New proposed regulations under the centralized partnership audit regime address how and when partnerships and their partners adjust tax attributes to take into account partnerships’ payment adjustments. They also provide, among other additions and clarifications to earlier proposed regs, rules to adjust basis and capital accounts if the partnership adjustment is a change to an item of gain, loss, amortization or depreciation.
Take away. “These proposed regulations layer additional complexity onto two sets of already complicated regulations: partnership allocations are under Code Sec. 704(b)and previously issued regulations interpreting the Centralized Partnership Audit Regime,” Michael Grace, Esq., consulting counsel, Wiley Rein LLP, and former IRS pass-throughs attorney, told Wolters Kluwer. For example, under these proposed regulations, Grace observes that tax professionals must distinguish two categories of allocations under Code Sec. 704(b) that may result from a Centralized Partnership Audit:
Items the allocations of which can have substantial economic effect, but only if the items are allocated as these regulations prescribe; and
Allocations (including allocations of newly defined “notional items”) that cannot have substantial economic effect but nevertheless will be deemed to accord with the partners’ interests in the partnership if allocated as these regulations require.
The new centralized partnership audit regime, put into place under the Bipartisan Budget Act of 2015 (BBA), generally must be applied to audits of partnership returns filed for the 2018 tax years and thereafter. Their implementation generally looks to assessment at the partnership level, leaving the partnership to collect from existing partners, but with certain exceptions. In proposed regs that were issued in June 2017 (NPRM REG-136118-15), the IRS acknowledged that more guidance was necessary. In November, the IRS issued proposed regs on how certain international rules operate within the framework of the new centralized partnership audit regime (NPRM REG-119337-17). In December, the IRS issued proposed regs on the operation of the “push-out” rules for partner/partnership liability in tiered structures (NPRM REG-120232-17).
The preamble to the new regulations admits to not addressing all tax attributes that conceptually should be adjusted following a “partnership adjustment.” “Specified Tax Attributes” must be adjusted under these regulations for only some but not all purposes under the Centralized Partnership Audit Regime, Grace observes. Tax professionals continuously will have to figure out (i) what attributes must be adjusted? (ii) under which rules? and (iii) for which purposes? And, after applying the pertinent rules, tax professionals also will have to determine whether they’ve interpreted the rules “in a manner that reflects the economic arrangement of the parties and the principles of Subchapter K of the Code” (Prop. Reg. Section 301.6225-4(a)).
When a positive partnership adjustment is taken into account in determining an imputed underpayment, Code Sec. 6225 does not provide for any item of taxable income to be allocated to partners. Instead, calculations are made at the partnership level, with the partnership paying the liability in the form of an imputed underpayment arising in the year of the audit adjustment. If, however, there are no adjustments to outside basis that reflect partnership adjustments that caused the imputed underpayment, a partner could effectively be taxed twice on the same income—once indirectly on the payment of the imputed underpayment, and again on a disposition of the partnership interest or a distribution of cash by the partnership. To prevent effective double taxation or other distortions in these cases, the new proposed regs provide for adjustment to a partner’s basis in its interest, and certain other tax attributes that depend on basis.
No imputed underpayment
The new proposed regs provide that an allocation of an item arising from a partnership adjustment that does not result in an imputed underpayment will not be deemed to have substantial economic effect ( Prop. Reg. §1.704-1(b)(4)(xiii)). It will, nevertheless, be deemed to be in accordance with the partners’ interests in the partnership if it is allocated in the manner in which the item would have been allocated in the reviewed year under the Code Sec. 704 regulations. taking into account the Code Sec. 704 successor rules.
Code Sec. 6226(b) describes how partnership adjustments are taken in account by the reviewed year partners if a partnership makes a “push-out” election under Code Sec. 6226(a). Under Code Sec. 6226(b)(1), each partner’s tax is increased by the aggregate of the adjustment amounts determined under Code Sec. 6226(b)(2).
The new proposed regs provide that the reviewed year partners or affected partners must take into account items of income, gain, loss, deduction or credit with respect to their share of the partnership adjustments as reflected on statements relating to pushed-out items in the reporting year ( Prop. Reg. §301.6226-4(b)). Partnerships adjust tax attributes affected by reason of a pushed-out item in the reviewed year.
The new regulations under Section 6225 require a partnership and its partners to adjust “specified tax attributes” while the new regulations under Section 6226 require any “tax attribute” to be adjusted. Grace points out that the Code requires this distinction. Code Sec. 6226(b)(3)requires that “any tax attribute” be appropriately adjusted when a partnership has elected to “push out” an imputed underpayment to its partners.
Code Sec. 704(b)
An allocation of a pushed-out item does not have substantial economic effect under Code Sec. 704, since the allocation relates to two different tax years (that is, while generally determined with respect to the reviewed year, notional items are taken into account in the adjustment year). Nevertheless, the proposed regs provide that the allocation of such an item will be deemed to be in accordance with the partners’ interests in the partnership if it is allocated in the adjustment year in the manner in which the item would have been allocated under the rules of Code Sec. 704(b) in the reviewed year, followed by any subsequent tax years, concluding with the adjustment year ( Prop. Reg. §1.704-1(b)(4)(xiv)).
Under the Code Sec. 704(b) regulations, “substantial economic effect”requires both “economic effect” and “substantiality.” Traditionally, substantiality has been tested less mechanically than economic effect. Under these proposed regulations, Grace warns, however, that the economic effect of an allocation can be substantial “only if” an item is allocated in a particular way. This approach departs from tradition, although it arguably mitigates these rules’ complexity.
Burdens of partnership underpayments
Under the new regulations, persons who were not partners in a reviewed year may be allocated some of a partnership’s payment to the IRS. If the “reviewed year partner” to whom the payment generally would be allocated is no longer around, then the payment instead must be allocated to that partner’s “successor.”
This possibility, Grace notes, raises the question of how successors should be compensated economically and the technical question of how to do this under Code Sec. 704(b).