Imputed Underpayments

Imputed Underpayments

Under subchapter K of the Internal Revenue Code, a partnership does not compute and pay an income tax upon filing Form 1065 but instead passes through any profits and losses to its partners. However, when a partnership is examined under the BBA regime, any partnership adjustment resulting in an imputed underpayment and the applicability of any penalty, addition to tax, or additional amount (plus interest as provided by law) that relates to such adjustment is determined, assessed and collected at the partnership level.

There are two types of imputed underpayments: a general imputed underpayment and a specific imputed underpayment. Each type of imputed underpayment is based solely on partnership adjustments with respect to a single taxable year.

Determination of an imputed underpayment 

Section 6225(b)(1)(B) provides that the determination of an imputed underpayment is made by “applying the highest rate of tax in effect for the reviewed year under section 1 or 11.” Consistent with section 6225(b)(1)(B), §301.6225-1 provides that an imputed underpayment is determined by multiplying the total netted partnership adjustment by the highest rate of federal income tax in effect for the reviewed year under section 1 or 11 and increasing or decreasing that product by certain adjustments to credits and creditable expenditures. 

The Single-Year Approach.

§301.6225-1(a)(1) provides that each imputed underpayment determined under §301.6225-1 is based solely on partnership adjustments with respect to a single taxable year. 

Section 6225(b) sets forth the rules for determining an imputed underpayment. The statutory structure of section 6225(b) is premised on the concept that an imputed underpayment is determined with respect to a reviewed year and that adjustments with respect to the reviewed year result in such imputed underpayment or are adjustments that do not result in an imputed underpayment. Section 6225(a). Section 6225(b)(1)(A) expressly provides that “any imputed underpayment with respect to any reviewed year shall be determined by the Secretary by appropriately netting all adjustments with respect to such reviewed year . . . .” (emphasis added). The statute does not reference adjustments with respect to any year other than the reviewed year. Accordingly, the IRS takes the position that the statute does not provide for the netting of adjustments across tax years. 

The IRS takes the position that netting across multiple tax years would not constitute “appropriately netting” within the meaning of section 6225(b)(1)(A). A fundamental federal income tax principle is that each taxable year stands alone. Commissioner v. Sunnen, 333 U.S. 591 (1948) (“Income taxes are levied on an annual basis. Each year is the origin of a new liability and of a separate cause of action.”). A rule that provides for netting across tax years could be viewed, it is argued, as inconsistent with this fundamental principle. Because adjustments relating to multiple years may affect items that are allocable to different partners or in different amounts, the IRS does not allow for offsetting those types of adjustments against each other when determining the imputed underpayment. 

Adjustments Subject to Additional Limitations.

Section 6225(b)(4) provides that if any adjustment would result in a decrease in the amount of the imputed underpayment and could be subject to any additional limitation under the Code if taken into account by any person, such adjustment should not be taken into account in the netting process described in section 6225(b)(1)(A). This provision codifies the presumption that, except as otherwise provided, taxpayer favorable adjustments subject to any possible limitation under the Code if taken into account by any person are disregarded when determining an imputed underpayment. The statute does not require the IRS to determine whether taxpayer favorable adjustments are in fact subject to such limitations. 

The regulations under §301.6225-1(a)(1) maintain the requirement that an imputed underpayment be based solely on partnership adjustments with respect to a single taxable year.

Grouping, Subgrouping, and Netting of Partnership Adjustments 

In order to determine an imputed underpayment, each partnership adjustment determined by the IRS is first placed into one of four groupings pursuant to §301.6225-1(c) according to the type of partnership-related item being adjusted: the reallocation grouping, the credit grouping, the creditable expenditure grouping, or the residual grouping. Adjustments are then subgrouped, if appropriate, and netted to produce the total netted partnership adjustment. §301.6225-1(b)(2), (d) and (e). 

Grouping involves placing each proposed audit adjustment into one of four groupings: reallocation, credit, creditable expenditure and residual. 

After an adjustment is placed into a grouping, subgrouping is the process of further defining that adjustment into a subgrouping, generally in accordance with how that adjustment would be required to be taken into account separately under section 702(a) or any other provision of the Code. This is necessary to keep adjustments that are similar in nature together while keeping adjustment that are different apart. These subgroups generally follow the line items on Schedule K/K-1 or other separate and distinct line items on Form 1065 and schedules. However, subgrouping is only necessary when any proposed adjustment within a grouping is a negative adjustment.

A negative adjustment is any adjustment that is a decrease in an item of gain or income, an increase in item of loss or deduction, or an increase in an item of credit or creditable expenditure.

A positive adjustment is any adjustment that is not a negative adjustment.

Generally, netting is the process of summing all adjustments together within each grouping or subgrouping, as appropriate.

Once all adjustments have been grouped, subgrouped (if applicable) and netted, the total netted partnership adjustment (TNPA) can be determined. The TNPA is the sum of all net positive adjustments in the reallocation grouping and the residual grouping. If, after netting, either the reallocation or residual grouping summed total is less than or equal to zero, it is not taken into account in calculating the TNPA.

A net positive adjustment means an amount that is greater than zero which results from netting adjustments within a grouping or subgrouping. A net positive adjustment includes a positive adjustment that was not netted with any other adjustment.

A net negative adjustment means any amount which results from netting adjustments within a grouping or subgrouping that is not a net positive adjustment. A net negative adjustment includes a negative adjustment that was not netted with any other adjustment.Multiply the TNPA by the highest rate of Federal income tax in effect for the reviewed year under section 1 or 11 and increase or decrease the product by the net positive adjustments from the creditable expenditure grouping.

The design of section 6225(a) and (b) and the grouping and netting rules under §301.6225-1 is to create an imputed underpayment amount that is based on the highest rate of tax and that disregards any taxpayer favorable adjustments which would otherwise reduce the imputed underpayment. Given this formula, an imputed underpayment determined under §301.6225-1 will likely reflect an amount that is larger than the cumulative amount of tax the partners would have paid if the partners took the partnership adjustments into account separately. 

This formula is a feature of section 6225(a) and (b). The statute expressly disregards certain adjustments that may be subject to limitations and that would otherwise reduce the imputed underpayment and mandates the application of the highest applicable tax rate. Section 6225(b)(1)(B), (2) and (4). 

By removing the obligation on the IRS to consider partners’ facts and circumstances, such as whether adjustments that would otherwise reduce the imputed underpayment might be allowed at the partner level or whether adjustments might be taken into account by partners at a rate lower than the highest rate, section 6225(b) shifts the burden from the IRS during this phase of a partnership examination. Because the imputed underpayment determined at this phase in the examination is not required to reflect the facts and circumstances of the ultimate partners, modifications may be necessary to more closely reflect the proper tax treatment. 

Modifications and Push Outs.

After the preliminary determination of the imputed underpayment amount under §301.6225-1, the burden is shifted to the partnership to utilize the modification procedures under §301.6225-2 if the partnership so chooses. Modification is designed to allow the partnership and its partners to arrive at an imputed underpayment amount that is closer to the correct amount of tax while maintaining the assessment and collection efficiencies of a centralized audit process. See Joint Comm. on Taxation, JCS-1-16, General Explanations of Tax Legislation Enacted in 2015, 65-66 (2016) (JCS-1-16). As an alternative to modification and paying an imputed underpayment, the partnership can elect under section 6226 to push out the adjustments to its partners. Both modification and the push out election provide the opportunity to establish that the correct amount of tax is collected from the partnership and its partners. 

Thus, a partnership and its partners may be able to reduce the rate used in computing an imputed underpayment by requesting modification under section 6225(c). For example, the partnership may request modification under §301.6225-2(d)(3) with respect to partnership adjustments that are allocable to a tax-exempt entity or modification under §301.6225-2(d)(4) with respect to adjustments to capital gains or qualified dividends that are attributable to an individual. The partnership may also make a push out election under section 6226, allowing partners to take into account the adjustments and pay tax using their respective marginal tax rates, including taking into account the effect of the alternative minimum tax. 

Tax Attributes and Grouping.

The regulations require that adjustments be placed into groupings and subgroupings based on how the adjusted items are treated pursuant to the Code, the regulations, forms, instructions, and other guidance and do not generally permit the netting of adjustments that might otherwise be subject to limitations or restrictions under the tax laws. Accordingly, the grouping and netting rules are designed with regard to generally applicable provisions of the Code. 

The tax attributes of the partnership’s partners generally do not factor into the preliminary determination of the imputed underpayment. Rather, the imputed underpayment determined under §301.6225-1 is computed without regard to the partners’ tax circumstances, for example whether a partner would be able to offset additional partnership income with additional deductions or whether a partner’s tax attributes would reduce the amount of tax due as a result of the adjustments. See section 6225(b)(1)(B), (2) and (4). Modification as described under section 6225(c) and §301.6225-2 was deemed the more appropriate stage of the examination for the IRS to take into account specific partner tax attributes. 

Nonetheless, §301.6225-1(c)(1) and (d)(1) provide that the IRS may, in its discretion, place adjustments in groupings and subgroupings in a manner different from that described in the regulations to appropriately reflect the facts and circumstances of each examination. This rule is intended to allow the partnership to provide information to the IRS to demonstrate that certain partner tax attributes should be taken into account when grouping and subgrouping to achieve a more appropriate netting of the adjustments. 

The regulations give the IRS the discretion to decide whether or not to use this information in the initial examination phase, that is, prior to modification. This rule contemplates that the partnership and the IRS may not agree as to whether the groupings and subgroupings requested by the partnership are appropriate. If the partnership and the IRS do not agree on the groupings and subgroupings recommended by the partnership during the exam, the partnership is not without recourse. The partnership may request during modification that the IRS include one or more partnership adjustments in a particular grouping or subgrouping or request that certain partnership adjustments be treated as if no limitations or restrictions apply with the result those adjustments may be subgrouped with other adjustments. See §301.6225-2(d)(6). 

Accordingly, modification is generally the appropriate point in the administrative phase at which partner tax attributes may be raised by the partnership and considered by the IRS. For example, the partnership and its partners can utilize the amended return procedure or the alternative procedure to filing amended returns, which require partners to take the adjustments into account in light of their individual tax attributes. Those procedures would potentially allow partners to offset passive income with any passive losses.  In the alternative, the partnership may elect to push out the adjustments under section 6226, and the partners would be required to take into account the adjustments and any effects on the partners’ tax attributes. At that stage, the partners could use passive losses to the extent permitted by the rules under §301.6226-3 (regarding how partners take into account pushed out adjustments). 

Although the IRS is permitted to consider partner tax attributes during the first phase of the partnership exam, the statute and the regulations provide clear guidance on the modification process and specifically how a partnership may request that partners’ tax attributes be taken into account to reduce the imputed underpayment. 

However, a partnership may request that the IRS take into account facts and circumstances relating to its partners pursuant to the rules under §301.6225-1(d)(1) and (e)(1), which may allow for more appropriate grouping and subgroupings of adjustments. The partnership may also request during modification to reduce the amount of the imputed underpayment based on the partners’ specific tax attributes. 

“Appropriately netting” within the meaning of section 6225(b)(1)(A) means, as a general matter, that when netting partnership adjustments for purposes of determining an imputed underpayment, all limitations under the Code should be considered, including limitations that would otherwise prevent the partnership from netting certain items. Section 6225(b)(4)’s rule regarding taxpayer favorable adjustments subject to additional limitations under the Code if taken into account by any person supports this interpretation. Because certain items could be subject to limitations in the hands of certain partners, the statute requires that limitations be accounted for by assuming they exist for purposes of determining the imputed underpayment during the initial stage of the examination. The partnership may ameliorate any discrepancies caused by that assumption by demonstrating that no such limitations exist either under §301.6225-1(d)(1) or (e)(1) or in the modification phase. The partnership can also make the election under section 6226, and the partners will account for such limitations when taking into account the adjustments. 

The Code permits corporate taxpayers to deduct capital losses to the extent of capital gains. Section 1211(a). In the case of taxpayers other than corporations, the Code allows a deduction for any capital loss exceeding capital gain up to $3,000 ($1,500 in the case of a married individual filing separately). Section 1211(b). 

A partnership that wishes to request that the IRS take into account its partner’s tax circumstances, including that certain partners are otherwise entitled to a capital loss deduction under section 1211(b), may utilize the discretionary grouping and subgrouping rules under §301.6225-1(d)(1) and (e)(1) or make a modification request under §301.6225-2(d)(6). 

Section 6225(b)(1) provides that the imputed underpayment is determined by appropriately netting all partnership adjustments and applying the highest rate of tax under section 1 or 11. Section 6225(b)(3) requires that the partnership adjustments are first separately determined and netted as appropriate within each category of items that are required to be taken into account separately under section 702(a) or other provision of the Code. When “appropriately netting” under section 6225(b)(1)(A), section 6225(b)(4) requires that negative adjustments that could be subject to any limitation or restriction if taken into account by any person be disregarded unless provided otherwise by regulation. The regulations incorporate this rule in §301.6225-1(d)(3). The regulations also provide the ability, however, to take facts and circumstances into account to allow negative or downward adjustments, where appropriate, to be subgrouped and thus netted with other adjustments. See §301.6225-1(d)(1). 

Subgrouping Principles.

Section 202(a) of the TTCA added section 6225(b)(3) to provide that partnership adjustments shall first be separately determined (and netted as appropriate) within each category of items that are required to be taken into account separately under section 702(a) or other provision of the Code. Section 6225(b)(4) provides if any adjustment would (but for section 6225(b)(4)) result in a decrease in the amount of the imputed underpayment, and could be subject to any additional limitation under the provisions of the Code (or not allowed, in whole or in part, against ordinary income) if such adjustment were taken into account by any person, such adjustment shall not be taken into account when appropriately netting partnership adjustments under section 6225(b)(1)(A) except to the extent otherwise provided by the Secretary. 

§301.6225-1(d)(3)(i) provides that adjustments are subgrouped, when appropriate, according to how the adjustment would be required to be taken into account separately under section 702(a) or any other provision of the Code or regulations applicable to the adjusted partnership- related item. By separating adjustments into subgroupings according to how and whether the adjustments would be separately stated pursuant to section 702(a), the rules under §301.6225-1(d)(3)(i) seek to ensure that items that do not properly net against each other at the partnership level under section 702(a) do not net against each other for purposes of determining an imputed underpayment. 

For example, under §301.6225-1(c) a positive adjustment to intangible drilling costs and a negative adjustment to gain or loss from a sale of property described in section 1231 are both placed in the residual grouping. Pursuant to §301.6225-1(d)(3)(i), each adjustment is then placed in a separate subgrouping to reflect that one adjustment is a negative adjustment and that the items being adjusted are required to be separately stated pursuant to section 702(a). See section 702(a)(3), §1.702-1(a)(8)(i). Under §301.6225-1(e)(1), adjustments from separate subgroupings cannot be offset against one another. Accordingly, just as a positive amount of intangible drilling costs would not be netted with a section 1231 loss under section 702(a), a positive adjustment to intangible drilling costs would not net against a negative adjustment to 1231 gain or loss for purposes of determining an imputed underpayment. 

Some items that are not separately stated pursuant to section 702(a) may nevertheless be subject to other limitations under the Code or may not otherwise be allowed to net against ordinary income. To account for those types of limitations, §301.6225-1(d)(3)(i) further provides that if any adjustment could be subject to any preference, limitation, or restriction under the Code (or not allowed, in whole or in part, against ordinary income) if taken into account by any person, the adjustment is placed in its own separate subgrouping. For example, an increase in loss attributable to a trade or business activity of the partnership may not be deductible in the hands of a particular partner because that partner did not materially participate in the partnership activity.  See section 469. Because the loss may be limited in the hands of a particular partner, the increase in loss is placed in its own separate subgrouping to prevent any inappropriate netting against an adjustment increasing income of the partnership. 

Generally, under §301.6225-1(d), reallocation adjustments must be placed into their own subgroupings, but there is an exception for when multiple reallocation adjustments apply to a single partner or group of partners. §301.6225-1(d)(3)(ii) provided that if a particular partner or group of partners has two or more reallocation adjustments allocable to such partner or group, such adjustments may be subgrouped in accordance with §301.6225-1(d)(3)(i) and netted in accordance with §301.6225-1(e). §301.6225-1(d)(3)(iv) provides a similar rule with respect to recharacterization adjustments. 

Negative Adjustments.  

Under §301.6225-1(e), adjustments from each subgrouping (or grouping if there is no subgrouping within that grouping) are netted to produce either a net positive adjustment or a net negative adjustment with respect to each grouping or subgrouping. When determining an imputed underpayment, generally only net positive adjustments are taken into account, and net negative adjustments are generally treated as adjustments that do not result in an imputed underpayment. Adjustments to credits and creditable expenditures are treated separately. 

§301.6225-1(b)(4) provides that if the effect of a partnership adjustment under chapter 1 of the Code is reflected in another adjustment taken into account in the imputed underpayment determination, the IRS may treat an adjustment as zero for the purposes of calculating the imputed underpayment. This rule is designed to ensure that when calculating an imputed underpayment, an adjustment is not counted twice if the tax effect of that adjustment is reflected by another adjustment made by the IRS. A partnership can request that the IRS utilize this rule to treat an adjustment as zero if the partnership believes it will avoid double taxation. 

The regulations under §301.6225-1(b)(4) clarify that the IRS has the discretion to treat adjustments as zero for purposes of determining the imputed underpayment if the effect of the adjustment under the Code is reflected in another adjustment. 

Other Issues Regarding Grouping and Netting Adjustments.

Section 6225(a)(1) refers to adjustments to partnership-related items “with respect to any reviewed year.” Section 6225(b)(1) provides that any imputed underpayment “with respect to any reviewed year” shall be determined by appropriately netting all partnership adjustments “with respect to such reviewed year.” In addition, section 6225(d)(2) defines adjustment year to mean, in the case of an examination, the year in which an FPA is mailed under section 6231 or in the case of adjustment pursuant to a decision in a proceeding under section 6234, the year in which the decision is final. As a result, at the time of the modification phase of the examination, the adjustment year will not yet be determined. 

The modification period will in every case come before the issuance of the FPA. As a result, the adjustment year will not yet have been determined, and therefore the adjustment year partners will not yet be known. In addition, section 6225(c)(2) provides the ability for partners to file amended returns in modification. The statute’s use of the phrase “amended return” implies that a prior return must have been filed. A prior return could not have been filed for the adjustment year at this point in the examination because the adjustment year would not yet be determined. The partners from the reviewed year, therefore, must be the partners that utilize the modification procedures under section 6225(c)(2) through the filing of amended returns for the reviewed year. The reviewed year partners’ amended returns could not take into account adjustment year adjustments and apply them against reviewed year returns. Under the statute, adjustments for purposes of determining an imputed underpayment are the adjustments with respect to a reviewed year, not the adjustment year. 

Furthermore, section 6225(a)(1) provides the partnership shall pay an amount equal to such imputed underpayment in the adjustment year as provided in section 6232. In the case of adjustments that do not result in an imputed underpayment, section 6225(a)(2) provides that such adjustments shall be taken into account in the adjustment year. Section 6225(a)(2)’s explicit statement that adjustments not resulting in an imputed underpayment are taken into account in the adjustment year, and the absence of similar language in section 6225(a)(1) makes clear that only those partnership adjustments that do not result in an imputed underpayment are taken into account in the adjustment year. 

§301.6225-3 provides that adjustments that do not result in an imputed underpayment are taken into account in the adjustment year, that is, when the imputed underpayment is also required to be paid. To that extent, any adjustments that do not result in an imputed underpayment may mitigate the burden of the imputed underpayment on adjustment year partners. 

Section 6225 provides that if the adjustments result in an imputed underpayment, the partnership shall pay an amount equal to such imputed underpayment in the adjustment year as provided in section 6232. Accordingly, the year partnerships must pay is, by statute, the adjustment year, and if the partnership pays the imputed underpayment without modification or does not make an election under section 6226, the statute is designed so that the adjustment year partners bear the burden of that payment. See section 6241(4) and §301.6241-4 (denying any deduction to the partnership for any payment made by the partnership, including the imputed underpayment). Additionally, there is no authority within subchapter C of chapter 63 to allow the Treasury Department or the IRS to require that reviewed year partners file amended returns, though partners have the option to do so in modification. The partnership may also make the election under section 6226 which would result in adjustments relating to the imputed underpayment for which the election was made being taken into account by the reviewed year partners. 

Section 6225 is prescriptive as to how an imputed underpayment is determined. The determination process expressly does not determine the imputed underpayment as if the partnership were an individual or an entity. Instead, the process for determining the imputed underpayment, including “appropriately netting all partnership adjustments” under section 6225(b)(1)(A) in accordance with §301.6225-1 generally does not take into account partner tax attributes, including whether a partner is an individual or a person subject to the Code provisions that apply to individuals. The IRS has the discretion to take into account an attribute of a particular partner when grouping or subgrouping the adjustments, but the IRS is not required to do so. §301.6225-1(d)(1), (e)(1). For instance, the IRS may consider whether a certain ownership percentage of the partnership was held by individuals, S corporations, or closely-held corporations and group adjustments based on information submitted by the partnership. 

The statute provides a baseline assumption that partners’ tax attributes are not taken into account. The imputed underpayment that best reflects the facts and circumstances of the partners should be determined through application of the permissive grouping and subgrouping rules under §301.6225-1(d)(1), (e)(1) or through modification. 

Section 6225(b) only provides specific rules with respect to one type of adjustment, that is, the rule that adjustments to distributive shares of partners not be netted under section 6225(b)(2). In order to effectuate the rule under section 6225(b)(2), there is no need to know whether a partner is an individual, a corporation, a pass-thru partner, or some other entity. Section 6225(b)’s lack of reference to any particular tax attributes of specific partners indicates that the determination of an imputed underpayment is not dependent on knowing any partner’s specific tax attributes.

Section 6225 does not reference either partner tax attributes or current year partners as a consideration in determining the imputed underpayment. The Treasury Department and the IRS ultimately took the position that section 6225(b) supports a process in which the determination of the imputed underpayment does not depend on specific partners’ tax attributes. 

Recharacterization Adjustments.

Facts and circumstances unique to specific partners are generally not taken into account in determining whether the adjustments result in an imputed underpayment. The regulations give the IRS wide latitude to consider such facts and circumstances, but the rules do not narrowly define the circumstances when that occurs. See §301.6225-1(d)(1) and (e)(1). 

§301.6225-1(c)(6)(iii) provides that a recharacterization adjustment results in at least two separate adjustments: one adjustment reversing the improper characterization of the partnership- related item, and the other adjustment effectuating the proper characterization of the partnership-related item. Generally, one of those adjustments is a positive adjustment and the other is a negative adjustment, but each adjustment is normally the same numerical amount. Under §301.6225-1(d)(3)(iv), the positive adjustment and the negative adjustment are each placed into its own separate subgrouping. Because an adjustment in one subgrouping may not be netted against an adjustment from another subgrouping, the positive adjustment is not offset by the negative adjustment, and the result is a net positive adjustment that forms the base for an imputed underpayment amount. §301.6225-1(e)(2) and (3)(i). 

The regulations under §301.6225-1(e)(2) provide that positive adjustments and negative adjustments within the same subgrouping may only net within that same subgrouping. No netting is permitted across subgroupings.

Credits and Creditable Expenditures.  

In determining whether partnership adjustments result in an imputed underpayment, adjustments to credits are placed in the credit grouping described under §301.6225-1(c)(3). 

The subgrouping rules under §301.6225-1(d)(3)(i), including the application of those rules to the credit grouping, take into account any limitations or restrictions under the Code. 

Adjustments to creditable expenditures are placed in the creditable expenditure grouping described under §301.6225-1(c)(4). §301.6225-1(c)(4)(B), (d)(3)(iii), and (e)(3)(iii) provide specific rules relating to foreign creditable tax expenditures. 

With the exception of the rules under §301.6225-1 regarding foreign tax creditable expenditures, the Treasury Department and the IRS did not issue regulations regarding the treatment of creditable expenditures. However, the regulations do clarify that the general subgrouping principles under §301.6225-1(d)(3)(i) apply when subgrouping adjustments to creditable expenditures. The regulations also clarify that a net positive adjustment to creditable foreign tax expenditures is excluded from the calculation of the total netted partnership adjustment under §301.6225-1(b)(2).

A recapture of a credit generated by partnership activities constitutes a partnership adjustment as defined under §301.6241-1(a)(6), and the credit recapture would constitute a positive adjustment under §301.6225-1(d)(2)(iii)(A) and be placed in the credit grouping under §301.6225-1(c)(3). The full amount of the credit recapture would be taken into account in the determination of the imputed underpayment, unless the partnership requests, subject to IRS approval, that the credit recapture should be taken into account differently during the partnership-level proceeding or pursuant to a modification request. See §301.6225-1(d)(1), (e)(1), §301.6225-2. This rule is necessary because the initial determination of an imputed underpayment does not account for the attributes of the partnership’s partners, including whether and to what extent any partners actually benefited from the original credits. Accordingly, the regulations include a credit recapture amount in the amount of the imputed underpayment, and this amount is not limited to the amount partners actually benefited from the recaptured credits unless the partnership can affirmatively demonstrate to the satisfaction of the IRS during exam either before issuance of the NOPPA or on modification the appropriate partner-level tax treatment. 

Because a net negative adjustment to a credit, that is, an increase in an item of credit, would generally be subject to limitations under the Code, the regulations under §301.6225-1(e)(3)(ii) clarify that a net negative adjustment to a credit is treated as an adjustment that does not result in an imputed underpayment as described in §301.6225-1(f)(1), unless the IRS determines otherwise. This rule is intended to prevent the total netted partnership adjustment from inappropriately being reduced by an increase in credit that would subject to limitations in the hands of the partners of the partnership.

Steps in computing the imputed underpayment (IU)

Computing the IU requires approximately 7 steps:

Step 1

The first step in computing an IU involves the placing of each proposed adjustment into one of four groupings: reallocation, credit, creditable expenditure and residual groupings. Each of the four groupings is explained below:

  • Reallocation grouping – In general, any adjustment that allocates or reallocates a PRI to and from a particular partner or partners is a reallocation adjustment, except for an adjustment to a credit or to a creditable expenditure. Each reallocation adjustment generally results in at least two separate adjustments, each of which become a separate subgrouping. See step 2 which discusses the concept of “subgrouping.”
  • One leg of the reallocation adjustment reverses the effect of the improper allocation of a PRI that will result in a negative adjustment. This adjustment must be taken into account by the partnership in the adjustment year and cannot generally be netted against other adjustments. See step 3 which discusses the concept of “netting.”
  • The other leg of the adjustment makes the proper allocation of the PRI and will result in a positive adjustment.
  • These reallocations are theoretical to the actual partners impacted, that is, they will not impact the partner themselves.

Credit grouping – Any adjustment to a PRI that is reported or could be reported by a partnership as a credit on the partnership’s return, including a reallocation adjustment to such PRI, is placed in the credit grouping.

  1. Generally, a decrease in credits is treated as a positive adjustment, and an increase in credits is treated as a negative adjustment.
  2. A reallocation adjustment relating to the credit grouping is placed into two separate subgroupings and will not be netted together nor will they be netted with other credit adjustments (except for other credit reallocation adjustments allocable to that partner or group of partners).
    1. A decrease in credits allocable to one partner or group of partners is treated as a positive adjustment generally in its own subgrouping.
    1. An increase in credits allocable to another partner or group of partners is treated as a negative adjustment generally in its own subgrouping and does not result in an IU and must be taken into account by the partnership in the adjustment year.

Creditable expenditure grouping – Any adjustment to a PRI where any person could take the item that is adjusted (or item as adjusted if the item was not originally reported by the partnership) as a credit (i.e., creditable foreign tax expenditure or qualified research expense), including a reallocation adjustment to a creditable expenditure, is placed in the creditable expenditure grouping.

Generally, a decrease in creditable expenditures is treated as a positive adjustment to credits, and an increase in creditable expenditures is treated as a negative adjustment.

A reallocation adjustment relating to creditable expenditure grouping is placed into two separate subgroupings and will not be netted together.

A decrease in creditable expenditures allocable to one partner or group of partners is treated as a positive adjustment to credits.

An increase in creditable expenditures allocable to another partner or group of partners is treated as a negative adjustment and does not result in an IU and must be taken into account by the partnership in the adjustment year.

Example: if the adjustment is a reduction of qualified research expenses, the adjustment is to a creditable expenditure grouping because any person allocated the qualified research expenses by the partnership could claim a credit with respect to their allocable portion of such expenses under section 41, rather than a deduction under section 174.

Residual grouping – Any adjustment to a PRI that doesn’t belong in the reallocation, credit, or creditable expenditure grouping is placed in the residual grouping. Also includes any adjustment to a PRI that derives from an item that would not have been required to be allocated by the partnership to a reviewed year partner under section 704(b), such as an adjustment to a liability amount on the balance sheet.

Creditable expenditure grouping – Any adjustment to a PRI where any person could take the item that is adjusted (or item as adjusted if the item was not originally reported by the partnership) as a credit (i.e., creditable foreign tax expenditure or qualified research expense), including a reallocation adjustment to a creditable expenditure, is placed in the creditable expenditure grouping.

  1. Generally, a decrease in creditable expenditures is treated as a positive adjustment to credits, and an increase in creditable expenditures is treated as a negative adjustment.
  2. A reallocation adjustment relating to creditable expenditure grouping is placed into two separate subgroupings and will not be netted together.
    1. A decrease in creditable expenditures allocable to one partner or group of partners is treated as a positive adjustment to credits.
    1. An increase in creditable expenditures allocable to another partner or group of partners is treated as a negative adjustment and does not result in an IU and must be taken into account by the partnership in the adjustment year.
    1. Example: if the adjustment is a reduction of qualified research expenses, the adjustment is to a creditable expenditure grouping because any person allocated the qualified research expenses by the partnership could claim a credit with respect to their allocable portion of such expenses under section 41, rather than a deduction under section 174.

Residual grouping – Any adjustment to a PRI that doesn’t belong in the reallocation, credit, or creditable expenditure grouping is placed in the residual grouping. Also includes any adjustment to a PRI that derives from an item that would not have been required to be allocated by the partnership to a reviewed year partner under section 704(b), such as an adjustment to a liability amount on the balance sheet.

Any adjustment that changes the character of a PRI is a recharacterization adjustment. A recharacterization adjustment will generally result in at least two separate adjustments in the appropriate grouping (reallocation, credit, creditable expenditure, or residual).

  1. One adjustment reverses the improper characterization of the PRI that will result in a negative adjustment.
  2. The other adjustment makes the proper characterization of the PRI and will result in a positive adjustment.
  3. The adjustments that result from a recharacterization are generally placed into separate subgroupings.

If the effect of a partnership adjustment is reflected and taken into account in one or more other partnership adjustments, you may treat the adjustment amount as zero solely for purposes of computing the IU.

Step 2

The second step in computing an IU is to determine if any proposed adjustment, within one of the four groupings, needs to be subgrouped. If all the proposed adjustments within any grouping are positive adjustments only, then subgrouping is not required for such grouping, and you can determine the IU at this point by plugging in the positive numbers to the above formula. If any of the proposed adjustments within a grouping is a negative adjustment, then subgrouping for that grouping is required. Each of the proposed adjustments will need to be subgrouped according to the following rules.

  • Each adjustment is subgrouped according to how the adjustment would be required to be taken into account separately under section 702(a) or any other provision of the Code, regulations, forms, instructions, or other guidance prescribed by the IRS applicable to the adjusted PRI. For purposes of creating subgroupings, if any adjustment could be subject to any preference, limitation, or restriction under the Code (or not allowed, in whole or in part, against ordinary income) if taken into account by any person, the adjustment is placed in a separate subgrouping from all other adjustments within the grouping.
  • Generally, each separate line item of Schedule K/K-1 or return schedule (i.e., Schedule L, etc.), represents a separate and distinct subgrouping. The format for Schedule K/K-1 generally follows the requirement of section 702(a) that each partner is required to take into account separately their distributive share of each class or item of partnership income, gain, loss, deduction or credit. Thus, adjustments to ordinary income must be placed in a different subgroup as capital gain income or interest income since each of those items is required to be separately stated under section 702(a).
  • Separate line items on Schedule K/K-1 (or other schedules onForm 1065) may include multiple components making up the total shown. If any line item on Schedule K/K-1 or other schedules consists of multiple items and the components are required to be taken into account separately under the Code, regulations, forms, instructions, or other guidance prescribed by the IRS, then such line item must be further subgrouped. For example, if there is more than one type of income to be included on Schedule K/K-1, line 11, Other Income/(loss), the partnership is required to attach a statement to Form 1065 that separately identifies each type and amount of income for each distinct category and each of those would constitute a separate subgroup. As another example, if the Schedule K/K-1, line 1 ordinary income/(loss) entry includes income/loss from more than one trade or business activity, the partnership must identify on an attached statement to Schedule K/ K-1 the amount from each separate activity. Accordingly, the income/(loss) from each separate activity from Schedule K/K-1, line 1 would constitute a separate subgroup.
  • The ordinary income/(loss) amount reflected on line 1 of Schedule K/K-1, is sourced from Form 1065, page 1 and is a net amount consisting of various page 1 line items of income and expenses. Although those separate page 1 line items are distinct items of income and expense, if they are appropriately netted and included on line 1, Schedule K/K-1, the net amount will be considered a single subgroup, unless such amount is required to be separately delineated, such as when the partnership has more than one trade or business as previously noted.
  • If you have a negative adjustment along with a positive adjustment in the same line item of Schedule K/K-1, you must consider whether they may be properly netted at the partnership level and whether they are required to be taken into account separately by any partner because it may be subject to a limitation or preference under the Code before you can place them in the same subgroup.
  • A negative adjustment that is not otherwise required to be placed in its own subgrouping must be placed in the same subgrouping as another adjustment if the negative adjustment and the other adjustment would have been properly netted at the partnership level and such netted amount would have been required to be allocated to the partners of the partnership as a single item for purposes of section 702(a) or other provision of the Code and regulations.

A partnership may request to subgroup adjustments in a manner other than the manner described above, such request is generally done in modification under §301.6225-2 after the issuance of the NOPPA. With that being said, you have discretion to review and grant such request based on the facts and circumstances and you must contact the BBA POC before agreeing to the request.

Any request must be supported by the facts and circumstances, such as partner-level information that a negative adjustment is not subject to a presumed preference, limitation, or restriction under the Code, or in fact allowed in full against ordinary income.

Step 3

The third step in computing the imputed underpayment is to appropriately net all the proposed adjustments within each of the groupings and subgroupings.

  • Netting means summing all adjustments together within each grouping or subgrouping, as appropriate.
  • Positive adjustments and negative adjustments may only be netted against each other if they are in the same grouping or subgrouping. An adjustment in one grouping or subgrouping may not be netted against an adjustment in any other grouping or subgrouping. Adjustments from one taxable year may not be netted against adjustments from another taxable year.
  • If any grouping only includes positive adjustments (i.e., there are no subgroupings for that grouping), all adjustments in that grouping are added together to come up with a sum of all net positive adjustments.
  • All adjustments within a subgrouping are netted to determine whether there is a net positive adjustment or net negative adjustment for that subgrouping.
    • A net positive adjustment means an amount that is greater than zero which results from netting adjustments within a grouping or subgrouping. A net positive adjustment includes a positive adjustment that was not netted with any other adjustment. A net positive adjustment includes a net decrease in an item of credit.
    • A net negative adjustment means any amount which results from netting adjustments within a grouping or subgrouping that is not a net positive adjustment. A net negative adjustment includes a negative adjustment that was not netted with any other adjustment.

Step 4

The fourth step is to compute the TNPA. The TNPA is the sum of all net positive adjustments in the reallocation grouping and the residual groupings.Each net positive adjustment with respect to a particular grouping or subgrouping in the residual or reallocation grouping that results after netting the adjustments is included in the calculation of the TNPA.

  • Each net negative adjustment with respect to a residual or reallocation grouping or subgrouping that results after netting the adjustments is excluded from the calculation of the TNPA because those adjustments do not result in an imputed underpayment.

Step 5

  • The fifth step is to determine the highest rate in effect for the reviewed year under section 1 or 11.

Step 6

  • The sixth step is to determine the sum of net positive adjustments to creditable expenditure and credit groupings that will increase or decrease the product of the TNPA times the highest rate in effect.
  • A net decrease to creditable expenditures is treated as a net positive adjustment to credits and increases the product of the TNPA times the highest tax rate in effect. A net increase to creditable expenditures is treated as a net negative adjustment that is excluded from the calculation of the TNPA and is an adjustment that does not result in an imputed underpayment.
  • For the credit grouping, a net positive adjustment will increase the product of the TNPA times the highest tax rate in effect. A net negative adjustment, including net negative adjustments resulting from a credit reallocation adjustment, will be treated as an adjustment that does not result in an imputed underpayment, unless the examination team determines that it is appropriate to allow the net negative adjustment to credit to reduce the product of the TNPA times the highest tax rate in effect.

Step 7

The seventh and final step is to compute the IU based on the results of steps 4 through 6 and insert those results into the IU formula identified above.

Examples

1. The AB Partnership’s 2019 return is under examination. Form 1065, page 1 consists of gross receipts of $1,000 and COGS of $250 for a net ordinary business income of $750 from a single activity. The $750 of net ordinary business income was included on Schedule K, line 1. The revenue agent proposes to increase gross receipts by $100 and increase COGS by $30. The $100 increase in gross receipts represents a positive adjustment while the increase in COGS represents a negative adjustment. Both of these adjustments are placed in the residual grouping since neither is properly classified as a reallocation, credit or creditable expenditure grouping. Since one of the adjustments is negative, subgrouping is required. The agent verified that AB Partnership netted the gross receipts and COGS as a single partnership-related item on Schedule K, line 1, and therefore, the negative adjustment for COGS will be subgrouped with the positive gross receipts adjustment. After netting these adjustments, the result is a net positive adjustment of $70 in the Schedule K, line 1 subgroup as well as a net positive adjustment in the residual grouping. The $70 will be included in the total netted partnership adjustment for purposes of computing the imputed underpayment.

2. The facts are the same as example 1 above, except the partnership’s operations included two distinct activities (“Activity A” and “Activity B”). The net income from each activity were separately stated on a statement attached to Form 1065. The audit adjustment to gross receipts of $100 (increase) was identified as being related to Activity “A” while the adjustment to COGS of $30 (increase) was identified as being related to Activity “B.” Again, both the positive adjustment to gross receipts of $100 and the negative adjustment of $30 to COGS are placed in the residual grouping. Since the separate net income from each activity are required to be separately stated on line 1 of Schedules K/K-1 (via an attached schedule), those amounts were not treated as a single partnership-related item for purposes of section 702(a) and were not allocated as a single item on the filed tax return as was proper. Therefore, each adjustment must be placed into a separate subgroup within the residual grouping. The two subgroups (within the residual grouping) could be identified as “Schedule K, line 1, Activity A” and “Schedule K, line 1, Activity B” or similar. Under the netting rules, netting adjustments across subgroups is not permitted and the positive $100 adjustment and the negative $30 adjustment may not be netted. Thus, the residual grouping contains a net positive adjustment of $100 (netting rules only allow positive adjustments to be added together in each grouping to arrive at a net positive adjustment). This amount will be included in the total net partnership adjustment for purposes of computing the imputed underpayment. The net negative adjustment of $30 is an adjustment that does not result in an imputed underpayment and must be included on the partnership’s tax return for the year in which such adjustment becomes final.For any reallocation adjustment, the IRS will include the name and TIN of the impacted partner and whether the allocation is “to” or “from” such partner.