When a Positive Adjustment Does Not Mean More Tax: The BBA Balance-Sheet Problem
By Cody Heimerdinger, CPA, Director
In our prior discussion of the Bipartisan Budget Act partnership audit rules, we focused on an important concept: the first number calculated by the IRS is not always the final number owed by the partnership. That is because the BBA centralized partnership audit regime uses a standardized process to convert partnership-level adjustments into an imputed underpayment, or IU.
But there is another distinction that can become just as important:
A positive partnership adjustment does not necessarily mean the partnership generated additional taxable income.
That may sound counterintuitive. After all, if the IRS identifies a positive adjustment, shouldn’t that mean somebody owes additional tax? Not necessarily.
The BBA rules apply to a much broader universe of partnership-related items than merely taxable income and deductions. Depending on the facts, an examination can produce adjustments involving allocations, liabilities, capital accounts, tax attributes, informational items, or other amounts appearing on a partnership return.
Those adjustments may be important. They may even be correct. But the existence of an adjustment and the existence of additional federal income tax are two different questions.
The BBA Calculation Is Its Own System
To understand the issue, it helps to remember how the BBA default calculation works. In general, partnership adjustments are classified, grouped, subgrouped, and netted under a specific set of rules. Net positive adjustments can then become part of the total netted partnership adjustment, which is generally multiplied by the highest applicable federal income tax rate in determining the partnership’s imputed underpayment.
The IRS Internal Revenue Manual itself recognizes that this calculation may produce an amount greater than the cumulative tax the partners would actually have paid if the partnership items had originally been reported correctly.
Why? Because the imputed underpayment is a partnership-level tax determined under its own statutory computation.
The default calculation generally does not begin by reconstructing the individual tax liability of every partner. That approach makes the audit regime administratively workable. But it also means practitioners need to look carefully at what is actually inside the calculation.
Income Adjustments Versus Non-Income Adjustments
Consider a straightforward income adjustment. Suppose a partnership understated business income by $500,000. The IRS increases partnership income by $500,000. Conceptually, it is easy to understand why that adjustment could produce additional tax.
Income that should have been reported was omitted. Now consider something different. Suppose an examination determines that a liability reported on the partnership’s balance sheet should have been a different amount. That is still potentially a partnership-related item subject to adjustment.
In fact, the IRS’s own BBA examination procedures specifically recognize that the residual grouping can include adjustments to partnership-related items that would not ordinarily be allocated to partners under Section 704(b), giving an adjustment to a liability amount on the balance sheet as an example.
Now we have a different analytical question. If a balance-sheet liability changes by $500,000, does that automatically mean the partnership earned $500,000 of additional taxable income? Of course not. The adjustment may have consequences elsewhere in the tax law.
Depending upon the facts, it may affect basis, allocations, gain recognition, deductions, distributions, or other tax attributes. But simply identifying a positive adjustment does not, by itself, answer the ultimate question: what additional Chapter 1 federal income tax liability results from this adjustment?
That question requires a second layer of analysis.
Why “Positive” Can Be Misleading
Part of the confusion comes from terminology. In everyday language, “positive” sounds beneficial. In tax examinations, it can sound ominous. But under the BBA computational rules, a positive adjustment is essentially a classification used in determining how an adjustment enters the imputed-underpayment calculation.
The IRS Internal Revenue Manual defines a net positive adjustment as an amount greater than zero resulting from the applicable netting rules, including a positive adjustment that has not been netted with another adjustment.
That definition does not say: “This amount represents additional taxable income received by a partner.”
It describes how an adjustment enters the BBA computation. That distinction matters.
The IRS's Own Procedures Recognize the Problem
The IRS’s current BBA examination procedures contain an especially important concept for certain non-income adjustments. The Internal Revenue Manual provides that when an examiner has reviewed a material percentage of impacted partners and determines that a second or subsequent positive adjustment is an adjustment to a non-income item that would have no effect, or only an immaterial effect, on the Chapter 1 liability of the reviewed partner returns, the examiner may treat that non-income adjustment as zero for purposes of computing the imputed underpayment.
That guidance illustrates the issue perfectly. An adjustment can exist. It can be positive. It can be relevant to the partnership return. Yet, after examining the actual tax consequences at the partner level, the adjustment may have little or no effect on federal income tax liability.
The IRS procedures therefore recognize that simply feeding every positive non-income adjustment into the imputed-underpayment calculation can sometimes produce a result that does not reflect the actual Chapter 1 consequences.
A Simple Example: Assume a partnership has two adjustments during an examination.
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First, the IRS determines that depreciation expense was overstated by $200,000. That is an income-related adjustment. Reducing depreciation increases taxable income.
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Second, the same examination produces a $200,000 adjustment to an informational or balance-sheet item related to that underlying adjustment.
If both $200,000 amounts are simply treated as positive amounts in the IU computation, the partnership could appear to have $400,000 of adjustments entering the calculation. But economically, there may be only one $200,000 income adjustment. The second adjustment may simply describe another tax attribute affected by the same underlying event.
Tax professionals therefore have to ask whether that second adjustment independently produces additional federal income tax. If the answer is no, taxing both amounts as though they were separate income items risks counting tax consequences that do not actually exist.
This is not a theoretical concern. The IRS’s own examination guidance uses Section 199A-related adjustments to illustrate situations in which underlying income adjustments can produce additional adjustments to items such as qualified business income, wages, and unadjusted basis immediately after acquisition.
The procedures then specifically address when certain subsequent non-income adjustments may be treated as zero for IU purposes after considering their effect on partner-level Chapter 1 liability.
Adjustment Does Not Equal Imputed Underpayment
This brings us back to one of the most important BBA concepts. A partnership adjustment and the resulting imputed underpayment are not the same thing.
Treasury Regulation Section 301.6225-2 expressly recognizes this distinction in the modification context. An approved modification may increase or decrease the amount of the imputed underpayment without changing the amount of the underlying partnership adjustment. In other words, the IRS adjustment can remain intact while the tax calculation associated with that adjustment changes. That is an important concept for taxpayers.
Sometimes the dispute is: “the IRS adjustment is wrong.”
But sometimes the more precise argument is:“even assuming the adjustment is correct, the proposed tax resulting from that adjustment does not accurately reflect its federal income tax consequences.”
Those are very different arguments.
Adjustments That Do Not Result in an Imputed Underpayment
The BBA rules also expressly recognize the category of adjustments that do not result in an imputed underpayment. Such adjustments do not simply disappear. Depending on the circumstances, they may instead have to be taken into account on the partnership’s adjustment-year return or addressed through another BBA procedure.
The IRS guidance specifically explains how adjustments that do not result in an IU may be reported in the adjustment year, pushed out when applicable, or potentially addressed through modification.
For items that are not income, gain, loss, deduction, or credit, the IRS procedures further state that the partnership takes the adjustment into account by adjusting the relevant item on the adjustment-year return to the extent the item would otherwise appear there.
Importantly, the partnership generally does not create a new income or deduction item merely because the non-income item was adjusted. That provides another reminder that an adjustment can matter without necessarily being current taxable income.
The Practical Question: What Does This Adjustment Actually Do?
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For taxpayers and practitioners facing a BBA examination, the analysis therefore should not stop with the sign next to an adjustment.
Instead, each material adjustment should be traced through several questions:
- What partnership-related item is being adjusted?
- Is the item income, gain, loss, deduction, or credit?
- Or is it a balance-sheet, informational, basis-related, or other non-income item?
- How was the adjustment grouped and subgrouped for purposes of the IU calculation?
- Is the adjustment economically related to another adjustment already producing taxable income?
- Which partners are affected?
- What happens when the adjustment reaches those partners?
- Does it actually increase Chapter 1 federal income tax liability?
- If so, by how much?
- If not, should the adjustment nevertheless remain in the imputed-underpayment calculation?
Those questions become especially important when several adjustments arise from the same underlying transaction. Without that analysis, there is a risk of treating multiple tax consequences of one underlying event as though each independently represents additional taxable income.
Follow the Adjustment All the Way Through
One of the biggest lessons of the BBA regime is that partnership audits require more than reviewing whether an IRS adjustment is technically correct. You also have to understand what the adjustment does after it is made.
- A balance-sheet adjustment may affect tax attributes.
- An allocation adjustment may change which partner bears an item.
- A basis adjustment may affect tax in another transaction or another year.
- And an income adjustment may create immediate tax.
They are not interchangeable.
That is why the most useful question may not be:“is this a positive adjustment?”
Instead, ask: “what federal income tax consequence does this adjustment actually create?”
Because under the BBA rules, a positive number can be important without necessarily representing additional taxable income. And just as the first tax number is not always the final tax number, the label attached to an adjustment does not always tell you its tax result.