correcting capital account errors on partnership...
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Correcting Capital Account Errors on Partnership Returns
WEDNESDAY, JUNE 10, 2020, 1:00-2:50 pm Eastern
FOR LIVE PROGRAM ONLY
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June 10, 2020
Correcting Capital Account Errors on Partnership Returns
John Colvin, Partner
Colvin & Hallett
Joseph C. Mandarino, Partner
Smith Gambrell & Russell
Jellia Dai, Manager
Ernst & Young
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
Page 5
► Overview
► Capital Account Maintenance and Adjustments
► CARES Act Brief
Jellia Dai,
EY
Introduction to Partnership Capital Accounts
Page 6
Overview
Page 7
Capital Accounts
► The capital account is an equity account and tracks how companies
compute partners’ investments and their interests in the partnership.
► The financial accounts of a partnership, including its capital accounts,
are maintained using the partnership's normal method of accounting
and must be adjusted periodically to take into account the partnership's
operations for the year, as well as any contributions to, or distributions
from, the partnership that may have occurred.
Page 8
Capital Accounts Basics
► A capital account is like a bank account, and the partnership is the
bank.
► Deposit money, account balance increases.
► Earn interest (or other income), balance increases
► Withdraw money, balance decreases.
► Amounts held in account lose value, balance decreases.
► Write a check for more money than in the account? You owe.
Page 9
Capital Accounts Tracking
contributions income
ending
capitaldistributions loss
+ +
- -=beginning
capital
Page 10
Capital Accounts: Contribution
► A partner's capital account is increased by the amount of money plus
the fair market value of any property (net of liabilities) contributed by
that partner.
► There are two aspects of this rule that should be emphasized:
▪ First, the contributing partner's tax basis in the property is not relevant for
this purpose. The theory is that the partners will have struck their business
deal on the basis of the contributed property's value, not its tax attributes.
▪ Second, since liabilities are separately stated on the balance sheet, the
adjustment to the capital account is net of any liabilities on the property.
This is also consistent with the notion that the balance of a capital account
should represent the equity of the partner, after liabilities are deducted.
6/3/2020
Page 11
Capital Accounts: Operations
► A partner's capital account is increased by her share of the
partnership's income for the year, and is decreased by her share of
the partnership's losses for the year. For this purpose, the tax
character of the income or loss does not matter.
• E.g. Tax exempt income is treated the same as ordinary income, and
capital losses and passive activity losses are treated the same as ordinary
business losses.
• The function of capital accounts is to reflect the partners' economic shares
of the partnership's assets, thus the tax character of any receipt, and the
deductibility of any expense, is irrelevant;
• If the book value of partnership assets increases or decreases for any
reason other than increased or decreased liabilities, then a corresponding
increase or decrease in capital must occur.
6/3/2020
Page 12
Capital Accounts: Distribution
► A partner's capital account is decreased by the amount of money plus
the fair market value of any property (net of liabilities) distributed to
that partner.
► This is the mirror image of contributions and is treated consistently.
► The adjustment is based on value not tax basis, and the adjustment is
made net of liabilities.
► Distributions of property raise one additional complication: Any
inherent gain or loss in the property distributed, even though not
recognized for tax purposes, must be taken into account for book
purposes. This is necessary to insure that the partners share the
inherent gain or loss in the distributed property in accordance with
their agreement.
6/3/2020
Page 13
Capital Accounts: Distribution Example 1
► Facts:
• A and B are equal partners who each have a balance in their capital ac-counts of
$500.
• AB plans to distribute $200 cash to A and $200 worth of stock to B which has a
book value of only $150.
• There has been $50 of appreciation in the stock that has never been reflected on
the partnership's books.
► Solutions:
• As an economic matter, A and B are receiving equal distributions and the
adjustments to their capital accounts should be the same.
• This is accomplished by requiring AB first to recognize and allocate between the
partners the $50 of inherent gain in the stock for book purposes and then to reduce
their respective capital accounts by the full amount of the distribution.
• In this case that would mean each partner's capital account first would be increased
from $500 to $525 and then reduced by $200 to $325.
6/3/2020
Page 14
Capital Accounts: Liabilities
► On a balance sheet, liabilities are separately stated and
not reflected in capital accounts.
► Therefore, no adjustments are made to capital accounts
when a partnership borrows or repays a loan, and the
adjustments to capital accounts for contributed and
distributed property are made net of liabilities.
6/3/2020
Page 15
Capital Accounts: Example 2
► Facts:
► A and B form a partnership;
each contributes $400. They
will share all profits and
losses equally. AB's initial
balance sheet is as follows:
6/3/2020
Asset
Cash $800
Liability $0
Equity
A $400
B $400
$800
Page 16
Capital Accounts: Example 2
► Initial Transactions:
• PRS immediately buys an
apartment for $1,000,
pays $200 cash and
giving $800 mortgage for
the balance. AB also
invest some of its excess
cash in stock $150 and
tax exempt bonds ($150).
AB’s balance sheet would
look as follows:
6/3/2020
Assets: $1,600
Cash $300
Stocks $150
Bonds $150
Bldg $1,000
Liabilities:
Mortgage $800
Equity:
A $400
B $400
Page 17
Capital Accounts: Example 2
► Operations:
• AB depreciates building in 20
years straight-line (i.e. $50 per
year), AB has dividend income
$10, tax exempt income $15,
Net income from building $35
(rents of $85 less $50
depreciation) for a total of $60
income which A and B share
equally. Stock went up in value
of $200. There were no
distributions.
6/3/2020
Assets: $1,660
Cash $410
Stocks $150
Bonds $150
Bldg $950
Liabilities:
Mortagage $800
Equity:
A $430
B $430
Page 18
Capital Accounts: Example 2
► YE Transaction:
• AB makes a $100 payment to
mortgage;
• AB makes a Charitable
contribution $10;
• AB distributes stock to A and
$200 cash to B
6/3/2020
Assets: $1,200
Cash $100
Stocks $0
Bonds $150
Bldg $950
Liabilities:
Mortgage $700
Equity:
A $250
B $250
Page 19
Capital Accounts
► The capital account analysis is based on the following three
requirements:
► Capital account requirement: The partnership must maintain its capital
accounts in accordance with the rules found in § 1.704-1(b)(2)(iv)
► Distribution requirement: Upon liquidation, liquidating distributions must
be made in accordance with the positive balances in the partners' capital
accounts.
► Deficit make up requirement: If after liquidation any partner has a deficit
in her capital account, she must be un-conditionally obligated to restore
that deficit. § 1.704-1(b)(2)(ii)(b)(3)
Page 20
Capital Account Maintenance and Adjustments
Page 21
Capital Accounts
► When accounting for Capital Accounts, partnerships may maintain a
single partnership capital account for all partners.► Must maintain a supporting schedule which breaks out the related capital
account for each partner(profits and losses earned by the business allocated
to the partners based on the provisions of the partnership agreement).
► Partnership may maintain separate capital accounts within the
accounting system for each partner.► Over the long term individual accounts are easier to see in the trial balance.
► Easy to determine the amount to be distributed upon liquidation.
► Profits and losses earned by the business allocated to the partners based on
the provisions of the partnership agreement.
► Capital accounts are maintained on both a book and tax basis.
► Differences arise due to different treatment of items for book and tax
purposes.
Page 22
Tax Basis Capital Accounts
► A partner will have both inside and outside tax basis in their partnership
interest.
► Inside basis will be adjusted by item that occur inside the partnership
and outside basis will be adjusted by those that occur outside the
partnership.
► Each partner’s “outside” tax basis is the sum of their tax capital account
balance plus their allocable share of partnership debt.
► A partner’s tax capital account may go negative as long as the partner
has outside basis to cover it (e.g. outside basis from allocations of
partnership debt).
Page 23
Tax Basis Capital Accounts
► Tax basis capital accounts will be affected by items in a different
manner than book capital accounts.
► Examples of items which will affect such basis differently for tax
purposes include depreciation expense and accrued expenses which
are not deductible for tax purposes.
► Tax reform has impacted the calculation of tax capital accounts with
adjustments such as the disallowed interest expense carry over.
Page 24
Partnership Tax Concepts
► Qualified Income Offset (QIO)
► Each partner should maintain a positive capital account when possible.
► Income may be reallocated in an amount necessary to eliminate any
negative capital account in cases where a partner’s capital account
unexpectedly goes negative after initial contributions and allocations of
taxable income/losses.
► This is established using a qualified income offset provision in the
partnership agreement.
Page 25
Partnership Tax Concepts
► Deficit Restoration Obligation (DRO)
► A deficit restoration obligation (DRO) is an obligation by a partner to restore
a negative balance in its capital account when the partnership liquidates.
► A partner with a negative capital account may sign up for a limited DRO to
continue being allocated losses even if the partner’s capital account goes
negative.
► A limited DRO may be required in ITC deals to ensure allocation of ITCs to
the investor during the recapture period.
Page 26
Example 3
► Assume that we have two partners: LP, who contributes $90 million, and GP,
who contributes $10 million.
► Partnership buys a building for $100 million.
► Losses are allocated first to reverse out prior profits (if any) and then 100% to
the LP.
► Profits are allocated first to reverse out prior losses (if any) and then 90/10.
► Operating cash flow is distributed 90/10.
► Assume, for convenience, that the building gives rise to $2.5 million of
depreciation deductions per year for the 40 years after it is placed in service.
► Assume also that the partnership has $1 million of rental income per year,
which it distributes 90/10.
Page 27
Example 3 (cont’d)
► Q: Does the allocation of the entire $1.5m net loss to LP have economic
effect?
► A: Yes. The allocation has economic effect, because the allocation does
not drive the LP’s adjusted capital account ($87.6m) below zero.
Page 28
Example 3 (cont’d)
► However, let’s jump ahead to year 37.
► Assume that future distributions to LP are expected to exceed future
offsetting increases to LP’s capital account by $2m.
► LP’s adjusted capital account for purposes of the QIO is therefore $2m
less than LP’s actual capital account.
Page 29
Example 3 (cont’d)
► The tentative allocations for the year will look like this:
► Question: Does the allocation of the entire $1.5m of loss for the year to
LP have economic effect?
Year 37 LP GP
Initial capital accounts $3.6m $6.4m
Adjustment pursuant to
Reg. § 1.704-1(b)(2)(ii)(d)(4)-(6)($2m) $0
Adjusted capital accounts $1.6m $6.4m
Contributions $0 $0
Distributions ($900k) ($100k)
Adjusted capital accounts $.7m $6.3m
Allocation of net loss ($1.5m) $0
Tentative capital accounts ($.8m) $6.3m
Page 30
Example 3 (cont’d)
► Question: Does the allocation of the entire $1.5m of loss to LP have
economic effect?
► Answer: No, because the allocation reduces the LP’s adjusted capital
account below zero.
Page 31
Example 3 (cont’d)
► Accordingly, a part of the loss must be reallocated to the GP, as follows:
Year 37 LP GP
Initial capital accounts $3.6m $6.4m
Adjustment pursuant to
Reg. § 1.704-1(b)(2)(ii)(d)(4)-(6)($2m) $0
Adjusted capital accounts $1.6m $6.4m
Contributions $0 $0
Distributions ($900k) ($100k)
Adjusted capital accounts $.7m $6.3m
Allocation of net loss ($1.5m) $0
Tentative capital accounts ($.8m) $6.3m
Reallocation of loss $.8m ($.8m)
Final capital accounts $0 $5.5m
Page 32
Capital Tracking Example
Tax Year 2017 1/1/2017-12/31/17 Period
Event Date §704(b) Tax BIG / (BIL) §704(b) Tax BIG / (BIL) §704(b) Tax BIG / (BIL)
Beginning 01/01/17 - - - - - - - - -
Initial Capital Contribution 01/01/17 - - - - - - - - -
Property Contributions 18,000 9,770 8,230 - - - 18,000 9,770 8,230
Cash Contributions 4,500 4,500 - 4,500 4,500 - - - -
- - - - - - - - -
Gain from Disguised Sale 01/01/17 - 2,557 (2,557) - - - - 2,557 (2,557) Current Liabilities From Disguise Sale 01/01/17 - (500) 500 - - - - (500) 500
- - - - - - - - -
Additional Contributions 12/31/17 - - - - - - - - -
- - - - - - - - -
Partnership Income / (Loss) before D&A 12/31/17 (43) (43) - (11) (11) - (32) (32) -
Depreciation and Amortization 12/31/17 (2,568) (1,959) (608) (642) (507) (135) (1,926) (1,453) (473)
+ Nondeductible Items 12/31/17 - 2 (2) - 1 (1) - 2 (2)
Total Income Allocation 12/31/17 (2,611) (2,000) (611) (653) (517) (136) (1,958) (1,483) (475)
Cash Distributions 01/01/17 (4,500) (4,500) - - - - (4,500) (4,500) -
- Nondeductible Items 12/31/17 - (2) 2 - (1) 1 - (2) 2
Balance at December 31, 2017 12/31/17 15,389 9,825 5,564 3,847 3,982 (135) 11,542 5,843 5,699
Ownership Percentage 12/31/17 100.0% 25.0% 75.0%
Partner 2Total Partner 1
Page 33
CARES Act
Page 34
CARES Act agenda
► Net operating loss (NOL) relief
► NOL carryback implications
► Section 163(j)–business interest deductions
Page 35
CARES Act overviewNOL relief
► The CARES Act amends TCJA and allows taxpayers to carry back NOLs
arising in tax years beginning after 31 December 2017, and before 1 January
2021, to the five tax years preceding the tax year of such loss.► Refunds from NOL carrybacks are intended to provide an immediate liquidity
benefit.
► This benefit is “supercharged” where 21% tax rate losses are carried back into
35% tax rate income years.
► Taxpayers can elect under Section 172(b)(3) to waive the carryback period► A carryback waiver may be advantageous where a carryback would adversely
affect favorable tax attributes (e.g., forgone deductions limited by taxable income after
NOLs).
► Questions exist regarding the extension of Section 172(b)(3) to consolidated
groups; further guidance may be needed (e.g., for “partial waiver” elections).
► A special waiver election is provided for Section 965 tax year(s) (discussed below).
Page 36
NOL carryback implicationsSection 965 impacts of NOL carrybacks
► A taxpayer that carries back an NOL to a Section 965 tax year is deemed to
have made a Section 965(n) election to not apply an NOL (current, carryforward
or carryback) to the Section 965 inclusion.► The scope of the deemed election is unclear where there was an NOL carryforward or
current year loss but an actual election was not made.
► Mechanics from final Section 965 regulations apply for expense apportionment and
allocation where a Section 965(n) election is made.
► A taxpayer can elect to not carry back an NOL to a Section 965 transition tax.► Corporations should model the consequences of an election to exclude.
► Amended return requires revisiting positions impacted by subsequently finalized
regulations.
► Reduction in Section 965 liability is not currently refundable; future transition
tax installments are reduced.
Page 37
NOL carryback implicationsSection 965 and FTC example
Pre-CARES Act: Calendar year US taxpayer
► Loss = ($100)
► Carryback not allowed
Tax Year End (TYE) 2016 TYE 2017 TYE 2018
► Taxable Inc = $20
► FTC = $5
► Taxable Inc = $70
► ($40) loss w/o Section 965
► $110 Section 965
► No Section 965(n) election
Post-CARES Act: Calendar year US taxpayer
TYE 2016 TYE 2017 TYE 2018
► Loss = ($100)
► Elect carryback to 2016
► Taxable Inc = $0
► FTC = $0
► Taxable Inc = $70
► ($40) loss w/o Section 965
► $110 Section 965
► Impact on 2016 attribute carryforward
► Forgo carryback to 2017 due to deemed Section 965(n)
election
Page 38
Section 163(j) limitationIncrease to Section 163(j) business interest expense deduction limitation
► The CARES Act increases the adjusted taxable income (ATI) limitation to 50%,
which allows for a greater amount of interest to be deducted in a year.
► A special election permits a taxpayer to use its 2019 ATI in lieu of 2020 ATI
when applying the 50% interest expense limitation for 2020, which is helpful as
many businesses will likely have lower ATI in 2020 than in 2019 due to the
economic downturn.
30% of ATI 50% of ATI Change
Taxable income before interest 1,000 1,000 –
Interest expense (base erosion payments) (300) (500) (200)
Regular taxable income 700 500 (200)
Tax rate 21% 21% –
Income tax 147 105 (42)
FTCs (77) (77) –
Regular tax liability 70 28 (42)
Page 39
Section 163(j) limitationSpecial rules
► Special rules for partnerships:
► The elective increase to 50% of ATI does not apply to a partnership tax year beginning
in 2019.
► Instead, 50% of the excess of the partnership’s 2019 business interest expense
allocated to the partner is treated as paid or accrued in the partner’s 2020 tax year
(without regard to any requirement that would need to be satisfied) and is not
otherwise subject to Section 163(j) at the partner level.
► The 50% rule above does apply to a partnership’s 2020 tax year.
J O H N M . C O L V I N
C O L V I N + H A L L E T T , P . S .
Revised Partnership Audit RulesUnder the BBA
Page 40
Overview
The Bipartisan Budget Act of 2015, P.L. 114-74, § 1101 (enacting new §§ 6221-6241).
Repealed and replaced the TEFRA partnership rules and the (seldom used) electing large partnership (ELP) rules for tax years beginning after December 31, 2017.
The goal of the changes was to shift the burden of making adjustments from the IRS to partnerships and their partners.
Page 41
Why the Change?
After making substantive adjustments at the partnership level, the IRS spent months or years locating partners and collected little or no tax.
The trouble with tiered partnerships - GAO and TIGTA reports.
Given these frustrations, It was clear that Congress was going to revise the rules in order to assess and collect tax at the entity level.
In October 2015, the Real Estate Roundtable Tax Policy Advisory Committee suggested modifications, many of which were ultimately incorporated, including the alternative K-1 “push‐out” procedures.
BBA applies to all partnerships and entities filing partnership returns (even if it’s later determined that the entity is not a partnership) (§6241(1) and (8)).
Page 42
TEFRA vs. BBA
Page 43
Opting Out of the BBA Audit Rules
Make election on timely filed return. § 6221(b)(1)(D)(i). Only available if partnership has 100 or fewer partners, all of whom are individuals,
C corporations (including foreign entities that would be taxed as C corporations), S corporations (but counting each S corporation shareholder as a partner for purposes of the 100-partner limit), or estates of deceased partners. § 6221(b)(1)(B) & (C). Must provide IRS with name and TIN of each partner and provide notification to partners.
§ 6221(b)(1)(D)(ii) & (E). If a partner is an S corporation, the partnership must provide the name and TIN of each S corporation shareholder, but the S corporation’s Forms K-1 alone can fulfill this requirement. § 6221(b)(2)(A).
100-partner limit based on the number of Forms K-1 required to be filed (not actually filed). See §6221(b)(1)(B).
Why do this? Do not want to be joined at the hip with the partnership. Preserve personal penalty defenses.
Page 44
Additional Issues Regarding Opting Out
Partnership cannot opt out if partners include disregarded entities (DREs), other partnerships, or trusts (even grantor trusts). See § 6221(b)(1)(C).
If partnership has pass-through entities as partners, may want to change status (e.g., have domestic LLC formerly taxed as partnership make an S election) to preserve ability to opt out.
REITs and RICs are eligible partners for purpose of opting out because these entities are technically C corporations (e.g., all corporations are c corporations if they are not an S corporation pursuant to § 1361(a)(2)).
Page 45
Effective Date
BBA partnership audit rules generally apply to tax years beginning on January 1, 2018.
Partnerships were allowed to elect into application of the BBA provisions for partnership tax years beginning after November 2, 2015 (date BBA was enacted).
Page 46
Partnership Representative - § 6223
Partnership will designate (in manner prescribed by the Secretary) a partner (or other person) with a “substantial presence in the United States” to be the Partnership Representative. § 6223(a).
Partnership Representative has sole authority to act on behalf of partnership for purposes of the BBA partnership audit rules. Id.
If no partnership designation, the IRS “may select any person as the partnership representative” Id. (emphasis added).
Partnership and all of its partners are bound by actions taken by the partnership pursuant to Subchapter 68C (the BBA Partnership Audit rules). § 6223(b)(1).
Page 47
Basic Procedure
IRS sends out Notice of Selection for Examination (Letter 2205-D) (new concept in Regs). IRS sends out Notice of Initiation of Administrative Proceeding. § 6231(a)(1). After audit complete, IRS sends out Notice of Proposed Partnership Adjustment.
§ 6231(a)(2). Partnership provides info supporting modification to IRS within 270-day period after
issuance of Notice of Proposed Adjustment. During this 270-day period, the IRS is barred from issuing a Notice of Final Partnership Adjustment. § 6225(c)(1) and (7); § 6231(b)(2)(A).
IRS sends out Notice of Final Partnership Adjustment. § 6231(a)(3). Like Notices of Deficiency, sent to the “Last Known Address” of Partnership Representative or Partnership.
§ 6231(a) (hanging paragraph).
Unclear, but above steps may also be required if the partnership files an AAR. § 6231(a) (hanging paragraph) (“The first sentence shall apply to any proceeding with respect to an administrative adjustment request filed by a partnership under section 6227.”).
Page 48
BBA Basic Audit Procedure
270 days
Audit60 Day
LetterAppeals NOPPA
“Pull In”/ Partners File Amended
Returns
Options
(1)
Imputed Underpayment Modifications: Reductions to Rate (if p-ship
will pay)
(2)
270 Days After
NOPPA
FPA
“Push Out”/ K-1
Alternative
Partnership Assessment
Petition
90 Days
45 Days
Agree
Page 49
Definitions: Reviewed Year and Adjustment Year
“Reviewed Year”– the partnership taxable year to which the item(s) being adjusted relates. § 6225(d)(1).
“Adjustment Year” – § 6225(d)(2) – the partnership tax year in which either:
A court proceeding under § 6234 becomes final;
An AAR under § 6227 is made; or
If not covered above, the Notice of Final Partnership Adjustment is mailed.
If partnership ceases to exists before an adjustment is made, the former partners of the partnership are required to take the adjustment into account. § 6241(7).
Page 51
“Imputed Underpayment”
“Imputed Underpayment”– net adjustments multiplied by highest rate of tax under section 1 or 11. § 6225(b).
Modifications that may reduce “imputed underpayment”: Take into account any amounts reported on amended returns filed by Reviewed Year
partners (along with payment). § 6225(c)(2).
Disregard portion allocable to tax-exempt partners. § 6225(c)(3).
Make adjustments with respect to amounts allocable to individual partners if such amounts would have been subject to capital gain/qualified dividend rate. § 6225(c)(4)(A)(ii).
Make adjustments with respect to amounts allocable to partners subject to section 11 rate (if lower than section 1 rate) (i.e., C corporations). § 6225(c)(4)(A)(i).
Other factors. § 6225(c)(5) and (6).
Page 52
“Imputed Underpayment” - Character of Adjustments
Regulations attempt to preserve character as much possible in computing “imputed underpayment” through use of grouping procedure. Treas. Reg. § 301.6225-1.
Page 53
Imputed Underpayment: Reduce by Amending Returns
The net liability of the partnership and its partners in virtually all cases will be minimized if the partners file amended returns within the 270-day period.
Benefit of lower marginal rates, use of partners’ other tax attributes to mitigate the adjustment.
Any penalty at partnership level should be based on aggregate net adjustments. The aggregate net adjustments will ordinarily be lower if partners file amended returns.
Alternative: “pull-in” procedure which allows partnership to submit the relevant information on behalf of the relevant partner (reflecting what would have been owed) as well as make payment.
Page 54
Some But Not All Partners File Amended Returns, AndThe Partnership Pays Some Imputed Adjustment
Considerations:
Partners who do not file amended returns should be treated differently from those who do not file amended returns with respect to the imputed underpayment paid by the partnership.
Partners who file amended returns and pay tax should not have to share in the tax burden remaining at the partnership level.
Logical solution would be to treat portion of imputed adjustments as distribution to the non-paying partners.
Page 55
Imputed Underpayment: Adjustments Relating to Inter‐Partner Allocations
If an adjustment reallocates distributive shares of any item from one partner to another, these are not netted. § 6225(b)(2). Instead, the imputed underpayment is determined by disregarding any decrease in
any item of income or gain and any increase in any item of deduction loss or credit. § 6225(b)(2).
The partnership can avoid the imputed adjustment only if all partners who are subject to the reallocation file amended returns. § 6225(c)(2)(B) & (C).
Page 56
Imputed Underpayment: Assessment and Collection
“Imputed Underpayment” assessed and collected in same manner as if it were a tax imposed for the Adjustment Year. § 6232(a).
If AAR showing tax due is filed, payment of underpayment is due when the AAR is filed.
In tiered partnership setting, failure to comply with consistency requirement is treated like math error. § 6232(d)(2).
Partners not subject to joint and several liability for any liability determined at the partnership level. House 2015 Bipartisan Budget Act Section-by-Section Summary. Possibility that IRS will assert transferee liability if there have been distributions that
leave partnership insolvent and unable to pay tax.
Page 57
Imputed Underpayment:Treat Payment as Distribution to Partner
To the extent that the partnership obligation to pay an imputed underpayment is related to the income/loss of (or distributions to) any partner, the amounts required to be paid by the partnership with respect to such partner (including taxes, penalties and interest) seems to be appropriately treated as a distribution to that partner.
Prop. Reg. § 301.6225-4(c) treats payments of imputed underpayment (and any interest and penalties) as non-deductible, non-capitalizable expenses under §705(a)(2)(B).
To the extent that the items are attributable to persons who were partners in the Reviewed Year, but who are not partners in the Adjustment Year, there is a disconnect.
To the extent that there is no mechanism for recovering from departed partners, this burden will have to be spread across Adjustment Year partners.
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Partnership Generally Pays Interest and Penalties
The assessment amount is computed for the Adjustment Year by calculating interest accrued from the Reviewed Year to the Adjustment Year, taking into account the effect of changes in the intervening years. § 6233(a)(2).
Regular interest runs from Adjustment Year forward. § 6233(b)(2).
Partnership is liable for penalties (including accuracy and fraud penalties) as if it had been an individual subject to tax on amount of imputed adjustment in Reviewed Year. § 6233(a)(3).
In case of a failure to pay an imputed underpayment for Adjustment Year, the partnership is subject to the delinquency penalties, including failure to pay under § 6651(a)(2). § 6233(b)(3).
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Alternative to Imputed Underpayment: “Push-Out” Adjustments to Partners in Year of Adjustment – § 6226
Must elect no later than 45 days after issuance of Notice of Final Partnership Adjustment. § 6226(a)(1).
In the Adjustment Year, the partnership issues Form K-1-type statements to those who were partners during the Reviewed Year. § 6226(a)(2).
Partners are required to include a tax amount on their personal tax returns for the Adjustment Year equal to the amount (plus interest) that would have been paid if taken into account in Reviewed Year, plus any adjustments for intervening tax years (years between Reviewed Year and Adjustment Year) where the adjustments made would result in an increase in tax in those years. § 6226(b)(1) and (2). Deficiency procedures do not apply to Reviewed Year partners who do not include K-1 amount on personal
tax return.
Any tax attributes affected had adjustments been taken into account during the Reviewed Year, or any year between Reviewed Year and Adjustment Year, must also be “appropriately adjusted.” § 6226(b)(3). In many cases, additional income in the earlier years would provide basis in later years (shielding
distributions). It is unclear if this can be taken into account. File protective AARs for intervening years?
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Push-Out/Form K-1 Alternative: Interest and Penalties
Interest is computed at “hot interest” rates (federal short term rate plus 5%) from “due date of return to which the increase is attributable” (Reviewed Year and any later year where tax is “appropriately adjusted”). § 6226(c)(2).
Applicability of penalties determined at partnership level, but those persons who were “partners of the partnership for the reviewed year shall be liable for any such penalty.” § 6226(c)(1). Thus, there is no personal defense to the penalty for the partners who receive Forms K-1.
Even if a partner filed an amended return prior to the issuance of the Final Notice of Partnership Adjustment, eliminating the portion of the partnership imputed understatement attributable to him, if penalties are applicable, the Form K-1 could require the partner to pay his share of the penalty, plus “hot interest” thereon.
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§ 6225(a)(2) – Situations Where There Is No Imputed Underpayment
To the extent that audit adjustments do not result in an imputed underpayment (e.g., the audit adjustment generates refunds), the adjustment is generally taken into account by the partnership in the Adjustment Year as a reduction in non-separately stated income. § 6225(a)(2).
While the imputed underpayment includes an interest component, there is no statutory mechanism to provide refund interest if the adjustments result in refunds.
The Adjustment Year partners (current partners) get the benefit of net taxpayer favorable adjustments (assuming no AAR filed), while the Reviewed Year partners will bear the burden of net underpayment adjustments if the § 6226 push-out method is elected.
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Administrative Adjustment Request (AAR)
Statute authorizes filing of AAR to adjust one or more items of income, gain, loss, deduction or credit. § 6227(a).
May be filed by partnership (under “rules similar to” § 6225 default rule) or by partnership and partners (under “rules similar to” § 6226 Form K-1 method). § 6227(b)(1) and (2).
If there is no imputed adjustment (e.g., AAR reflects a reduction of income or increase in loss/deduction/credits), must use the § 6226 Form K-1 method. § 6227(b) (hanging paragraph) (“In case of adjustment that would not result in an imputed underpayment, paragraph (1) shall not apply and paragraph (2) shall apply with appropriate adjustments.”) Thus, any refund generated by an AAR will go to the partners.
Must be filed within 3 years of later of: (1) date original return was filed, or (2) due date of return without regard to extensions. § 6227(c).
There is no stand alone “refund jurisdiction” for the courts with respect to an AAR. If a Final Partnership Adjustment is made as a result of an AAR, it appears that the matter may be contested in court. See § 6231(a) (last sentence of hanging paragraph).
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Observations Regarding AARs
The time limit on an AAR (3 years) makes filing one in the case of potential timing adjustments (i.e., deficiency in one year and refund in later year) absolutely essential.
The AAR provisions make timing adjustments potentially problematic for a partnership. Cash flow mismatch: While the partnership could pay an imputed adjustment in the
Adjustment Year of the year under of the audit, the persons who were partners during the AAR year would get the benefit of any refund.
Complexity increases if a new partner arrives in the middle of a timing adjustment, which increases income in an earlier year and decreases income in a later year. There will be a windfall to the incoming partner who will receive the benefit of a refund, while the outgoing partner could end up paying a deficiency on an amended return or under § 6226 procedures.
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Other Implications
Financial Statements. Possibility that partnership will incur an entity-level tax means that partnerships may have to reflect a provision for taxes on their financial statements under FASB No. 109 (ASC Topic 740). FIN 48 (“Accounting for Uncertainty in Income Taxes”) may also be applicable.
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Reporting Tax Basis Capital Accounts
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Background – Part 1
Partnerships have long been required to report capital accounts on the Schedule K-1 to Form 1065 (and 8865).
Many partnerships maintain their capital accounts on a § 704(b) book basis or GAAP basis, rather than on a tax basis.
Reporting on book or GAAP basis allows the partnership to better track the economic agreement between the partners by measuring the value of assets contributed to a partnership at the time of contribution (rather than by their historical, pre-contribution tax basis), but also requires taxpayers to make adjustments at tax time, e.g., § 704(c).
Capital accounts maintained on a § 704(b) book basis or on a GAAP basis may differ substantially from capital accounts maintained on a tax basis.
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Background – Part 2
It is permissible for a partner to have a negative capital account balance, usually in tandem with an allocation of partnership debt, or a deficit restoration obligation.
Negative capital accounts can result if the partner has taken a distribution or losses financed by partnership debt. Whether a distribution is taxable depends on whether it exceeds a partner’s tax basis in his partnership interest (plus his share of partnership liabilities). Similarly, partners cannot take losses in excess of their tax basis (including their share of partnership liabilities.)
Negative tax basis capital accounts can also result when a partner contributes property to a partnership that is subject to debt in excess of its basis.
Because partnerships did not previously have to report capital accounts on a tax basis, the IRS could not readily determine if distributions or losses exceeded basis.
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2018 Returns: IRS Requires Partnerships toReport Negative Tax Basis Capital Accounts
The instructions to Schedule K-1 to Form 1065 now require larger partnerships (with assets of more than $1 million or gross receipts of more than $250,000) and late filing partnerships, who do not otherwise report capital accounts on a tax basis, to now report on line 20 of Schedule K-1 (using code AH) the amount of every partners’ “tax basis capital” at the beginning and end of the year if either amount is negative.
The “tax basis capital” is essentially the partner’s tax basis in his partnership interest (not including the partner’s share of partnership liabilities, which is reported elsewhere on the Form K-1). This information will make it much easier for the IRS to determine if a partner may have received a distribution or claimed losses in excess of basis.
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Penalty Relief Provided for 2018 Tax Returns Wherethe Negative Tax Basis Capital Accounts Were Not Reported
In light of the enormity of the task, return preparers were worried that errors in the computation of tax basis capital accounts could result in the assertion of penalties under §§ 6698 or 6722 for failure to file a correct partnership returns and/or Forms K-1.
In March of 2019, in Notice 2019-20, 2019-13 IRB 1, the IRS announced that penalties would not be imposed so long as the required information was supplied in a separate schedule within one year of the un-extended due date for the partnership tax return (the contents of the schedule are set out in the FAQs discussed below).
In April of 2019, the IRS put out an FAQ on its website regarding “negative tax basis capital.” https://www.irs.gov/businesses/partnerships/form-1065-frequently-asked-questions.
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IRS FAQs - Initial Tax Basis Capital Account and Increases
Money contributed to partnership, PLUS
i. The adjusted tax basis of non-cash property contributed by the partner to the partnership, less the liabilities assumed by the partnership (or to which the property is subject) in connection with the contribution;
ii. The sum of the partner’s distributive share for the taxable year and prior taxable years of partnership income or gain (including tax-exempt income);
iii. The partner’s distributive share of the excess of the tax deductions for depletion (other than oil and gas depletion) over the tax basis of the property subject to depletion;
iv. The amount of liabilities of the partnership assumed by the partner, excluding liabilities assumed in connection with a distribution of property; and
v. The partner’s distributive share of any increase to the tax basis of partnership property under § 734(b) or with respect to partnership property under § 743(b).
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IRS FAQs – Decreases to Tax Basis Capital Account
i. Distributions of money to the partner;
ii. The adjusted tax basis of property distributed to the partner from the partnership, less the liabilities assumed (or to which the property is subject) in connection with the distribution;
iii. The sum of the partner’s distributive share for the taxable year and prior taxable years of partnership losses and deductions (including expenditures which are not deductible in computing partnership taxable income and which are not capital expenditures);
iv. The partner’s distributive share of the tax deductions for depletion of any partnership oil and gas property, not to exceed the partner’s share of the adjusted tax basis of that property;
v. The partner’s distributive share of the adjusted tax basis of charitable property contributions and foreign taxes paid or accrued;
vi. The amount of a partner’s individual liabilities that are assumed by the partnership, excluding liabilities assumed in connection with a contribution of property to the partnership; and
vii. The partner’s distributive share of any decrease to the tax basis of partnership property under § 734(b) or with respect to partnership property under § 743(b).
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FAQs – Example of Negative Tax Basis Capital Account
Example 1: On January 1, 2019, A and B each contribute $100 in cash to a newly formed partnership. On the same day, the partnership borrows $800 and purchases Asset X, qualified property for purposes of § 168(k), for $1,000. Assume that the partnership properly allocates the $800 liability equally to A and B under § 752. Immediately after the partnership acquires Asset X, both A and B have tax basis capital accounts of $100 and outside bases of $500 ($100 cash contributed, plus $400 share of partnership liabilities under § 752). In 2019, the partnership recognizes $1,000 of tax depreciation under § 168(k) with respect to Asset X; the partnership allocates $500 of the tax depreciation to A and $500 of the tax depreciation to B. On December 31, 2019, A and B both have tax basis capital accounts of negative $400 ($100 cash contributed, less $500 share of tax depreciation) and outside bases of zero ($100 cash contributed, plus $400 share of partnership liabilities under § 752, and less $500 of share tax depreciation).
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FAQs – Tax Capital Account Where Partner AcquiresInterest in Partnership from Another Partner
A partner that acquired its partnership interest by transfer from another partner, for example, by purchase or in a non-recognition transaction, has a tax capital account immediately after the transfer equal to the transferring partner’s tax capital account immediately before the transfer with respect to the portion of the interest transferred, except no portion of any § 743(b) basis adjustment the transferring partner may have is transferred to the partner acquiring the interest as part of the transaction.
If the partnership has a § 754 election in effect, the partnership increases or decreases the tax capital account acquired by the transferee partner by an amount equal to the positive or negative adjustment to the tax basis of partnership property under § 743(b) as a result of the transfer.
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FAQs – Safe Harbor For Determining Whether Or Not A Partner Has A Negative Tax Basis Capital Account
Partnerships may calculate a partner’s tax basis capital account by subtracting the partner’s share of partnership liabilities under § 752 from the partner’s outside basis (safe harbor approach).
If a partnership elects to use the safe harbor approach, the partnership must report the negative tax basis capital account information as equal to the excess, if any, of the partner’s share of partnership liabilities under § 752 over the partner’s outside basis.
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FAQs – Certain Partnerships Not Required to ReportNegative Tax Basis Capital Account Information
A partnership that satisfies all four of the conditions provided in question 4 on Schedule B to the Form 1065 does not have to comply with the requirement to report negative tax basis capital account information. The conditions are:
a. The partnership’s total receipts for the tax year were less than $250,000;
b. The partnership’s total assets at the end of the tax year were less than $1 million;
c. Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return; and
d. The partnership is not filing and is not required to file Schedule M-3.
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2020 Partnership Tax Returns Changes
Some draft 2019 partnership forms and instructions (Forms 1065 and 8865) required most partnerships to report all partner capital accounts on a tax basis. Predictably, there was an outcry.
In Notice 2019-66, 2019-52 IRB 1509, the IRS delayed this requirement until 2020.
The Notice indicates that further guidance on the definition of partner tax basis capital accounts will be published, and comments requested.
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Other Reporting Change – Unrecognized § 704(c) Gain/Loss
For 2019 partnership tax returns, the IRS imposed a requirement that taxpayers report the partners’ shares of unrecognized § 704(c) gain or loss. Form 1065 , Schedule K-1, Item N.
The instructions did not provide a definition of “unrecognized § 704(c) gain or loss.”
Commenters requested additional guidance, especially with respect to multiple layers of forward and reverse § 704(c) gain & loss, tiered partnerships, and partnership mergers and divisions.
Notice 2009-70, 2009 IRB 255, requested comment on these issues prior to the imposition of the reporting requirement.
Notice 2019-66, 2019-52 IRB 1509, provided a stopgap definition of “unrecognized §704(c) gain or loss” for 2019 reporting, defining it as “the partner's share of the net (net means aggregate or sum) of all unrecognized gains or losses under § 704(c) in partnership property, including § 704(c) gains and losses arising from revaluations of partnership property.”
Additional guidance is likely forthcoming.
Notice 2019-66 also clarified that this requirement will not apply to publicly-traded partnerships until further notice.
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© 2020 Smith, Gambrell & Russell, LLP, All Rights Reserved
Correcting Capital Account Errors –
Interpretation of Partnership Agreements
Joseph C. MandarinoSmith, Gambrell & Russell, LLP
Promenade II, Suite 31001230 Peachtree StreetAtlanta, Georgia 30309
www.sgrlaw.com
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Disclaimer
IRS CIRCULAR 230 DISCLOSURE:
Unless explicitly stated to the contrary, this outline, the presentation to which it relates and any other documents or attachments are not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
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Overview
• Background and Stakes
• Contractual Interpretation Issues
• Interpretation of §704(b) Capital Account
Maintenance Rules
• Interpretation of Other Tax Provisions
• Examples – Disputes and Resolutions
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Terminology
• For brevity and because of the relative popularity
of limited liability companies, these slides will
often refer to LLCs, but such term should be
understood to include general partnerships,
limited partnerships, LLPs, LLLPs, and other
entities that are taxed as partnerships for federal
income tax purposes.
• Similarly, references to operating agreements also
include partnership agreements, and references
to members also include partners.
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Interpretation of Partnership Agreements
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Background
• Most operating agreements provide for capital accounts.
• A capital account is to a member what a stock certificate is
to a shareholder – arguably the most important
representation of the member’s ownership.
• Operating agreements that provide for capital accounts also
generally provide rules for calculating the starting balance of
these accounts and adjustments based on the profits,
losses, contributions, distributions, and other events.
• In some instances, these rules repeat or cross reference the
capital account maintenance regulations under §704(b).
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Stakes – Targeted Allocations
• In some cases, members will agree on distributions and
then provided for “targeted” allocations that result in capital
account balances that are in accordance with the agreed
shares of the partnership’s assets.
• If mistakes creep into the calculation of those balances, a
member may receive allocations of income and loss that are
incorrect.
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Stakes – Tax Distributions
• In many cases, the operating agreement will provide for “tax
distributions” – cash distributions to members to pay
estimated and actual taxes.
• Often, these distributions are a function of income and loss
allocations for the current or prior year.
• If mistakes are made in the calculations of income and loss
allocations, then the tax distribution amounts may be
erroneous as well.
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Stakes – Regular Distributions
• In some cases, the members will agree on allocations and
then provide for distributions that are a function of, or are
triggered by, some metric involving these allocations.
• For example, a junior tranche of members may not be
untitled to distributions until a senior level of member
receives allocations that reach a specified dollar amount or
IRR.
• If there are mistakes in allocations, they will cascade
through to these calculations as well.
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Stakes – Proceeds on Liquidation
• In many cases, a member’s right to share in a liquidation of
the LLC is a function of the member’s capital account
balance.
• If mistakes have crept into the calculation of that balance, a
member may be over- or under-paid.
• Even if the operating agreement does not provide for
liquidation in accordance with capital account balances, the
tax code may require it – errors will have tax complications
as well.
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Contractual Interpretation Issues
• One of the most common sets of capital account mistakes
are errors that arise from interpretations of the operating
agreement.
• For simplicity, we refer to these as contractual interpretation
issues.
• In practice, there are three major areas of contractual
interpretation issues:
• yield/preferred return/IRR calculations
• flip events
• hypercomplexity
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Yield/Preferred Return/IRR
• Many operating agreements provide for different classes of members
who are entitled to different economic rights. For example, a senior
member may be entitled to a preferred return on his/her investment.
• Often, the description of that return is lacking. Problems can arise if
the parties have different views of how the calculation should be
interpreted.
• “Class A members shall be entitled to a 10% preferred return on their
capital contributions.”
• Is this a compounding return or a simple return?
• What is the basis for the return? The original investment? The
member’s capital account balance, as adjusted?
• What happens if there are insufficient funds to pay distributions?
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Yield/Preferred Return/IRR
• There are ways to avoid these problems:
• better descriptions (could refer to Excel calc functions, etc.)
• numerical examples included as exhibits
• circulating the calculation ahead of time
• requiring the LLC to include calculations to the members so that
disagreements can be flushed out ASAP.
• If problems do arise, alternative dispute resolution (“ADR”) provisions
can shield the LLC and its members from litigation sink holes:
• Interpretation differences can be resolved by arbitration, a panel
of experts, etc.
• Some agreements grant the LLC full discretion to interpret the
operating agreement.
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Flip Events
• Some operating agreements will have shifting
allocations/distributions based on certain events.
• Some of these events may be the attainment of certain
yield/preferred return/IRR goal posts, but some may be
dependent on the attainment of certain profit or revenue
targets, zoning or licensing results, financing events, or
calendar dates.
• Problems could be avoided by the use of better
descriptions.
• An additional approach is to provide regular notices of the
existence of flip events and how “close” they are.
• As above, ADR clauses will not foreclose a dispute over the
timing or existence of a flip event, but can minimize the pain
of such disputes.
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Hypercomplexity
• Particularly with large projects that involve a number of
investors with different economics, the operation of
allocations and distributions can involve many different tiers
or waterfalls, numerous flip events, and/or a significant
number of conditional or contingent allocations and
distributions.
• While any one of these provisions may be administrable, the
weight and complexity of multiple provisions can make an
operating agreement difficult to interpret.
• Particularly if there were several waves of investment, and
different deals were struck each time, the parties may not
agree on the interaction of different provisions and disputes
may arise.
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Hypercomplexity
• There may be no way to avoid hypercomplexity, especially
when there are different groups of investors who came in at
different stages and have different economic deals.
• Ways to avoid disputes in this area include better
descriptions and the inclusion of numerical examples as
exhibits.
• If problems do arise, ADR provisions can temper the time
and expense of disputes.
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Interpretation of §704(b) Capital Account Maintenance Rules
• In most operating agreements, there is a lengthy set of
rules, many of which are culled from, or refer to, the tax
regulations issued under IRC 704(b) (the capital account
maintenance rules).
• These provisions are often adopted whole scale, even if
there is no tax attorney or expert advising the LLC or its
members.
• As a result, disputes can arise because the members did
not have a good understanding of how these rules and
regulations operate.
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Capital Account Maintenance Rules
• Some common issues that come up in practice are:
• differences between GAAP and tax capital accounts
• contributions of non-negotiable notes by members
• distributions of LLC notes to members
• contributions of property subject to nonrecourse debt
• revaluations of capital accounts
• IRC §704(c) allocations
• successor capital accounts
• oil & gas depletion and related issues
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Capital Account Maintenance Rules
• How can these issues be avoided?
• With proper drafting, disputes involving the interpretation of the
capital account maintenance rules can be minimized. If compliance
with these rules is mandated in the operating agreement, there may
be are few areas of interpretational differences.
• Instead, disputes really boil does to the fact that members often didn’t
understand how these rules would operate.
• That is a different complain and one for which there may be no
remedy at law.
• Some solutions to “I-didn’t-understand-what-I-was-signing” are to
document that members were advised that the tax aspects of an
investment in an LLC are complicated and to obtain their own tax
advice.
• ADR clauses can also be helpful.
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Interpretation of Other Tax Provisions
• The remaining category of items that can give rise to
interpretational differences is a catch all.
• Many of these items do not directly drive capital account
adjustments, but can have secondary effects on income/loss
and distributions that may affect capital account balances.
• Common items are:
• operation of the minimum gain chargeback rules
• allocation of partnership liabilities
• elective and mandatory basis adjustments
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Other Tax Provisions
• It is difficult to forestall disputes over these types of
provisions.
• As with the capital account rules, in many cases the
substance of the complaint is that a member did not
understand how a specific tax provision might affect the
economics of his/her investment.
• Thus, disclaimers and ADR clauses can help to tamp this
down.
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Contractual Interpretation Example
• The balance of this section considers two examples that
involve a dispute over a preferred return clause.
• We hope to examine the consequences of the dispute and
how the parties could proceed, including settlement options.
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Example – Base Facts
• Newco has three members, A, B and C.
• A invests $1 million and is entitled to a preferred return of
10% on that amount. Once A receives her $1 million plus
the preferred return, A is entitled to a 40% interest in profits
and losses.
• B invests $200,000 and is entitled to a 40% interest in
profits and losses, subject to A’s preferred return.
• C invests no money but is given a profits interest of 20%.
• Newco invests the total of $1.2 million in a single investment
asset.
• For the first three years, Newco has losses.
• At the start of Year 4, Newco sells the investment asset for
$3 million.
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Example – Base Facts
• The allocations made by Newco for the four-year period are
as follows:
Year
total
income/loss A B C totals
1 -100,000 100,000 -133,000 -67,000 -100,000
2 -100,000 100,000 -133,000 -67,000 -100,000
3 -100,000 100,000 -133,000 -67,000 -100,000
4 2,300,000 920,000 920,000 460,000 2,300,000
2,000,000 1,220,000 521,000 259,000 2,000,000
1,000,000 purchase price
-300,000depreciation
700,000 tax basis
3,000,000 amount received
-700,000 tax basis
2,300,000 gain
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Example – Base Facts
• A argues that she is entitled to $331,000 in preferred returns
(i.e., 10% compounded annually for three years) before the
40% share kicks in.
• B and C argue that A is only entitled to $300,000 (i.e., a
10% simple return) before A’s 40% share kicks in.
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Example – Base Facts
• Under A’s interpretation, the allocations for the four-year
period should have been as follows:
Year
total
income/loss A B C totals
1 -100,000 100,000 -133,000 -67,000 -100,000
2 -110,000 110,000 -140,000 -70,000 -100,000
3 -121,000 121,000 -147,333 -73,667 -100,000
4 2,300,000 920,000 920,000 460,000 2,300,000
2,000,000 1,251,000 499,333 249,667 2,000,000
1,000,000 purchase price
-300,000 depreciation
700,000 tax basis
3,000,000 amount received
-700,000 tax basis
2,300,000 gain
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Example 1
• If there are dispute resolutions provisions in the operating
agreement, this may be resolved quickly.
• If she is not bound by such provisions, A could sue to
enforce her view of the agreement.
• Litigation would be time consuming. Even ADR could take
so long that, in the interim, Newco would have to file tax
returns and issue K-1s.
• If Newco stuck to its position, the dispute over how to
interpret A’s preferred return would transmit to the capital
accounts maintained for the members.
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Example 1
• If A were ultimately successful in ADR or litigation, Newco
and the other members might have to make up the preferred
return shortfall.
• But this could be years after Newco sells its investment
asset.
• Normally, A would be required to include the K-1 information
on her personal return.
• However, there is a procedure under which A could take an
inconsistent position, disclose it to the IRS and then
(potentially) avoid penalties.
• IRS Form 8082 (Notice of Inconsistent Treatment) is used
for this purpose.
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Example 1
• Conversely, A could report the K-1 as prepared by Newco
and proceed with ADR or litigation.
• If A were ultimately successful, A would then have two
options:
• File amended returns to correct the capital account
mistakes and other disputed items.
• Treat the litigation outcome as a separate taxable event.
• The former is more complicated and the other participants
might not go along.
• The latter can sometimes be simpler. One important
qualification is to ensure that the parties characterize the
settlement consistent with the dispute from which it arises.
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Example 1
• For example, if A prevailed in ADR or litigation and it was
determined that A should have received a preferred return of
$331,000 instead of $300,000, then A would be entitled to
$31,000 in damages plus (in many cases) interest, and (in
rarer cases) attorney fees.
• The preferred return income is likely to be characterized as
ordinary income.
• Under the Arrowsmith case, A may be required to report
these damages as ordinary.
• Characterization of judicial interest?
• Characterization of attorney fees?
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Example 2
• Same facts as Example 1, but when A brings up her claim,
B and C agree with her.
• The parties then have to fix the problem.
• After three years of errors, if A should have been allocated
more income (and, therefore, B and C allocated more loss),
there are at least two options to the parties:
• fix the capital accounts by filing amended returns, or
• fix the capital accounts with catch up allocation in the
current period.
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Example 2
• Filing amended returns can raise several issues.
• cost of new return prep
• closed tax years
• interest and penalties for retroactive allocations
• Catch-up allocations (net allocations that eliminate the
difference between the erroneous capital account balances
and what the parties agree should be the true balances) are
much simpler.
• But can the parties make catch up allocations?
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Example 2
• The allure of a catch up allocation is that amended returns
are unnecessary. Instead, the correct balances are
determined and the LLC determines the plug allocation that
will result in those balances.
• Under IRC §761(c), retroactive allocations that go back a
single year are allowed under certain circumstances:
For purposes of this subchapter, a partnership
agreement includes any modifications of the
partnership agreement made prior to, or at, the time
prescribed by law for the filing of the partnership
return for the taxable year (not including extensions)
which are agreed to by all the partners, or which are
adopted in such other manner as may be provided
by the partnership agreement.
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Example 2
• Some would read this to mean that filing amended returns
cannot be done if the “new” interpretation is in substance a
retroactive amendment of the operating agreement. Under
this view, only a catch up allocation (or possible a one-year-
back allocation) could be done.
• Conversely, if the parties agree that the new interpretation is
the correct interpretation and should have been applied in
prior years (but was not), then the filing of amended returns
does not involve the amendment of the operating
agreement but the application of the original intent of that
agreement. Accordingly, IRC §761(c) should pose no
barrier to the filing of amended returns.
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Example 2
• If IRC §761(c) does not prevent the parties from filing
amended returns or utilizing a catch-up allocation, are there
policy concerns that are implicated?
• In this example, A should have been allocated more income
and B and C should have been allocated more loss in the
three prior years.
• For B and C, the filing of amended returns that report more
loss is unlikely to cause negative ramifications. However, if
A underreported its income, the filing of amended returns
may result in penalties and interest.
• A would generally prefer a catch up allocation under these
facts.
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Example 2
• Could the IRS treat a catch up allocation as a “shifting
allocation” and thereby ignore it?
• Under Treas. Reg. §1.704-1(b)(2)(iii)(b)(1), a shifting
allocation can be disregarded if, among other things,
The total tax liability of the partners (for their respective
taxable years in which the allocations will be taken into
account) will be less than if the allocations were not
contained in the partnership agreement (taking into
account tax consequences that result from the
interaction of the allocation (or allocations) with partner
tax attributes that are unrelated to the partnership).
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Example 2
• Under our facts, A is arguing that it should have been
allocated more income in prior years. As a result, it will
recognize less gain in the year that Newco disposes of its
sole asset, and B and C would recognize more gain.
• If B and C were in lower tax brackets than A, the IRS could
argue that at the time the catch up allocation was made
there was “a strong likelihood” that the overall tax liability
would be reduced as a result of the allocation.
• This would create a presumption that the allocation was an
impermissible “shifting allocation.” The burden would fall on
the taxpayers to overcome this presumption “by a showing
of facts and circumstances that prove otherwise.”
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Example 2
• A similar analysis would apply under the test for impermissible
“transitory allocations.”
• However, it would appear from these facts that a catch up
allocation would not meet the definition of a transitory allocation. A
transitory allocation occurs is present if
a partnership agreement provides for the possibility that one or
more allocations (the “original allocation(s)”) will be largely
offset by one or more other allocations (the “offsetting
allocation(s)”) . . . .
Treas. Reg. 1.704-1(b)(2)(iii)(c).
• Note that a catch up allocation does not flip back but, instead,
charts a new course of allocations that are intended to be different
from the original allocations.
• But under different facts, this could be an issue.
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Example 2
• If the IRS raises the argument that a catch up allocation is
an impermissible shifting allocation, could the parties rebut
the presumption?
• If the interpretational dispute was sufficient clear, it is
possible that the parties could rebut the presumption.
• However, even if they could not rebut the presumption, and
the IRS prevailed, the effect of disregarding the catch up
allocation would only have an effect for tax purposes.
• That is, A would be entitled to the additional $31,000 in
preferred return, but arguably would not pay tax on it (B and
C would).
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Example 2
• The IRS is likely to worry that a faux contractual dispute
could be used to make an opportunistic change in tax
allocations.
• If the parties were motivated for tax and not economic
reasons, then the IRS might reasonably fear that the
claimed dispute was really a sham.
• But under our facts, the settlement of the dispute would
result in A actually receiving an additional $31,000, while B
and C would receive $31,000 less. That is a settlement that
has real economics and would seem to suggest that there
was an actual dispute. It is not logical that B and C would
agree to forego $31,000 in cash proceeds simply to obtain
$31,000 of tax losses.
• Key – does the settlement result in a real change in
economics?119
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Summary
• There are a number of provisions that can give rise to
disputes that affect capital account balances.
• Tighter drafting, disclaimers, and ADR clauses can help
minimize this.
• If the parties resolve matters on their own or one party
prevails in ADR or court, capital account balances can be
fixed by amending returns or a catch up allocation.
• While catch up allocations are attractive, the parties must be
aware that the IRS could disregard the allocations.
• Documenting a clear dispute, and showing that the catch up
allocations result in a real economic change will help protect
the parties.
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New Partnership Audit Rules
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Background – The TEFRA Audit Rules
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TEFRA - Background
• 1970s and 1980s saw a marked increase in the use of large partnerships, as the rise of syndicated tax shelters relied heavily on tax partnerships
• TEFRA - Tax Equity and Fiscal Responsibility Act of 1982
• Objective of TEFRA audit rules was to enhance enforcement of tax rules for larger partnerships by streamlining the partnership audit procedure through entity-level examination
• If IRS was successful under a TEFRA audit, the partnership would file amended returns and each partner was required to report the change consistently
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Pre-TEFRA Problems
• Pre-TEFRA audits required the IRS to conduct audits and control returns at the partner level
• IRS generally identified a partnership it wanted to audit, and then attacked at the partner level and audit partners
• Wholly impractical for partnerships with hundreds, and sometimes thousands of partners
• Led to inconsistent treatment of different partners from the same partnership (appeals may be in different locations, ruling law may differ, statute of limitation periods may differ between partners, etc.)
• Actual adjustment for each partner often didn’t justify resources expended to collect the additional tax
• Tiered partnerships provided additional enforcement hurdles
• Settlement with one partner did not bind any other partners, and each partner
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TEFRA – Overview
• Audits now conducted at the entity level
• Statute of limitations controlled at the entity level
• Requires consistency between partnership tax returns and returns of the partners
• Established difference between “partnership items” and “non-partnership items” for audit purposes
• Partnership Items: Items required to be taken into account for the Partnership’s taxable year to the extent such item is more appropriately determined at the partnership level than at the partner level (Code Sec. 6231)
• Non-Partnership Items: any item which is not a Partnership Item
• Certain partners permitted to participate in the partnership audit and challenge certain adjustments if not otherwise addressed by the TMP
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TEFRA – Overview
• Partnership audits are coordinated through the “Tax Matters Partner” (the “TMP”)
• Authorized to extend statutes of limitation for all partners’ partnership items
• Authorized to execute settlement agreements
• Required to keep partners informed on the audit proceeding and acts as the liaison between the IRS and the partners
• At the conclusion of an audit, adjustments are determined by the service center and can be assessed against partners without a notice of deficiency
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TEFRA – Example
• Newco is an LLC taxed as a partnership. It is formed in 2011 with 50 partners. In that year, Newco reported $5 million in depreciation deductions which it allocated to its partners.
• In 2012, the IRS audits Newco and determines that the depreciation related to a power facility that was not placed in service until 2012.
• Newco appeals the determination, but in 2013, after going through appeals, Newco agrees to the adjustment.
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TEFRA – Example
• As part of the settlement, Newco issues amended K-1s to each partner that reverses the depreciation deduction. It also issues amended 2012 K-1s, correcting the depreciation taken in that year.
• Note that, per the TEFRA rules, each partner is required to take a consistent position with these amended K-1s (or disclose that they are taking inconsistent positions).
• The IRS did not have to perform 50 separate audits to achieve this result.
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GAO Quickie Summary of TEFRA Audit Rules
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TEFRA – The Reality
• In 2014 the GAO published a report on TEFRA’s Efficiency and Effectiveness
• Found that between 2002 and 2011 number of large partnerships (i.e. having >100 partners and >$100mm in assets) increased more than 3x
• Nearly 2/3 of large partnerships had (i) more than 1,000 direct and indirect partners, (ii) six or more tiers, and (iii) reported being in the finance or insurance industry
• Inefficiency with partnership audits manifests in (i) difficulty identifying the TMP, (ii) litigating whether items are partnership items (i.e., governed by the TEFRA audit rules) or non-partnership items (i.e., not governed by the TEFRA audit rules), and (iii) logistics and costs associated with passing through adjustments to ultimate partners
• FY 2012 – IRS 0.8% of large partnerships as opposed to 27.1% of C-corporations having >$100mm in assets
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The New Rules
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New Rules -- Overview
• Enacted on November 2, 2015, as part of the Bipartisan Budget Act of 2015.
• Is effective for partnership tax years beginning after 2017.
• BUT – may be able to elect to apply new rules to earlier years.
• Repeals the TEFRA rules and creates new terms and rules for partnership audits.
• New Rules are located in Code Sections 6221 through 6241.
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New Rules – Overview
• Like TEFRA, the IRS will audit and litigate partnership items at the partnership level.
• BUT – unlike TEFRA, liability is asserted against the partnership itself at the highest applicable tax rate.
• HUGE CHANGE IN TAX LAW!!!
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Partnership Representative
• Partnership designates a Partnership Representative (the “PR”) to conduct the audit with the IRS and bind the partnership and partners.
• Generally replaces the concept of the TMP.
• Does NOT need to be a partner in the partnership.
• Must have substantial U.S. presence.
• Has sole authority to act on behalf of the partnership in an audit and bind the partnership and the partners.
• IRS will appoint a partnership representative if one is not otherwise appointed by the partnership.
• Important for GP or manager to appoint a partnership representative if only to block the IRS from picking one.
• No authority or standing by partners to participate in audits or challenge assessments.
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The Audit Rules – Consistency
135
• After the final resolution of an audit, all partners are
bound by that determination.
• Partners do not have the right to participate in a
proceeding or receive notice of the same – this is
another change from TEFRA as it shifts the burden
of keeping the partners informed from the IRS to the
partnership.
• Partners can file a notice of inconsistent position.
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The Audit Rules – Key Terms
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• “reviewed year” – the year under audit.
• “adjustment year” – the year in which the adjustment
for the reviewed year occurs.
• Can happen by settlement or court decision in
the case of an adjustment stemming from an
audit.
• Can also be the year in which an adjustment is
made because the partnership requests an
administrative adjustment (i.e., tantamount to an
amended return).
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Settlement/Payment
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• Any adjustment is assessed in the adjustment year,
not the reviewed year.
• Example: IRS audits Newco in 2020 for its 2018
tax year. In 2021, IRS proposes a net adjustment
to the 2018 tax year and Newco concedes. The
tax liability is assessed in the 2021 tax year.
• Moreover, the tax liability – the “imputed
underpayment amount” and any related penalties
and interest – are assessed against the partnership,
not the partners.
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Settlement/Payment – IUA
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• “imputed underpayment amount” (“IUA”) – the net
non-favorable adjustment to the partnership tax year,
multiplied by the highest applicable tax rates in
section 1 or 11 of the Code (currently 37%) with few
exceptions.
• Thus, for the first time, income taxes are assessed at
the entity level and not at the partner level.
• The burden to collect from partners has been shifted
from the IRS to the partnership.
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Settlement/Payment – IUA
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• Note that penalties are also determined at the
partnership level. Any partner-level defenses to
penalties are irrelevant.
• Only the partnership statute of limitations controls.
• For example, the 6-year substantial
understatement statute of limitations is
determined at the partnership level, not the
partner level.
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Settlement/Payment – IUA
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• Statute provides that the following should be taken
into account in calculating the IUA :
• if a portion of any reallocation would go to a tax-
exempt entity;
• if ordinary income amounts are allocable to a C
corporation;
• if capital gain or qualified dividends are allocable
to individuals; and
• if there are reallocations from one partner to
another that results in a decrease income/gain or
a decrease in deductions/losses/credits.
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Settlement/Payment – Returns
141
• The partners for the reviewed may file amended tax
returns reflected any partnership adjustment, and
pay the resulting tax.
• Such payments will reduce the partnerships IUA by
the amount of such taxes.
• It is unclear how this will work. Presumably, there is
no credit until the partner level taxes are paid by the
partners. Does the partnership then file an entity-
level tax refund claim?
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Partnerships Affected By New Rules
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• The new rules only apply to certain partnerships. If a
partnership qualifies, it can elect out on its tax return.
• If the election is effective, the partnership will not be
subject to the new rules and, because the TEFRA
rules are repealed for all purposes, will not be
subject to those rules either.
• Effectively, an electing out partnership can go back
to the “bad old days” when the IRS had to audit
individual partners.
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Election Out
• A partnership can elect out if it has 100 or fewer
partners.
• The total partners is determined by counting K-1s, so
clarify whether your partnership may be issuing K-1s
when unnecessary.
• Also, each shareholder of partner that is an S
corporation is included in the count.
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Election Out
• Partnerships with 100 or fewer partners, can only
elect our if all the partners are one of the following:
• an individual
• a C corporation
• a foreign C corporation
• an S corporation, or
• an estate of a deceased partner.
• If there are any other types of entities, or any
partners that are themselves taxed as partnerships
(“Upper-Tier Partnerships”), then the election out is
not permitted.
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Election Out
145
• The “Upper-Tier Partnership” limitation is so
significant that it may cause partnerships to limit who
can become a partner and to limit transfers so that
disqualifying partners cannot enter the partnership.
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Push-Out Election
• Another alternative is the so-called “push-out”
election.
• Under this approach, the partnership makes a
special election without 45 days of receiving a final
partnership administrative adjustment (“FPAA”).
• The partnership then issues “statements” (i.e.,
amended K-1s) to the partners for the reviewed year
reflecting the FPAA.
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Push-Out Election
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• But, for the reviewed year partners it is not as simple
as determined the additional tax liability in the
reviewed year and paying the tax.
• Each partner also has to take into account any tax
liabilities in the interim years as a result of the effect
of the resulting change in tax attributes in the
reviewed year.
• The sum of such liabilities, plus penalties, plus
interest in due in the year in which the statement is
issued.
• And, the interest rate is 2% points higher than
whatever interest rates would otherwise apply.
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Push-Out Election
148
• The push-out election does save the partnership
from paying entity-level taxes and places the burden
for those taxes on the reviewed year partners, which
seems fairer.
• But the interest rate increase has to be taken into
account, and the complicated tax liability calculations
that are needed.
• Even with these hurdles, it may be more equitable
(from the partnership’s perspective) to make this
election and it may be simpler than setting up an
indemnity regime to recover these amounts.
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Effect on Capital Account Mistakes
• Generally, a mere correction of a capital account will not trigger the
new audit rules – only if the resolution of the error triggers changes in
amounts allocated or distributed to the partners.
• In some of our examples, the resolution affects specific partners, but
does not result in a change in total income.
• Even in that case, the nature of the partner receiving the allocation
matters.
• This could be the case if income or loss is shifted between a
taxable partner and a tax-exempt partner.
• This could also occur if capital gain or loss is shifted between a
corporate partner and an individual partner.
• Any of these types of shifts could result in an imputed underpayment
amount.
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Effect on Capital Account Mistakes
• Assuming the resolution of an error would give rise to an imputed
underpayment amount, the next step is to consider the entity-level tax
effects.
• As noted, an IUA will generally result in an entity level tax that is born
by the partners in the year of adjustment, not in the year from which
the error arose.
• In that instance, the parties may decide to make the push out election
to tag the IUA to the relevant partners, even though that would result
in a higher underpayment interest rate.
• Because of these complexities, it would appear much simpler to avoid
several of these issues by making a catch-up election in the year of
settlement. Presumably, this would avoid having to navigate the new
audit rules altogether.
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Effect on Capital Account Mistakes
• If an error has short-changed a departed partner,
however, then it would seem to be impossible to easily
resolve the matter.
• One solution would be to re-admit the partner for a single
year in order to make a catch up allocation. However,
this would invite scrutiny under the shifting and transitory
allocation rules.
• Another approach, specific to the departed partner
problem, is to have the partnership pay a settlement
amount to the former partner, the cost of which would
could be specially allocated among the remaining
partners in the current year to take account of which
partners should properly bear the expense.151
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Effect on Capital Account Mistakes
• While many issues will turn on the application and
interpretation of regulations, the impact of the new
audit rules is likely to make it even more difficult to
resolve capital account mistakes.
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THANK YOU
Joseph C. MandarinoSmith, Gambrell & Russell, LLP
Promenade II, Suite 31001230 Peachtree StreetAtlanta, Georgia 30309
www.sgrlaw.com
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