IRS Issues Proposed Regulations on Centralized Partnership Audit Regime
The IRS has issued proposed regulations on the new centralized partnership audit regime, which went into effect last month. The new proposed regulations would provide guidance on how partnerships and their partners adjust tax attributes to take into account partnership adjustments under the new regime. The regulations also would provide guidance in a number of areas that were “reserved” in proposed regulations issued in June 2017 and would make a number of amendments to those regulations.

The proposed regulations provide rules that would govern a partnership adjustment that is taken into account in the determination of the imputed underpayment, including rules for adjusting partnership asset basis and book value, rules for the creation of “notional” items (referred to as such because their sole purpose is to affect partner-level specified tax attributes, and thus they are not considered to be items for purposes of adjusting other tax attributes), rules for allocating these notional items under Section 704(b) (section references are to the Internal Revenue Code of 1986, as amended (the Code)), and successor rules for situations in which reviewed-year partners are not adjustment-year partners. The proposed regulations also provide rules for the allocation of any partnership expenditure related to the imputed underpayment, as well as guidance in the case of a partnership adjustment that does not give rise to an imputed underpayment.

Highlights of the proposed regulations include:

• Adjustments where partnership adjustment results in imputed underpayment. Under the proposed regulations, when there is a partnership adjustment, the partnership and its adjustment-year partners generally would be required to adjust their “specified tax attributes.” Specified tax attributes are the tax basis and book value of a partnership’s property, amounts determined under Section 704(c) (generally, allocations by a partnership of income, gain, loss and deductions for property contributed by a partner to take into account variations between the property’s adjusted tax basis and its fair market value at the time of contribution), adjustment-year partners’ bases in their partnership interests, and adjustment-year partners’ capital accounts determined and maintained in accordance with Treasury Regulation Section 1.704-1(b)(2).
  
  In the case of a partnership adjustment that results in an imputed underpayment, the adjustments to specified tax attributes would need to be made on a partnership-adjustment-by-partnership-adjustment basis (i.e., without regard to their summation as part of the determination of the total netted partnership adjustment).

• Adjustment of specified tax attributes. A partnership would be required to first make appropriate adjustments to the book value and basis of property to take into account any partnership adjustment. Amounts determined under Section 704(c) also would have to be adjusted to take into account the partnership adjustment, but would require no adjustments of the book value or basis of partnership property with respect to property that was held by the partnership in the reviewed year but is no longer held by the partnership in the adjustment year.
  
  Under Proposed Regulation Section 301.6225-4(b)(3), notional items would then be created with respect to the partnership adjustment, and these notional items would be allocated according to the rules described below. In the case of a partnership adjustment that is an increase in income or gain, a notional item of income or gain would be created in an amount equal to the partnership adjustment. Similar rules would apply in the case of a partnership adjustment that is an increase of an expense or a loss. In the case of a partnership adjustment that is a decrease of income or gain, however, a notional item of expense or loss would be created in an amount equal to the partnership adjustment, with similar rules applying in the case of a partnership adjustment that is a decrease of an expense or a loss.
  
  Based on the preamble to the regulations, these rules would have the effect of reversing the reviewed-year allocation to the extent necessary to reflect the partnership adjustment (i.e., an adjustment-year partner would increase its outside basis for notional income that is allocated to it, and a partnership that determines and maintains capital accounts would adjust capital accounts for notional items). There are also a limited number of situations under the proposed regulations where notional items are allocated to a partner but a corresponding basis adjustment is disallowed, including situations involving transfers of a partnership interest from a tax-exempt partner to a taxable partner.
  
  For certain types of partnership adjustments (e.g., ones that do not derive from items that would have been allocated in the reviewed year under Section 704(b)), notional items would not be created, but specified tax attributes would nonetheless be adjusted for the partnership and its reviewed-year partners (or their successors) in a manner consistent with how the partnership adjustment would have been taken into account under the partnership agreement in effect for the reviewed year.

• Allocation of notional items. Under the proposed regulations, the allocation of a notional item would not have substantial economic effect, but it would be deemed to be in accordance with the partners’ interests in the partnership if it were made in the manner in which the corresponding actual item would have been allocated in the reviewed year under the Section 704 regulations. Additionally, the allocation of a notional item of expense or loss or a notional item of income or gain must be allocated to the reviewed-year partners that were originally allocated that excess item in the reviewed year (or their successors, which are treated as reviewed-year partners under the proposed regulations).

• Successors. A reviewed-year partner’s successor generally would be defined either as a transferee that succeeds to the transferor partner’s capital account under Proposed Regulation Section 1.704-1(b)(2)(iv)(1) or, in the case of a complete liquidation of a partner’s interest, as the remaining partners to the extent their interests increased as a result of the liquidated partner’s departure. The proposed regulations also modify the June 2017 proposed regulations to provide that if a partnership cannot determine the transferee for a partnership interest under Proposed Regulation Section 1.704-1(b)(1)(viii)(b)(2), the successor is deemed to be those partners in the adjustment year that were not also partners in the reviewed year or otherwise identifiable as successors to reviewed-year partners, in proportion to their respective interests in the partnership.

• Accounting and allocation of certain expenditures. A partnership’s expenditure arising from an imputed underpayment would be taken into account by the partnership and its partners under the rules at Proposed Regulation Section 301.6225-4(c). The expenditure would be allocated under Section 704(b) and its regulations. The IRS noted, in the preamble to the proposed regulations, that under existing rules, a partnership’s payment of an imputed underpayment under Section 6225 has the effect of converting what would have been a nondeductible partner-level expenditure into a nondeductible partnership-level expenditure. The proposed regulations provide that allocation of the nondeductible expenditure would be considered “substantial” only if the partnership allocates it in proportion to the notional item to which it relates.
  
  The proposed regulations also would provide that in order for an allocation of an expenditure for interest, penalties, additions to tax or additional amounts as determined under Section 6233 to be substantial, it would have to be allocated to the reviewed-year partner in proportion to the allocation of the related imputed underpayment, the related payment made by a pass-through partner under Proposed Regulation Section 301.622-3(e)(4) or the related notional item to which it relates (whichever is appropriate), taking into account modifications under Proposed Regulation Section 301.6225-2 attributable to that partner.

• Adjustments that do not result in imputed underpayments. Proposed Regulation Section 1.704-1(b)(4)(xii) expands upon the June 2017 proposed regulations to provide that an allocation of an item arising from a partnership adjustment that does not result in an imputed underpayment, as defined in Proposed Regulation Section 301.6225-1(c)(2), would not have substantial economic effect, but it would be deemed to be in accordance with the partners’ interests in the partnership if it were allocated in the manner in which the item would have been allocated in the reviewed year under the Section 704 regulations, taking into account the successor rules, described above.

• “Pushed-out” items. The proposed regulations would provide that the reviewed-year partners or affected partners, as described in Proposed Regulation Section 301.6226-3(e)(3)(i), must take into account items of income, gain, loss, deduction or credit with respect to their share of the partnership adjustments as contained in the statements described in Proposed Regulation Section 301.6226-2 (pushed-out items) in the reporting year, as defined in Proposed Regulation Section 301.6226-3(a). Similarly, partnerships would adjust tax attributes affected by reason of a pushed-out item in the reviewed year. In the case of a reviewed-year partner that disposed of its partnership interest prior to the reporting year, that partner would be able to take into account any outside basis adjustment under the proposed regulations in an amended return to the extent otherwise allowable under the Code.
  
  An allocation of a pushed-out item would not have substantial economic effect under Section 704(b)(2), but it would be deemed to be in accordance with the partners’ interests in the partnership if certain requirements were satisfied.

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