The First Number Is Not Always the Final Number: Understanding BBA Partnership Audit Modifications
By Cody Heimerdinger, CPA, Director
For partnerships subject to the Bipartisan Budget Act of 2015, commonly referred to as the BBA centralized partnership audit regime, an IRS examination can look very different from a traditional audit. One of the biggest differences is deceptively simple: the amount initially proposed by the IRS may not be the amount ultimately owed. That is because the BBA generally allows the IRS to determine adjustments and calculate an imputed underpayment, or “IU,” at the partnership level. But Congress also created a formal modification process that allows partnerships to demonstrate why the initial calculation should be changed. Understanding that process can make a significant difference.
Why the BBA Changed Partnership Audits
Before the BBA regime, partnership adjustments often had to flow through to individual partners before the IRS could ultimately collect additional tax. That could become administratively difficult, particularly with large partnerships or partnerships whose ownership changed over time.
The BBA centralized much of that process.
Under the current regime, the IRS generally determines partnership adjustments at the partnership level and, when those adjustments result in an imputed underpayment, can assess that amount directly against the partnership. The starting calculation is intentionally standardized. In simplified terms, positive adjustments are grouped and netted under detailed rules and generally subjected to the highest applicable federal income tax rate. That provides the IRS with an administratively efficient starting point. It does not, however, necessarily reproduce the tax that the partners would actually have paid had the items originally been reported differently.
That distinction is where modification becomes important.
What Is a BBA Modification?
A modification is a formal request to change the calculation of a proposed imputed underpayment based on additional facts about the partnership, its partners, or the tax consequences of the adjustments. Once the IRS issues a Notice of Proposed Partnership Adjustment, or NOPPA, the partnership representative generally has 270 days to submit a modification request. That period may be extended by agreement. The request is generally made electronically using Form 8980, Partnership Request for Modification of Imputed Underpayment Under IRC Section 6225(c).
This is an important procedural point. The NOPPA is a major milestone in a BBA examination, but the proposed imputed underpayment shown on it should not automatically be viewed as the final economic result.
In many cases, the next question should be: does the proposed calculation accurately reflect who the partners were, what type of taxpayers they were, and what the actual federal income tax consequences of the adjustments would be?
There Is More Than One Type of Modification
Depending on the facts, the Internal Revenue Code and regulations provide several ways an imputed underpayment may potentially be modified. For example, modification may be appropriate when an adjustment is allocable to a tax-exempt partner. If the partner would not have owed federal income tax on the adjustment because of its tax-exempt status, the partnership may be able to request that the related amount be removed from the imputed underpayment calculation. Form 8983 is used in connection with certain tax-exempt partner modification requests.
Another possibility involves partners filing amended returns and taking the partnership adjustments into account themselves. Subject to the detailed requirements of the BBA rules, tax paid by partners through this process can reduce the amount that must otherwise be collected at the partnership level. There are also circumstances involving different tax rates, passive versus ordinary treatment, capital gains, qualified dividends, and other characteristics that may affect the appropriate computation. In other words, modification is not simply about disputing whether the IRS adjustment is correct.
Sometimes the partnership may accept an adjustment for purposes of moving the examination forward while still challenging how that adjustment translates into tax. Those are two separate questions.
The Allocation Workpapers Matter
One lesson that becomes particularly important in BBA examinations is that reviewing only the bottom-line proposed assessment is rarely enough.
You also need to understand the underlying workpapers.
The IRS generally provides explanations and computations showing the proposed adjustments and how those adjustments were categorized, allocated, grouped, and ultimately converted into the proposed imputed underpayment.
Those details matter because modification frequently depends on tracing an adjustment back to the appropriate partner. Consider a simplified example.
Assume an IRS examination produces a $2 million positive partnership adjustment. Looking only at the partnership level, applying a standardized rate could create a substantial proposed imputed underpayment. But now assume that the economics of that $2 million adjustment relate to a particular partner.
The analysis may then require asking:
- Who should properly be associated with the adjustment?
- What type of taxpayer is that partner?
- Would the adjustment have produced additional federal income tax if reported by that partner?
- Was some portion attributable to a tax-exempt organization?
- Does the character of the adjustment affect the applicable tax rate?
- Are there offsetting adjustments that should be grouped or netted differently?
- Is the adjustment itself an income-producing item, or is it primarily a balance-sheet, capital-account, basis, or reallocation adjustment?
Those questions can produce a very different answer from simply multiplying a gross adjustment by the highest federal tax rate.
A Partnership Adjustment Does Not Always Equal Additional Tax
This may be the most important conceptual point. An IRS adjustment can be very real without producing an equivalent amount of additional tax. For example, an examination may involve adjustments to allocations among partners, capital accounts, balance-sheet items, basis-related items, or other partnership attributes. Those adjustments may be important for federal tax purposes, including their effect on future years. But the existence of a positive adjustment does not necessarily mean there is a corresponding current-year federal income tax liability of the same magnitude.
The BBA regulations themselves contemplate modification of the computation of an imputed underpayment, including circumstances in which certain adjustments or portions of adjustments can be removed from that computation when the requirements for modification are satisfied. That is why practitioners need to distinguish between:
- the partnership adjustment,
- the IRS’s initial imputed underpayment calculation, and
- the actual tax consequences after modification.
They are related, but they are not necessarily the same thing.
Modification Is a Documentation Exercise
A strong modification request requires more than saying, “The IRS calculation is too high.” The partnership generally must substantiate why the proposed imputed underpayment should change.
That may require reviewing:
- the NOPPA and IRS examination workpapers;
- partnership agreements and ownership records;
- Schedules K-1;
- partner entity classifications;
- tax-exempt documentation;
- individual, corporate, trust, estate, or partnership returns;
- amended returns and proof of payment;
- calculations tracing adjustments to specific partners; and
- the character and tax effect of each adjustment.
The partnership representative also plays an especially important role. Under the BBA regime, the partnership and its partners are generally bound by actions taken by the partnership representative, including requesting modification, extending or waiving the modification period, agreeing to certain IRS determinations, and making a push-out election. So these are not merely computational decisions. They are procedural decisions with potentially significant consequences.
Modification Versus the Push-Out Election
Modification is also different from another major BBA tool: the push-out election. Rather than having the partnership pay an imputed underpayment, a qualifying partnership may elect to push the underlying adjustments out to its reviewed-year partners, who then account for those adjustments under a separate set of rules.
Whether modification, push-out, payment at the partnership level, or some combination of available procedures produces the most appropriate result depends heavily on the facts. Ownership changes can matter. Partner tax attributes can matter. Tax-exempt partners can matter. The character of the adjustments can matter. And perhaps most importantly, the partnership must pay close attention to the procedural deadlines associated with each option.
The Bigger Lesson
BBA examinations have added an entirely new layer to partnership tax controversy. Receiving a proposed partnership adjustment is no longer simply a question of deciding whether to agree or disagree with the IRS’s tax position.
Practitioners must also ask: even if the adjustment stands, is the IRS calculating the resulting tax correctly?
That requires carefully reconciling the examination workpapers, understanding how adjustments were grouped and allocated, identifying the taxpayers economically connected to those adjustments, and considering the modification procedures available under Section 6225. Sometimes that review confirms the IRS’s proposed amount. Sometimes it produces a modest adjustment. And sometimes the difference can be substantial.
The important point is that the number appearing on the first IRS computation should be treated as the beginning of the analysis, not necessarily the end of it.
For partnerships facing a BBA examination, the period following issuance of a NOPPA can therefore be one of the most important phases of the entire audit. It is the point where technical partnership tax rules, partner-level facts, procedural deadlines, and detailed computational work all come together. And as is often the case in tax law, the math only tells the right story when the facts behind the math are right too.