Beware of Surprises When Fixing Partnership Data on Tax Forms

The Bipartisan Budget Act of 2015 changed the way partnerships and partners handle corrections to partnership related items as of Dec. 31, 2017. If a partnership subject to the BBA corrects a previously filed return, the regime prohibits partnerships from issuing amended Schedules K-1 to their partners. Instead, a partnership must file an administrative adjustment request.

This process comes with its own surprises and pitfalls for the unwary tax preparer, including nuances with calculating the imputed underpayment, potential penalties and interest, and favorable adjustment limitations.

Calculating Imputed Underpayment

With an AAR, the partnership reports any adjustments to partnership-related items for the tax year in which the adjustments relate (reviewed year), and it must determine if the adjustments result in an imputed underpayment. An IU calculation always must be made and presented on the AAR filing, even if the IU is zero or less than zero. If the partnership makes an election under Section 6227(b)(2) of the tax code to have the reviewed year partners account for the adjustments, the AAR also must include an IU calculation.

The regulations describe a potential pitfall that may result in an unanticipated IU. Adjustments to partnership related items are first sorted into groups, with the last being the “residual” group.

One definition for items that fall within this grouping is “adjustments to partnership-related items that are not allocated under section 704(b).” Within the regulation, the seventh example discusses how reclassifying a recourse liability into a nonrecourse liability results in an IU. The example illustrates how this type of adjustment would be a positive adjustment in the residual group, clarifying that this type of recharacterization could lead to “taxable income if taken into account by any person.”

This example broadens the scope of partnership-related items that result in an IU, and it indicates partnership items not directly related to income or loss also can trigger an IU—for example, any adjustment in partnership items that potentially affect a partner’s basis in their partnership interest.

Potential Penalties and Interest

The IU calculation includes any applicable penalties and interest, as noted in Section 6233(a)(3), that are “determined at the partnership level as if such partnership had been an individual subject to tax under chapter 1 for the reviewed year and the IU were an actual underpayment (or understatement) for such year.”

Penalties could include a failure to pay, inaccuracies, or an underpayment of estimated tax. If the partnership pays the IU, the payment will include amounts related to applicable penalties and interest. If the partnership instead pushes out the adjustments, the applicable penalties are noted on Form 8986, but the penalty amounts calculated for the IU aren’t noted.

The regulations state that the reviewed-year partner calculates the amount of penalty related to the partnership adjustments. No penalty is due if, after considering the partnership adjustments, the partner doesn’t have an underpayment of tax or has an understatement below the applicable threshold for the related penalty.

Interest also is calculated at the partner level and may not tie to the partnership’s calculation of interest related to the IU. If the adjustments pushed out to the partner result in an underpayment of tax, interest is calculated from the due date (without extension) of the reviewed year partner’s return.

For example, assume a partnership files an AAR in tax year 2023 and has unfavorable adjustments that result in an IU related to tax year 2021, while electing to have the reviewed-year partners consider the adjustments. The reviewed-year partners would receive Form 8986 noting their share of unfavorable adjustments, and they would include the unfavorable adjustments in their 2023 tax year filings. Interest on any underpayment of tax related to the 2021 adjustments would start to accrue from the due date (without extension) of the 2021 tax year filings, until the amount is paid.

Adjustment Limitations

If adjustments don’t result in an IU, the partnership must push them out to the partners. The adjustments are taken into account in the reporting year—generally the tax year in which the partnership filed the AAR. The regulations require the partnership to furnish statements to the reviewed-year partners on the date the AAR is filed with the IRS. This statement is Form 8986.

Favorable adjustments may result in a reduction of tax, producing a refund for any overpayment as noted in the regulations. But any reduction of tax in excess of tax payments is apparently nonrefundable. This is commonly called the “stranded overpayment” problem.

This leaves room for some tax planning, because a partnership can file an AAR within the standard three-year statute of limitations. Since the partners pick up adjustments in the tax year in which the AAR is filed, an AAR with favorable adjustments may be filed in a tax year in which the partners expect to have enough tax due to absorb the full tax benefits generated from the favorable adjustments.

Another surprise that has caught tax preparers off-guard is that any “stranded overpayment” doesn’t reduce self-employment taxes. Adjustments included in an AAR relate to Chapter 1 tax, or income tax, and may not provide any benefit or reduction in other taxes such as self-employment tax, which is a Chapter 2 tax.

Favorable adjustments also could have unforeseen alternative minimum tax implications. For instance, the partnership would need to file an AAR if it elected out of bonus depreciation and instead depreciated those assets under the modified accelerated cost recovery system, and discovered it missed additional MACRS depreciation on those assets after filing a tax return. The additional depreciation would be a favorable adjustment reducing regular tax, but apparently there is no reduction to the tentative minimum tax, meaning the partner could be subject to AMT even though they otherwise wouldn’t be.

For partnerships, amended Schedules K-1 are a thing of the past, and the new AAR process now controls. A proper understanding of this new process is critical for practitioners to avoid unintended consequences.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Todd Laney is a senior manager at Eide Bailly LLP’s National Tax Office. He has more than 10 years of public accounting experience providing clients with income tax compliance and tax advisory services.