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

[email protected]

Joseph C. Mandarino, Partner

Smith Gambrell & Russell

[email protected]

Jellia Dai, Manager

Ernst & Young

[email protected]

Notice

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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.

► Overview

► Capital Account Maintenance and Adjustments

► CARES Act Brief

Jellia Dai,

EY

Introduction to Partnership Capital Accounts

Overview

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.

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.

Capital Accounts Tracking

contributions income

ending

capitaldistributions loss

+ +

- -=beginning

capital

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

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

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

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

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

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


► 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


► 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


► 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

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)

Capital Account Maintenance and Adjustments

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.

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).

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.

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.

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.

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.

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.


► 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.


► 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


► 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.


► 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

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

CARES Act

CARES Act agenda

► Net operating loss (NOL) relief

► NOL carryback implications

► Section 163(j)–business interest deductions

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).

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.

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


► ($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


► FTC = $0


► ($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

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)

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

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.

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)).

TEFRA vs. BBA

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.

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)).

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).

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).

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.”).

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

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).

“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).

“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.

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.

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.

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).

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.

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.

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).

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?

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.

§ 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.

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).

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.

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.

Reporting Tax Basis Capital Accounts

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.

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.

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.

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.

https://www.irs.gov/businesses/partnerships/form-1065-frequently-asked-questions

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).

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).

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).

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.

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.

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.

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.

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.

© 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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http://www.seblaw.com/


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.

100


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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• 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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• 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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• 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

105


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.

106


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.

107


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.

108


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.

112


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.

113


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).

115


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.”

116


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.

117


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).

118


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


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.

120


New Partnership Audit Rules

121


Background – The TEFRA Audit Rules

122


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

123


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

124


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

125


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

126


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.

127


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.

128


GAO Quickie Summary of TEFRA Audit Rules

129


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

130


The New Rules

131


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.

132


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!!!

133


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.

134


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.


The Audit Rules – Key Terms

136

• “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).


Settlement/Payment

137

• 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.


Settlement/Payment – IUA

138

• “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.



139

• 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.



140

• 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.


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?


Partnerships Affected By New Rules

142

• 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.


143

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.


144

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.


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.


146

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.


Push-Out Election

147

• 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.


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.


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.

149



• 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.

150



• 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



• 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.

152


THANK YOU

Joseph C. MandarinoSmith, Gambrell & Russell, LLP

Promenade II, Suite 31001230 Peachtree StreetAtlanta, Georgia 30309

www.sgrlaw.com

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