The centralized partnership audit regime (CPAR) revolutionized how the IRS examines most Forms 1065, U.S. Return of Partnership Income. As a consequence to CPAR’s dramatic changes, most partnerships are unable to amend Form 1065; instead, they will now “amend” Form 1065 via an administrative adjustment request (AAR). Possibly the most critical concept in CPAR is the imputed underpayment (IU). The IU is a partnership-level income tax for any positive adjustments (e.g., increases to income, decreases to expenses, decreases to credits) to Form 1065. To the extent the partnership does not wish to pay the IU, there is a complex system to push the positive adjustments to the partners. Prior to CPAR, the IRS was responsible for administering any adjustments made to a Form 1065. CPAR essentially shifts this burden to partnerships and their advisors..
CPAR was created in 2015 via the Bipartisan Budget Act (BBA). The BBA dictated that CPAR was first mandatory for the 2018 Form 1065. Essentially, this meant the IRS would implement CPAR in 2020, which is when 2018 Forms 1065 would be examined and amended. However, the Coronavirus Aid, Relief and Economic Security (CARES) Act further delayed the implementation of the CPAR rules for AARs. Moreover, the IRS opened little to no new examinations during the pandemic. Functionally, the pandemic further delayed the implementation of CPAR until 2022. What follows are four takeaways from 2022, our first full CPAR year.
Partners in a CPAR partnership are (finally) beginning to receive push-out statements, i.e., IRS Form 8986, Partner’s Share of Adjustment(s) to Partnership-Related Item(s). If a pass-through partner receives a Form 8986 that reports positive adjustments, the pass-through partner can either (a) pay an imputed underpayment or (b) push the positive adjustments to its owners. These options apply equally to S corporations and non-CPAR partnerships. A pass-through partner’s failure to make the push-out election by the extended due date of the AAR partnership’s return will result in an IU assessment against the pass-through partner. Non-pass-through partners, on the other hand, must report the contents of the pushout statement on the income tax return for the year in which they receive a push-out statement.
For example, Partnership A files a 2020 AAR in 2022. Partner B, an individual, reports the adjustments on the push-out statement via the 2022 Form 1040. Partner C, an S corporation, has the option to push out any positive adjustments or simply pay the IU.
Negative adjustments (e.g., decreases to income, increases to expenses and increases to credits) may create nonrefundable credits that a partner cannot carry into subsequent years. As such, CPAR partnerships should exercise caution before filing AARs to report negative adjustments. In an AAR setting, a partnership must push out negative adjustments to its partners. Those partners will report the Form 8986 on the income tax return for the year in which the Form 8986 is received. CPAR essentially requires partners to prepare a “dummy” income tax return for the year the Form 8986 relates to and then claim any resulting credit based on any difference tax for the year in which the Form 8986 relates.
For example, Partnership A files a 2020 AAR during 2022 to report negative adjustments. Presume Partner B paid $100 of income tax with the 2020 Form 1040. Further, Partner B has a net operating loss on the 2022 Form 1040. Partner B will report the contents of the push-out statement via a 2022 Form 8978, Partner’s Additional Reporting Year Tax. The Form 8978 will produce a credit for Partner B in 2022. However, because Partner B has a 2022 NOL, Partner B cannot use the credit because there is no tax for the credit to offset and the credit does not carry forward.
If the above-described “Doomsday Scenario” applies, a partnership and its partners should consider various planning options. The partnership could accelerate 2022 income (so its partners can absorb the 2022 credit). The partners can also accelerate 2022 income. Finally, the partnership could also consider filing its AAR in 2023, hoping that the Doomsday Scenario would not apply at the partner level.
When Congress passed the BBA, the consensus was that IUs were unhelpful for taxpayers because taxpayers calculate the IU by multiplying any positive adjustments by the highest marginal tax rate in effect. The IU generally does not account for the actual impact an adjustment would have at the partner level. Thus, in most cases, it is prudent to file push-out statements and administer adjustments at the partner level.
However, there are cases in which the IU can be helpful. Consider, for example, partnerships with complex tiered structures. For relatively small positive adjustments, the professional fees to administer the push-out statements plus the public relations downside of amending Schedules K-1 may outweigh the cost of the IU. Moreover, the partnership can modify the IU in certain circumstances. The so-called modification procedures allow CPAR partnerships to account for adjustments that would be subject to capital gains tax rates. Likewise, the modifications procedures can account for tax-exempt partners or C corporation partners that have a lower tax rate than the highest marginal tax rate. Given the right fact pattern, an IU can be a simplified procedure to adjust a Form 1065.
In an IRS examination, the partnership representative (PR) has unilateral power to make all decisions. Under the prior examination regime (i.e., TEFRA), the IRS was required to provide notices and appeal rights to various partners. Now, the PR is solely responsible for negotiating penalties and conducting the exam with the IRS; there is no opportunity for other partners to participate in the examination proceedings. As such, partnerships should exercise caution when selecting the PR. The PR does not have to be a partner in the partnership. Baker Tilly’s experience has been that the PR is an important designation in IRS examinations. Failure to select a diligent PR will result in the IRS selecting a PR for the partnership.
CPAR remains in its infancy. Taxpayers, practitioners and the IRS are all still wrestling with the new processes to adjust partnership tax returns. We anticipate administrative and judicial developments in the coming years. In the meantime, it is prudent to consult with tax professionals for CPAR examinations and AARs.
For more information on this topic, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.