By Phil Jelsma
The IRS's proposed regulations on the new centralized audit regime are looming -- and have many people scratching their heads in uncertainty about the ramifications.
Under the new regime which is effective January 1, 2018, adjustments and underpayments are calculated at the partnership or LLC level instead of the partner or member level.
Our first piece provided an overview of these rules, while part two described who could elect out of these rules. This week we focus on how the adjustments are actually made at the partnership or LLC level.
Under the new rules, any adjustment to income, gain, loss, deduction or credit of a partnership or LLC or any adjustment to a partner's or member's distributable share of income, gain, loss, deduction or credit is determined at the partnership or LLC level.
If the adjustment results in an underpayment of tax, the partnership or LLC is required to pay the imputed underpayment in the year of the adjustment.
In general, there are four groups of adjustments:
Reallocations Grouping - adjustments that reallocate income, gain or deductions among the partners or members.
Credit Grouping - adjustments to tax credits that are claimed or could be claimed.
Creditable Expenditure Grouping - adjustments to creditable expenditures.
Residual Grouping - all remaining adjustments.
An imputed underpayment is determined by netting out all adjustments within a group and multiplying the net positive adjustment by the highest rate of federal income tax applicable to either corporations or individuals who are in effect for the reviewed year.
A net negative adjustment in one group does not reduce the net positive adjustments in another group. This will lead many partnerships and LLCs to push out the adjustments to their owners where net negative adjustments can offset positive adjustments.
An imputed underpayment may be modified with the IRS's approval after it issues a Notice of Proposed Partnership Adjustment ("NOPPA").
These modification procedures provide if one or more partners or members file amended returns -- the returns must take into account all adjustments made by the IRS that are properly allocable to such partners or members, and the payment of any tax due must be included with the amended returns.
In the case of an adjustment that reallocates a distributive item from one partner or member to another, the modification will only apply if amended returns are filed by all partners or members affected by the adjustment.
The modification will also be determined with respect to the portion that the partnership or LLC demonstrates is allocable to a partner or member who would not owe any tax as a result of its status as a tax exempt entity.
In addition, the modifications will provide for a lower rate if the partner or member is an individual and the income is either a capital gain or a qualified dividend income which may be taxed at a 15% or 20% tax rate. For this purpose, an S corporation is treated as an individual.
In some instances, the IRS may calculate an imputed underpayment to a group of partners or members.
Generally, a modification must be requested within 270 days of issue of the NOPPA. The request must be made by the partnership's representative.
When requesting the modification, the partnership or LLC is required to substantiate the facts supporting its request and may be required to provide information on any upper tier or indirect partners or members.
The partnership or LLC is able to request an extension of the 270-day period if the partnership and the IRS agree to waive the 270 day requirement.
When viewing a modification the IRS may consider amended returns, the status of a tax-exempt partner, a lower rate of tax than the highest applicable rate and utilization of passive losses in publicly traded partnerships. If the IRS does not approve a modification, there is no recourse or appeal right.
There is a certain "heads I win, tails you lose" element to these new regulations. Net positive adjustments result in a tax liability at the highest marginal rate. Net negative adjustments are ignored.
As a result, most partnerships and LLCs will either elect out of these previouisly discussed rules -- if possible -- or push the adjustments out to the owners. Next week, we will discuss the push out elections which transfers the adjustments to the partners or members.
Phil Jelsma is a partner and chair of the tax practice team at Crosbie Gliner Schiffman Southard & Swanson LLC (CGS3), a San Diego-based commercial real estate law firm with offices in Los Angeles. Phil Jelsma is recognized as a leading joint venture and tax attorney, with a 30-year background in real estate exchange transactions, syndications, nonprofit corporations and international tax planning.