership, the lesser of the passive activity loss of such partner which is separately determined with respect to such partnership under §469(k) with respect to such partner's taxable year in which or with which the reviewed year of such partnership ends, or such passive activity loss so determined with respect to such partner's taxable year in which or with which the adjustment year of such partnership ends. Section 6225(c)(5)(B).
j. Additional Rules. Section 6225(c)(6) provides that the Secretary may by regulations or guidance provide for additional procedures to modify imputed underpayment amounts on the basis of such other factors as the Secretary determines are necessary or appropriate. With additional comments expected by members of various professional and trade groups on the Proposed Regulations, it is reasonable to expect additional modifications as well as applicable rules in this area.
 For more in-depth treatment of the subject see, in general, August, “The New Partnership Audit Rules: Guidance Needed”, J. Corp. Tax’n (Jan/Feb 2017); August “The Case for Repealing the TEFRA Partnership Audit Rules”, Practical Tax Lawyer (February, 2017); August, “Repeal of the TEFRA Entity Level Audit Rules”, Journal of Tax Practice & Procedure, (August/September 2016); August and Cuff, “The TEFRA Partnership Audit Rules Repeal: Partnership and Partner Impacts”, ALI-CLE Video Webcast (7/17/2016); August, “The Good The Bad, and Possibly the Ugly in the New Audit Rules: Congress Rescues the IRS From Its Inability to Audit Large Partnerships”, Business Entities (WG&L) (May/June 2016); August, “Entity-Level Audit Rules Continue to Pose challenges for Partners”, Parts 1 and 2, Business Entities (WG&L) (Nov./Dec. 2014) (July/Aug. 2015). Section 1101, Pub. L. No. 114-74, the Bipartisan Budget Act of 2015. Section 1101 repeals the current rules governing partnership audits with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level. On the new audit provisions generally, see New York State Bar Association, Tax Section, Report No. 1347, “Report on the Partnership Audit Rules of the Bipartisan Budget Act of 2015” (May 25, 2016).
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