Editor: Mark Heroux, J.D.
The Bipartisan Budget Act of 2015, P.L. 114-74, complicated partnership examinations by adopting the centralized partnership audit regime (CPAR), which has lengthened examinations and created convoluted traps, all while shifting the administrative onus from the IRS to partnerships and their representatives. Congress and the IRS made the burden shifting clear in specifying the procedures to close a CPAR exam.
Once the IRS completes its field procedures, it issues a summary report to the partnership representative containing the preliminary audit results and the imputed underpayment computation. If the partnership representative indicates he or she does not agree with the proposed changes or does not respond to the summary report, the IRS will issue a 30-day letter package to the partnership representative, which provides information for the partnership representative to request an Appeals conference and protest proposed changes.
The revenue agent must issue a Notice of Proposed Partnership Adjustment (NOPPA) after the 30-day letter. The NOPPA contains the revenue agent’s imputed underpayment calculation and a Form 886-A, Explanation of Items, to explain the calculation. The partnership has 270 days from the date of the NOPPA to submit a request for imputed underpayment modification and supporting documents. Thus, the partnership’s representative has a specified time to consider the IRS’s changes, how it affects all the partners, and how to best modify the imputed underpayment to minimize the burden on the partnership.
Unless the proposed partnership adjustment is modified, the partnership must pay the highest marginal tax rate on any positive adjustments (IRS-favorable) and defer negative adjustments (taxpayer-favorable) to the current year’s tax return. The partnership’s representative has an ethical obligation to his or her client to understand the CPAR’s nuances and end the examination advantageously.
This item discusses how to request modification of an imputed underpayment.
Imputed underpayment: The basics
The imputed underpayment is equal to the total netted partnership adjustment multiplied by the highest rate of federal income tax in effect for the reviewed year, increased or decreased by the net credit grouping adjustment (Regs. Sec. 301.6225-1(b)(1)).
The partnership first categorizes each of the IRS’s adjustments as either positive or negative. Then the partnership groups the adjustments into (1) the reallocation grouping, (2) the credit grouping, (3) the creditable expenditure grouping, or (4) the residual grouping. A majority of adjustments fall under the residual grouping, as this group encompasses any change in income or loss that is not reallocated among the partners.
Next, the partnership subgroups the positive and negative adjustments in each grouping. Specifically, the partnership reviews the items in each grouping to determine if any positive and negative adjustment can net together. Subgrouping is appropriate if the adjustments would be aggregated for purposes of Sec. 702(a). Any adjustment that may be subject to a preference, limitation, or restriction is placed in separate subgroupings. Thus, subgrouping is not allowed if any provision in the Internal Revenue Code would treat an adjustment as a preference, limitation, or restriction. This specific step in the calculation is responsible for imposing the “worst-case scenario” imputed underpayment.
Example: XYZ partnership is under examination for the 2019 tax year. The IRS determines that XYZ should have reported a $100 capital gain as ordinary income and that XYZ could not substantiate $10 of expense that it used to calculate the research-and-development credit. XYZ has a $100 positive adjustment to ordinary income, a $10 positive adjustment as a result of the decrease in the research-and-development credit, and a $100 negative adjustment due to the decrease in capital gain. XYZ will group each $100 adjustment in the residual grouping and the $10 negative adjustment in the credit grouping. XYZ cannot subgroup any of the adjustments because each is separately stated under Sec. 702(a).
The imputed underpayment is $47. XYZ first multiplies the $100 positive adjustment to ordinary income by 37%, or the highest marginal tax rate for tax year 2019. Then XYZ adds the $10 positive credit adjustment to arrive at the final imputed underpayment. XYZ will push out the $100 negative adjustment to its partners, who will take the capital loss on their current-year tax return.
Types of modifications
XYZ’s imputed underpayment calculation provides a glimpse into the importance of requesting a modification of the imputed underpayment. XYZ’s partners paid tax on the capital gain in 2019. Assuming X is an individual, his capital in XYZ decreases by his share of the imputed underpayment, and he is subject to the capital loss limitations. X is in a net negative position when considering the time value of money because he pays today on the increase to ordinary income adjustment, while benefiting from the decrease to capital gain adjustment over time.
XYZ can request to modify the imputed underpayment and affect how the adjustments affect its partners. Regs. Sec. 301.6225-2(d) provides the list of potential modifications applicable at the end of a CPAR exam:
- Modifications to take into account amended pull-in returns by relevant partners;
- Modifications to take into account partner-level adjustments under an “alternative procedure” that mimics the results of amended partner pull-in returns;
- Modifications to take into account a partner’s tax-exempt status;
- Modifications based on a rate of tax lower than the highest applicable rate;
- Modifications with respect to certain passive activity losses of publicly traded partnerships;
- Modifications with respect to qualified investment entities (regulated investment companies and real estate investment trusts);
- Modifications attributable to closing agreements (Regs. Sec. 301.6225-2(d)(8));
- Modifications to apply treaty provisions (Regs. Sec. 301.6225-2(d)(9)); and
- Any other modification approved by the IRS.
In most cases, multiple modifications may apply. Some of these will be readily apparent and necessary. For example, if Y of XYZ partnership is a tax-exempt entity, it would not make sense or be fair for XYZ to pay an imputed underpayment for adjustments that would otherwise be nontaxable to Y. Assuming no adjustment is unrelated business income to Y, *XYZ’*s modification would result in a $31 imputed underpayment. The modification automatically reduces the $100 positive adjustment to $66, for an initial payment of $24.40 when multiplied by 37%. Then, XYZ increases the payment by $6.60, for approximately $31.
Other readily apparent modifications include modifying the rate of tax (if all partners are corporations, for example) or applying a treaty provision (for foreign partners). However, many partnerships will benefit from the pull-in return procedures or alternative amended return procedures. Under the amended return procedures, the partners prepare and file amended returns for the examined tax year with the IRS’s adjustments. The partners can account for positive and negative adjustments and avoid the punishing assumptions of the imputed underpayment. XYZ’s partners, for example, can report the increase in ordinary income while also paying less than the marginal tax rate because they already paid tax on the capital gain.
The alternative procedures are similar to the amended return procedures. The partners bear the burden of the IRS’s adjustments without needing to file amended returns. While the procedures are simpler in some respects, the partners do not receive a refund if there is a net negative adjustment.
The amended return procedures and push-out statements both require partners to account for any positive or negative adjustment resulting from an IRS examination, with one key difference. Typically, partners must defer negative adjustments to the current-year tax return. However, the Treasury regulations reverse this assumption for the amended return, alternative amended return, changes in the composition of the imputed underpayment, and the catch-all modifications. This difference may be beneficial for partnerships if, for example, there is a decrease in capital gain that an individual partner may not take in full due to capital loss limitations.
How to request a modification
The process to request modification of the imputed underpayment seems deceptively simple. A partnership must electronically file Form 8980, Partnership Request for Modification of Imputed Underpayments Under IRC Section 6225(c), and supporting documents, utilizing IRS Publication 5346, Instructions for Form 8980. The supporting documentation provides the main source of complexity. The Treasury regulations provide only that the IRS must be satisfied that the modification is appropriate under the circumstances.
If a partnership elected to modify the imputed underpayment by filing amended returns, then each partner would file amended tax returns, pay the additional tax, and submit confirmation of each to the IRS. Congress was vague when stating whether the IRS must approve the modification request after the partners have filed their amended returns. Sec. 6225 provides that partnerships may modify the imputed underpayment “only upon approval” by the IRS, without saying whether the IRS necessarily must accept a modification if the partnership meets all requirements. Additionally, the broad language that Congress used in requiring IRS approval may limit judicial review of the IRS’s determination to deny an imputed underpayment modification.
The CPAR’s relentless punishment of partners is only beginning as the first wave of IRS examinations after the COVID-19 pandemic end. Over the next decade, partnerships will be forced to navigate the inconsistency, vagueness, and nuance of the CPAR. Many battles with the IRS will go to court, where partners will soon discover the limited scope of judicial review. Center stage will be the imputed underpayment and its modifications, which will be the single largest area of procedural dispute within the CPAR.
Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago. Contributors are members of or associated with Baker Tilly US, LLP. For additional information about these items, contact Mr. Heroux at email@example.com.