BBA, Partnerships and Schedule UTP

We welcome back Monte Jackel, Of Counsel at Leo Berwick. Since 2010, Schedule UTP has been used by certain corporations to report uncertain tax positions. In today’s post Monte discusses whether the BBA centralized audit partnership regime supports mandating Schedule UTP for partnerships. Monte discusses the history why partnerships were not originally required to furnish the form, as well as whether BBA subjects partnerships to additional financial reporting, and the current AICPA position on the latter issue. Les

For over a decade now, Schedule UTP has been mandated for corporations with $10 Million or more in assets and who maintain an audited financial statement and has one or more disclosable tax positions. See Schedule UTP Instructions. When initially issued a decade or so ago, the IRS indicated that similar reporting may be required of partnerships in the future. However, corporations with the requisite assets and financial statements who were partners in a partnership from which the return position arose were required to disclose that partnership position on the schedule as originally issued. 

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About a year or so later, it was reported that IRS Chief Counsel Wilkins had decided not to extend the schedule reporting to partnerships (See Jeremiah Coder, IRS Not Considering UTP Reporting for Passthroughs, Wilkins Says, 41 Ins. Tax Rev. 16, July 1, 2011, Wilkins Tax Notes Story) because, as the story quotes the former Chief Counsel, “the UTP reporting process relies heavily on the reporting that financial accounting rules already require of entities, Wilkins said. Thus, unless the accounting literature changes, the UTP reporting technique really doesn’t address positions that might exist in passthroughs, he said….For now the UTP reporting approach ‘does not fit that well with passthroughs as the accounting practices exist today,’ IRS Chief Counsel William J. Wilkins said.” 

ASC 740 applies only to business entities subject to income taxes. (See Alistair M. Nevius, Journal of Accountancy, June 1, 2011, ASC 740 excerpt.) If that is the case, then those entities would be subject to the financial accounting rules and maintain a financial statement. 

When the centralized audit partnership regime came into being in 2015, the question became whether partnerships subject to these new audit rules would now be subject to ASC 740 because the default position for partnerships subject to these new audit rules was that the partnership would pay an imputed underpayment (section 6225). This could then make those partnerships subject to federal income tax and subject to the accounting rules, and then perhaps the rationale for not subjecting partnerships to schedule UTP would no longer exist. Partnership reporting on Schedule UTP would presumably then help the selection of partnership tax returns for audit by the IRS, which has been one of their stated public goals. 

The potential impact of the centralized partnership audit regime on financial accounting was addressed by the AICPA in March 2018 (See AICPA Technical Practice Aids, TIS section 7200.09). In the case of partnerships subject to this centralized audit system, the question presented was whether the imputed underpayment that could be paid by the partnership was a federal tax imposed on the partnership directly in its taxpayer capacity or, alternatively, whether the tax underpayment is being made on behalf of the partners. If the former, the ASC 740 rules would apply and mandating a schedule UTP for partnerships could then make more sense. If not, then those financial reporting rules would not apply and schedule UTP reporting arguably should not then be extended to partnerships. 

In the public announcement issued by the AICPA, it was stated: 

“How should a partnership account for amounts it pays to the IRS for previous underpayments of tax, interest, and penalties? Said another way, does the underpayment represent an income tax of the partnership or the partners? 

“Reply — In accordance with paragraphs 226–229 of FASB ASC 740-10-55, if income taxes paid by the entity are attributable to the entity, they should be accounted for under the FASB ASC 740, Income Taxes, accounting model. If, however, the income taxes paid by the entity are attributable to the owners, they should be accounted for as a transaction with the owners….In the case of the IRS partnership audit regime, the collection of tax from the partnership is merely an administrative convenience on the part of the government to collect the underpayment of income taxes from the partners in previous periods. Accordingly, the income taxes on partnership income, regardless of when paid, should continue to be attributed to the partners and, therefore, the partnership would not apply the FASB ASC 740 accounting model to account for amounts it pays to the IRS for previous underpayments of tax, interest, and penalties. Rather, a payment made by the partnership under the IRS partnership audit regime should be treated as a distribution from the partnership to the partners in the financial statements of the partnership.”

Is this statement of position by the AICPA correct? Section 6221(a) of the Internal Revenue Code states in part that any tax attributable to an adjustment by the IRS of a partnership-related item shall be assessed and collected at the partnership level. And section 6225(a)(1) states that if there is such an adjustment, the partnership shall pay an amount equal to the imputed underpayment. The regulations at reg. §301.6221(a)-1(a) reaffirm this by stating that any such tax under chapter 1 of the Internal Revenue Code shall be assessed and collected at the partnership level. However, section 701 of the  Internal Revenue Code states clearly that “a partnership as such shall not be subject to the income tax imposed by [chapter 1]”, and this provision was not amended when the 2015 centralized partnership audit regime was enacted into law. 

Whether the imputed underpayment is indeed a tax imposed on the partnership and not on behalf of its partners is an important question. However, if the financial accounting treatment will determine any action by the IRS in extending Schedule UTP to partnerships, should it otherwise decide to do so, then the financial accounting treatment would be driving the federal income tax treatment and that does not seem appropriate. 

The centralized audit regime is so focused on partnership level adjustments and related matters that if applying schedule UTP to partnerships is determined to otherwise be a good idea, it should not be tied to the financial accounting treatment. 

Would extending schedule UTP to partnerships be a good idea? What has the experience been over the past decade or so on corporate reporting? It would seem that if partnership audits are going to be treated more seriously today, these reporting questions should be addressed and resolved. 

Disguised Sales to Partnerships, BBA Centralized Audits and Due Process

Returning to look at the BBA regime, Monte Jackel examines final BBA regulations and issues relating to a partner’s gain on a disguised sale with a partnership. Les

The final BBA regulations reflect that “partnership-related items” are the items that are subject to the uniform centralized partnership audit regime. (T.D. 9844; Reg.§301.6241-1(a)(6)(ii)-vi)). These “partnership-related items” are those shown or reflected, or required to be shown or reflected, on a partnership income tax return (form 1065), or is otherwise required to be maintained in the partnership’s books and records. On the other hand, an item shown or required to be shown on an income tax return of a person other than the partnership that results from the application of the Internal Revenue Code to a partnership-related item based upon the other person’s specific facts and circumstances, including an incorrect application of the Code or taking into account erroneous facts and circumstances of that person, is not a partnership-related item.

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On the surface, the distinction between non-partnership related items and partnership- related items seems clear in most cases. Examples 1 and 2 under reg. §301.6241-1(a)(6)(vi) are the most helpful in this regard. Example 1 stands for the proposition that even though an income producing event occurs between a non-partner person and the partnership, only the deduction or expense relating to the transaction, and not the income of the other person from the very same transaction, is a partnership-related item. Similarly, example 2 involves a purported loan to the partnership by a non-partner person whereby it is stated that although the treatment of the purported loan on the partnership’s return, which presumably includes whether it is debt or equity and related interest expense, is a partnership-related item, the treatment of the purported loan in the hands of the other person, which also presumably includes a debt versus equity determination, is not a partnership-related item. Further, that appears to be the case if the persons in examples 1 and 2 were instead partners of the transferee partnership. For example, if there was a disguised sale under reg. §1.707-3, the tax effects of a purchase must clearly be reported on the partnership return but the sales gain would apparently only be reported on the partner’s separate form 1040. 

Even though the very same transaction with the same parties is involved on both sides of the transaction, the final regulations push strongly in the direction noted immediately above, although it would have been very useful if alternative facts under examples 1 and 2 had tested the results if the other person had been a partner instead. 

In both examples 1 and 2, the other person is clearly not identified as a partner in the partnership at issue. If that were otherwise the case, section 6222 would generally require the partner to follow the partnership’s treatment of the item. The most pertinent example of the case where the other person is in fact a partner, for purposes of this commentary, is a disguised sale by the partner to the partnership under section 707(a)(2)(B) and reg. §1.707-3. (It should be noted as an aside that the only significant set of BBA audit regulations that are still in proposed form are those relating to attribute adjustments under sections 704, 705, 706, 6225, and 6226, REG-118067-17, Feb. 2, 2018). 

The regulations are also unclear, and this relates to the main point at issue in this commentary, as to whether the computation of the imputed underpayment (IU) includes the sales gain that the partner will incur if it is determined in a partnership proceeding that a sale and purchase occurred under section 707(a)(2)(B) and its underlying regulations. 

As a technical matter, in computing an IU, there is first a determination of whether there is a “partnership adjustment” which is any adjustment to a partnership-related item. (Reg. §§301.6241-1(a)(6)(i), 301.6225-1(a)(1), 301.6225-1(b)). Thus, unless the item is a “partnership-related item”, it will not enter into the computation of an IU. 

Similarly, if an election is made under section 6226 to push out a partnership adjustment that is part of an IU, there first needs to be a determination of whether the item is a partnership-related item. 

For these reasons, it is critical to understand whether, in the case of partner-partnership transactions, the item attributable to the partner side of the transaction is a partnership-related item and a partnership adjustment. Given the fact that the proposed regulations specifically listed disguised sales and related items as partnership-related items (prop. reg. §301.6241-6(b)(5)) and the final regulations do not include that language but contain instead the “reportable on the partnership return” or “reportable on the other person’s return” standard, the apparent answer is that the partner sale gain on a disguised sale with a partnership will not be part of the computation of an IU.  

The preamble to T.D. 9844 is confusing and circular in how it describes what is a partnership-related item in these types of cases, particularly when there is a transaction between a partner and the partnership. It states, in pertinent part:

“[The proposed regulations] provided as an example of an “item of income, gain, loss, deduction, or credit” any items related to transactions between a partnership and any person including disguised sales, guaranteed payments, section 704(c) allocations, and transactions to which section 707 applies….One comment suggested that this provision inappropriately included partner items such as a disguised fee under section 707(a)(2)(A) and the gain or loss a partner may realize from a disguised sale under section 707(a)(2)(B). … Similarly, another comment expressed concern about situations where a partner was not acting in the partner’s capacity as a partner, but rather as a counterparty to a transaction with the partnership. …. These comments are addressed by the final regulations …regarding the definition of partnership-related item. …[T]he final regulations clarify that items or amounts relating to transactions of the partnership are items or amounts with respect to the partnership only if those items or amounts are shown, or required to be shown, on the partnership return or are required to be maintained in the partnership’s books and records. The final regulations further clarify that items or amounts shown, or required to be shown, on a return of a person other than the partnership (or in that person’s books and records) that result after application of the Code to a partnership-related item and that take into account the facts and circumstances specific to that person are not partnership-related items and, therefore, are not determined at the partnership level under the centralized partnership audit regime. ….”

There are a number of issues with how this particular provision (partnership-related item) is defined and the explanation given for it in the final regulation preamble as it relates to transactions between a partner and a partnership where the partner is acting in a partner capacity and, thus, the transaction is not governed by section 707(a)(1) (partner acting in non-partner capacity). In that latter case, the final regulation is worded properly because unless either res judicata or collateral estoppel apply to the other non-partner person, the determination at the partnership level has nothing to do with how the other person reports the transaction, which can be inconsistent with how the partnership treats it because that other person is not a partner.  An assessment of tax at the partnership level will have absolutely no effect on the assessment of tax of that other person in that case.

A transaction between a partner and the partnership invokes, first, section 6222 which generally requires the partner to report the transaction consistently with how the partnership reports it. Thus, if the partnership treats a contribution of built-in gain property to it as a purchase because it is determined to be a disguised sale under reg.§1.707-3, then the partner must also treat the transaction as a purchase by the partnership absent timely notice of inconsistent treatment by the partner. 

This would seem to mean that since the same factors are taken into account in determining whether there is a sale and a purchase under reg. §1.707-3(b)(1) and 1.707-3(b)(2), it would be difficult for a partner who files an inconsistent treatment statement under section 6222(c) to sustain a position that there is no sale by him even though the partnership either reports or is required to report that a purchase occurred as part of a partnership level proceeding. 

If the issue of whether the partner sold property to a partnership is determined first before the partnership level proceeding, section 6222(d) states that if the partnership was not a party to the partner proceeding then the partner determination is not binding on the partnership. Although such a determination is not technically binding on the partnership, it is difficult to see how a later separate partnership level proceeding based on the same facts with the same parties could lead to a different result but that is not discussed or explained in any set of BBA audit regulations. 

However, the reverse is not true. Thus, section 6222 does not prohibit a proceeding at the partnership level from binding the partner in a partner level proceeding relating to the same transaction with the same facts. It would seem that any partnership level proceeding as to whether there was a sale would bind the partner as well under common law rules given that the same prime legal issue (whether there was a sale) and the same facts as well as the same parties are involved. Section 6223(b) says as much by stating that “A partnership and all partners of such partnership shall be bound (1) by actions taken …by the partnership, and (2) by any final decision in a proceeding …with respect to the partnership.” See, also, reg. §301.6223-2(a). 

Now, for the “due process of law” question left unaddressed in the regulations. Assume, as it appears is most likely the case as discussed above, that the gain portion of the disguised sale is not a partnership-related item but only the purchase side of the transaction is a partnership related item. (If the sales gain was part of the computation of the IU, the liability for tax under section 6225 would then be shared by all adjustment year partners and would not be limited to the selling partner only. If, on the other hand, the push-out election is made under section 6226 in that case, then the partners with whom the partnership-related adjustment “is associated” will be required to include the amount in income. That push-out may allocate all of the sales gain to the seller although the regulations do not address that issue either). 

Left unresolved by the regulations, and here I think lies the due process question in a nutshell, is whether the selling partner may still contest in a separate proceeding whether he owes tax on the now determined (by the partnership) disguised sale to the partnership. It seems that the legal issue involved (sale versus contribution) will be resolved by how the partnership treats the transaction or is required to treat the transaction in a partnership level proceeding. And section 6222(b) seems to allow for immediate assessment as a mathematical error the inconsistent treatment by the partner as a non-sale if the partnership treats the transaction as a purchase and the partner does not file a notice of inconsistent treatment. And even if the partner does file a notice of inconsistent treatment, it is not clear whether the doctrines of collateral estoppel or res judicata or other common law doctrine will apply to prevent the selling partner from relitigating the question in a separate court proceeding.

But this is not all there is to the question. Only the partnership representative can represent the partnership in a proceeding with the IRS regardless of the limitations on the representative’s power in the partnership agreement. This seems to mean that the selling partner, if he is not the partnership representative, can be forced solely to pay tax on a transaction, the sale, without the partner’s participation in the IRS proceeding with the partnership. If the partnership proceeding occurs first, can inconsistent treatment by the partner result in an immediate math error assessment? If a notice of inconsistent treatment is given, is the prior partnership proceeding legally binding so that no challenge to the merits can occur anyway in the separate partnership proceeding? And, is this a violation of due process by the government taking property from the partner without any rights by the partner to contest or challenge the partnership proceeding?

The answer to this question is not clear. On the one hand, the partner has agreed to enter into the partnership and will be charged with the knowledge that the partnership representative is the sole party representing the partnership with the IRS. Thus, it may be argued, the partner has given his consent to the consequences of not being able to participate in his own audit in this kind of case. On the other hand, are the terms of the statute and regulations sufficient to override fundamental notions of no taking of property by either the federal government or the states “without due process of law” as set forth by the Fifth and Fourteenth amendments to the U.S. Constitution? 

It should be noted that the regulations could most likely have eliminated this issue by stating that the seller partner side of the transaction is also a partnership-related item along with the partnership purchase side of the transaction. In that case, the tax liability would be shared by all adjustment year partners under section 6225 and there would be no meaningful due process question. (Otherwise, the entire BBA audit regime would be unconstitutional). But the regulations seem to say just the opposite, as this commentary has explained. 

I know that both sides of this argument have been taken by a number of practitioners. I have previously taken the position that there is a clear violation of due process in this case and the BBA statutory regime is invalid to that extent. I still think so. What do others think?  

CARES Act Triggers IRS to Allow Amended Returns For Partnerships Subject to BBA

The ripple effect of COVID-19 extends to many areas in tax procedure and tax administration. In this post, guest contributor Marilyn Ames discusses a recent IRS revenue procedure that allows partnerships subject to BBA more immediate access to the relief provided by the CARES Act by allowing them to amend Form 1065 and Schedules K-1. Marilyn was an attorney with the Internal Revenue Service Office of Chief Counsel for over 30 years and is a contributing author on Saltzman and Book, IRS Practice and Procedure. Along with Greg Armstrong and Rochelle Hodes, Marilyn wrote the inaugural chapter in the treatise on the BBA centralized partnership audit procedures. Les

In its herculean efforts to implement the economic relief provided by Congress in the CARES Act, the Internal Revenue Service has looked beyond the provisions of Section 7508A of the Internal Revenue Code to other provisions, including those involving partnerships.  Under the provisions of the Bipartisan Budget Act (BBA), partnerships became subject to a centralized audit procedure, with limited exceptions.  In order to amend a partnership return, Section 6227 of the Code requires the partnership to file an administrative adjustment request (AAR). Under Section 6031(b), a BBA partnership cannot amend the Schedules K-1 after the original partnership return has been filed except to account for audit adjustments in certain circumstances. Generally, the adjustments contained in an AAR for an earlier year are accounted for in the partnership tax return in the year during which the AAR is submitted and any adjustments that do not result in an imputed underpayment (in other words, those that create a possible reduction in tax liability for the partners) are pushed out to the partners for use on the partners’ returns for the year in which the AAR was submitted. Without any adjustments to the BBA partnership audit provisions, if a partnership files an AAR in 2020 for tax years ending in 2018 or 2019 in order to take advantage of the liberalized CARES net operating loss provisions, the partners could possibly have to wait until 2021 when they file their 2020 tax returns to see any effect. 

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However, Section 6031(b) does allow the Secretary to provide for an exception to the general rule prohibiting the issuance of amended Schedules K-1. The Service has utilized this authority and published Revenue Procedure 2020-23 to give this permission, allowing partnerships more immediate access to the relief provided by the CARES Act by filing an amended Form 1065 and amended Schedules K-1.  This is not required – partnerships may still opt to file an AAR to claim the relief provided by CARES should they choose to do so.  Additionally, eligible partnerships are not limited to amending the partnership return based solely on changes in the tax law contained in CARES.  As noted in Section 3.02 of the revenue procedure, a partnership may amend a return to take into account “any other tax attributes to which the partnership is entitled by law.”

The most important point to note about Rev. Proc. 2020-23 is that it has a VERY short time period in which to act.  The option to file an amended partnership return and issue the corresponding Schedules K-1 expires on September 30, 2020.  

So what partnerships are eligible to file an amended Form 1065 and issue amended Schedules K-1? Rev. Proc. 2020-23 provides that any partnership that filed a Form 1065 and furnished all required Schedules K-1 for the tax years beginning in 2018 or 2019 prior to the issuance of the revenue procedure may amend. The Service will treat the amended documents as replacements for any prior returns, including any AARs previously filed for these years.  If the partnership filed an AAR for the same year as the year of the amended return, the amended return should conform the amended return to the AAR for any partnership items adjusted in the AAR. Section 3.04 provides for coordination with Notice 2019-46 if a partnership applied the proposed GILTI regulations to the return in question. If the partnership return is already being audited, the partnership is not precluded from filing an amended return, but must send notice to the revenue agent in writing prior to or contemporaneously with the filing of the amended return, and provide the revenue agent with a copy when the amended return is filed.

To amend the prior return, the partnership should use a Form 1065 and check the “Amended Return” box.  All corresponding amended Schedules K-1 should be included.  The preparer of the return should write “FILED PURSUANT TO REV PROC 2020-23” at the top of the return, and should attach a statement with each Schedule K-1 sent to the partners with the same notation.  

The partnership may file the documents electronically or using snail mail.  As we all know, electronic filing is probably going to result in the Service processing the amended return faster.  

Filing an amended partnership under Rev. Proc. 2020-23 will not change the application of the BBA audit procedures, as the revenue procedure is quick to point out.  If the partnership was subject to the BBA procedures before filing the amended return, it will remain subject to the BBA audit procedures.

Presumably, once the amended return is filed and the amended Schedules K-1 have been issued, partners can act to utilize any net operating loss carrybacks pursuant to the provisions of the newly-enacted Section 172(b)(1)(D) under the guidance given in Rev. Proc. 2020-24, thus getting refunds into the hands of the partners in a timelier manner.