This article originally appeared in the March 28, 2022, issue of Tax Notes Federal.
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Matthew Lay is a managing director in the passthroughs group in the Washington National Tax office of Deloitte Tax LLP. He thanks Ira Aghai for assisting in the preparation of this article.
In this article, Lay examines how an S corporation that is a passthrough partner under the centralized partnership audit rules can become subject to some of those rules if it owns an interest in a lower-tier partnership.
Copyright 2022 Deloitte Development LLC.
All rights reserved.
Under the centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015 (the BBA rules, codified as sections 6221 through 6241), a partnership generally has two options for taking into account positive adjustments to items on its originally filed return, such as an increase to ordinary business income: pay an imputed underpayment (IU) based on the adjustments, or “push out” the adjustments to its reviewed-year partners. S corporations that do not own interests in partnerships are not subject to the BBA rules. Nevertheless, as discussed below, an S corporation that owns an interest in one or more lower-tier partnerships (LTPs) that are subject to the BBA rules may need to apply specific BBA rules if there are adjustments to an LTP’s previously filed return.
Not Every Partnership Is Subject to the BBA Rules
Under section 6221(b), eligible partnerships are permitted to elect out of the BBA rules on an annual basis. A partnership is an “eligible partnership” if (1) it is required to furnish 100 or fewer Schedules K-1 (Form 1065), “Partner’s Share of Income, Deductions, Credits, etc.,” for the relevant tax year, and (2) all of its partners are eligible partners. Eligible partners include individuals, C corporations, and S corporations.1 Partners that are ineligible include partnerships, trusts, and disregarded entities.2 When an S corporation is a partner, the Schedules K-1 (Form 1120-S), “Shareholder’s Share of Income, Deductions, Credits, etc.,” required to be furnished by the S corporation to its shareholders are counted towards the 100-partner limit (in addition to the Schedule K-1 furnished to the S corporation).3
If a partnership makes a valid election out of the BBA for a specific tax year, the IRS must follow the deficiency procedures that apply outside the BBA rules to audit, assess, and collect tax from the ultimate owners of that partnership. This article discusses BBA rules that apply to S corporations owning interests in partnerships that haven’t elected out of the BBA.
Adjustments in Tiered Structures
Sections 6226 and 6227(b)(2) generally permit an LTP to push out some or all of the adjustments resulting from an audit or from an administrative adjustment request (AAR), respectively. In the AAR context, adjustments that don’t result in an IU (for example, a decrease to ordinary business income) must be pushed out, and adjustments that do result in an IU may be pushed out. Although most adjustments resulting from an IRS examination can be pushed out, favorable adjustments that aren’t associated with an IU cannot be and must be taken into account by the partnership in the adjustment year.4
If an LTP pushes out adjustments, any partner that isn’t a “passthrough partner,” such as an individual or a C corporation, generally must take into account the effect that those adjustments would have had on the partner’s income tax liability for the first affected tax year and any intervening tax years. Rather than amending its returns for those years, the partner would report the net tax impact of the adjustments on those years (plus interest and penalties, if applicable) in its tax year that includes the date the AAR or audited partnership furnished Form 8986 to its reviewed-year partners (the reporting year).5
A passthrough partner, such as another partnership or an S corporation, generally has the same two alternatives that AAR partnerships or audited partnerships have for taking into account the effect of the adjustments: paying an IU based on the adjustments or pushing the adjustments out to its owners. An S corporation partner uses forms 8985 and 8986 to push out its share of adjustments. If the S corporation partner chooses to pay an IU, it would file Form 8985 (as well as Form 8985-V, “Tax Payment by a Pass-Through Partner,” if paying by check; alternatively, the S corporation may pay the IU electronically). A Form 8985 filed by an S corporation must be signed by an individual with the authority to sign the S corporation’s information return.
S corporation pushes out. If an LTP pushes out adjustments to an S corporation, and the S corporation chooses to push out its share of adjustments, it is critical that the S corporation pushes out (that is, files forms 8985 and 8986) by no later than the extended due date of the federal income tax return for the AAR or audited partnership’s adjustment year; otherwise, the S corporation automatically becomes liable for an IU based on its share of the adjustments. The extended due date for the adjustment year is shown in item F of Part II of Form 8986. Special rules apply if an S corporation partner is subject to tax at the corporate level on its share of an LTP’s adjustments or a portion of the adjustments under section 1374 (relating to built-in gains) or 1375 (relating to excess passive investment income).6 The IRS recently amended the instructions to Form 8985 to provide that an IU calculation isn’t required if the passthrough partner pushes out all adjustments.
S corporation pays IU. If an LTP pushes out adjustments to an S corporation, and the S corporation chooses to pay an IU based on its share of the adjustments, the S corporation must compute the IU. The calculation of the IU may not be familiar to many S corporations, and it can be complicated if there are adjustments to multiple items. In general, the BBA rules provide a seven-step process for computing an IU that involves grouping, subgrouping, and potential netting of adjustments.7 Any unfavorable adjustments to items other than credits and creditable expenditures that increase income generally are multiplied by the highest tax rate applicable to individuals or C corporations in the reviewed year.
The ability to net favorable and unfavorable adjustments and request modifications is limited, and many owners of passthrough entities aren’t taxed at the highest rate. Also, the IRS has taken the position that changes to “non-income items” — that is, items that aren’t items of income, gain, loss, deduction, or credit — may need to be taken into account in determining the amount of an IU. Therefore, an IU typically overstates the tax liability that the owners would have incurred if the original returns had been prepared correctly.
Common Contractual Provisions
The BBA rules vest the partnership representative (PR) with the sole authority to bind the partnership in the context of an AAR or an IRS examination. Unlike the 1982 Tax Equity and Fiscal Responsibility Act procedures that applied to partnerships under prior law, the BBA rules don’t allow partners in an audited partnership to participate in a partnership-level audit (unless a partner is also the PR). The BBA rules also don’t require an audited partnership to notify its partners that the partnership is under audit. If an audited or AAR partnership decides to pay an IU at the partnership level, the BBA rules allow it to request modifications to the amount of that IU.8 The purpose of these modifications is to more closely approximate what the partners’ actual tax liability would be as a result of the adjustments. However, even though some of the available modifications require cooperation by the partnership’s direct and indirect partners, nothing in the BBA rules requires the partners to cooperate.
Many partnerships have included language in their partnership agreements to address these issues. Partnership agreements drafted or amended since the enactment of the BBA may include, for example, provisions requiring (1) the partners to be notified of an IRS examination; (2) some or all of the partners to approve various actions that can be taken by the PR, such as filing an AAR, extending the period of limitations, or agreeing to a final partnership adjustment; (3) partners to take actions reasonably necessary to assist the PR to request a modification to an IU; or (4) former partners to reimburse the partnership for their shares of any IUs paid by the partnership. It also is common for partnership agreements to require, or at least permit, the PR to push out any adjustments resulting from an IRS examination or an AAR.
Any contractual arrangements between the LTP and its direct partners ordinarily wouldn’t govern the relationships between the S corporation and its shareholders. If an S corporation owns an interest in a partnership subject to the BBA, the S corporation and its shareholders may wish to discuss with counsel whether any tax issues that might arise under the BBA should be addressed in the agreements among those parties.
Adjustments to Tax Attributes
When an AAR partnership or an audited partnership pays an IU, the payment is treated as a nondeductible, noncapitalizable expenditure.9 If a passthrough partner is an S corporation that pays an IU, the same treatment should apply.
In 2018 Treasury and the IRS proposed regulations that would address the effects of paying an IU at the partnership level or pushing out adjustments under the BBA rules.10 The regulations were reproposed later that year to address amendments to the BBA made by Congress in 2018.11 The regulations would apply to partnership tax years beginning after December 31, 2017. Under those regulations:
the partnership generally would create notional items of income or loss for each partnership adjustment for purposes of adjusting specific tax attributes of the adjustment-year partners, such as the partners’ outside bases, capital accounts, and (if applicable) earnings and profits;12
the partnership’s allocation of notional items generally would be respected if they are allocated to the reviewed-year partners —
in the case of an adjustment that is an increase to income or loss, in the manner that the corresponding actual item would have been allocated in the reviewed year, and
in the case of an adjustment that is a decrease to income or loss, in the manner that the excess item was allocated in the reviewed year;13
the partnership’s allocation of its IU expense also would generally be respected if the IU is allocated to the reviewed-year partners in proportion to the allocation of the notional items to which the IU relates, taking into account any modifications; and14
special successor partner rules would be provided for situations in which the ownership of the partnership has changed between the reviewed year and the adjustment year.15
Prop. reg. section 1.704-1(b)(4)(xiii) also would provide that, in the audit context, the allocation of adjustments that don’t result in an IU and are taken into account by the partnership in the adjustment year will be respected if they are allocated to the reviewed-year partners or their successors in the manner that the items would have been allocated to them in the reviewed year.
S corporations generally must allocate income, gain, loss, deduction, and credit among their shareholders pro rata on a per-share, per-day basis.16 These allocations, in turn, result in adjustments to the shareholders’ adjusted bases in S corporation stock and indebtedness.17 The proposed tax attribute regulations don’t address how S corporations, trusts, and estates that pay an IU, and their owners, should take the IU expense into account and adjust tax attributes. Instead, Treasury and the IRS requested comments on these issues.18 It would be helpful for future guidance to clarify whether S corporations are permitted or required to allocate items resulting from the payment of an IU (or items described in prop. reg. section 1.704-1(b)(4)(xiii)) to reviewed-year shareholders or their successors, even if the S corporation’s other items are allocated pro rata under the usual rules.
Conclusion
Although S corporations usually aren’t subject to the BBA rules, those that own interests in partnerships may need to apply some of those rules if there are adjustments to the partnership’s previously filed return through an AAR or an IRS examination. S corporations and their shareholders may need to decide whether to push out their share of those adjustments or compute and pay an IU (potentially resulting in changes to S corporation and shareholder tax attributes).19
FOOTNOTES
4 Reg. section 301.6225-3.
5 See Form 8978, “Partner’s Additional Reporting Year Tax,” and Schedule A (Form 8978), “Partner’s Additional Reporting Year Tax (Schedule of Adjustments).”
6 See reg. section 301.6226-3(e)(6).
7 See generally section 6225(b); reg. section 301.6225-1.
8 See generally sections 6225(c) and 6227(b)(1); reg. sections 301.6225-2 and 301.6227-2(a)(2).
9 See section 6241(4) and reg. section 301.6241-4(a).
10 REG-118067-17, 83 F.R. 4868.
11 REG-136118-15, 83 F.R. 41954.
12 Prop. reg. section 301.6225-4(b)(3).
13 Prop. reg. section 1.704-1(b)(4)(xi).
14 Prop. reg. section 1.704-1(b)(2)(iii)(f).
15 Prop. reg. section 1.704-1(b)(1)(viii)(b).
16 See sections 1361(b)(1)(D), 1366, and 1377(a)(1).
18 83 F.R. at 4875.
19 This article contains general information only and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this article.
END FOOTNOTES