Why Partnerships Are Surprised by High Imputed Underpayments

“Why is my imputed underpayment so large?” is a common question from partnership representatives. The calculation rules for imputed underpayments (IU) under the Bipartisan Budget Act of 2015 (BBA) often results in unexpectedly high amounts, primarily due to the inclusion of items other than items of income, gain, loss, deduction, or credit (referred to as “Non-Income Items”). These Non-Income Items can significantly inflate the IU associated with the results of an IRS audit or a partnership-filed administrative adjustment request (AAR). §6241(2)(B); Treas. Reg. §301.6241-1(a)(6)(ii); 87 Fed. Reg. 75,475 (2022). This article explains how Non-Income Items factor into IU calculations during IRS audits and partnership AARs and highlights the implications to BBA partnerships and their partners.

The following Example will be analyzed throughout the article and assumes the following facts:

• Partnership PRS is subject to the BBA with respect to its 2022 calendar tax year (the reviewed year). Treas. Reg. §301.6241-1(a)(9).
• PRS determines in 2026 (the adjustment year (Treas. Reg. §301.6241-1(a)(1)) that its 2022 tax return incorrectly reported a $1,000 depreciable asset as being placed in service when the asset had not yet been placed in service. PRS, therefore, understated ordinary business income by $200 (the depreciation inadvertently deducted).
• PRS also determined that it inadvertently understated ending nonrecourse liabilities by $100.
• PRS is hoping to file an AAR in 2026 and pay the IU and related interest, and penalties, if applicable, rather than create an administrative burden for its direct and indirect partners by electing to “push out” the adjustments. (As will be discussed below, partnerships that file an AAR have the option to either pay the imputed underpayment based on the adjustments requested or elect under §6227(b)(2) to “push out” the adjustments to its partners in which case the partnership is no longer liable for the IU.)
• PRS prepares an AAR to adjust the following items with respect to its 2022 tax return:
  
  • Increase Schedule K-1, Box 1, ordinary income by $200;
  • Increase Schedule K-1, Box 20Z, qualified business income (QBI) by $200; Decrease Schedule K-1, Box 20Z, unadjusted basis immediately after acquisition (UBIA) by $1,000;
  • Increase Schedule K-1, Item K, ending nonrecourse liabilities by $100;
  • Increase the tax basis of its assets in its books and records by $200; and
  • Many other partnership related items may be impacted by these adjustments, including but not limited to §163(j), §1402(a), and Schedule K-3 international reporting. For simplicity, the Example assumes only the noted items are impacted, and further assumes there is no impact on the allocation of any other partnership related item amongst the partners. One can imagine (and the author has seen in practice) many other Non-Income Items being adjusted in similar fact patterns, particularly given the voluminous information often required by Schedule K-3. Although changes to partner capital accounts were implied to give rise to an IU in IRS Notice 2021-13, the IRS website showing an example computation of an IU does not include partner capital accounts (How to figure an imputed underpayment|Internal Revenue Service (irs.gov)).

Note that on Nov. 24, 2020, the IRS and Treasury published proposed regulations (the “2020 Proposed Regulations”) addressing, among other things, the treatment of Non-Income Items in the calculation of the IU. As acknowledged in the preamble to the 2020 Proposed Regulations, the final regulations published February 27, 2019 (the “2019 Final Regulations”), did not address how Non-Income Items are treated for purposes of calculating an IU. As discussed in more detail below, the 2020 Proposed Regulations proposed that Non-Income Items be included in the calculation of the IU. Additional final regulations published in the Federal Register on December 9, 2022 (the “2022 Final Regulations”) confirm the inclusion of Non-Income Items in the IU calculation.

At a macro level, the calculation of the IU in this Example is the total netted partnership adjustment (“TNPA”), multiplied by the highest rate under §1 or §11 for the 2022 tax year (37%). The TNPA might be any of the following depending upon the application of the “Subsume Rule” (discussed in more detail later). Minimum possible TNPA: $200 ordinary income + $100 nonrecourse liabilities = $300 Maximum possible TNPA: $200 ordinary income + $200 QBI + $1,000 UBIA + $100 nonrecourse liabilities + $200 tax basis in assets = $1,700. Possible alternative TNPA: $200 ordinary income + $1,000 UBIA + $100 nonrecourse liabilities = $1,300.

Because the IU rules require the inclusion of Non-Income Items, and the ambiguities in the application of some of these rules, PRS could have an IU ranging from a minimum of $111 ($300 x 37 percent) to a maximum of $629 ($1,700 x 37 percent), before any potential modifications (Treas. Reg. §301.6227-2(a)(2) in the case of an AAR) (discussed in more detail below).

The IU may be more than the increase in the partnership’s income itself ($200). The modifications available to PRS in an AAR context are unlikely to significantly change the IU related to Non-Income Items (discussed in more detail below). PRS is likely to decide to “push out” the adjustments to its reviewed year partners instead of paying the IU. §6227(a); Treas. Reg. §301.6227-2(c). Depending on the number of PRS direct or indirect (through tiers of pass-through ownership) partners, the collective administration burden of the affected taxpayers and the IRS could be quite substantial.

I. General BBA Rules

Enacted in 2015 and generally effective for tax years beginning after Dec. 31, 2017, the BBA repealed the rules governing IRS audits of most partnerships—the Tax Equity and Fiscal Responsibility Act (TEFRA) and the electing large partnership regime (ELP)—and replaced them with a new centralized partnership audit regime.

The BBA provides the rules governing partnerships, other than those that can and do elect out of the BBA. Treas. Reg. §301.6221(b)-1. Any partnership with a partnership, trust, certain ineligible foreign entity, disregarded entity, estate, nominee, or qualified subchapter S subsidiary cannot elect out, significantly limiting the pool of eligible partnerships that can elect out.

The BBA rules apply in two situations:

• IRS audits of partnerships (§6221-§6241); and
• Partnership requests for adjustments to a previously filed partnership tax return via an AAR after the extended due date of the originally filed return (§6227 and the regulations thereunder).

The common theme in both scenarios is that all determinations are centralized and made at the partnership level. §6221(a); Treas. Reg. §301.6221(a)-1(a).

Partnership adjustments can result in an IU, which the partnership must pay along with any applicable interest and penalties, unless the partnership elects to “push out” the partnership adjustments that caused the IU to its partners.. §6225(a); §6226(a); §6227(a); Treas. Reg. §301.6225-1(a); Treas. Reg. §301.6226-1(a); Treas. Reg. §301.6227-2(c). The partnership may request certain modifications to the IU, subject to approval by the IRS in an audit context (§6225(c); Treas. Reg. §301.6225-2(a)), or the partnership may affirmatively apply certain modifications to the IU reported on and paid with an AAR (Treas. Reg. §301.6227-2(a)(2)). The modifications available in an AAR context are more limited than in the IRS audit context. Treas. Reg. §301.6225-2(d); Treas. Reg. §301.6227-2(a)(2).

The payment of the IU and any applicable penalties and interest are nondeductible expenditures of the partnership. Treas. Reg. §301.6241-4(a). If the IRS later initiates an audit with respect to the AAR in which the IU was originally paid and the IRS determines the IU was understated, the partnership must pay the incremental IU and does not have the option of pushing out. Treas. Reg. §301.6226-2(g)(4); 87 Fed. Reg. 75,476 (2022). Any partnership adjustment that does not result in an IU is generally taken into account in the partnership’s adjustment year return in the case of an IRS audit (Treas. Reg. §301.6225-1(f)(2)) or is required to be pushed out to the reviewed year partners in the case of an AAR. Treas. Reg. §301.6227-2(d).

A partnership with adjustments that result in an IU can elect to push out those adjustments to its reviewed year partners. §6226; Treas. Reg. §301.6226-1(a). If the partnership makes the election, all partnership adjustments, including those adjustments that do not result in an IU, are pushed out to the reviewed year partners. Treas. Reg. §301.6226-1(b)(1); Treas. Reg. §301.6225-3(b)(6); Treas. Reg. §301.6227-3(a). The reviewed year partners account for the partnership adjustments in their reporting year returns via a recomputation of their reviewed year, and intervening year(s) if applicable, tax liability resulting under subtitle A, chapter 1 of the Internal Revenue Code (“Chapter 1”) (§6226(b)(1); Treas. Reg. §301.6226-3(a)). Treas. Reg. §301.6226-3(a); Treas. Reg. §301.6227-3(a). Generally, the reporting year of the direct or indirect partner and the adjustment year of the partnership that filed the AAR or was subject to an IRS audit are the same if the taxpayers share the same tax year end.

The recomputation results in an increase or decrease to the partner’s reporting year Chapter 1 tax. A partnership that has made a valid push out election is no longer liable for the IU. Treas. Reg. §301.6226-1(a); Treas. Reg. §301.6226-1(b)(2).

II. BBA Definitions Relevant to the IU

The following selected definitions are particularly relevant to the IU computation.

A. Partnership-Related Item
A partnership-related item is (i) any item or amount with respect to the partnership (regardless of whether the item or amount appears on the partnership’s return and including an IU and any item or amount relating to any transaction with, basis in, or liability of the partnership) which is relevant in determining the Chapter 1 tax liability of any person or (ii) any partner’s distributive share of any such item or amount. §6241(2)(B); Treas. Reg. §301.6241-1(a)(6)(ii). The regulations provide examples including but not limited to: the partnership’s basis in its assets, the amount and character of partnership liabilities, and the character, timing, source, and amount of the partnership’s income, gain, loss, deductions, and credits. Treas. Reg. §301.6241-1(a)(6)(v). The definition of a partnership-related item is very broad, includes more than just items of income, gain, loss, deduction, or credit, and does not require the item to have actually impacted the Chapter 1 tax liability of any person.

B. Partnership Adjustment
A partnership adjustment is an adjustment to a partnership-related item that is either proposed by the IRS as the result of an audit or by the partnership in an AAR filing. §6241(2)(A); Treas. Reg. §301.6241-1(a)(6)(i). The adjustment may be either a negative or positive adjustment. Treas. Reg. §301.6225-1(d)(2).

C. Negative Adjustment
A negative adjustment is any partnership adjustment that is a decrease in an item of income or gain, an increase in an item of loss or deduction, an increase in an item of credit, a decrease in an item of tax, penalty, addition to tax, or additional amount for which the partnership is liable under Chapter 1, or a decrease to an IU previously computed and paid. Treas. Reg. §301.6225-1(d)(2)(ii).

D. Positive Adjustment
A positive adjustment is any partnership adjustment that is not a negative adjustment. Treas. Reg. §301.6225-1(d)(2)(iii).

E. Non-Income Items
As noted above, Non-Income Items are items other than items of income, gain, loss, deduction, or credit. §6241(2)(B); Treas. Reg. §301.6241-1(a)(6)(ii); 87 Fed. Reg. 75,475 (2022). Due to the broad definition of partnership-related items, the scope of Non-Income Items is also quite broad and can include items, ranging from but not limited to, basis of partnership assets and liabilities, §199A information, §163(j) information, and international items reported on Schedule K-2 Partners’ Distributive Share Items—International and Schedule K-3 Partner’s Share of Income, Deductions, Credits, etc.—International.

All Non-Income Items are positive adjustments by default because negative adjustments are narrowly defined and limited to income items. 87 Fed. Reg. 75,475-6 (2022). (The preamble to the 2022 Final Regulations states: “A negative adjustment is any adjustment that is a decrease in an item of income (or treated as a decrease in an item of income), or an increase to an item of credit. An adjustment to an item that is a non-income item is not a decrease in an item of income. Therefore, adjustments to a partnership’s nonincome items are always positive adjustments, are never negative adjustments, and arenot netted against any adjustments to a partnership’s items of income, gain, loss, deduction, or credit under section 702(a).”)

F. Imputed Underpayment
As a baseline, it is helpful to understand that Treasury has explicitly stated that an IU is not intended to be the amount of tax that the partners would be liable for based on the adjustments imposed by the IRS or requested in an AAR. 87 Fed.Reg. 75,478 (2022). (The preamble to the 2022 Final Regulations states: [T]he imputed underpayment under the centralized partnership audit regime is not designed to be the exact amount of the tax liability that would have been paid by the partners, nor is it a substitute for partner tax liability. Rather, it is an entity-level liability of the partnership alone computed by reference to any adjustments made to partnership-related items, regardless of whether those adjustments would have actually resulted in a tax liability to any particular partner. Therefore, given that adjustments are made to a specific taxable year, the adjustments could result in an imputed underpayment in situations where no income would have been recognized if the item had been correctly reported originally.”)

An IU is calculated by “appropriately netting all partnership adjustments with respect to the reviewed year and applying the highest rate of tax in effect for the reviewed year.” §6225(b). The regulations provide a mechanical calculation that involves (i) grouping and subgrouping adjustments, (ii) netting the adjustments, (iii) calculating the TNPA, (iv) multiplying the TNPA by the highest rate of federal income tax in effect for the reviewed year under §1 or §11, and (v) increasing or decreasing the product of (iii) and (iv) by adjustments to credits. Treas. Reg. §301.6225-1(b)(1).

The netting allowed is very limited, usually only when adjustments would net and be reported on the same line of Form 1065 Schedule K or Schedule K-1. As a result, except in limited scenarios when a negative adjustment “appropriately nets” with a positive adjustment, only positive adjustments (which include all Non-Income Items as noted above) are included in the IU calculation. The IRS has additional discretion on how to apply netting in an IU calculation as part of an IRS audit. Treas. Reg. §301.6225-1(b)(4). As discussed later, a partnership filing an AAR has some ability to exclude duplicate positive adjustments from the IU calculation, and the IRS has similar but broader ability in an audit context. Treas. Reg. §301.6225-1(b)(4).

In the case of an audit, the IRS computes the IU. In the case of an AAR, the partnership must calculate the IU as part of the AAR package filed with the IRS. Treas. Reg. §301.6227-1(a). Certain modifications to the IU are available, as discussed later. Treas. Reg. §301.6225-2(d); Treas. Reg. §301.6227-2(a)(2).

III. Non-Income Items in the IU Calculation

If a taxpayer or tax practitioner’s conceptual starting point is that the IU should approximate the income tax that would have been owed by the reviewed year partners if the partnership-related items had been reported correctly originally, they may be disappointed. The inclusion of Non-Income Items in the calculation of the IU, and more specifically the manner in which they are included in the IU under the existing regulations, often results in a higher IU than one might expect. This disconnect arises for at least four reasons.

Adjustments to Non-Income Items were added to the formula for calculating an IU when Congress amended §6225(a) by replacing “any item of income, gain, loss, deduction, or credit of a partnership, or any partner’s distributive share thereof” [Emphasis added] with “any adjustments by the Secretary to any partnership-related items with respect to any reviewed year of a partnership” [Emphasis added] in 2018. [cite]. According to the legislative history, this change was made so that the BBA “partnership audit rules are not narrower than the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”) partnership audit rules, but rather, are intended to have a scope sufficient to address those items described as partnership items, affected items, and computational items in the TEFRA context.” Joint Committee on Taxation, Technical Explanation of the Tax Technical Corrections Act of 2016, JCX-91-16, p. 9 (Dec. 6, 2016).

A. Adjustments to Non-Income Items are All Positive Adjustments
As noted previously, all adjustments to Non-Income Items are positive adjustments because of the way positive and negative adjustments are defined in the regulations. Positive adjustments generally increase the IU. Therefore, Non-Income Items are effectively treated as “unfavorable” regardless of whether they theoretically could have resulted in an increase to any person’s Chapter 1 tax liability.

For example, a decrease to a partner’s share of nonrecourse liabilities could conceptually result in an increase to the partner’s Chapter 1 tax liability under certain fact patterns, e.g., the partner was relying on the basis provided by the nonrecourse liabilities to either not recognize a gain on distribution in excess of basis under §731(a) or deduct losses without limitation under §704(d). That increase in gain or reduction in deduction or loss could be up to, but not more than, the amount of the partner’s share of the reduction in the nonrecourse liability.

However, an increase to the partner’s share of nonrecourse liabilities as occurred in the Example could not be expected to result in an increase to a partner’s Chapter 1 tax liability. Yet either adjustment—an increase or a decrease to a partner’s share of nonrecourse liabilities—results in a positive adjustment which generally will create or increase an IU. The $100 increase in nonrecourse liabilities in the Example thus contributed $37 of IU, even though the partners would not have owed additional Chapter 1 tax with respect to the adjustment.

Similar issues can arise with other Non-Income Items. For example, an absolute increase in §199A QBI would also be a positive adjustment; however, the adjustment would likely be favorable if pushed out to a partner eligible for a §199A deduction because the deduction, before certain limitations, is computed as a percentage (20%) of QBI.

B. The “Subsume Rule”
The 2022 Final Regulations provided a revised rule to treat certain adjustments as zero solely for the purposes of computing an IU. The final rule published in the 2022 Final Regulations, which has been colloquially referred to by IRS officials and others as the “Subsume Rule” (Treas. Reg. §301.6225–1(b)(4)) states:

“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. In addition, if a positive adjustment to an item is related to, or results from, a positive adjustment to another item, one of the positive adjustments will generally be treated as zero solely for purposes of calculating any imputed underpayment unless the IRS determines that an adjustment should not be treated as zero in the calculation of the imputed underpayment. This paragraph applies to the calculation of any imputed underpayment, including imputed underpayments calculated by a partnership or pass-through partner (for example, as part of the filing of an administrative adjustment request (AAR) under section 6227).”

The 2020 Proposed Regulations’ version of the Subsume Rule was arguably unclear as to whether the Subsume Rule could only be applied by the IRS or could also be applied by partnerships.

The Department of the Treasury and the IRS expressed that it was clear the rule applied to persons other than the IRS, but nonetheless, revised and clarified the language. 87 Fed. Reg. 75,478 (2022). (The preamble to the 2022 Final Regulations states: “In response to the comment that the language is unclear, the language of proposed §301.6225–1(b)(4) is modified to clarify that this provision applies to both the IRS and partnerships, and the rule has been broadened further. As modified, §301.6225–1(b)(4) as set forth in this Treasury decision provides that if any positive adjustment is related to, or results from, a second positive adjustment, a partnership may treat one of the positive adjustments as zero solely for purposes of computing the imputed underpayment unless the IRS determines that the adjustment should not be treated as zero. With this change, a partnership may treat an adjustment to a non-income item as zero if the adjustment to the non-income item is related to, or results from, another adjustment to a non-income item.”)

The first sentence of the revised Subsume Rule appears to apply to the IRS, while the second sentence seems to apply to the taxpayer, subject to the IRS determining otherwise. The “reflected in” language in the first sentence without reference to a positive adjustment appears to be broader and more flexible than the “related to, or results from” language in the second sentence that requires a positive adjustment. Treasury has clarified that the second sentence of the Subsume Rule does not apply if a positive adjustment to one item is related to, or results from a negative adjustment to another item. 87 Fed. Reg. 75,478 (2022).

The preamble to the 2022 Final Regulations includes this language: However, this rule does not allow the partnership to treat an adjustment as zero if one adjustment is positive and one is negative. For example, if a partnership changes an ordinary loss to a capital loss, which results in a positive adjustment to ordinary income and a negative adjustment to capital loss, the partnership could not treat the negative adjustment to capital loss as zero for purposes of calculating the imputed underpayment. This change provides more relief to partnerships and more closely aligns with the intended purpose of this rule. Therefore, a negative adjustment to an income item that creates a positive adjustment to a Non-Income Item will not allow the application of the Subsume Rule to the Non-Income Item. Further, if an adjustment to a Non-Income Item is not reflected in another adjustment (IRS rule) or has no relationship to another adjustment nor does it result from another adjustment (taxpayer rule), it seems the Subsume Rule cannot apply. That is the case for the partnership liabilities in the Example.

Despite the government’s broadening of the Subsume Rule, uncertainty exists with the application in certain fact patterns where multiple positive adjustments arise. First, what if multiple positive adjustments relate to or result from another positive adjustment of the same amount? Does the Subsume Rule apply to all the related or resultant adjustments (a “Multiple Subsumption Approach”)? In the Example, the $200 positive adjustment to ordinary income arguably resulted in the $200 positive §199A QBI adjustment and resulted in or related to the $200 positive adjustment to the tax basis of PRS’ assets.

A plain reading of the regulation suggests a Multiple Subsumption Approach could apply to the Subsume Rule because there is no language limiting the Subsume Rule to one related or resultant adjustment. In other words, the original positive adjustment has a distinct 1:1 relationship with each separate related or resultant positive adjustment. Further, the 2022 Final Regulations preamble specifies that “[a]s modified, §301.6225–1(b)(4) as set forth in this Treasury decision provides that if any positive adjustment is related to, or results from, a second positive adjustment, a partnership may treat one of the positive adjustments as zero solely for purposes of computing the IU unless the IRS determines that the adjustment should not be treated as zero.” [Emphasis added.] The use of “any” certainly does not suggest that only one of multiple related or resultant positive adjustments can be treated as zero for purposes of calculating the IU.

Second, could a positive adjustment that relates to or results from another positive adjustment in a different amount be treated as zero for purposes of calculating the IU (a “Nonmatching No Duplication Approach”)? In the Example, the $1,000 positive adjustment to the §199A UBIA was in a sense related to the $200 positive adjustment to ordinary income given the $200 depreciation adjustment was a function of the property not yet being placed in service, the same reason that the $1,000 cost basis must be excluded from §199A UBIA pursuant to §199(b)(6)(A)(ii). Nowhere in the provision itself or the preamble is it specified that the treatment of a related or resultant positive adjustment as zero is limited to situations where both positive adjustments are for the same dollar amount.

However, in this context, it may be a stretch given one amount is not a component of the other amount or in a direct relationship to the other. What if instead PRS’ gross sales were adjusted up by $80 and PRS’ interest income was adjusted up by $100, resulting in PRS’ gross receipts being increased by $100 in total (gross receipts being reported separately in Schedule K-1 Box 20AG, for example)? Could the $100 adjustment to gross receipts be treated as zero? Arguably, there are two separate positive adjustments to Schedule K-1 Box 20AG gross receipts that could each separately be treated as zero due to relation to the gross sales and interest income adjustments, respectively. Any narrower interpretation would seem contrary to the intent of preventing the IU from reflecting duplicate impacts of an adjustment.

Adopting the Multiple No Duplication Approach or the Nonmatching No Duplication Approach in an AAR context comes with risk. If the partnership adopts the Multiple No Duplication Approach or the Nonmatching No Duplication Approach and pays the IU, the IRS could later review and take the view that the Multiple No Duplication and/or the Nonmatching No Duplication Approach is incorrect and adjust the IU upon audit. If that happens, the partnership does not have the option to push out the adjustment to the IU as part of the audit and must instead pay the incremental IU. Treas. Reg. §301.6226–2(g)(4).

C. All Non-Income Items Are Treated the Same
The IU calculation simply multiplies the TNPA, which includes the dollar adjustments to Non-Income Items, by the highest federal income tax rate under §1 or §11 in effect for the reviewed year. §6225(b); Treas. Reg. §301.6225–1(b)(1). Adjustments to many Non-Income Items, by their very nature of not being an item of income, gain, loss, or deduction, would generally not have been dollar-for-dollar adjustments to a partner’s taxable income.

The $1,000 reduction in §199A UBIA in the Example reduces the potential §199A deduction of a partner by at most $25 (2.5% x $1,000). §199A(b)(2)(B)(ii). As a further example, if an adjustment involved a $1,000 reduction in §199A wages, that would reduce the potential §199A deduction of a partner by at most $500 (50% x $1,000). §199A(b)(2)(B)(i). The amount of the IU attributable to the $1,000 adjustment in both cases would be $370, even though the maximum theoretical Chapter 1 tax increase to the direct and indirect partners in aggregate would be $9.25 ($25 x 37%) or $185 ($500 x 37%), respectively. Thus, all Non-Income Items are not “equal,” yet they are treated as equal in the IU calculation. Similar issues arise with Non-Income Items such as excess taxable income and most of the items reported on Schedules K-2 and K-3. Again, by definition, a Non-Income Item generally does not have a dollar-for-dollar impact on taxable income of a partner.

D. Modifications to IUs
If a partnership has received a notice of proposed partnership adjustment as part of an IRS audit, the partnership may request certain modifications to the IU, subject to approval by the IRS. §6225(c); Treas. Reg. §301.6225-2(a). If a partnership filing an AAR does not make a push out election, the partnership may affirmatively apply certain modifications to the IU reported on and paid with the AAR. Treas. Reg. §301.6227-2(a)(2).

The modifications available in the audit scenario include modifications with respect to all items reported on either amended returns filed by partners or through an alternative procedure to partners filing amended returns, certain items of tax-exempt partners, lower tax rate income of C corporation partners and individual partners (specifically, capital gains and qualified dividends of individual partners), certain passive losses of publicly traded partnerships, the number and composition of IUs, certain income with respect to RIC and REIT partners, closing agreements, tax treaties, and a catch all “other modifications.” Treas. Reg. §301.6225-2(d).

The modifications available in the AAR context include the modifications available in an audit scenario with the exclusion of the amended returns by partners, alternative procedure to partners filing amended returns, closing agreements, and “other modifications.” Treas. Reg. §301.6227-2(a)(2). No guidance has been issued to date regarding “other modifications” in either context. A detailed discussion of the modification procedures is outside the scope of this discussion. To the extent a partnership filing an AAR pushes out the adjustments, no modifications are available for any pass-through partner when the pass-through partner is required to choose whether to pay an IU or push-out the adjustments that would have resulted in an IU. Treas. Reg. §301.6227-3(c).

Given the ability to fully account for partner-level attributes and tax profiles, the amended returns and alternative procedure are arguably the only modifications that would ensure that payments made by the partnership (IU) or by the partners (as a result of the modification procedures) reflect an amount equal to the aggregate Chapter 1 tax liability of the partners if the amounts were reported correctly originally (notwithstanding the stranded overpayment issue that is outside the scope of this discussion.) Treas. Reg. §301.6227-3(b)). However, as noted above, these two modifications are not available when a partnership files an AAR and are often impractical in complex IRS exams involving multi-tiered partnerships or many partners.

Although not entirely clear, it seems Non-Income Items allocated to direct or indirect tax-exempt partners could be removed from the IU calculation under the tax-exempt partner modification as the rule focuses on adjustments “with respect to which the partner would not be subject to tax for the reviewed year.” Treas. Reg. §301.6225-2(d)(3)(iii). Similarly, Non-Income Items allocated to direct or indirect corporate partners arguably could have the corporate rate applied to them under the lower tax rate modification as the rule simply covers “adjustments attributable to a relevant partner that is a C corporation.” Treas. Reg. §301.6225-2(d)(4).

Returning to the Example, none of the available modifications for AARs would allow PRS to remove the Non-Income Items (i.e., §199A QBI, §199A UBIA, nonrecourse liabilities, or tax basis in depreciable assets) in PRS’ IU calculation. PRS may be able to apply a corporate rate to the portion of the IU attributable to direct or indirect corporate partners, if any, or PRS was able to remove the portion of the IU (including as a result of Non-Income Items) attributable to direct or indirect tax-exempt partners, if any. However, those modifications do not necessarily solve the general issue.

IV. Takeaways

The inclusion of Non-Income Items in the calculation of an IU will frequently result in an IU that is higher (often materially) than the aggregate Chapter 1 tax liability the reviewed year partners would have owed had the partnership reported the items correctly on the originally filed return. Non-Income Items typically result in an IU even if they theoretically could not have increased the partners’ aggregate Chapter 1 tax liability.

The Subsume Rule can allow Non-Income Items in certain situations to be treated as zero for purposes of calculating an IU; however, the rule does not always eliminate Non-Income Items and there is uncertainty around the application of the rule in many fact patterns. Non-Income Items are multiplied by a Chapter 1 tax rate to determine an IU even though the Chapter 1 tax impact of most Non-Income Items does not equal the product of the Non-Income Item multiplied by a Chapter 1 tax rate. Modifications available in an AAR context often will not change the Non-Income Items’ impact on the IU calculation.

Partnerships and their partners should be aware of the counterintuitive IU calculation rules before assuming the partnership should pay an IU. Practically, the overstated nature of the IU results in most partnerships not paying the IU but pushing out instead.

Why is the IU so large? The treatment of Non-Income Items under the BBA is a common culprit.

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

Author Information

Joseph Vetting is a Managing Director in the Deloitte Tax LLP Washington National Tax Passthroughs Group. Copyright © 2026 Deloitte Development LLC.

The author thanks Andrew Miller, Matt Cooper, Jen Ray, and Jenny Alexander for their helpful comments on earlier drafts.

This article contains general information only, and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this article. Deloitte refers to one or more of Deloitte Touche Tohmatsu Ltd. (DTTL), a U.K. private company limited by guarantee, its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as Deloitte Global) does not provide services to clients. In the United States, Deloitte refers to one or more of the U.S. member firms of DTTL, their related entities that operate using the Deloitte name in the United States, and their respective affiliates. Certain services may not be available to attest clients under the rules and regulations of public accounting. Please see www.deloitte.com/about to learn more about our global network of member firms.

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