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INSIGHT: IRS Memo Suggests Expanded Role For Appeals Within the Partnership Audit Procedures

April 12, 2019, 1:00 PM

The role of the Internal Revenue Service Office of Appeals within the partnership audit procedures enacted by the Bipartisan Budget Act of 2015 (BBA) has been the subject of much interest and debate. The preamble to the BBA final regulations issued in February 2019 offered some guidance, but did not provide a complete picture. A recent IRS Interim Guidance memorandum sheds further light on Appeals’ role, including hints that Appeals will review determinations made during the BBA modification process. This is important news for partnerships that find themselves the subject of a BBA audit and potentially liable for a BBA imputed underpayment.


In the BBA, Public Law 114-74, Congress enacted new audit procedures for examining partnerships required to file Form 1065, U.S. Return of Partnership Income. The BBA procedures generally apply to partnership taxable years beginning on or after Jan. 1, 2018. As a default rule, the BBA procedures provide that the partnership, and not its partners, must pay any tax attributable to any adjustments made to the partnership return. The BBA procedures, however, also provide a process referred to as “modification” by which the partnership may reduce this amount of tax through several methods, including by providing information concerning the tax attributes of the partnership’s partners or by having the partners file amended returns to take into account the IRS adjustments.

A lingering question since BBA’s enactment has been whether and to what extent review by IRS Appeals applies to the BBA procedures, particularly in the context of the modification process. Although the preamble to final regulations issued in February 2019 provided some answers, certain questions still remained. An Interim Guidance memorandum issued in late March helpfully provides further insight as to the IRS’s thinking regarding the role of Appeals.

Under the BBA procedures, the IRS makes adjustments to the partnership return and determines whether those adjustments result in an “imputed underpayment.” The general rule is the partnership must then pay this imputed underpayment at the conclusion of the IRS audit. Under tax code Section 6225(b) and the regulations thereunder, an imputed underpayment is determined by first netting adjustments, as appropriate, within each category of items that are required to be taken into account separately under tax code Section 702(a) or other provision of the tax code. In general, any adjustments that may be subject to limitations in the hands of the partners and that would otherwise reduce the imputed underpayment are disregarded from the imputed underpayment calculation. After the adjustments are netted, the “total netted partnership adjustment” is then multiplied by the highest rate of tax in effect under tax code Section 1 or 11 for the audited year. See generally Treasury Regulation Section 301.6225-1(b), (c), (d) and (e).

For example, assume in an audit of a 2018 partnership return, the IRS recharacterizes a $1 million long-term capital gain (LTCG) reported on the partnership return as a $1 million item of ordinary income. Pursuant to Treas. Reg. Section 301.6225-1(c)(6)(iii), the recharacterization adjustment results in two adjustments—an increase of $1 million in ordinary income and a corresponding decrease of $1 million in LTCG. Because the $1 million decrease in LTCG is required to be taken into account separately under tax code Section 702(a) and would otherwise reduce the imputed underpayment if it were netted with the $1 million increase in ordinary income, the decrease in LTCG is disregarded for purposes of computing the imputed underpayment. (The method in the regulations for achieving this result is more complex than as just described, but the rules have been simplified for purposes of this discussion. See Treas. Reg. Section 301.6225-1(h)(4).) The $1 million increase in ordinary income is then multiplied by the highest rate of tax, 37 percent in tax year 2018, to produce an imputed underpayment of $370,000, which, as a general matter, the partnership must pay at the conclusion of the IRS audit.

Final Regulations

Recognizing that the imputed underpayment will likely reflect an amount that is larger than the cumulative amount of tax the partners would have paid if the partnership and its partners had reported correctly, the statute and the regulations provide “modification” procedures. According to the preamble to the BBA final regulations published Feb. 27, 2019, modification is designed “to determine an imputed underpayment amount that reflects, as closely as possible, the tax the partners would have paid had they correctly reported the adjusted items, while at the same time maintaining the efficiencies of a streamlined examination and collection process.” TD 9844, 84 FR 6468, 6487.

For example, during modification the partnership may demonstrate to the IRS that all of its partners in 2018 were C corporations and therefore request that the imputed underpayment be computed using a 21 percent rate instead of the highest rate of 37 percent. Treas. Reg. Section 301.6225-2(d)(4). Alternatively, during modification the partnership may demonstrate that the adjustments resulting in the imputed underpayment are solely allocable to a partner that is a tax-exempt entity (and that the adjustments would not have produced unrelated business taxable income) and may request that the imputed underpayment be determined to be zero on the ground that the partner allocated the adjusted item does not pay tax. Treas. Reg. Section 301.6225-2(d)(3).

Given the clear importance of the rules governing how imputed underpayments are determined and how the modification process will work, multiple commentators asked for clarification of those rules in the BBA final regulations. Certain commentators specifically asked for clarification regarding the interaction of the modification procedures and the rules governing IRS Appeals, including rules regarding a partnership’s ability to raise various issues and determinations with Appeals and the timing of any involvement by Appeals. Although the final regulations themselves do not provide rules pertaining to Appeals, the preamble to the final regulations does indicate that:

“The IRS plans to adopt procedures under which the partnership will have an opportunity to resolve with IRS Appeals any issues with respect to the adjustments made during the examination prior to the mailing of the NOPPA [notice of proposed partnership adjustment, which triggers the modification process]. Therefore, all issues with respect to the adjustments will generally be resolved at the administrative level prior to the mailing of the NOPPA and the start of the 270-day modification period.” TD 9844, 84 FR 6468, 6500.

This language from the preamble to the final regulations is helpful guidance for partnerships concerned about the availability of Appeals’ review of adjustments made during a BBA audit. The preamble does not address, however, how or whether Appeals’ review is available for any determinations made by the IRS during the modification process. For example, the IRS may determine that a partner to whom the adjustments are allocable is not a tax-exempt entity (or the IRS may determine that the adjustments allocable to that partner produce unrelated business taxable income) and therefore conclude that modification should not be approved.

IRS Interim Guidance Memo

In an Interim Guidance memorandum (AP-08-0319-0005) issued March 25, 2019, the IRS appears to have addressed the question of whether Appeals will review modification determinations. The memorandum, which indicates that BBA cases are an Appeals Coordinated Issue, provides guidance to IRS Appeals employees regarding the handling of BBA cases and requires BBA cases to be routed to the Appeals TEFRA team (ATT) in Laguna Niguel, Calif., for initial screening and assignment of an ATT Appeals Officer to serve as a consultant to the BBA case. Pursuant to the memorandum, referrals are mandatory for all BBA cases including, among other bulleted items, “Modification Dispute Screening” and “Tax Computation Imputed Underpayment.”

The memorandum also introduces new codes for Appeals employees to distinguish between three different types of BBA cases—key cases, investor cases, and “BBA elect out cases”—and to describe the BBA work on those cases. Two codes pertain to the “initial hearing on substantive issues” and the “notice of proposed partnership adjustment.” These codes are consistent with the statements in the preamble to the final regulations regarding Appeals’ review of adjustments made during the examination and appear to confirm that partnerships will have an opportunity to dispute adjustments in Appeals prior to the issuance of the NOPPA and the start of the modification period. Two additional codes, however, seemingly pertain to modification work, an area not heretofore addressed by the IRS in the final regulations or other guidance. One code describes a “BBA modification hearing” and another refers to “final partnership adjustment” (which is the notice mailed by the IRS to provide its final determinations regarding the audit adjustments and any approvals or denials of modification requests).

Taken as a whole, the Interim Guidance memorandum strongly suggests, without actually stating, that Appeals’ review will be available not only for adjustments made during a BBA examination, but also generally will be available for determinations made during the modification process. This is important news for partnerships potentially subject to a BBA audit and that may become liable for an imputed underpayment amount that is clearly in excess of what the partners would have paid had the partnership and the partners reported correctly.

Election Out of BBA

Certain partnerships may elect out of BBA provided they meet the eligibility requirements and they follow the election out procedures. Under Treas. Reg. Section 301.6221(b)-1(e)(1), the partnership and all partners are bound by an election out of BBA unless the IRS determines the election is invalid. (This includes situations in which the election out is not fully compliant with all applicable rules.) The preamble to proposed regulations issued in June 2017 indicated that “the IRS intends to carefully review a partnership’s decision to elect out of the [BBA] centralized partnership audit regime,” but did not explain how that review process will work. 82 FR 27334, 27344. Treas. Reg. Section 301.6221(b)-1(e)(2) provides that if the IRS determines that an election out is invalid, the IRS will notify the partnership in writing and the BBA procedures will apply to that partnership taxable year. The preamble to final regulations issued in January 2018 rejected a recommendation to include a mechanism for allowing the partnership to cure compliance errors related to an election out, indicating that such procedures “are more appropriately addressed in sub-regulatory guidance … .” TD 9829, 83 FR 24, 30.

As indicated above, the Interim Guidance memorandum identifies three different types of BBA cases, one of which is a “BBA elect-out case.” The memorandum does not explain what constitutes a “BBA elect-out case,” but a plain reading of the phrase suggests a case involving the validity of an election out of BBA. If Appeals’ review is available for determinations regarding elections out of BBA, this too would be a notable development for partnerships that thought they had successfully opted out of BBA, only to be notified later that their election was invalid. Such a determination by the IRS has significant consequences for the partnership, as the validity of the election out determines whether the IRS must follow deficiency procedures with respect to the direct and indirect partners of the partnership, or instead, whether the BBA procedures will apply. Absent review by Appeals, it is not clear what ability a partnership has to challenge a determination by the IRS that an election out is invalid.


Clearly, further guidance from the IRS is needed regarding Appeals’ involvement in BBA cases, but this memorandum is an important first step. The memorandum indicates that the interim guidance applies until Internal Revenue Manual 8.19, Appeals Pass-Through Entity Handbook, is revised later this year.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Greg Armstrong is a director in the Practice, Procedure, and Administration group of KPMG LLP’s Washington National Tax practice. Mr. Armstrong would like to thank Ossie Borosh, Mike Dolan, and Curt Wilson of KPMG LLP for their helpful comments and edits.

The information in this article is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author(s) only, and does not necessarily represent the views or professional advice of KPMG LLP.

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