In late 2015, newly enacted legislation significantly revamped audit procedures for partnerships. The centralized partnership audit regime (CPAR) dramatically overhauled both the way that partnership returns are examined and procedures for correcting partnership returns for taxable years beginning on or after January 1, 2018. The CPAR was enacted as part of the Bipartisan Budget Act of 2015 (thus, partnerships covered by the CPAR are called BBA partnerships) as a way for the IRS to more easily assess and collect tax on partnership adjustments. For example, by default, the CPAR requires any “imputed underpayment” to be paid by the partnership, instead of by the partners. Partners should be aware, however, that this default approach almost always results in dramatically unfavorable consequences compared to reporting the adjustments by the partners on their returns. To reduce the amount of tax paid on partnership adjustments determined under the CPAR procedures, partnerships may want to take advantage of certain exceptions that allow adjustments to flow through to, and the corresponding tax to be calculated and paid directly by, the partners in the partnership. In addition, eligible partnerships can elect out of the CPAR.

 

What is the Centralized Partnership Audit Regime?

The CPAR provides procedures, timelines, and statutes of limitations that must be followed when the IRS examines a partnership return. Notably, the CPAR enables the IRS to assess tax, interest, and penalties on any “imputed underpayment” against the partnership itself – a major shift from the pre-2018 partnership audit rules, known as TEFRA, which required the IRS to individually assess each of the partnership’s partners the tax calculated on their share of partnership adjustments. The concept of the imputed underpayment is unique to the CPAR, which sets forth how the imputed underpayment is calculated.

The CPAR rules also affect the way a partnership modifies a previously filed return. Under the CPAR,  a partnership self-reports adjustments to partnership items by filing an administrative adjustment request (AAR), rather than filing an amended return with amended K-1s. AAR’s may be one of two types:

• A “default” AAR where the imputed underpayment is assessed and collected at the partnership level at the time the AAR is filed; or
• A “push-out AAR,” in which the partnership makes an election to have the imputed underpayment reported and paid in the year the AAR is filed by those who were partners in the partnership during the taxable year under review (the reviewed-year partners).

The CPAR rules create a specific role called the partnership representative, who is the sole authority and contact for purposes of a CPAR exam or AAR. The partnership and partners are bound by the actions of the partnership representative in dealings with the IRS. The partnership representative is appointed year by year on a timely filed partnership return.

The CPAR only applies to Subtitle A, Chapter 1 income tax and does not apply to the tax on self-employment income, the net investment income tax, withholding obligations for fixed or determinable annual or periodical income (FDAP) or income that is effectively connected with the conduct of a U.S. trade or business (ECI), withholding relating to U.S. real property (FIRPTA), or withholding relating to foreign accounts (FATCA). A consequence of this is the added complexity to resolving IRS examinations as well as voluntarily reporting corrections that affect more than Chapter 1 income tax.

 

How is the Imputed Underpayment Calculated?

If an AAR is voluntarily filed or is filed in connection with an IRS examination, the default method is for the partnership to make an imputed underpayment. The imputed underpayment is calculated on adjustments to “partnership-related items,” which, in general, include any item or amount that is relevant in determining a partner’s tax liability or a partner’s distributive share of a partnership-related item.

The calculation of the imputed underpayment is a multi-step process according to which individual adjustments to partnership-related items are categorized as either negative (meaning taxpayer favorable) or positive (taxpayer unfavorable) and are assigned to one of the following four groupings:

1. Reallocations among partners;
2. Adjustments to partner credits;
3. Adjustments to creditable expenditures; or
4. All remaining (residual) adjustments. Generally, most adjustments to partnership-related items fall in the residual category.

Adjustments within a grouping must be further divided into subgroupings based on their character (ordinary versus capital) or other limitations (for example, long-term versus short-term capital gain). Positive and negative adjustments within the same grouping or subgrouping are netted, and any resulting positive net adjustments (but not negative net adjustments) are aggregated to determine the imputed underpayment. Groupings and subgroupings that yield negative net adjustments (i.e., the net adjustment is taxpayer-favorable) are not included in the computation of the imputed underpayment. These negative net adjustments must be pushed out to partners in an AAR filing. In calculating the imputed underpayment, adjustments to items of taxable income, deductions, gain, or loss are taxed at the highest effective tax rate for the reviewed year, which is currently 37%.

For purposes of the imputed underpayment, positive adjustments also include non-income items. Non-income items may include, for example, partner contributions, distributions, liability allocations to partners, Section 199A (qualified business income) information, and asset basis information.

Modifications may be available to reduce the imputed underpayment. Partnerships may request certain modifications to reduce the imputed underpayment. Modifications include the effects of lower tax rates for certain entities (for example, corporations or tax-exempt organizations) or capital gain income, amended returns of partners, “pull-in” procedures that allow partners to calculate their share of the tax based on their tax rates and attributes without having to file an amended return, tax treaties, closing agreements, and certain passive activity losses.

 

Which Partners Bear the Tax Liability on Adjustments to Partnership Returns?

The CPAR rules provide alternatives for taking partnership adjustments into account, and different persons may be liable (or bear the economic burden) under different alternatives. Under the CPAR’s default rule, the partnership pays the imputed underpayment, plus any interest and penalties owed. Here, the economic burden falls on those who are partners in the year the payment is made, unless the partnership or the partners have been indemnified for the expense (for example, by prior partners in the partnership).

However, the reviewed-year partners will become liable for the imputed underpayment in the following situations:

• The partnership elects out of the CPAR;
• A reviewed-year partner files a return that is inconsistent with the partnership’s return, and the IRS conducts an audit of that partner but not an audit of the partnership; or
• The partnership makes a valid “push-out” election.

The partners in a year after the reviewed year may be liable for additional amounts that are due if the partnership has “ceased to exist,” or if the partnership fails to pay the amount due within 10 days of receiving notice and demand for payment. A partnership ceases to exist if the partnership terminates within the meaning of Internal Revenue Code Section 708(b)(1) or the partnership is unable to pay what it owes under the CPAR, but only if the IRS makes an official determination.

 

Making a Push-Out Election

Making a push-out election shifts the liability to pay an imputed underpayment from the partnership (where the liability is borne by the payment-year partners) to the reviewed-year partners. Considerations when deciding whether to make a push-out election include the cost or benefit to the partners, changes in partner composition between the reviewed year and the adjustment year, and partnership liability.

In lieu of paying an imputed underpayment, a partnership that undergoes a CPAR examination can elect to push out the adjustments to the reviewed-year partners within 45 days of the Notice of Final Partnership Adjustment. However, if an examination results in an overall negative net adjustment (i.e., there is no imputed underpayment), the partnership must take the negative adjustment into account on its return in the year the adjustment becomes final. If an examination results in the IRS determining that there are multiple imputed underpayments for a tax year, the partnership can elect to push out all of the adjustments or push out a subset of them.

If an AAR results in an imputed underpayment, the partnership can make a push-out election by filing a push-out AAR. An AAR that does not report an imputed underpayment is automatically a push-out AAR.

Each partner that receives a push out adjustment is required to recalculate its tax liability for each affected tax year. The partner reports the additional increase or decrease in tax with its tax return filed for the year in which the AAR was filed.

Importantly, a push out adjustment that is an overall decrease in tax is considered a nonrefundable “tax credit” and may only reduce the partner’s current year tax liability to zero. Consequently, under the existing rules, any tax credit in excess of the partner’s current year tax liability is permanently lost.

 

Should a Partnership Elect Out of the CPAR?

Eligible partnerships may elect out of the CPAR. An eligible partnership has no more than 100 partners, each of which is an eligible partner, i.e., an individual, a C corporation (including a regulated investment company and a real estate investment trust), a foreign entity that would be treated as a C corporation if it were a domestic entity, an S corporation, or an estate of a deceased partner. For purposes of determining the number of partners, each shareholder in an S corporation is counted. Note that if even one partnership interest is owned by a disregarded entity, such as a single member limited liability company or a grantor trust, then the partnership may not elect out of the CPAR.

The election out of the CPAR is year by year and, to be valid, must be made as prescribed on a timely filed partnership return. The partnership is required to notify each partner within 30 days after making the election.

Partnerships that elect out are not subject to the CPAR examination rules. When a partnership elects out, the IRS is responsible for assessing and collecting any tax due on partnership adjustments from the reviewed-year partners based on their tax rates and other applicable tax attributes in the year to which the adjustment relates. Electing out of the CPAR may be beneficial for partners, for example, in cases where the calculated tax due at the partner level would be less than the imputed underpayment.

However, thought should be given to the potential costs as well as the benefits of electing out. If a partnership elects out of the CPAR, each partner is potentially subject to a separate examination for that year with respect to their share of partnership items.

A partnership that has elected out of the CPAR files an amended return, not an AAR, to self-report adjustments to a previously filed return for years for which the election is made. Any adjustments are taken into account by the partners for the year to which the adjustments relate, generally on amended returns.

 

Planning Considerations for CPAR Partnerships

Partnerships that cannot or do not elect out of the CPAR may also want to consider the following planning opportunities:

• A partnership has flexibility as to when it files an AAR and it should consider the most advantageous timing for its partners. The date the AAR is filed will determine the year in which a partner may take into account a nonrefundable “credit,” and a partner may be able to obtain more benefit from the adjustments in one year than in another year. For example, if a partner has net losses in Year 1 and net income in Year 2, the partner may benefit from the adjustments if the adjustment year is Year 2, but not if the adjustment year is Year 1. Note that if a partnership files an AAR, it extends the time the IRS has to make adjustments to partnership returns to at least three years from the date the AAR was filed.
• Partners may file amended income tax returns that are inconsistent with the K-1 they receive from the partnership. This approach can be beneficial if the partnership expects to push out favorable corrections to the partners but the partners do not have sufficient income to absorb the credit in the adjustment year.
• To preserve the ability to make corrections to both the partnership return and Schedules K-1 up to the extended due date, partnerships should consider requesting an extension of time to file by filing an extension request on Form 7004. Even if a partnership plans to file its return by the original due date, if necessary, it could file a superseding return before the extended due date, thus avoiding the need to file an AAR to report those adjustments.
• An AAR may not be filed once the IRS has mailed the partnership a Notice of Administrative Proceeding (NAP) with respect to that tax year. Therefore, partnerships that have been selected for audit may want to file an AAR before the NAP is mailed to correct previously filed returns before the IRS examination begins. When an AAR is filed in connection with an IRS examination, an increased rate of interest is charged on any underpayment at two percentage points over the usual underpayment rate. Filing an AAR before an IRS examination commences can avoid this increased cost.
• As part of their due diligence review, buyers of a partnership interest should consider their exposure to pre-acquisition partnership imputed underpayment obligations. Buyers may face “wrong taxpayer” risk to the extent of their allocable share of an uncertain tax position related to a review year under the default rule and may want to consider explicitly addressing CPAR audits within transaction agreements.
• Sellers of partnership interests may be obligated under the partnership agreement to indemnify the partnership after the sale date. Sellers also may face risk if the IRS determines that the partnership has ceased to exist and the sellers were partners in the partnership during the last tax year for which a partnership return was filed. Addressing these risks within the transaction agreements may be advisable.

 

Written  by Neal Weber. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com