Practical Tips for Preparing an Administrative Adjustment Request

Posted on Oct 30, 2024

By Jenni Black

Jenni Black is a managing director at Citrin Cooperman and leader of the tax procedure and controversy practice of the firm’s National Tax Office She thanks Lee Meyercord and Kate Kraus for all their comments and suggestions in writing this post.

In this post, Black addresses what adjustments are required to be included on administrative adjustment requests and how the IRS can make adjustments to them, and she provides practical tips for practitioners preparing such requests.

JENNIBLACK

One of the hottest topics related to the centralized partnership audit regime enacted under the Bipartisan Budget Act of 2015 is administrative adjustment requests (AARs) under section 6227. AARs are the mechanism that a BBA partnership must use if it needs to revise a previously filed partnership return.1 In an AAR, any adjustments to partnership-related items (PRIs)2 are taken into account under rules similar to section 6225 (paying an imputed underpayment (IU)) or section 6226 (push out) 3 Within this hot topic, one of the most frequently asked questions is what adjustments are required to be included on the AAR and how the IRS can make adjustments to an AAR This article will attempt to alleviate some of the apprehension around adjustments reported on AARs as well as provide some practical tips for those preparing AARs, a topic I will return to in a follow-up article.

Inability to Push Out IRS Adjustments to theIU

One reason for practitioner anxiety is the potential consequence if the partnership computes the IU incorrectly. The IU is a partnership-level liability computed on adjustments to PRIs (as relevant here, the adjustments on the AAR).4 If the partnership chooses to pay the IU with the filing of an AAR but miscalculates the amount of that IU, the IRS could audit the partnership and determine the IU paid by the partnership should have been higher As the IU is calculated on adjustments, and not how an item would have been taxed (or not) had it been reported on the original returns, practitioners are often concerned that, if they miscalculate the IU, the IU they thought was small could balloon into a large, unexpected amount. If the partnership chose to pay the IU with the AAR instead of electing to

push out the adjustments, the partnership cannot go back and change its mind after the AAR has been filed if the IU is bigger than expected

Reg section 301 6226-2(g) is clear that a partnership cannot push out anything that is the partnership’s liability to its partners (this includes any chapter 1 taxes or penalties that are the liability of the partnership, any foreign withholding under chapters 3 and 4 of the code, and any IU the partnership has elected to pay). In other words, once something is the partnership’s liability, the partnership cannot shift its liability to someone else. When the AAR was filed, the partnership had a choice for any adjustments that resulted in an IU — pay the IU or push out the adjustments to its partners — and that choice cannot be subsequently changed by the partnership.5 This concern results in many partnerships choosing to push out the adjustments (which brings with it material administrative expense) instead of paying the IU

However, it’s important to know what types of IRS adjustments may result in an increased partnership-level liability that cannot be pushed out In situations where the partnership omits an adjustment (including a related adjustment), the IRS cannot just add the adjustment to the AAR and include it in the IU that the partnership must pay This is no different than if the partnership omits an item from the partnership return and the IRS audits the partnership and makes adjustments 6 Generally, in order to adjust a PRI and assess an IU, the IRS must issue a notice of final partnership adjustment (FPA).7 Therefore, if the IRS wants to change an adjustment included on an AAR, adjust an item that was not on the AAR, or adjust the IU included on the AAR, it must open an exam and issue an FPA

As mentioned, if the IRS adjusts the calculation of the IU that results from the adjustments included in the AAR, the partnership cannot elect to either push out the change to the IU for its partners to pay nor can it choose to push out the adjustments on the AAR as it did not elect to do so at the time the AAR was filed When the IRS adjusts the IU, it is adjusting the IU as calculated on the adjustments actually included in the IU — it is not adding new adjustments to the calculation 8 Therefore, the adjustments the IRS can make to the IU are primarily limited to calculation issues and not substantive issues. For example, the IU could be adjusted, with the partnership being liable for any additional IU that is owed, if the partnership incorrectly treats adjustments as zero under reg section 301.6225-1(b)(4), inappropriately nets items in the calculation of the IU, uses the wrong tax rate, or misapplies modifications to the IU calculated on the AAR In addition, the IRS could determine the partnership made an invalid push-out election on its AAR (for example, because it did not include all adjustments in the AAR on the push-out statements) and is now liable for an IU calculated on the adjustments included in the AAR 9 These errors in calculating the IU and applying the various BBA rules could result in large changes to the IU calculated by the partnership.

If the IRS adjusts the adjustments in the AAR or any PRI not included on the AAR (for example, an omitted adjustment), all of the normal BBA options, including the push-out election, would generally be available to the partnership. For example, consider a partnership that adjusted ordinary income on the AAR but failed to make a corresponding adjustment to net earnings from self-employment (NESE). For the IRS to adjust NESE, the IRS would have to open an audit of the partnership and make

the adjustment to the unadjusted PRI (in this example, NESE). This adjustment would result in an IU and the partnership could elect to push out with respect to that IU.10

What AreAdjustments That Should BeReported on an AAR?

An AAR adjusts PRIs on a previously filed Form 1065.11 Any change to one of those PRIs on the Form 1065 is an adjustment to a PRI that is included in the calculation of the IU. While this may sound simple, there is sometimes confusion as to what items or amounts on the Form 1065 are PRIs, and which are not. The adjustments that go on the AAR are the same adjustments used to calculate the IU.12 Therefore, it is important to properly identify what PRIs are being adjusted on the AAR in order to properly calculate the IU so that partnerships can make fully informed decisions regarding whether to pay the IU or elect to push out the adjustments. Some have referred to the IU as a “reporting” tax and treat any change to a line on the Form 1065 as an adjustment to a PRI to be included on the AAR (and, thus, in the IU) But a strict application of this concept can result in a PRI being adjusted more than once, which could result in an overstated IU. Many items on a Form 1065 appear on more than one line.13

For example, if ordinary income is increased by $100, that same $100 would be included on several lines on the Form 1065 including:

1. Three places on page 1 of the Form 1065,

a. Gross receipts

b Total income (loss)

c. Ordinary business income (loss)

2 On the Schedule K Line 1, ordinary business income (loss),

3. Net income (loss) on page 6 (line 1) (calculated using the amounts on the Schedule K),

4 On the Schedule M-1 (reconciling book income with tax income included on certain lines of Schedule K),

5 On the Schedule M-2 (net income (loss), and

6. In the partners’ capital accounts

7 Split amongst the partners on the Schedules K-1

But increasing ordinary income by a $100 does not result in more than seven $100 adjustments. In this example, there is only one adjustment to a PRI — the $100 increase to ordinary income Ordinary income is the PRI, not the lines on the Form 1065. See reg. section 301.6241-1(a)(6)(v) (providing examples of PRIs which are items of income, gain, loss, deduction, or credit and other items such as liabilities but not listing lines on the Form 1065 as PRIs). Although the lines on the Form 1065 contain PRIs, they are not PRIs themselves — that is, “ordinary income” is a PRI but “Schedule K, line 1” is not a PRI. The PRI is the ordinary income on the Schedule K, line 1, not the line itself. Therefore, if, in the previous example, a partnership included all of those lines on its AAR, it would adjust the same PRI (ordinary income) at least seven times, when it is only actually being adjusted once (increasing it by

$100). In turn, this would result in the partnership erroneously calculating the IU on at least $700 in positive adjustments instead of a single $100 positive adjustment.14

However, not every change to the Form 1065 as the result of an adjustment to a PRI is the same PRI It is important to look at the underlying item to determine whether it is a different PRI, not why the item changed For example, if our $100 increase in ordinary income above resulted in a $100 increase to the partnership’s NESE, the $100 increase to NESE is not the same adjustment as the $100 increase in ordinary income Those adjustments are related to, or result from, each other such that one of those positive adjustments could be treated as zero in the calculation of the IU15 (even if an adjustment is treated as zero for purposes of calculating the IU, the adjustment must still be on the AAR), but NESE is a different PRI than ordinary income. While, in this example, NESE only increased because ordinary income increased, whether income qualifies as NESE depends on different criteria than whether something is ordinary income. Not all ordinary income is NESE.16 As they are separate items with separate criteria, they are separate PRIs and, in this example, both PRIs were adjusted.

Conclusion

In a future post, I will discuss additional issues related to this post, including how to report adjustments on an AAR, as well as what happens if a PRI that can appear in multiple places on the Form 1065 is reported correctly in some places but not on other places. As the BBA presents many unaddressed issues for practitioners and taxpayers, I hope to return to Procedurally Taxing to discuss some of these issues that will increase in importance for taxpayers and practitioners alike.

FOOTNOTES

1 Under section 6227, a BBA partnership may make an administrative adjustment request in order to change a partnership-related item on a previously filed partnership return. In addition, as part of the BBA (and further amended by the Tax Technical Corrections Act of 2018), Congress amended section 6031(b) to provide that BBA partnerships cannot amend the information furnished to its partners after the due date of the partnership return, except as provided under the BBA (specifically, modification under section 6225 and push out under section 6226) or as otherwise provided by the Secretary The amendment and section 6227 effectively cut off the ability of BBA partnerships to file amended returns (note that partnerships subject to the previous regime under the Tax Equity and Fiscal Responsibility Act of 1982 also could not file amended returns and had to file AARs)

2 A PRI is any item or amount that: 1) is on (or required to be on) the Form 1065 filed by the partnership or required to be maintained in the partnership’s books and records; and 2) is relevant to determining the tax liability of any person under chapter 1, regardless of whether the item or amount has an actual effect on the tax liability of any person. Reg. section 301.6241-1(a)(6). Under this broad definition, nearly every item on the Form 1065 is a PRI, including balance sheet items such as the partnership’s assets and liabilities. Id. Reg. section 301.6241-1(a)(6)(v) contains a list of examples of PRIs which include things such as the character, timing, source, and amount of the partnership’s income, gain, loss, deduction, or credit and the amount and character of partnership liabilities.

4 Section 6225.

5 Not only do the code and regulations not provide any way for a partnership to change its mind at a later date, there is arguably no way to make a valid push-out election after the AAR has been filed. In order to have a valid push-out election, the partnership must timely furnish the push-out statements (Form 8986) to its partners. In the case of an AAR, any push-out statements are required to be furnished to the partners at the time the AAR was filed. Once the AAR has been filed, there is no way to go back and issue statements to the partners at the time the AAR was filed.

6 Seesections 6221(a), 6231, 6232(b).

7 Seesections 6221(a), 6231, 6232(b), 6241(2)(B). Exceptions to this rule are if the partner files inconsistently from the partnership and does not file a notice of inconsistent treatment and in situations where there is a mathematical or clerical error. Section 6232(d). The IRS may also assess an IU included on AAR, if the partnership chooses to pay the IU. Section 6232(a)(2).

8 See87 Fed Reg 75486 (discussing the difference between adjusting a previously calculated IU and changing the adjustments in the AAR); reg sections 301 6225-1(c)(3) (discussing adjustments to an IU “previously calculated” by the partnership).

9 The regulations under section 6227 do not clearly provide that adjustments that are not allocated to partners on the Schedule K-1 must be included in the push-out statements furnished to partners In fact, reg. section 301.6227-1(e) only refers to items previously reported to partners on the partnership return and items not included on the partnership return being adjusted Some items adjusted in an AAR (for example, balance sheet items) would not have been allocated to partners on the partnership return but would have been on the partnership return But the regulation does provide that the statements must include any other information required by the IRS in forms and instructions. The January 2024 instructions to the Form 8985, “Pass-Through Statement — Transmittal/Partnership Adjustment Tracking Report,” provide that balance sheet adjustments must be included in Part V of the form. However, this instruction is not repeated in the instructions to Form 8986, “Partner’s Share of Adjustment(s) to Partnership-Related Item(s),” and there can be adjustments to PRIs that are not balance sheet items but also not included on the Schedule K-1. The IRS and Treasury should consider clearly providing rules governing how adjustments to items that are not on the Schedule K-1 should be included in push-out statements furnished to partners. Given the uncertainty, this author recommends including all adjustments made on the AAR in the push-out statements issued to partners, even if the item adjusted is not an item normally included on the Schedule K-1 issued to partners

10 Sections 6225, 6226.

11 Reg. section 301.6227-1(b).

13 Although outside the scope of this article, this author queries whether changing a line or statement on the partnership return when the item is properly reported elsewhere on the partnership return results in an adjustment at all For example, if a partnership makes basis adjustments under sections 743(b) and 734(b) and properly includes those basis adjustments on the Form 1065 and applicable Schedules K-1 but fails to include the statement which includes the computation of the section 734(b) basis adjustments and how it has been allocated, would the partnership be making an adjustment to a PRI if it files an AAR to include the statement?

14 Although technically all the “extra adjustments” are all the same adjustment listed multiple times and not separate adjustments, if all these “extra adjustments” were separately listed, they could be treated as zero in the calculation under reg. section 301.6225-1(b)(4).

15 Reg section 301 6225-1(b)(4)

16 SeeSection 1402 END FOOTNOTES