For calendar-year partnerships, the centralized partnership audit rules in the Bipartisan Budget Act of 2015 (BBA) generally have been in effect since 2018. Understandably, most of the guidance under the BBA relates to adjustments of items of income, gain, loss, deduction, and credit (income items). In contrast, there has been very limited guidance on how adjustments to other items (non-income items) should be taken into account.
On Nov. 24, 2020, the Treasury Department and the IRS proposed new regulations under the centralized partnership audit procedures (2020 proposed regulations). 85 Fed. Reg. 74940. Although most of the 2020 proposed regulations concern “special enforcement matters,” they also address the way that adjustments to non-income items are taken into account in computing an imputed underpayment (IU) for which partnerships are generally liable. This provision is proposed to be applicable on Nov. 20, 2020.
Adjustments to partnership-related items (PRIs) may be initiated by a partnership if the partnership representative files an administrative adjustment request (AAR). Adjustments also may be initiated by the IRS after a partnership-level examination. PRIs generally include any item or amount that is (i) shown or reflected, or required to be shown or reflected, on a partnership’s return or (ii) required to be maintained in a partnership’s books or records, if that item or amount is relevant in determining the tax liability of any person under Chapter 1 of the tax code (Chapter 1 tax). See Treasury Regulation Section 301.6241-1(a)(6). Under the BBA rules, a positive adjustment generally can be multiplied by the highest tax rate applicable to individuals or corporations for the reviewed year (highest rate) to compute an IU.
Guidance under the Tax Cuts and Job Act, enacted in 2017, has resulted in a dramatic increase in the amount of non-income items required to be reported by partnerships to their partners. As the IRS prepares to audit more partnerships in 2021, the effect, if any, of adjustments to non-income items on IUs may become even more important. This article highlights concerns that are raised by the proposed treatment of adjustments to non-income items provided in the 2020 proposed regulations and other recent guidance.
Prior Guidance on Non-Income Items
On Aug. 17, 2018, to reflect changes to the BBA made by the Tax Technical Corrections Act of 2018, Treasury and the IRS withdrew regulations that had previously been proposed in June, November, and December of 2017, and February of 2018 to the extent the provisions in those prior proposed regulations had not been finalized, and proposed new regulations in their place (the 2018 proposed regulations). 83 Fed. Reg. 41954. The 2018 proposed regulations included two examples involving the IRS’s recharacterization of a partnership liability (liability examples).
In the first example, the IRS recharacterized a $100 partnership liability from recourse to nonrecourse and treated the adjustment as a $100 positive adjustment that was taken into account in determining an IU. Proposed Treas. Reg. Section 301.6225-1(h)(7) (Example 7). The example stated that the adjustment was treated as a positive adjustment because the recharacterization could result in up to $100 in taxable income if taken into account by any person. This example was finalized in February 2019.
In the second example, a partnership treated a $200 liability as nonrecourse and allocated it equally to the partnership’s two partners. Prop. Treas. Reg. Section 301.6225-4(e) (Example 5). The IRS recharacterized the liability as recourse and determined that the recharacterized recourse liability should be allocated entirely to one of the partners. The example treated the “cumulative effects” of the adjustments as a decrease to the other partner’s share of liabilities. This decrease was treated as a positive adjustment that was taken into account in determining an IU. This example is part of the proposed regulations on the effect of partnership-level adjustments on tax attributes, which have not been finalized.
In a memorandum dated October 24, 2019 (2019 memorandum), the IRS described how IRS employees should conduct partnership-level audits under the BBA. See LB&I-04-1019-010. The 2019 memorandum provides that assessing self-employment tax (SE tax) attributable to partnership income requires dual procedures. First, the IRS will conduct a partnership-level audit to adjust net earnings from self-employment (NESE) (reported on line 14 of Schedules K and K-1) to correspond in full or in part with the partnership’s ordinary business income (reported on line 1). The 2019 memorandum states that an increase to NESE (a non-income item) of $100,000 would result in an IU of $37,000, even though the partnership’s ordinary business income (the corresponding income item) was reported correctly. This statement is especially surprising given that the only potential Chapter 1 tax effect of an increase in NESE would be to increase the partner’s deduction for the employer’s portion of the SE tax—a favorable effect.
IU Guidance in the 2020 Proposed Regulations
Treas. Reg. Section 301.6225-1(b)(4) provides that, “[i]f the effect of one partnership adjustment is reflected in one or more other partnership adjustments, the IRS may treat the one adjustment as zero solely for purposes of calculating” an IU. The 2020 proposed regulations would amend this rule to provide a similar rule for adjustments to non-income items. The preamble to the 2020 proposed regulations states that, under the 2020 proposed regulations, an adjustment to a non-income item “generally” would be treated as zero for purposes of determining an IU if the adjustment to the non-income item “results from” or is “related to” an adjustment to an income item. According to the preamble, examples of non-income items include, “the partnership’s assets, liabilities, and capital accounts.”
Although the language of the proposed regulation refers to an adjustment to an income item that results from or is related to an adjustment to a non-income item, this discrepancy from the preamble appears to be inadvertent. The following paragraph shows how Treas. Reg. Section 301.6225-1(b)(4) would be amended by the proposed regulations if they followed the rule in the preamble:
(4) Treatment of adjustment as zero. If the effect of one partnership adjustment is reflected in one or more other partnership adjustments, the IRS may treat the one adjustment as zero solely for purposes of calculating the imputed underpayment. If an adjustment to an item [that is not an item] of income, gain, loss, deduction, or credit is related to, or results from, an adjustment to an item that is [ ] an item of income, gain, loss, deduction, or credit, the adjustment to the item that is not an item of income, gain, loss, deduction, or credit will generally be treated as zero solely for purposes of calculating the imputed underpayment unless the IRS determines that the adjustment should be included in the imputed underpayment.
Under this proposal, even if an adjustment to a non-income item “generally” were treated as zero, the IRS would not be precluded from later determining that the adjustment must be taken into account in determining an IU. However, the 2020 proposed regulations do not indicate what the proper standard would be for the IRS to make such a determination.
Many non-income items seem to be “related to” each other, even though they are not completely overlapping. For example, an adjustment to the amount of a partnership liability may require a corresponding adjustment to the partnership’s adjusted basis in an asset purchased with proceeds of that liability; an adjustment in a partnership’s basis in its assets may require an adjustment to the partners’ tax capital accounts; and an adjustment in a partner’s tax capital account may require an adjustment to the partner’s Section 704(b) capital account. Unfortunately, none of these adjustments would be eligible to be disregarded under the 2020 proposed regulations, because none of the adjusted items is an income item.
Even if there are adjustments to both income and non-income items, the 2020 proposed regulations do not elaborate on when or to what extent an adjustment to a non-income item is related to or results from an adjustment to an income item. For example, an adjustment to the partnership’s non-separately stated income (line 1 of Schedule K) generally would be related to, while not necessarily matching exactly, many non-income items, some of which would affect other related items. Examples of non-income items that are related to non-separately stated income may include (1) qualified business income under Section 199A, (2) adjusted taxable income under Section 163(j), (3) trade or business income under Section 461(l), and (4) effectively connected income under Section 864(c).
Unfortunately, there are no examples in the current regulations or the 2020 proposed regulations illustrating a situation where an adjustment to a non-income item is treated as zero. The only example shedding any light on the application of Treas. Reg. Section 301.6225-1(b)(4) is an example in the 2020 proposed regulations involving a non-income item. In the example, the partnership overstated its adjusted basis in a single non-depreciable asset by $10. The asset was not sold during the partnership’s reviewed year. The example concludes that the partnership’s overstatement of its basis alone would be treated as a positive adjustment of $10 and taken into account in determining an IU at the highest rate. See Prop. Treas. Reg. Section 301.6225-3(d)(3). Thus, the partnership would have been required to pay $4 if there had not also been one other adjustment in the facts of the example—an increase to a credit that reduced the partnership’s IU to zero.
Notice 2021-13, released by the IRS on Jan. 19, 2021, provides partnerships with relief from certain penalties due to errors in reporting their partners’ beginning tax capital account balances on the 2020 Schedules K-1. Among other things, the notice provides that the IRS will waive accuracy-related penalties under Section 6662 for any taxable year “with respect to any portion of an [IU] that is attributable to an adjustment to a partner’s beginning [tax] capital account balance” for the 2020 taxable year, to the extent the adjustment arises from the inclusion of incorrect information and the partnership can show that it took ordinary and prudent business care in following the 2020 Form 1065 instructions to report its partners’ beginning tax capital account balances. See Section 4 of Notice 2021-13. Notwithstanding the helpful penalty relief, the IRS effectively declared in Notice 2021-13 that changes to a partner’s tax capital (a non-income item) can give rise to an IU.
Other types of capital accounts also might be implicated by the position taken in the notice. For example, many partnerships will continue to maintain capital accounts under the current Section 704(b) regulations in their books and records, even if they aren’t shown on the partnership’s return. It would not seem very equitable to require a partnership that has errors in any of its capital accounts to multiply those errors by the highest rate.
In some respects, the liability examples, the NESE discussion in the 2019 memorandum, the example in the 2020 proposed regulations regarding a partnership’s basis in one of its assets, and Notice 2021-13 (regarding tax capital) are consistent. In all of these cases, adjustments to non-income items would be taken into account in determining an IU. The last three cases, however, are problematic because in none of them could there be any possibility that the adjustment would have caused a partner to have income in the reviewed year equal to the amount of the adjustment. The cumulative effect of these examples is to illustrate that taking into account adjustments to non-income items in determining an IU could cause the IU to become entirely disconnected from the partners’ actual aggregate Chapter 1 tax liability.
In addition, none of these basic examples takes into account the vast amount of information that is reported on a typical partnership return. The instructions to Form 1065 have been expanded to require detailed reporting of non-income items such as tax capital, the allocation of Section 743(b) adjustments, allocations under Section 704(c), and items on draft Schedules K-2 and K-3 (regarding international reporting). There are over 150 different codes used on the 2020 Schedule K-1, each of which may be used to report multiple PRIs. Because there are so many non-income items, if a partnership fails to issue a Schedule K-1 to a partner, for example, there may be hundreds of non-income items that need to be adjusted. If adjustments to all of those non-income items potentially could be taken into account as positive adjustments in determining an IU, the IU could be far greater than the partners’ actual aggregate Chapter 1 tax liability, which the IU process is intended to approximate.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Matthew Lay is a managing director in the passthroughs group in the Washington National Tax office of Deloitte Tax LLP. Before joining Deloitte, Matthew worked for the Passthroughs and Special Industries division in the IRS Office of Chief Counsel in various roles, specializing in the taxation of partnerships.
Ira Aghai is a manager in the passthroughs group in the Washington National Tax office of Deloitte Tax LLP.
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