taxnotes federal
The Imputed Underpayment: Treating Adjustments as Zero Under The BBA
by Jenni Black
Reprinted from Tax Notes Federal, October 28, 2024, p. 679
by Jenni Black
Reprinted from Tax Notes Federal, October 28, 2024, p. 679
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 Kate Kraus and Lee Meyercord for their helpful comments in writing this article.
In this article, Black examines a provision that allows some adjustments to partnershiprelated items to be treated as zero when calculating an imputed underpayment, and she explains why it is important for partnerships to understand that provision as well as other options under the Bipartisan Budget Act of 2015.
The views expressed herein are the author’s and do not necessarily represent the views of Citrin Cooperman Advisors LLC.
Copyright 2024 Jenni Black. All rights reserved.
Under the centralized partnership audit rules in the Bipartisan Budget Act of 2015, almost any item on Form 1065, “U.S. Return of Partnership Income,” can be adjusted in a partnership audit. Those adjustments are multiplied by the highest applicable tax rate to determine an imputed underpayment (IU), which can be much greater than the tax that would have been owed had the items been reported correctly — and the IU can include multiple adjustments relating to the same issue. But under an often misunderstood provision, the BBA regulations allow some adjustments to be treated as zero — solely for purposes of calculating the IU. Partnerships in audit or filing an administrative adjustment request (AAR) might find that provision helpful.
Partnership-Related Items and Calculating the Imputed Underpayment
Under the BBA any adjustment to a partnership-related item (PRI) must be made at the partnership level, and all partnerships are subject to the BBA unless they elect out for a specific tax year.1 A PRI is any item or amount that is (1) 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) 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.2 Under that broad definition almost every item on the Form 1065 is a PRI, including balance sheet items like the partnership’s assets and liabilities.3 If an item or amount is a PRI, unless an exception applies, the IRS generally cannot adjust the item at the partner level.4
Unlike under the Tax Equity and Fiscal Responsibility Act of 1982, if the IRS makes adjustments to PRIs, the default rule (that is, the rule that will apply if the partnership takes no other action) is that the partnership will be liable
1 Section 6221.
2 Reg. section 301.6241-1(a)(6)(ii). An item or amount is relevant to determining the tax liability of any person under chapter 1 if it is possible for the item or amount to affect chapter 1 liability under the Internal Revenue Code; it does not have to have an actual effect on chapter 1 tax in any specific case.
3 See reg. section 301.6241-1(a)(6)(v). At the time of this writing, this author is aware of only two items on the Form 1065 that are not PRIs — withholding taxes (for example, the amount of any federal taxes withheld from the partnership) and Form 1065, Schedule K, line 20c, code Y, net investment income, which is relevant only to taxes under chapter 2A.
4 The IRS may adjust an item that is a PRI at the partner level solely for purposes of determining a non-chapter 1 tax, if a special enforcement provision applies, or if the partner files inconsistently with the partnership. See reg. sections 301.6222-1(c)(4), 301.6241-6, and 301.6241-7.
for an IU calculated on the adjustments.5 The calculation of the IU is not based on what the tax would have been on those adjustments had the items been reported correctly to begin with — or even how the adjusted items are normally taxed elsewhere in the Internal Revenue Code. Instead, the BBA provides a specific calculation of the IU. Under reg. section 301.6225-1, adjustments are classified as either “positive” or “negative.”6 Negative adjustments may offset positive adjustments only if they can be appropriately netted under the code, which might not occur very often.7 After adjustments are appropriately netted, all net positive adjustments are then multiplied by the highest tax rate in effect under sections 1 or 11 for the reviewed year,8 regardless of whether or how the item would have been taxed to the partners.9
The IU is then calculated by applying adjustments to post-tax-rate items such as credits, creditable expenditures, or chapter 1 taxes or penalties that are the liability of the partnership. Because the BBA taxes all adjustments in more or less the same manner, the calculation can result in an amount that differs significantly from the
amount of tax that would have been paid if the items had been reported correctly to begin with.10 However, the regulations implementing the BBA provide significant flexibility for both the IRS and taxpayers in calculating the IU. Reg. section 301.6225-1(b)(4) provides:
(4) Treatment of adjustment as zero for purposes of calculating the imputed underpayment. If the effect of one partnership adjustment is reflected in one or more other partnership adjustments, the IRS may treat the one adjustment as zero solely for purposes of calculating the imputed underpayment. In addition, if a positive adjustment to an item is related to, or results from, a positive adjustment to another item, one of the positive adjustments will generally be treated as zero solely for purposes of calculating any imputed underpayment unless the IRS determines that an adjustment should not be treated as zero in the calculation of the imputed underpayment. This paragraph applies to the calculation of any imputed underpayment, including imputed underpayments calculated by a partnership or pass-through partner (for example, as part of the filing of an administrative adjustment request (AAR) under section 6227).
5 Section 6225. Note that because BBA does not apply to taxes outside chapter 1, the IRS may still collect any non-chapter 1 taxes on the adjustments from the partners, such as self-employment tax. The IU is a separate liability of the partnership; it is not a collection of partner tax.
6 A positive adjustment is any adjustment that is not a decrease in income, an increase in an expense, or a decrease in a chapter 1 tax or penalty owed by the partnership, or an increase in a credit. Reg. section 301.6225-1(d)(2)(iii). As an adjustment to a non-income item is none of those, adjustments to non-income items are always positive.
7 The easiest way to determine if a negative adjustment can offset a positive adjustment is if the items net on the partnership return. Generally, the IRS makes adjustments to the Schedule K. Therefore, if the two adjustments appear on the same line or code on the Schedule K, they will generally net in the calculation of the IU.
8 The reviewed year is the tax year to which the adjustments relate. Reg. section 301.6241-1(a)(8).
9 Because nearly everything on the Form 1065 is a PRI, that means adjustments to balance sheet items or capital gains are taxed in the same way as ordinary income (because the highest tax rate is applied in the calculation). Also, items that could result in a deduction only at the partner level (for example, the informational items for section 199A) are also taxed as if they were ordinary income. That is one reason it is so important to understand the rules in reg. section 301.6225-1(b)(4) and all the choices the BBA provides partnerships.
Reg. section 301.6225-1(b)(4) can be broken down into three distinct rules: (1) how the IRS may use the rule; (2) when the IRS must use the rule; and (3) how partnerships may use the rule. Reg. section 301.6225-1(b)(4) was proposed August 17, 2018, providing a rule solely for use by the IRS.11 The preamble explained that the provision was intended to alleviate “double counting” when multiple adjustments are made regarding the same issue or transaction when some of the adjustments would have been
10 Under the BBA, the partnership has several options to reduce the amount of the IU or have the partners pay any tax they would have owed on those adjustments (or portions of an adjustment), instead of the partnership paying the IU. Those options are beyond the scope of this article, but partnerships and their representatives should ensure they fully understand the options to take the correct course of action based on that partnership’s circumstances. The options differ significantly and do not all lead to the same result.
11 REG-136118-15.
“subsumed” by other adjustments if the items had been reported correctly originally.12 When finalized on February 27, 2019, the rule remained limited to the IRS, and the preamble reiterated that the rule (1) provides flexibility to the IRS to treat adjustments as zero (solely for purposes of calculating the IU) if the tax effect of the adjustment is reflected in another adjustment, and (2) may alleviate concerns that the IU created a “double tax” on items.13
On November 24, 2020, the IRS proposed rules implementing section 6241(11), which deals with special enforcement matters.14 As part of that notice of proposed rulemaking, the IRS proposed changes to reg. section 301.6225-1(b)(4). As explained in the preamble, the changes were proposed to provide that “generally” adjustments to non-income items (an item that is not an item of income, gain, loss, deduction, or credit) are treated as zero in the calculation of the IU if the adjustment to the non-income item is related to or results from an adjustment to an item of income, gain, loss, deduction, or credit, unless the IRS determines the adjustment to the non-income item should not be treated as zero. The preamble also explained that the proposed changes would allow partnerships to treat adjustments to nonincome items as zero when a partnership calculates an IU (for example, as part of an AAR), if the adjustment to the non-income item is related to or results from an adjustment to an item of income, gain, loss, deduction, or credit, instead of the rule being limited solely to the IRS.
Notably, the preamble describes the proposed change (providing that an adjustment to a nonincome item will be treated as zero if it is related to or results from an adjustment to an item of income, gain, loss, deduction, or credit, unless determined otherwise by the IRS) as an addition
12 83 F.R. 41958. As originally proposed, the provision read, “If the effect of a partnership adjustment under chapter 1 of subtitle A of the Code to any person is reflected in another adjustment taken into account under this section, the IRS may treat an adjustment as zero solely for purposes of calculating the imputed underpayment.”
13 T.D. 9844. As finalized in T.D. 9844, the rule contained only the first sentence in current reg. section 301.6225-1(b)(4). Although the finalized language differs slightly from the proposed version, the preamble explained that changes were made to broaden the scope of the rule and allow the IRS more flexibility to treat adjustments as zero. 84 F.R. 6534.
14 85 F.R. 74944.
that clarifies and extends the existing rule; it does not describe the proposed change as supplanting the rule as it then existed in the final regulations.15 In fact, the notice of proposed rulemaking proposed only to add a second sentence to reg. section 301.6225-1(b)(4), leaving the original first sentence unchanged. That distinction is important because the original rule was not limited to treating adjustments to non-income items as zero and required the adjustment being treated as zero to only have its effect “reflected in” another adjustment — as opposed to requiring the adjustment being treated as zero to be “related to or resulting from” another adjustment.16
When the changes were finalized on December 9, 2022, the rule dropped the requirement that it be limited to adjustments to non-income items and instead broadened it to provide that “if a positive adjustment to an item is related to, or results from, a positive adjustment to another item, one of the positive adjustments will generally be treated as zero solely for purposes of calculating any imputed underpayment unless the IRS determines that an adjustment should not be treated as zero in the calculation of the imputed underpayment.”17 The preamble explained that the change was made to allow partnerships to treat adjustments as zero in more circumstances and to conform with the intended purpose of the rule, which was to alleviate potential double counting and overinclusion that could occur because of the nature of the calculation of the IU under the code.18 Changes were made to provide that the provision applied to both the IRS and partnerships.19
15 See 85 F.R. 74945.
16 Arguably, if one adjustment is “related to, or resulting from” another adjustment, the effect of that adjustment would also be “reflected in” another adjustment. However, as discussed below, the reverse might not be true.
17 T.D. 9969.
18 See T.D. 9969, 87 F.R. 75478; 83 F.R. 41958.
19 87 F.R. 75478. Noting that “the sentence added to section 301.62251(b)(4) that provides that a partnership may treat an adjustment as zero for purposes of computing the imputed underpayment was proposed to be expanded to provide for a broader application, including to allow partnerships to use this rule,” and the proposed language (that is, the added sentence) was “modified to clarify that this provision applies to both the IRS and partnerships.”
The first sentence in reg. section 301.62251(b)(4) provides that “if the effect of one partnership adjustment is reflected in one or more other partnership adjustments, the IRS may treat the one adjustment as zero solely for purposes of calculating the [IU].”20 Notably, this discretionary rule does not require that the adjustment itself be reflected in another adjustment; it merely requires the “effect” of the adjustment to be “reflected in” another adjustment. The regulations do not explain whether the effect of a partnership adjustment is sufficiently reflected in another partnership adjustment so that the IRS will treat the adjustment as zero. However, the IRS has provided examples of situations in which this criterion is satisfied.
The regulations contain an example in which an adjustment was treated as zero when a liability was recharacterized from recourse to nonrecourse and results in two separate adjustments.21 The IRS provides additional examples in the Internal Revenue Manual, including a situation in which an item is not only being adjusted in total but also recharacterized.22 Another example is adjusting qualified business income under section 199A or net earnings from self-employment if adjusted as a result of an adjustment to ordinary income of the partnership. There is also an example of an adjustment to total dividends with corollary adjustments to qualified dividends and investment income.
As noted, the stated purpose of the original rule was to give the IRS flexibility in calculating the IU when multiple adjustments result in an issue being included in the IU more than once. Comparing the preamble discussing the discretionary rule (including what the purported purpose of the provision is) with the various examples provided by the IRS provides insight into how the IRS applies the rule to treat an adjustment as zero in the calculation of the IU when the tax effect of the adjustment is sufficiently covered by another adjustment so that
20 To provide ease in reading, the first sentence in reg. section 301.6225-1(b)(4) will be referred to as the “discretionary rule.”
21 Reg. section 301.6225-3(d)(4).
22 IRM 4.31.9.9.2.2.5(2); 4.31.9.10.1(3)(d); Exhibit 4.31.9-1.
including both adjustments in the calculation of the IU could result in an issue being taxed more than once in the IU. However, because of the subjective and broad nature of the rule governing whether the effect of an adjustment is sufficiently reflected in another adjustment, the IRS arguably could treat any adjustment as zero if it decided it made sense to do so.
It is important to note that nothing in the discretionary rule requires the adjustments to be the same amount or character, nor does it require the adjustments to be positive. There is also nothing preventing the IRS from treating a negative adjustment as zero. In fact, the IRM offers an example in which the IRS treats a negative adjustment as zero. In the example, the IRS reallocates an item between the partners and recharacterizes a portion of the item. The IRS treats both recharacterization adjustments as zero because their effect is reflected in the reallocation adjustments.23 Thus, the only real limit appears to be that there must be more than one adjustment (because how could the effect of an adjustment be reflected in another adjustment if there is no other adjustment?). However, partnerships are unlikely to complain if the IRS uses its discretion to treat the only adjustment as zero for purposes of calculating the IU.
While the discretionary rule in reg. section 301.6225-1(b)(4) is discretionary on the part of the IRS, the second sentence contains a general rule the IRS must follow.24 Under reg. section 301.62251(b)(4), “if a positive adjustment to an item is related to, or results from, a positive adjustment to another item, one of the positive adjustments will generally be treated as zero solely for purposes of calculating any imputed underpayment unless the IRS determines that an adjustment should not
23 IRM 4.31.9.9.2.2.5(2)
24 As the preamble to the notice of proposed rulemaking explained, the proposed additions to reg. section 301.6225-1(b)(4) not only allow persons other than the IRS to treat adjustments as zero but also clarify the rule. 85 F.R. 74945. The only rule that needed clarification at that time was the rule that allows the IRS to treat an adjustment as zero if the effect of the adjustment is reflected in another adjustment. Also, the final regulation clearly states that the paragraph applies to all calculations of an IU. Therefore, it is clear the addition of the sentence providing that some adjustments will “generally” be treated as zero in specified circumstances applies to the IRS as well as partnerships.
be treated as zero in the calculation of the imputed underpayment.”
That additional provision is narrower than the discretionary rule in that, for an adjustment to “generally be treated as zero,” two conditions must be met: (1) the adjustment being treated as zero must be “related to or result from” another adjustment, and (2) the relevant adjustments must be positive. Therefore, unlike the discretionary rule, the adjustments must be more closely related before an adjustment is treated as zero, and the rule does not apply if one of the adjustments is negative.
Under that general rule, it is not enough that the effect of the adjustment is reflected in another adjustment: The adjustment itself must be related to or result from (that is, be caused by) another positive adjustment. The regulation provides that if that positive adjustment is related to or results from another positive adjustment, “generally” one of the adjustments will be treated as zero “unless the IRS determines that an adjustment should not be treated as zero.” While that seems to provide a way to avoid using the rule, the regulation provides that one of the adjustments will “generally” be treated as zero.25 Thus, the regulation is clear: The rule will apply in most cases (that is, generally). If the rule is to apply in most cases, that suggests the IRS can determine that an adjustment should not be treated as zero in the calculation of the IU (if both conditions are met) only if sufficient reason exists to overcome the presumption that the provision will apply in most cases — for example, to prevent distortions or abuse.
As with the discretionary rule, nothing requires the adjustments to be the same amount, and nothing limits the rule to a single adjustment. For example, a $100 increase in ordinary income could result in a $75 increase to net earnings from self-employment, and a $100 increase in qualified business income under section 199A.26 Both the $75 adjustment to net earnings from self-
25 The term “generally” means “as a rule,” “usually,” “with the greatest frequency,” and “in most instances.” See Merriam-Webster Dictionary (July 26, 2024); Oxford English Dictionary (July 26, 2024) (also used by Google as its dictionary).
26 For purposes of this example, the adjustments to net earnings from self-employment and qualified business income occur only because of the increase to ordinary income.
employment and the $100 increase in qualified business income “result from” the adjustment to ordinary income, and all adjustments are positive.27 Therefore, the test is met for both adjustments, and both the $75 adjustment to net earnings from self-employment and the $100 increase in qualified business income would be treated as zero solely for purposes of calculating the IU.
Reg. section 301.6225-1(b)(4) provides that “this paragraph applies to the calculation of any imputed underpayment, including imputed underpayments calculated by a partnership or pass-through partner (for example, as part of the filing of an administrative adjustment request (AAR) under section 6227).” As explained, the preamble to the proposed and final regulations made it clear that a purpose for the changes to reg. section 301.6225-1(b)(4) was to allow partnerships to treat adjustments as zero in the calculation of the IU, albeit on a more limited basis than the IRS.28 Thus, if a positive adjustment is related to or results from another positive adjustment, a partnership may treat one of the adjustments as
27 The adjustment to ordinary income is a positive adjustment because it is an increase in income. The adjustments to net earnings from self-employment and qualified business income are positive because they are not a decrease in income, an increase in an expense, an increase in a credit, or a decrease in a chapter 1 tax or penalty. See reg. section 301.6225-1(d)(2).
28 It is clear from the regulatory text and the preambles that partnerships may not use the broader portion of the rule (“effect . . . reflected in”) but may use only the narrow portion that requires adjustments to be “related to, or result[s] from” one another. Although the regulatory language states that “this paragraph” applies to all IUs, including those calculated by a partnership, “this paragraph” is the rule that allows some adjustments to be treated as zero solely for purposes of calculating the IU. There is no reason to believe that the discretionary rule (which states that “the IRS may”) also applies to partnerships. The final regulation preamble explained that “the sentence added to section 301.6225-1(b)(4) . . . provides that a partnership may treat a non-income item as zero for purposes of computing the [IU]” (emphasis added). T.D. 9969. Also, if the discretionary rule also allowed partnerships to treat an adjustment as zero if the effect of the adjustment is reflected in another adjustment, even when the adjustments do not relate to or result from one another, the second sentence is superfluous for partnerships that use the rule.
zero solely for purposes of calculating any IU it is paying.29 Partnerships calculate IUs as part of the filing of an AAR, and when a passthrough partner is paying the IU because the passthrough partner did not furnish push-out statements to its partners in response to it receiving a push-out statement. As with the IRS, the partnership may treat multiple adjustments as zero as long as they are positive and are related to or result from another positive adjustment.
If the IRS determines that an adjustment treated as zero by the partnership in the calculation of the IU should not have been treated as zero, the IRS must open an examination of the partnership to adjust the IU calculated by the partnership.30 The IU is a PRI.31 To adjust a PRI (that is, the IU), the IRS must generally open an examination of the partnership and issue a notice
of final partnership adjustment.32 That allows the partnership to contest any determination that the adjustment should not have been treated as zero (including whether there is sufficient reason for the general rule to not apply) as part of the exam process (including Appeals) or in court.
29 Although reg. section 301.6225-1(b)(4) does not specify which of the related adjustments may be treated as zero (the larger one or smaller one), if a partnership were to abuse this rule, for example, by treating a $1 million adjustment as zero while calculating an IU on the related $5 adjustment, the IRS would likely be justified if it determined that the $1 million adjustment should not be treated as zero in the calculation of the IU. To prevent abuse the IRS and Treasury should consider adding further guardrails to this provision, such as requiring the smaller adjustment to be treated as zero. Also, the IRS and Treasury should consider amending the regulations to clarify whether adjustments to credits and creditable expenditures are separate from other adjustments when applying this rule.
30 See generally reg. sections 301.6225-1(c)(3) (placing adjustments to IUs calculated by the partnership in the credit grouping); 301.62262(g)(4) (providing that a partnership may not push out any adjustments made to an IU calculated by the partnership).
31 Section 6241(2)(B); reg. section 301.6241-1(a)(6)(ii)(C).
In sum, reg. section 301.6225-1(b)(4) provides taxpayers with a significant benefit — it allows them to treat some adjustments as zero in the calculation of the IU and it provides a general rule under which the IRS should treat an adjustment as zero. By allowing partnerships to treat adjustments as zero when filing an AAR or paying an IU instead of furnishing push-out statements after receiving a push-out statement from another partnership, this could make paying the IU a more economically feasible option, especially when considering the costs of furnishing statements to partners. In the context of an exam, partnerships should review the calculation of the IU to ensure the general rule in reg. section 301.6225-1(b)(4) is being properly applied and work with agents to locate situations in which it may be appropriate for the IRS to apply its more discretionary, and broader, authority to treat adjustments as zero solely for purposes of calculating the IU.
32 Sections 6221(a), 6231. If a partner in a BBA partnership filed inconsistently from another BBA partnership but did not file a notice of inconsistent treatment, the IRS may adjust the partner to be consistent with the BBA partnership and assess an IU on those adjustments without opening an examination. Section 6232(d)(1)(B); reg. section 301.62321(d). The IRS may adjust PRIs at the partner level when one of the special enforcement provisions is used or a partner has filed a notice of inconsistent treatment. Reg. sections 301.6222-1(c)(4) and 301.6241-7.