On December 8, Treasury issued final regulations (the “Final Regulations”) updating the existing centralized partnership audit regime. These regulations largely adopt the provisions of regulations that were previously proposed in November 2020 (the “Proposed Regulations”).
The most significant aspect of the Final Regulations is Treasury’s reaffirmation that adjustments to items that are not items of income, gain, loss, deduction, or credit (“non-income items”) must be included in the computation of an imputed partnership underpayment. As a result, it is possible for a partnership to owe tax that is greater than its partners’ aggregate tax liability.
Under the centralized partnership audit regime’s default rules, the IRS audits items of income, gain, loss, deduction, credit, and distributive shares at the partnership level. A partnership-level tax liability is then imposed on any imputed partnership underpayment resulting from IRS adjustments of partnership-related items. An “imputed underpayment” is determined by netting all partnership adjustments and then applying the highest rate of tax for individuals or corporations. A “partnership-related item” is, generally, any item or amount that is relevant in determining the tax liability with respect to the partnership or of a partner. For purposes of netting partnership adjustments, a “negative adjustment” is generally a decrease in an item of income or an increase to an item of credit. Any other adjustment is a “positive adjustment.” Therefore, adjustments to a partnership’s non-income items are always positive adjustments. Accordingly, a partnership could owe taxes in excess of its partners’ aggregate tax liability. This scenario may arise, for example, where the basis of a partnership asset is adjusted (whether increased or decreased). This would cause an imputed underpayment and the partnership would have an immediate tax liability, even though its partners would have owed no tax with respect to this asset until a recognition event had occurred.
Treasury was unsympathetic to complaints regarding the above issue that were voiced in response to the Proposed Regulations. Instead, they embraced the technical view that the imputed underpayment is an entity-level liability, regardless of what the tax consequences would have been had the partners correctly taken into account the adjustments in the reviewed year. Treasury further posits that many aspects of the centralized partnership audit regime result in income, gain, loss, deduction, or credit, and any taxes on those items, being recognized in taxable years other than the taxable year where the item would have been reported if the regime did not apply. Treasury also points out that the centralized partnership audit regime offers relief to partnerships by providing options that would modify or eliminate the imputed underpayment and would make the underpayment amount closer to the amount of tax that would have been paid if the partners had reported the proper amounts of items in the correct year.
On a more taxpayer-friendly note, the Final Regulations clarify that adjustments to non-income items are not, in and of themselves, recognition events. As a result, no tax is owed where the adjustments do not result in an imputed underpayment. The Final Regulations also alleviate commentators’ concerns regarding potential double taxation by clarifying that an item will not be adjusted at the partner level if the partner can demonstrate that the adjustment was previously taken into account by the person in an examination under the centralized partnership audit regime (e.g., by filing an amended return as part of a modification of the imputed underpayment). The Final Regulations also allow partnerships that cease to exist to continue to request modifications of the imputed underpayment under Section 6225(c).
Treasury also clarified that if a positive adjustment relates to, or results from, a positive adjustment to another item, a partnership may treat one of the positive adjustments as zero solely for the purpose of computing the imputed underpayment, unless the IRS determines otherwise. Based on these changes, a partnership may treat an adjustment to a non-income item as zero if the adjustment relates to, or results from, another adjustment to a non-income item. An adjustment cannot be treated as zero, however, if one adjustment is positive and the other is negative.
Although the treatment of adjustments to non-income items is the most significant aspect of the Final Regulations, they also contain provisions regarding the election out of the default rules for certain partnerships with 100 or fewer partners and the treatment of items that involve special enforcement matters. The Final Regulations generally apply to taxable years ending on or after November 20, 2020.
