February 16, 2018 IRS issues proposed regulations on adjusting tax attributes under centralized partnership audit regime The IRS has issued proposed regulations (REG-118067-17, proposed attribute regulations) addressing the adjustment of tax attributes to reflect partnership adjustments under the centralized partnership audit regime introduced by the Bipartisan Budget Act of 2015 (BBA). The proposed attribute regulations also address the allocation of an imputed underpayment. Background BBA centralized partnership audit regime The BBA overhauled the manner in which partnerships are audited and how any resulting tax liability is computed, assessed and collected. Before the BBA, a partnership audit generally was conducted in accordance with the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which did not provide any statutory mechanism for collecting tax at the entity level. Rather, the IRS generally had to seek payment of underpaid tax directly from the partners who would have owed such tax had the partnership properly reported its items on its original return. The BBA brought in a new regime that changes procedural rules, expands who might be liable for additional tax, and revises how additional taxes may be computed. These new rules are generally effective for most partnerships for tax years that start after December 31, 2017. Regulations issued to date under BBA regime The IRS has issued multiple sets of regulations relating to the BBA. Aside from the proposed attribute regulations, the IRS has issued one set of temporary and proposed regulations, three sets of proposed regulations and one set of final regulations. On August 4, 2016, the IRS released temporary and proposed regulations addressing the election to apply the BBA to tax years beginning after November 2, 2015 and before January 1, 2017. For a detailed discussion, see Tax Alert 2016-1344. On June 13, 2017, the IRS released the "June Proposed Regulations," which provide guidance on the applicable procedures, the determination of the amount of taxes, interest and penalties owed, and other consequences of an adjustment to a partnership tax return. Among other provisions, the June Proposed Regulations include procedures for electing out of the new regime, designating a partnership representative, filing administrative adjustment requests, and determining amounts owed by a partnership or its partners from adjustments following partnership exam. For a detailed discussion, see Tax Alerts 2017-0168 and 2017-1002. On November 30, 2017, the IRS issued proposed regulations providing guidance on the application of certain international tax rules under the BBA centralized partnership audit regime. For a detailed discussion, see Tax Alert 2017-2056. On December 19, 2017, the IRS published proposed regulations addressing Section 6226 push-out elections in tiered partnership structures. Those proposed regulations also address certain procedural issues, including tax assessment and collection, penalties and interest, periods of limitations and judicial review of partnership adjustments. See Tax Alert 2017-2184. On January 2, 2018, the IRS issued final regulations on electing out of the BBA partnership audit regime. See Tax Alert 2018-0013. Proposed attribute regulations The new proposed regulations address how and when partnerships and their partners adjust tax attributes to take into account partnership adjustments under Sections 6225 and 6226. They also address the economic and tax allocation of an imputed underpayment. Rules relating to Section 6225 Under the BBA, some adjustments to a partnership or partner tax return will result in an imputed underpayment. The proposed attribute regulations address how attributes will be adjusted to reflect the item that resulted in the imputed underpayment. For example, if the partnership omitted income, the proposed attribute regulations address how basis and capital accounts will be adjusted to reflect this omitted income. The proposed attribute regulations also address how the associated imputed underpayment must be allocated. Some adjustments do not result in an imputed underpayment. The proposed attribute regulations also address the treatment of attributes when such adjustments are made. Attribute adjustments to reflect omitted income or other adjustments that result in an imputed underpayment When an adjustment to a partner or partnership return results in an imputed underpayment, certain attributes are adjusted to reflect the adjustment to the return. For example, if the partnership omitted $1 million of income, then upon an audit adjustment reflecting an inclusion of $1 million, inside basis, outside basis, and capital accounts would generally be increased by $1 million under the proposed regulations. The allocation of the attribute adjustments is generally determined by how the tax item should have been allocated to the partners in the reviewed year. Therefore, if half of the omitted income should have been allocated to Partner A in the reviewed year, Partner A's attributes would generally be adjusted as if it were allocated half of that omitted income. Although the attributes are adjusted based on how allocations should have been made in the reviewed year, the attributes are not actually adjusted until the adjustment year. In other words, attributes are adjusted in the adjustment year to reflect income and loss that was recognized in the reviewed year. Outside basis and capital accounts are normally adjusted to reflect income and loss recognized in the year at issue, not a prior year. Therefore, the proposed attribute regulations take the position that outside basis and capital accounts are not automatically adjusted under the general rules of subchapter K when an adjustment is made to a partnership's income or loss. Instead, the partnership's actual items of income or loss from the reviewed year that were misreported would be treated as "notional items" that are recognized in the adjustment year, for purposes of adjusting outside basis and capital accounts. If a reviewed-year partner is no longer a partner in the adjustment year, its successor will adjust its capital account and outside basis to reflect the omitted income or other item that was adjusted. The proposed attribute regulations specify when an adjustment-year partner is a successor to a reviewed-year partner. When Section 6225 applies to an adjustment that results in an imputed underpayment, only "specified tax attributes" are adjusted. Specified tax attributes are the partnership's tax basis and book value of its property, amounts determined under Section 704(c), and the adjustment-year partners' capital account balances and basis in their partnership interests. No adjustment is made to other tax attributes, such as Section 743(b) basis adjustments or the basis a reviewed-year partner has in its partnership interest when that partner is no longer a partner in the adjustment year. The proposed attribute regulations provide two anti-abuse rules that would prevent adjustments to outside basis in certain situations in which the reviewed-year partner was tax-exempt or the adjustment-year partner is a successor to a reviewed-year partner and acquired its partnership interest in a nonrecognition transaction. Allocations of an imputed underpayment When a partnership adjustment results in an imputed underpayment, attributes must be adjusted to reflect the item that was adjusted. In addition, the imputed underpayment is a Section 705(a)(2)(B) expenditure of the partnership that must be taken into account for tax purposes. Under the proposed attribute regulations, the allocation of this Section 705(a)(2)(B) expense must generally correspond to the allocation of an associated notional item. For example, if a partnership omitted $10 million of income and 10% of that income should have been allocated to Partner A in the reviewed year, Partner A would be allocated a notional item of $1 million of income in the adjustment year, and its outside basis and capital account would increase by $1 million in the adjustment year. In addition, if the applicable tax rate were 40% and the partnership had an imputed underpayment of $400,000 as a result of the $1 million that should have been allocated to Partner A, the partnership would be required to allocate this Section 705(a)(2)(B) expense of $400,000 to Partner A. Moreover, if the partners' rights to distributions were not determined by their capital account balances, the partnership would have to specially allocate the economic burden of $400,000 of its imputed underpayment to Partner A. The allocation of an imputed underpayment takes into account modifications under Treasury Regulation 301.6225-2. For example, if Partner A were tax-exempt and the partnership therefore paid $0 in connection with the $1 million that should have been allocated to Partner A, but the partnership had an imputed underpayment with respect to income that it should have allocated to other partners, none of the imputed underpayment would be allocated to Partner A. These allocations of the Section 705(a)(2)(B) expense and the economic burden of the imputed underpayment would be mandatory. This is unusual. In subchapter K, partners are ordinarily free to determine their economic agreement but then must make tax allocations that accord with their economic agreement. The proposed attribute regulations, however, would mandate a specific allocation of the economic burden of an imputed underpayment. Attribute adjustments to reflect overreported income or other adjustments that do not result in an imputed underpayment Under Section 6225, when a partnership overreports income, it generally corrects this error by omitting income in its adjustment year. The proposed attribute regulations provide that such corrections should be allocated in a manner that corresponds with how the item should have been allocated in the reviewed year. Successor rules apply when there has been a change in who the partners are. The general intent is to produce the result that would have arisen had the partnership properly reported its items on its original return, but this result will not always be obtained. Rules relating to Section 6226 The proposed attribute regulations also address the treatment of attributes when a partnership makes a Section 6226 "push out" election. Under these regulations, all tax attributes of the partnership and the reviewed-year partners are adjusted to reflect the adjustment to the partnership's (or partner's) tax return. Unlike attribute adjustment under Section 6225, all attributes are adjusted upon an election under Section 6226. Although the amount of tax owed takes into account how attributes would be affected in tax years preceding the adjustment year, the attributes are not actually adjusted until the adjustment year. In addition, it appears that no adjustment is made to tax attributes (such as Section 743(b) adjustments or capital accounts) of partners who were not reviewed-year partners. Proposed effective date The proposed attribute regulations would apply to partnership tax years that begin after 2017, or earlier, if the partnership elects to apply the BBA to earlier tax years. Unaddressed issues The proposed attribute regulations leave open many questions, such as the treatment of partners that are S corporations, trusts or estates. They also request comments on whether to extend the anti-abuse rule and whether a chargeback or similar provision should be allowed to reverse an allocation of an imputed underpayment. Implications The statute and legislation left open the question of attribute adjustments, so this is a significant set of regulations that could have far reaching consequences when finalized. For example, the treatment of attributes will affect the extent to which a former partner should be required to indemnify the partnership (or another partner). It may therefore be worthwhile to take the proposed attribute regulations into account when drafting indemnities in partnership agreements and purchase and sale agreements. The attribute adjustment rules will also affect whether a Section 6226 push-out election should be made. Section 6226 requires partners to pay additional tax in connection with an unfavorable adjustment but generally does not enable partners to benefit from a favorable adjustment. The proposed attribute regulations do not change this result. In addition, the rigid system for allocating attributes deviates from the general approach under the Section 704(b) regulations, under which partners are free to determine their business deal and tax consequences must be consistent with that deal. Under the proposed attribute regulations, it would seem a partner could not agree to bear a disproportionate share of an expense, for example, if the partner felt the outcome was in part that partner's fault. It seems likely that inequities or uncertainties will result, although it will be necessary to wait until final regulations are released to see how these allocation rules play out. ———————————————
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