Chasing Waterfalls: Allocating Adjustments in a Push Out Election
by Jenni Black
Jenni Black is a managing director in Citrin Cooperman’s national tax office and the practice leader of the tax procedure and controversy practice.
In this post, Black explores what happens if partnership-related items, as adjusted, would be allocated differently than they were on the original return due to provisions in the partnership agreement.
Under the centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015, any adjustments to partnership-related items (PRIs) must be determined, and any tax attributable to those adjustments must be assessed and collected, at the partnership level, unless BBA provides for an exception.1 One of the exceptions to when the tax attributable to partnership adjustments must be assessed and collected at the partnership level is if the partnership makes an election under section 6226 (or section 6227 in the case of administrative adjustment requests (AARs)) to “push out” the adjustments to its partners from the reviewed year.2 This article will explore allocating adjustments to partners on push out statements. Specifically, this article will discuss what happens if the items, as adjusted, would be allocated differently than they were on
1 IRC section 6221(a).
2 The reviewed year is the tax year to which the adjustment relates. IRC section 6225(d)(1); reg. section 301.6241-1(a)(8).
the original return due to provisions in the partnership agreement. In part two of my article, I’ll discuss complications that may arise in tiered partnerships and what happens if the pushed-out adjustments would change as they flowed through the tiers based on the facts and circumstances of upper-tier partnerships. Despite TLC’s warning to the contrary, we will go chasing waterfalls.
Under section 6226(a)(2), the partnership must furnish, to each partner from the reviewed year, a statement of the partner’s “share” of any adjustment to a PRI if the partnership is pushing out the adjustments to its partners. The statute does not say what a partner’s “share” of the adjustment is. However, section 6226(a)(2) provides that the IRS can set the time and manner of furnishing the statements to the reviewed year partners — and it did, in reg. section 301.6226-2. Under reg. section 301.6226-2(f), adjustments are allocated to reviewed year partners “in the same manner” the adjusted item was originally allocated on the partnership’s reviewed year return, unless one of the two exceptions apply. One of the exceptions is for situations where the adjusted item did not appear on the original return, in which case the adjusted item is allocated in accordance with normal rules regarding partnership allocations (including the partnership agreement). The second exception is if the adjustment specified how the item is allocated, at which point the item is allocated in accordance with the adjustment. Reg. section 301.6227-1(e)(2)
provides virtually identical rules for allocating adjustments in AARs.3
‘In the Same Manner’
Many partnership agreements contain “waterfalls” — provisions that provide that items of the partnership are allocated in different ways based on the amount (or type) of income or specific circumstances and thresholds. Neither reg. section 301.6226-2(f) or reg. section 301.62271(e)(2) expressly defines what it means to allocate the adjusted items “in the same manner” as the item was allocated on the original return. Does it mean in the exact same percentage as the original return (for example, if the item was allocated 25 percent to A on the original return, must the adjustment also be allocated 25 percent to A?)? If “in the same manner” means the item must be allocated using the same percentage as on the original return, this could result in an allocation that differs from how the adjusted item would have been allocated if the item had been reported correctly to begin with. Or is it more of a same “method” standard (that is, if the item was originally allocated in accordance with the partnership agreement, the adjustment would be allocated in accordance with the partnership agreement, even if it is a different percentage than on the original return)?4
There is nothing in the BBA statutes or regulations that provide any insight as to what it means to allocate the adjustments “in the same manner” as on the original return. Reg. section 301.6226-3(h) contains many (long) examples of how push out works in the context of an exam, including furnishing statements and partners taking into account the adjustments on those statements. In all of the examples, the adjustments
3 Section 6227(b) does not mention how adjustments should be allocated but instead just says the partnership and partners take into account the adjustments “under rules similar to the rules of section 6226.”
4 I note that even if “in the same manner” means using the same method as the item was allocated on the original return, this does not mean the adjustment would be allocated in accordance with the partnership agreement. If the item was not originally allocated in accordance with the partnership agreement, then the adjustment would be allocated using the same method as on the original return, even if not in accordance with the partnership agreement. In the case of items not on the original partnership return, those items were not previously allocated, so reg. section 301.6226-2(f )(1)(ii) specifies the rules that must be used to allocate the adjustments. It does not allow the partnership to pick a different method of allocating the adjustment.
are allocated using the exact same percentages as on the original return (unless the item is being reallocated). However, none of the examples expressly contain a situation where the allocation would be different under the partnership agreement after the adjustment than the percentage used on the original return.
Aside from push out, adjustment allocations also matter for modifications.5 For purposes of modification, section 6225(c) and reg. section 301.6225-2 refer to the amount of the adjustments “allocable” or “properly allocable” to each partner or the partner’s “distributive share.”6 In the context of rate modification, reg. section 301.6225-1(b)(3)(iii)(A) provides that a partner’s “distributive share” is how the item was allocated in the notice of proposed partnership adjustment or, if the allocation was not addressed in the notice, how the item would be properly allocated to the partner under the rules of subchapter K of chapter 1 of the Internal Revenue Code. Although this same detail is not contained elsewhere in the modification rules (for example, to decide how adjustments are “properly allocable” as part of filing an amended return during modification), this suggests that, at least for some modifications, unless the allocations are expressly provided by the IRS, the normal rules of subchapter K would apply in determining how adjustments are allocated to partners. But there is a major difference between modification and push out — in modification, the IRS sees how the partnership is allocating the adjustments before those allocations impact anything under BBA (that is, in the case of modification, the IRS can see the allocations prior to approving the modification).7
5 Under modification, the partnership can request to lower amounts of the imputed underpayment based on attributes of the partners and/or actions of the partners (for example, partners filing amended returns to take into account their share of the adjustments). In order to request modification with respect to a particular partner you must first know the amount of the adjustments attributable to that partner. See IRC section 6225; reg. section 301.6225-2.
6 When requesting modification on Form 8980, “Partnership Request for Modification of Imputed Underpayments Under IRS Section 6225(c),” the partnership must detail how the adjustments are allocable to the direct or indirect partner that is the subject of the modification request. This allows the partnership to specify how those adjustments should be allocated.
7 If a partnership applies modifications as part of the calculation of the imputed underpayment in an AAR, the partnership applies the modifications prior to IRS approval of the modifications, which would include the allocation of items.
However, in the context of push out, the partnership allocates the adjustments without any pre-review by the IRS.
Similar to the rules for rate modification, under reg. section 301.6226-2(f)(1)(ii), if the adjusted item was not on the original return, the adjustment is allocated in accordance with the rules governing partnership allocations, which includes as set forth in the partnership agreement. So, clearly, the partnership agreement may govern allocations of partnership adjustments on push out statements, at least in some situations. As the rules under reg. section 301.6226-2(f) are for push out following an exam, the rule could have required the exam to specify how the adjustments should be allocated, but instead it allows the normal rules to be used for unreported items, unless the allocation is specifically adjusted or determined. Thinking about it from another angle, perhaps the “in the same manner” rule is more of an “anti-shenanigans” rule in case the partnership tries to allocate the adjustments in an entirely different way than it did originally.8 This could explain a rule requiring the partnership to allocate the adjustments using the “same manner” it did when it allocated the item on its original return as opposed to providing that all adjustments are allocated under the normal rules for partnership allocations, unless the allocation of the item is being adjusted, which may not have been the manner in which the item was allocated on the original return.9
Stepping back to look at the big picture: BBA is procedural regime under which changes are made to previously filed partnership returns (or creating a partnership return in the case of a nonfiler). BBA doesn’t override any substantive tax provisions — it doesn’t specify whether a
8 To be fair, it is questionable whether any allocation that materially differs from how the item was originally allocated would comport with the rules governing partnership allocations.
9 It is true that partnerships could include shenanigans in their partnership agreement in an attempt to allocate adjustments to unreported items in a “non-economic” manner. But the rule for allocating adjustments to items not on the original return does not allow the partnership to blindly follow the partnership agreement. Instead, the rule says that adjustment to items not contained on the original return must be allocated “under rules that apply with respect to partnership allocations, including under the partnership agreement.” If the allocations in the partnership agreement do not conform to the “rules that apply with respect to partnership allocations,” then arguably the partnership could not allocate the items in accordance with the partnership agreement.
partnership can take a deduction, whether something is income, what adjustments the IRS must make, and it doesn’t change the rules for allocating the partnership’s items under subchapter K of chapter 1. How a partnership allocates its items is not covered by BBA — it’s covered by subchapter K. BBA covers how to adjust the allocations, but it does not, itself, say how partnerships should allocate their items. As such, “in such manner” meaning using the same rules as the partnership did on the original return would be more consistent with this concept then using the same percentage as on the original return, even if that would be different than how it was allocated on the original return.
While certainly not without doubt, at least the “spirit” of BBA would suggest there is a (really good? I mean, I like it) good argument that “in the same manner” could be read to require a partnership to allocate the adjustments to its partners in a push out statement using the same rules it used when it allocated the items originally. But, to add a little foreshadowing, this may create some complications that don’t exist if the adjustments were allocated using the same percentages that were used on the original return. Stay tuned for part two of my article, where I discuss why any of this matters, potential complications involving unadjusted items, and what happens if a pass-through partner’s facts and circumstances would have impacted how the pass-through partner reported the items to its partners, if the items had been reported correctly to begin with.