More proposed guidance has emerged on the comprehensive partnership audit regime (CPAR) that was enacted as part of the 2015 Bipartisan Budget Agreement. CPAR is effective for tax years beginning after December 31, 2018, replacing the prior TEFRA consolidated audit regime with an even more centralized system. The new guidance, found at REG-118067-17, provide information on the attribute adjustments to be made following a CPAR examination of the partnership.
Under CPAR by default at the conclusion of a partnership exam, the IRS issues a bill for tax due, referred to as an “imputed underpayment,” to the partnership which pays the amount. The imputed underpayment is initially calculated by applying the maximum individual tax rate (37% for 2018) to the net adjustment of the partnership, though the partnership has various options to adjust the payment amount down to lower rates and/or remove portions of the adjustment from the imputed adjustment entirely.
Alternatively, after the partnership level changes in items of income, deduction, gain, loss, and credits are determined, the partnership representative can elect to push out the adjustment to those who were partners in the year being examined (the reviewed year) who will then compute and pay the tax on the return for the year the exam concludes (the adjustment year).
In the beginning of the preamble to the proposed regulations, the IRS notes:
These proposed rules are consistent with the policy described in “The General Explanation of Tax Legislation Enacted for 2015” (Bluebook), which explained that “[u]nder the centralized partnership audit regime, the flowthrough nature of the partnership under subchapter K of the Code is unchanged, but the partnership is treated as a point of collection of underpayments that would otherwise be the responsibility of partners.” Joint Comm. on Taxation, JCS-1-16, “General Explanations of Tax Legislation Enacted in 2015”, 57 (2016).
Or, to put it more succinctly, while the partnership may pay the tax, all other effects of the changes (such as to increase basis in the partner’s interest) remain the same. These regulations are meant to explain how taxpayers are to determine the proper adjustments to the various tax attributes in these situations.
The preamble continues:
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 flowthrough nature of partnerships under subchapter K. Thus, these 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.
The basic adjustments when there is a partnership adjustment is summarized in the preamble as follows:
…[W]hen there is a partnership adjustment (as defined in proposed § 301.6241-1(a)(6)), the partnership and its adjustment year partners (as defined in proposed § 301.6241-1(a)(2)) generally must adjust their specified tax attributes (as defined in proposed § 301.6225-4(a)(2)). Specified tax attributes are the tax basis and book value of a partnership's property, amounts determined under section 704(c), adjustment year partners' bases in their partnership interests, and adjustment year partners' capital accounts determined and maintained in accordance with § 1.704-1(b)(2). See proposed § 301.6225-4(a)(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 proposed § 301.6225-1(c)(3). See proposed § 301.6225-4(b)(1).
Under Proposed Reg. § 301.6225-4(b)(2) the partnership must make appropriate adjustments to the book value and basis of property to take into account a partnership adjustment, including taking adjustments into account for amounts determined under IRC §704(c). No adjustment is to be made for adjustments that relate to property that the partnership no longer holds in the adjustment year, though the IRS requests comments on whether, in that case, the basis of other partnership property should be adjusted in a manner similar to that used in allocating §734(b) adjustments under IRC §755.
The proposed regulations create “notional items” to be used in adjusting the partner level tax attributes. As the preamble continues:
Proposed § 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 according to the rules described in section (2)(B)(iii) of this preamble. 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. See proposed § 301.6225-4(b)(3)(ii) and (iii).
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. See proposed § 301.6225-4(b)(3)(iv) and (v). These rules have the effect of reversing out the reviewed year allocation to the extent necessary to reflect the partnership adjustment.
Thus, under these 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 § 1.704-1(b)(2)(iv) also adjusts capital accounts for notional items. See proposed § 301.6225-4(e), Example 1. In the case of a partnership adjustment that reflects a net increase or net decrease in credits as determined under proposed § 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. See proposed § 301.6225-4(b)(3)(vi).
The proposed regulations provide for adjustment only of certain tax attributes (referred to as “specified tax attributes”) but the IRS is asking for comments on more broadly affecting tax attributes. As the preamble continues:
Specific tax attributes for which comments are requested include gross income rules for publicly traded partnerships under section 7704(b) and qualified investment entities described in section 860. Other tax attributes for which comments are requested include net operating loss carryforwards, other tax accounting under subchapter K, and those that contain limitations based on adjusted gross income (for example, the earned income credit allowed under section 32, the child tax credit allowed under section 24). Comments are also requested as to whether any special rules should be provided for adjustments to tax attributes in the cross-border context, and how those adjustments should differ, if at all, from adjustments to tax attributes made in the domestic context.
The IRS deals with the allocation of the effects of these notional items in proposed changes to Reg. §1.704-1. The preamble states;
Commenters recommended applying the existing rules in subchapter K, including section 704(b), in the context of section 6225. While the basic principles of section 704(b) remain sound in the context of notional items, the unique nature of partnership adjustments under section 6225 requires the application of these principles to be modified. See proposed § 1.704-1(b)(1)(viii)(a). Specifically, 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 proposed § 301.6225-4(b)(3)(ii), or expense or loss described in proposed § 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 section 704 regulations. Additionally, the allocation of a notional item of expense or loss described in proposed § 301.6225-4(b)(3)(iv), or a notional item of income or gain described in proposed § 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). See proposed § 1.704-1(b)(4)(xi). As described in section (2)(B)(iv) of this preamble, however, these rules require treating successors as reviewed year partners.
As that last sentence notes, CPAR creates a problem because the partners that were partners in the reviewed year will often not all be the same as are partners in the adjustment year. Thus, the regulation looks at what it refers to as “successors.”
The IRS notes that if no adjustments were made to successor interests, double taxation would still result.
As noted in section (2)(B)(i) of this preamble, 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, these regulations provide successor rules under proposed § 1.704-1(b)(1)(viii)(b) for purposes of adjusting specified tax attributes, including outside basis.
The key first issue is to identify the successor partner. The preamble describes this process as follows:
A reviewed year partner's successor is generally defined as either a transferee that succeeds to the transferor partner's capital account under proposed § 1.704-1(b)(2)(iv)(l), 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.
While identifying that successor would be reasonably simple in a small partnership, large publicly traded partnerships would have a huge administrative task and potentially might simply be unable to find the appropriate successors. In the proposed regulations, the IRS decided:
… it is appropriate to provide rules in these proposed regulations relating to any situation in which a partnership is unable, after exercising reasonable diligence, to determine a successor for a partnership adjustment under section 6225 (not only reallocation adjustments). These rules require that the proposed standard in the June 14 NPRM be replaced with a new proposed regulation. Therefore, these regulations amend proposed § 301.6225-3(b)(4) by removing the final two sentences and provide a rule in proposed § 1.704-1(b)(1)(viii)(b)(3) that if a partnership cannot determine the transferee for a partnership interest under proposed § 1.704-1(b)(1)(viii)(b)(2), 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.
In certain cases, notional items are not created, but the regulations describe how adjustments will be made for those items. From the preamble:
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 section 704(b), such as a partnership adjustment based upon a partner's failure to report gain under section 731, a partnership adjustment that is a change of an item of deduction to a section 705(a)(2)(B) expenditure, or a partnership adjustment to an item of tax-exempt income. See proposed § 301.6225-4(b)(4). 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.
The preamble goes on to describe an IRS concern where the adjustment could create what the IRS perceives as an unfair tax benefit where no outside basis adjustment will be allowed.
As noted in section (2)(B)(i) of this preamble, partners normally adjust their outside bases for notional items that are allocated to them. However, in certain cases, the proposed rules 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. See proposed § 301.6225-4(b)(6)(iii)(B). 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. Comments are requested as to whether this rule should be extended to rate modifications described in proposed § 301.6225-2(d)(4) as well. 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 subchapter C of chapter 63 of the Code (subchapter C of chapter 63) and a principal purpose of the transfer was to shift the economic burden of the imputed underpayment among related parties. Comments are requested regarding whether basis adjustments should be disallowed in any other circumstances.
The regulations go on to deal with the tax that will be paid on the imputed underpayment. That tax will be treated as a nondeductible expense of the partnership covered by IRC §705(a)(2)(B). The regulations go on to determine if that allocation has substantial economic effect that will be recognized by the IRS.
Section 1.704-1(b)(2)(iv)(i) provides specific rules for determining whether an allocation of a section 705(a)(2)(B) expenditure has substantial economic effect. Specifically, it requires that a partner's capital account be decreased by allocations made to such partner of expenditures described in section 705(a)(2)(B). See also § 1.704-1(b)(2)(iv)(b). Further, under section 705(a)(2)(B), the adjusted basis of a partner's interest in a partnership is decreased (but not below zero) by expenditures of the partnership that are not deductible in computing its taxable income and not properly chargeable to capital account.
The preamble notes that, so long as the allocation of this payment of the imputed underpayment among the partners has economic effect it will be respected. But the IRS proposed creating some special rules to apply to this allocation.
The Treasury Department and the IRS have concluded, however, 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 these expenditures. When a partnership pays an imputed underpayment under section 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. See proposed §§ 1.704-1(b)(2)(iii)(a) and (f), 301.6225-4(c) and 301.6225-4(e), Example 4. 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 flowthrough nature of partnerships under subchapter K. Absent this substantiality rule in the regulations, 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 proposed § 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. See proposed § 1.704-1(b)(4)(xii). These proposed regulations do not address the extent to which the partnership may later reverse this allocation with a special chargeback or similar provision. Comments are requested on this issue.
All the prior material relates to the case where the partnership pays the imputed underpayment. However, the partnership has the option under §6226 to push the adjustment out to the reviewed year partners. Additional proposed regulations deal with the adjustment of attributes in this case.
In this case the reviewed year partner will end up an adjustment that includes the reviewed year and the tax impact on all intervening years. As the preamble notes:
The adjustment amounts determined under section 6226(b)(2) fall into two categories. Under section 6226(b)(2)(A), in the case of the taxable 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 chapter 1 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 section 6226(b)(2)(B), in the case of any taxable 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 chapter 1 tax would increase by reason of the adjustment to tax attributes determined under section 6226(b)(3) in each of the intervening years. The adjustment amounts determined under section 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 chapter 1 tax in accordance with section 6226(b)(1).
Per the preamble, the proposed regulations provide the following guidance on dealing with the adjustment of attributes:
Section 301.6226-4(b) of these proposed regulations provides that the reviewed year partners or affected partners (as described in § 301.6226-3(e)(3)(i)) 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 proposed § 301.6226-2 (pushed-out items) in the reporting year (as defined in proposed § 301.6226-3(a)). 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 under the Code.
Unlike the proposed rules under section 6225 and subchapter K described in section 2 of this preamble, under section 6226, all tax attributes (as defined in proposed § 301.6241-1(a)(10)) are adjusted for pushed out items of income, gain, deduction, loss or credit.