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Payment of tax generated by partnership audits at the partnership level – adjusting partnership items

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Payment of tax generated by partnership audits at the partnership level – adjusting partnership items

In the 2015 Bi-Partisan Budget Act (“2015 Act”), Congress enacted new centralized audit procedures for entities taxed as partnerships for Federal Income Tax purposes.  Because these rules are fairly complex, both for taxpayers and the IRS, they did not become effective until tax years beginning in 2018.

The default rule under these new audit procedures provides that any increase in partnership income as a result of an audit adjustment will generate an underpayment of tax for which the partnership itself is liable.  The underpayment is computed using the highest marginal income tax rate for individuals (37%) or corporations (20%).  The 2015 Act includes provisions allowing small partnerships to elect out of these new procedures and other provisions allowing the partnership to elect to “pushout” the audit adjustment to its partners so that the obligation to pay the tax falls on them.  However, for partnerships that do not or cannot elect out of these new rules, or that do not elect the alternative methods of reporting the change, the default rule would apply. This means the partnership itself will pay the tax, including any interest and penalties thereon.

Any adjustments that are made during the audit, along with the payment of tax by the partnership, must be allocated among the partners. In addition, the partnership’s payment of a tax liability as a result of any adjustment will have an impact on such things as a partner’s capital account and his outside basis in his partnership interest.  In February of 2018, Treasury published Proposed Regulations for adjusting certain tax attributes as a result of an audit.  These regulations were withdrawn and reproposed August 17, 2018.  While they have not yet been finalized, as proposed they would apply to a partnership tax year beginning in 2018.

Under the Proposed Regulations, if the partnership pays an underpayment of tax as a result of an adjustment, the partnership will create notational items of income regarding the adjustment which will be used to adjust specified tax attributes.  For example, if a partnership’s income is increased by $100 and the partnership pays the tax on that amount, it will create notational income of $100 which must be allocated among the partners for these certain tax attributes.  Note, however, that this notational income is not reported by the partners as income on their individual income tax returns (as the partnership has already paid the tax on it).  According to the Proposed Regulations, the tax attributes affected and that are to be accounted for by the partnership would be (1) the basis and book value of the partnership’s property, (2) adjustment year partners’ capital account balances and (3) amounts determined under Section 704(c) of the Internal Revenue Code, regarding built in gains.  The specified tax attributes that are accounted for by individual partners are limited to the adjustment year partners’ bases in their partnership interests (their outside basis), and in the case of corporate partners, earnings and profits under Section 312 of the Internal Revenue Code.

If the partnership pays a tax liability and determines that notational items of income need to be created, the partnership will allocate those items among its partners, reporting the items on Line 20 (Other information) of Schedule K-1 furnished to each partner.  The partnership will also allocate the expenditure for the payment of the tax among its partners, and the Proposed Regulations will respect the allocation if it follows the allocation of the notational items.  The payment by the partnership will be reported to the partners as a non-deductible expenditure under Section 705(a)(2)(B) of the Internal Revenue Code on Line 18, Code C, of Schedule K-1.

EXAMPLE

Assume Partnership P is owned equally by three partners, A, B and C.  In 2022, the partnership’s 2019 income tax return is audited and the audit results in an increase in income of $100,000 resulting in a tax underpayment of $37,000, plus interest.  Partnership P has not elected out of the centralized audit procedures. It elects not to push the changes out and to pay the tax at the partnership level, paying the $37,000 in tax. As a result, the following will occur:

  • If Partnership P had actually recognized $100,000 of income in 2019, that income would have been allocated equally among A, B and C under its operating agreement. The partnership will create notational income of $100,000 in adjusting the specified tax attributes in 2022 (the adjustment year). This notational income will be allocated equally to A, B and C, and reported on Line 20, Code AH of their Schedules K-1.  However, A, B and C will not be required to include the notational income on their personal returns.
  • The partnership’s allocation of the payment of the tax will be respected if made in the same proportion as the notational income resulting from the adjustment. In this case the $37,000 will be reported equally among A, B and C, and reported on Line 18, Code C of their Schedules K-1 for 2022.   In addition, any interest paid with respect to the underpayment will be similarly allocated and reported.
  • The partnership should also adjust the tax capital accounts of A, B and C to reflect the allocation of notational income. While not specifically covered in the Proposed Regulations, this adjustment could be reported as an “other increase” and explained in a statement included with each partners K-1.  A similar adjustment should be made on Form 1065, Schedule M-2, Line 4.
  • A, B and C individually are responsible for maintaining the outside basis of their interest in Partnership P. The notational income allocated to them should be treated like actual income for this purpose.

If we vary the facts of this example by assuming that in mid-2022, Partner A sells his entire interest in the partnership to new Partner D and withdraws, the partnership’s payment of the tax and the notational items will be reported to Partners B, C and D based on their percentage interests in the partnership because the adjustment items are treated as “extraordinary items” for applying the varying interest rules of Section 706(d)(1) of the Internal Revenue Code.  Nothing will be reported to Partner A because extraordinary items cannot be pro-rated between the buyer and seller of the partnership interest.

This is a very simple example of how to deal with the consequences of changes in partnership income resulting from an audit adjustment under the new centralized audit procedures and, in particular, dealing with the partnership’s payment of the tax.  However, it illustrates the issues that must be addressed when such a tax is paid.  There are many different types of adjustments that can be made in an audit, some of which may not create income at the partnership level (such as re-allocating partnership debt among partners or re-classifying recourse and non-recourse debt), yet these will result in underpayments of tax.  Generally, these rules will apply with the objective of allowing partners who are indirectly affected by the partnership paying the tax on an audit adjustment to receive appropriate adjustments to their capital accounts and basis.

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