Proposed Regs Address Adjustment of Tax Attributes Under Centralized Partnership Audit Rules

(Parker Tax Publishing March 2018)

The IRS issued proposed regulations which give further guidance on the centralized partnership audit regime rules that are effective for partnership with tax years beginning after 2017. These proposed regulations provide rules that were reserved in earlier proposed regulations and specifically address how and when partnerships and their partners adjust tax attributes to take into account partnership adjustments under both Code Sec. 6225 and Code Sec. 6226. REG-118067-17.

Background

The Bipartisan Budget Act of 2015 (BBA 2015), which was enacted into law on November 2, 2015, repealed the rules governing partnership audits and replaced them with a new centralized partnership audit regime that, in general, determines, assesses and collects tax at the partnership level. The revised rule are generally effective for partnerships with tax years that begin after 2017. Previously, proposed regulations relating to these new rules were issued on August 5, 2016, June 14, 2017, November 30, 2017, December 19, 2017, and January 2, 2018.

Code Sec. 6225, as amended by the BBA 2015, addresses partnership adjustments made by the IRS and the calculation of any resulting imputed underpayment. Prop. Reg. Sec. 301.6241-1(a)(6) provides that the term "partnership adjustment" means any adjustment to any item of income, gain, loss, deduction, or credit of a partnership, or any partner's distributive share thereof. Code Sec. 6225(a) generally provides that the amount of any imputed underpayment resulting from an adjustment must be paid by the partnership. Code Sec. 6225(b) describes how an imputed underpayment is determined, and Code Sec. 6225(c) describes modifications that, if approved by the IRS, may reduce the amount of an imputed underpayment. Under Code Sec. 6225(c), there is a special rule addressing certain passive losses of publicly traded partnerships. Code Sec. 6233 provides rules for computation of interest and penalties on an imputed underpayment.

Code Sec. 6226, as amended by the BBA 2015, provides an exception to the general rule under Code Sec. 6225(a)(1) that the partnership must pay the imputed underpayment. Under Code Sec. 6226, the partnership may elect to have the reviewed year partners take into account the adjustments made by the IRS and pay any tax due as a result of those adjustments. In this case, the partnership is not required to pay the imputed underpayment; instead the partnership pushes out the adjustments to the reviewed year partners. Code Sec. 6225(d)(1) defines the reviewed year to mean the partnership tax year to which the item(s) being adjusted relates.

On February 2, 2018, the IRS issued proposed regulations under Code Sec. 6225 and Code Sec. 6226. Additionally, related proposed regulations were issued under Reg. Secs. 1.704-1, 1.705-1, and 1.706-4.

The preamble to the June 14 proposed regulations announced that the IRS intended to provide additional rules providing for adjustments to the basis of partnership property and book value of any partnership property if the partnership adjustment is a change to an item of gain, loss, amortization or depreciation (i.e., the change is basis derivative). According to the IRS, the proposed regulations issued on February 2, when finalized, will provide this guidance.

Observation: Because these February 2 proposed regulations are supplementing the June 14, 2017, proposed regulations, the numbering and ordering of some of the provisions do not follow typical conventions. The IRS anticipates that these provisions will be appropriately integrated when both the regulations are finalized.

The issuance of the June 14 regulations included several proposed regulations under Code Sec. 6225 and Code Sec. 6226. Prop. Reg. 301.6225-1 provides that each partnership adjustment is either (1) taken into account in the determination of an imputed underpayment, or (2) considered a partnership adjustment that does not give rise to an imputed underpayment. For a partnership adjustment that is taken into account in the determination of the imputed underpayment, the proposed regulations issued on February 2 provide rules for adjusting partnership asset basis and book value, rules for the creation of notional items, rules for allocating these notional items under Code Sec. 704(b), successor rules for situations in which reviewed year partners are not adjustment year partners, and rules for determining the impact of notional items on tax attributes in certain situations. The February 2 proposed regulations also provide rules for the allocation of any partnership expenditure related to the imputed underpayment. Finally, the February 2 proposed regulations provide guidance in the case of a partnership adjustment that does not give rise to an imputed underpayment.

I. Provisions Relating To Code Section 6225

Adjustments in the Case of a Partnership Adjustment that Results in an Imputed Underpayment

Before the enactment of the centralized partnership audit regime, in the case of an adjustment to an item of income, gain, loss, deduction or credit in the context of an examination by the IRS for or related to a partnership, partnership adjustments were generally taken into account by the partners of the partnership for the year under examination by a new or corrected allocation of the relevant item, and partners took those items into account with respect to the partnership year under examination. In contrast, under the centralized partnership audit regime, for a partnership adjustment that is taken into account in the determination of an imputed underpayment, the partnership adjustment is generally taken into account by the partnership in the year in which the related payment obligation (the imputed underpayment) arises. Further, in light of the fact that these partnership adjustments are with respect to a partnership year that is earlier than the year in which the imputed underpayment arises, the partners of the partnership may have changed in the later year.

Generally, a partnership computes items of income, gain, loss, deduction or credit under Code Sec. 703, which are then allocated to the partners under Code Sec. 704. Under Code Sec. 705, a partner increases its basis in its partnership interest (outside basis) by its distributive share of taxable income of the partnership as determined under Code Sec. 703(a). However, in the case of a positive partnership adjustment that is taken into account in the determination of an imputed underpayment, Code Sec. 6225 does not itself provide for an item of taxable income under Code Sec. 703(a) to be allocated to partners. Instead, calculations are made at the partnership level and the partnership pays the liability in the form of an imputed underpayment.

Failure to provide adjustments to outside basis that reflect the partnership adjustments that resulted in the imputed underpayment could lead to a partner being effectively taxed twice on the same item of income, once indirectly on payment of the imputed underpayment and again on a disposition of the partnership interest or on a distribution of cash by the partnership. Taxing the same item of income twice is not consistent with the flow-through nature of partnerships under subchapter K. Thus, the February 2 proposed regulations provide for adjustment to a partner's basis in its interest - and certain other tax attributes that are interdependent with basis under subchapter K - in order to prevent effective double taxation or other distortions.

Specifically, under Prop. Reg. 301.6225-4(a)(1), when there is a partnership adjustment, the partnership and its adjustment year partners (as defined in Prop. Reg. Sec. 301.6241-1(a)(2)) generally must adjust their specified tax attributes (as defined in Prop. Reg. Sec. 301.6225-4(a)(2)). Specified tax attributes are the tax basis and book value of a partnership's property, amounts determined under Code Sec. 704(c), adjustment year partners' bases in their partnership interests, and adjustment year partners' capital accounts determined and maintained in accordance with Reg. Sec. 1.704-1(b)(2).

In the case of a partnership adjustment that results in an imputed underpayment, the adjustments to specified tax attributes must be made on a partnership-adjustment-by-partnership-adjustment basis, and thus are created separately for each partnership adjustment (whether a negative adjustment or a positive adjustment) without regard to their summation as part of the determination of the total netted partnership adjustment in Prop. Reg. Sec. 301.6225-1(c)(3).

Manner of Adjusting Specified Tax Attributes

The partnership must make appropriate adjustments to the book value and basis of property to take into account any partnership adjustment. This also requires amounts determined under Code Sec. 704(c) to be adjusted to take into account the partnership adjustment. The partnership does not make any adjustments to the book value or basis of partnership property with respect to property that was held by the partnership in the reviewed year but is no longer held by the partnership in the adjustment year.

Prop. Reg. Sec. 301.6225-4(b)(3) provides that notional items are then created with respect to the partnership adjustment, and these notional items are then allocated as appropriate. The items are considered notional items because their sole purpose is to affect partner-level specified tax attributes, and thus they are not considered to be items for purposes of adjusting other tax attributes.

In the case of a partnership adjustment that is an increase to income or gain, a notional item of income or gain is created in an amount equal to the partnership adjustment. Similarly, in the case of a partnership adjustment that is an increase to an expense or a loss, a notional item of expense or loss is created in an amount equal to the partnership adjustment. However, in the case of a partnership adjustment that is a decrease to income or gain, a notional item of expense or loss is created in an amount equal to the partnership adjustment. Similarly, in the case of a partnership adjustment that is a decrease to an expense or a loss, a notional item of income or gain is created in an amount equal to the partnership adjustment. These rules have the effect of reversing out the reviewed year allocation to the extent necessary to reflect the partnership adjustment. Thus, under the proposed regulations, an adjustment year partner increases its outside basis for notional income that is allocated to it. Similarly, a partnership that determines and maintains capital accounts in accordance with Reg. Sec. 1.704-1(b)(2)(iv) also adjusts capital accounts for notional items. In the case of a partnership adjustment that reflects a net increase or net decrease in credits as determined under Prop. Reg. Sec. 301.6225-1(d), the partnership creates one or more notional items of income, gain, loss, or deduction that reflects the change in the item giving rise to the credit.

Under these proposed regulations, only specified tax attributes are adjusted. Tax attributes are defined as anything that can affect, with respect to a partnership or a partner, the amount or timing of an item of income, gain, loss, deduction, or credit or that can affect the amount of tax due in any tax year. Examples of tax attributes include, but are not limited to, basis and holding period, as well as the character of items of income, gain, loss, deduction, or credit and carryovers and carrybacks of such items.

The proposed regulations also contain rules to coordinate the changes to specified tax attributes made under the proposed regulations with other rules of the Code, including the rest of the centralized partnership audit regime. To the extent a partner or partnership appropriately adjusted tax attributes before a final determination with respect to a partnership adjustment (for example, in the context of an amended return modification described in Prop. Reg. Sec. 301.6225-2(d)(2) or a closing agreement described in Prop. Reg. 301.6225-2(d)(8)), those tax attributes are not adjusted under the proposed regulations. For example, when a partnership requests a modification of the imputed underpayment with respect to a partner-specific tax attribute (for example, a net operating loss) by the filing of an amended return by a partner or by entering into a closing agreement, the partner-specific tax attribute must be reduced to the extent it is used to modify the imputed underpayment.

Allocation of Notional Items

Under Code Sec. 704(b), a partner's distributive share of income, gain, loss, deduction, or credit (or item thereof) is determined under the partnership agreement if the allocation under the agreement has substantial economic effect. According to the IRS, while the basic principles of Code Sec. 704(b) remain sound in the context of notional items, the unique nature of partnership adjustments under Code Sec. 6225 requires the application of these principles to be modified. Specifically, the IRS said, the allocation of notional items cannot have substantial economic effect because the allocation relates to two different years - while generally determined with respect to the reviewed year, notional items are taken into account in the adjustment year.

Thus, the proposed regulations provide that the allocation of a notional item does not have substantial economic effect, but, to address this issue, further provide that the allocation will be deemed to be in accordance with the partners' interests in the partnership if the allocation of a notional item of income or gain described in Prop. Reg. Sec. 301.6225-4(b)(3)(ii), or expense or loss described in Prop. Reg. Sec. 301.6225-4(b) (3)(iii), is made in the manner in which the corresponding actual item would have been allocated in the reviewed year under the Code Sec. 704 regulations. Additionally, the allocation of a notional item of expense or loss described in Prop. Reg. Sec. 301.6225-4(b)(3)(iv), or a notional item of income or gain described in Prop. Reg. Sec. 301.6225-4(b)(3)(v), must be allocated to the reviewed year partners that were originally allocated that excess item in the reviewed year (or their successors).

Successors

While the determination of partnership adjustments under Code Sec. 6225 is made with respect to reviewed year partners, it is the adjustment year partners that bear the economic burden (or benefit) of a partnership adjustment. Outside basis adjustments must be made to avoid effectively taxing the same item of income twice. While this concern is clearest when a reviewed year partner remains a partner in the adjustment year, the same concern generally exists when the interest is transferred as the failure to provide outside basis would result in effectively taxing the same item of income twice, just with respect to two different taxpayers. Thus, the proposed regulations provide successor rules for purposes of adjusting specified tax attributes, including outside basis.

A reviewed year partner's successor is generally defined as either a transferee that succeeds to the transferor partner's capital account or, in the case of a complete liquidation of a partner's interest, as the remaining partners to the extent their interests increased as a result of the liquidated partner's departure.

The proposed regulations provide rules relating to any situation in which a partnership is unable, after exercising reasonable diligence, to determine a successor for a partnership adjustment under Code Sec. 6225 (not only reallocation adjustments). Prop. Reg. Sec. 1.704-1(b)(1)(viii)(b)(3) provides that if a partnership cannot determine the transferee for a partnership interest, the successor is deemed to be those partners in the adjustment year who were not also partners in the reviewed year or otherwise identifiable as successors to reviewed year partners, in proportion to their respective interests in the partnership.

Adjusting Specified Tax Attributes in Certain Circumstances

For certain types of partnership adjustments, notional items are not created. Specifically, notional items are not created for a partnership adjustment that does not derive from items that would have been allocated in the reviewed year under Code Sec. 704(b), such as a partnership adjustment based upon a partner's failure to report gain under Code Sec. 731, a partnership adjustment that is a change of an item of deduction to a Code Sec. 705(a)(2)(B) expenditure, or a partnership adjustment to an item of tax-exempt income. Nevertheless, in these situations specified tax attributes are adjusted for the partnership and its reviewed year partners (or their successors) in a manner that is consistent with how the partnership adjustment would have been taken into account under the partnership agreement in effect for the reviewed year taking into account all facts and circumstances.

Special Rules for Outside Basis in Certain Cases

While partners normally adjust their outside bases for notional items that are allocated to them, in certain cases, the proposed regulations do not provide for adjustments to outside basis. Specifically, when a tax-exempt partner transfers its interest to a partner that is not tax-exempt (taxable partner) between the reviewed year and the adjustment year and the partnership requests a modification because of the reviewed year partner's status as a tax-exempt entity, the successor taxable partner is disallowed a basis adjustment.

According to the IRS, without this rule, a taxable successor partner would have a basis increase when no imputed underpayment was paid with respect to the partner's share of the partnership adjustment. A basis adjustment is also disallowed when a reviewed year partner transfers its interest to a related party in a transaction in which not all gain or loss is recognized during an administrative proceeding under the centralized audit regime and a principal purpose of the transfer was to shift the economic burden of the imputed underpayment among related parties.

Accounting and Allocation of Partnership Code Section 705(a)(2)(B) Expenditures

The IRS determined that the existing rules that determine whether the economic effect of an allocation is substantial should be modified to take into account the unique nature of Code Sec. 705(a)(2)(B) expenditures. When a partnership pays an imputed underpayment under Code Sec. 6225, it has the effect of converting what would have been a non-deductible partner-level expenditure into a non-deductible partnership-level expenditure. The proposed regulations provide that an allocation of the nondeductible expenditure will be considered to be substantial only if the partnership allocates the expenditure in proportion to the notional item to which it relates, taking into account appropriate modifications.

According to the IRS, this rule aligns the economics of the income allocation (in this case, the notional income allocation) with the directly associated imputed underpayment expense in a manner consistent with the flow-through nature of partnerships. Absent this substantiality rule in the regulations, the IRS said, partnerships could inappropriately allocate expenses to partners in the adjustment year in a manner inconsistent with the underlying economic arrangement of the partners. These new substantiality rules also apply to a payment made by a pass-through partner under Prop. Reg. Sec. 301.6226-3(e)(4).

Similarly, for partnerships that do not maintain capital accounts, the allocation of the expenditure cannot be in accordance with the partners' interests in the partnership to the extent it shifts the economic burden of the payment of the imputed underpayment away from a partner (or its successor) that would have been allocated the corresponding notional income item. However, the regulations provide that an allocation of an expense that satisfies the new substantiality rule and in which the partner's distribution rights are reduced by the partner's share of the imputed underpayment is deemed to be in accordance with the partners' interests in the partnership. These proposed regulations do not address the extent to which the partnership may later reverse this allocation with a special chargeback or similar provision.

The proposed regulations also provide that in order for an allocation of an expenditure for interest, penalties, additions to tax, or additional amounts as determined under Code Sec. 6233 to be substantial, it must be allocated to the reviewed year partner in proportion to the allocation of the related imputed underpayment, the related payment made by a pass-through partner under Prop. Reg. Sec. 301.6226-3(e)(4), or the related notional item to which it relates (whichever is appropriate), taking into account modifications under Prop. Reg. Sec. 301.6225-2 attributable to that partner.

In situations in which the reviewed year partner is not an adjustment year partner, the successor rules in Prop. Reg. Sec. 1.704-1(b)(1)(viii)(b) apply to the allocation of these expenditures. Under those rules, a partner admitted after the reviewed year will not ordinarily be allocated any Code Sec. 705(a)(2)(B) expenditure in the adjustment year.

Partnership Adjustments That Do Not Result in an Imputed Underpayment

The proposed regulations provide that an allocation of an item arising from a partnership adjustment that does not result in an imputed underpayment does not have substantial economic effect but will be deemed to be in accordance with the partners' interests in the partnership if it is allocated in the manner in which the item would have been allocated in the reviewed year under the Code Sec. 704 regulations, taking into account the successor rules.

II. Provisions Relating to Code Section 6226

Code Sec. 6226(b) describes how partnership adjustments are taken into account by the reviewed year partners if a partnership elects to opt out of the centralized audit system under Code Sec. 6226(a). Under Code Sec. 6226(b)(1), each partner's income tax is increased by the aggregate of the adjustment amounts as determined under Code Sec. 6226(b)(2). This increase in income tax is reported on the return for the partner's tax year that includes the date the statement described under Code Sec. 6226(a) is furnished to the partner by the partnership (reporting year). The aggregate of the adjustment amounts is the aggregate of the correction amounts.

The adjustment amounts determined under Code Sec. 6226(b)(2) fall into two categories. Under Code Sec. 6226(b)(2)(A), in the case of the tax year of the partner that includes the end of the partnership's reviewed year (first affected year), the adjustment amount is the amount by which the partner's income tax would increase for the partner's first affected year if the partner's share of the adjustments were taken into account in that year. Under Code Sec. 6226(b)(2)(B), in the case of any tax year after the first affected year, and before the reporting year (that is, the intervening years), the adjustment amount is the amount by which the partner's income tax would increase by reason of the adjustment to tax attributes determined under Code Sec. 6226(b)(3) in each of the intervening years. The adjustment amounts determined under Code Sec. 6226(b)(2)(A) and (B) are added together to determine the aggregate of the adjustment amounts for purposes of determining additional reporting year tax, which is the increase to the partner's income tax in accordance with Code Sec. 6226(b)(1).

Code Sec. 6226(b)(3) provides two rules regarding adjustments to tax attributes that would have been affected if the partner's share of adjustments were taken into account in the first affected year. First, under Code Sec. 6226(b)(3)(A), in the case of an intervening year, any tax attribute must be appropriately adjusted for purposes of determining the adjustment amount for that intervening year in accordance with Code Sec. 6226(b)(2)(B). Second, under Code Sec. 6226(b)(3)(B), in the case of any subsequent tax year (that is, a year, including the reporting year, that is subsequent to the intervening years referenced in Code Sec. 6226(b)(3)(A)), any tax attribute must be appropriately adjusted.

A reviewed year partner's share of the adjustments that must be taken into account by the reviewed year partner must be reported to the reviewed year partner in the same manner as originally reported on the return filed by the partnership for the reviewed year. If the adjusted item was not reflected in the partnership's reviewed year return, the adjustment must be reported in accordance with the rules that apply with respect to partnership allocations, including under the partnership agreement. However, under Prop. Reg. Sec. 301.6226-2(f)(1), if the adjustments, as finally determined, are allocated to a specific partner or in a specific manner, the partner's share of the adjustment must follow how the adjustment is allocated in that final determination.

Prop. Reg. Sec. 301.6226-4(b) provides that the reviewed year partners or affected partners must take into account items of income, gain, loss, deduction or credit with respect to their share of the partnership adjustments as contained on the statements described in Prop. Reg. Sec. 301.6226-2 (pushed-out items) in the reporting year. Similarly, partnerships adjust tax attributes affected by reason of a pushed-out item in the reviewed year. In the case of a reviewed year partner that disposed of its partnership interest prior to the reporting year, that partner may take into account any outside basis adjustment under these rules in an amended return to the extent otherwise allowable.

Unlike the proposed rules under Code Sec. 6225, under Code Sec. 6226, all tax attributes are adjusted for pushed out items of income, gain, deduction, loss or credit.

The proposed regulations provide that an allocation of a pushed-out item does not have substantial economic effect within the meaning of Code Sec. 704(b)(2). However, the allocation of such an item will be deemed to be in accordance with the partners' interests in the partnership if it is allocated in the adjustment year in the manner in which the item would have been allocated under the rules of Code Sec. 704(b) in the reviewed year, followed by any subsequent tax years, concluding with the adjustment year.

A reviewed year partner that is furnished a statement relating to a partnership election to push out partnership adjustments to partners is required to pay any additional income tax (additional reporting year tax) for the partner's tax year which includes the date the statement was furnished to the partner in accordance with Prop. Reg. Sec. 301.6226-2 (the reporting year) that results from taking into account the adjustments reflected in the statement. The additional reporting year tax is the aggregate of the adjustment amounts.

Observation: A practitioner recommended that adjustments to capital accounts and basis be made to the reviewed year partners in the reviewed year to prevent distortions. The IRS rejected this recommendation because, it said, in this context, Code Sec. 6226 clearly applies to the adjustment year. The proposed regulations provide that adjustments to partnership-level tax attributes are calculated with respect to each year beginning with the reviewed year, followed by subsequent tax years, concluding with the adjustment year.

Under the proposed regulations, to the extent a pass-through partner makes a payment in lieu of issuing statements to its owners described in Prop. Reg. Sec. 301.6226-3(e)(4), that payment will be treated similarly to the payment of an amount for purposes of any adjustments to bases and capital accounts, and accordingly, the rules in Prop. Reg. Sec. 301.6225-4 will apply to determine any appropriate adjustments to bases and capital accounts. To the extent that the pass-through partner continues to push out the partnership adjustments to its partners, the partners receiving those adjustments will adjust their bases and capital accounts in accordance with Prop. Reg. Sec. 301.6226-4.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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