The 2015 enactment of a centralized IRS audit regime for partnerships has raised questions about the income tax accounting considerations for a partnership that directly pays the income taxes resulting from adjustments made under the regime (an imputed underpayment). In this Alert, we review applicable portions of the new rules and discuss our conclusions regarding the applicability of ASC 740, Accounting for income taxes, to the income tax payment made by the partnership.

Background

General

On November 2, 2015, the Bipartisan Budget Act (BBA) was enacted, which implemented a new Internal Revenue Service (IRS) centralized audit regime for entities treated as partnerships for federal income tax purposes. The BBA significantly alters the audit and income tax liability rules governing partners and partnerships for tax years beginning after December 31, 2017, and for partnerships that early elect into the regime for tax years after November 2, 2015, and before January 1, 2018.

The BBA rules provide for a centralized partnership audit regime in which a partnership representative has sole authority to act on behalf of the partnership and its partners. Under the centralized partnership audit regime, all adjustments and items relating to a partnership are determined at the partnership level, and the IRS is no longer required to determine each partner's share of the adjustments to assess the correct tax due as a result of the partnership examination. Taxes resulting from adjustments to items under the regime are assessed and collected at the partnership level and referred to as an "imputed underpayment." Any penalties or additional amounts relating to such adjustments are also determined at the partnership level.

The IRS had released proposed regulations on the BBA rules that were subsequently withdrawn from the Federal Register by the Trump Administration. While the proposed regulations are not authoritative or precedential in nature, they provided interpretive guidance for the BBA and clarified the intent of the Treasury Department. Given that the BBA regime would be difficult to administer without regulatory guidance, it is likely that these proposed regulations will eventually be issued in some form.

Relevant elements of the statute

Electing out of the centralized audit

Partnerships are eligible to opt out of the regime if:

(1) They have 100 or fewer partners¹ during the year

(2) All partners are "eligible partners²" at all times during the tax year.

Imputed underpayment

Under the new centralized audit regime, partnerships are generally responsible for paying any imputed underpayment that results from an IRS examination. The IRS will examine the partnership's items of income, gain, loss, deduction, and credit and partners' distributive shares for a particular year of the partnership (the reviewed year). Any adjustments will be taken into account by the partnership in the year that the audit or any judicial review is completed (the adjustment year). Alternatively, adjustments will be taken into account by the partners if a so-called push-out election is made, as discussed below.

"Push-out" election

As an alternative to the partnership paying an imputed underpayment at its level, a partnership may file a "push-out election" and furnish to each partner, for the reviewed year, a statement showing the partner's share of any adjustment. Upon making this election, the partnership is no longer required to pay the imputed underpayment and the partners would then take the adjustment into account on their respective returns in the year they receive such statement.

As enacted, the "push-out" election is only available to the partnership under audit, and is not currently available to upper-tier partnerships that are partners in the entity. In December 2016, both the House and the Senate introduced bipartisan technical corrections that would address a number of issues discussed in the proposed regulations, including the ability for upper-tier partners that are partnerships themselves to make additional "push out" elections. At present, however, the technical corrections are not attached to any current legislative packages. At this time, the timing of any such legislation is unknown, as well as when such legislation could be enacted and how such legislation would affect the issuance of final regulations.

Administrative adjustment request

A partnership may also initiate a correction and file an "administrative adjustment request" relating to any partnership tax year to adjust the reporting of a previously reported item. Under the administrative adjustment request procedures, the adjustment is determined and taken into account for the tax year in which the administrative adjustment request is made. Prior year tax returns are not amended. Adjustments resulting in imputed underpayments may be taken into account by either the partnership or the partners in the year the administrative adjustment request is made.

Resulting overpayments

Under the centralized audit process in the BBA, adjustments that do not result in an imputed underpayment (i.e., over-reporting of income) are taken into account by the partnership in the adjustment /year. The statute provides that such adjustments are generally taken into account as a reduction in non-separately stated income or an increase in non-separately stated loss, or, in the case of an item of credit, as a separately stated item. There will likely need to be regulations to provide further guidance regarding these types of adjustments and any reallocation adjustments.

When a partnership makes an administrative adjustment request, if the adjustment being made would result in the correction of an over-reporting of income, the partnership may not take the adjustment into account at the partnership level. Such adjustments must be taken into account by the partners. Further guidance needs to be issued by the Treasury Department regarding the procedures for filing administrative adjustment requests. The withdrawn proposed regulations provided that the reviewed year partners would take such adjustments into account in the year they received the statement showing their share of such adjustments.

Other relevant sections

Partnerships that cease to exist

To the extent a cessation of the partnership occurs before the audit adjustment takes effect, the former partners of the partnership are required to include in their tax returns the partnership adjustments that resulted in the imputed underpayment or other amount due that was not paid by the partnership. Thus, the decision to settle any imputed underpayments and the collection of taxes by the partnership would appear to be generally an administrative ease on the part of the Government and to the partners in the partnership rather than an implication that the liability has truly shifted to the partnership under the new provisions.

Tax accounting implications

Tax accounting considerations for the partnership under audit

The accounting discussion that follows addresses the accounting in the stand-alone financial statements of the partnership under audit — that is, it does not address the accounting by the partner that, under US GAAP, may in some cases account for its interest on a consolidated, equity-method or cost-method basis, as discussed further below.

The new centralized partnership audit regime has raised the question of whether the settlement of an imputed underpayment and the related liability by the partnership is subject to the provisions under ASC 740 when the partnership does not elect to push out the imputed underpayment to the partners.

On 2 September 2009, the Financial Accounting Standards Board (FASB) issued additional implementation guidance, through examples, on the accounting for uncertainty in income taxes. This additional guidance clarifies that entities should attribute income taxes to either the entity or its owners based on how the tax laws and regulations of each jurisdiction attribute income taxes, rather than based on who pays the income taxes. The following examples from ASC 740-10-55-226 through 740-10-55-228 illustrate the accounting for attribution of income taxes to the entity or its owners.

740-10-55-226

Entity A, a partnership with two partners — Partner 1 and Partner 2 — has nexus in Jurisdiction J. Jurisdiction J assesses an income tax on Entity A and allows Partners 1 and 2 to file a tax return and use their pro rata share of Entity A's income tax payment as a credit (that is, payment against the tax liability of the owners). Because the owners may file a tax return and utilize Entity A's payment as a payment against their personal income tax, the income tax would be attributed to the owners by Jurisdiction J's laws whether or not the owners file an income tax return. Because the income tax has been attributed to the owners, payments to Jurisdiction J for income taxes should be treated as a transaction with the owners. The result would not change even if there were an agreement between Entity A and its two partners requiring Entity A to reimburse Partners 1 and 2 for any taxes the partners may owe to Jurisdiction J. This is because attribution is based on the laws and regulations of the taxing authority rather than on obligations imposed by agreements between an entity and its owners.

740-10-55-227

If the fact pattern in paragraph 740-10-55-226 changed such that Jurisdiction J has no provision for the owners to file tax returns and the laws and regulations of Jurisdiction J do not indicate that the payments are made on behalf of Partners 1 and 2, income taxes are attributed to Entity A on the basis of Jurisdiction J's laws and are accounted for based on the guidance in this Subtopic.

In the situation of a partnership paying an imputed underpayment, the liability assessed by the IRS and the payment of tax from the partnership is merely an administrative ease on the part of the Government to recoup the resulting additional tax due. This may be the case when there are a substantial amount of partners in a partnership and the partnership makes a determination to make the payment on the imputed underpayment as a means of administrative convenience to the partners. As the partners are responsible for the tax consequences of the transactions occurring within the partnership, the payment of the income tax related to the imputed underpayment is attributed to the partners and the payment made by the partnership should be treated as a distribution from the partnership to its owners (partners) in the stand-alone financial statements of the partnership. Accordingly, we do not believe ASC 740 applies to the liability related to the imputed underpayment even though the liability may be settled and the payment of tax can be made by the partnership. The payment of the imputed underpayment would be for the benefit of the partners and does not represent a tax on the income of the partnership.

Until the partnership elects not to push out or is no longer permitted to push out the imputed underpayment of tax under the BBA rules, the partnership does not have an obligation to make the tax payment. Once the partnership elects not to push out or is no longer permitted under the BBA rules to push out the payment to the partners, the partnership then is committed and obligated to making the payment to settle the imputed underpayment of tax on behalf of the partners. Generally, the partnership would not recognize the obligation for the imputed underpayment until it is obligated to make the tax payment and can estimate the amount of the settlement or, if earlier, the IRS has made notice of the adjustment. To the extent the partnership has a contractual or legal obligation (including the BBA rules) to settle the underpayment, the timing of when the partnership recognizes a liability could be different. Any payment from the partnership to the IRS would be treated as a distribution to the partners in a similar manner to a withholding payment.

The partnership will also need to consider the requirements under US GAAP to assess whether the partnership's commitment to make tax payments on behalf of its partners are required to be disclosed in the footnotes to its financial statements.

Tax accounting considerations for the partner

Under ASC 740, a partner's future tax consequences of recovering the financial reporting basis of its investment in the partnership are recognized as deferred tax assets or liabilities. Deferred tax assets and liabilities are recognized for the difference between the financial reporting basis and tax basis of the investment in the partnership at the investor level.

The accounting for the settlement of the imputed underpayment of income taxes, whether pushed out to the partners or paid by the partnership, continues to be subject to the income tax accounting under ASC 740. The partners' accounting and presentation of income tax expense and related liability will depend on whether the partner is an upper-tier partnership or the partner consolidates the partnership (including amounts allocated to any non-controlling interest holders) or accounts for its investment under the equity or cost methods. Based on the complexity of the partnership structure and the potential impact to the partner's tax basis related to the settlement of the imputed underpayment, corporate partners of effected audited partnerships should consider the potential impact on the carrying amount of their deferreds and/or any resulting uncertain tax positions.

———————————————

———————————————
ENDNOTES

¹ A partnership has 100 or fewer partners during the year if it is required to furnish 100 or fewer statements during the taxable year for which the partnership is making the election. For example, a partnership provides two Schedule K-1s to a partner (one for the general interest and the other is for the limited interest in the partnership). For purposes of this condition, the partnership is treated as only providing one Schedule K-1 because the partnership is only required to provide one statement to that partner under the partnership rules.

² Eligible partners are individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic, S corporations and estates of deceased partners.