Partnership Audits And BBA Graffiti

 

I am reading two amicus briefs filed with the Tax Court concerning a partnership audit.

I see that the IRS wants approximately $84 million in tax and $17 million in penalties.

Let’s talk about partnership audits this time. The issue here is caused by the IRS audit process itself.

Before 1982 the IRS would audit partnerships and – if there were adjustments – would also have to audit the partners separately. While not an issue with small partnerships, it was a significant issue with larger partnerships. Take a partnership with headquarters in Atlanta, for example. The partnership audit team might come from Georgia, but the partner audits might require IRS personnel from other states.  

Enter new rules with the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. The partnership would designate a representative to deal with the IRS. There was one audit to bind the partnership and partners, a single judicial review of that audit and a unified limitations period for all. Just the presence of the partnership representative (tax matters partner or “TMP”) was enormous, as this required only one audit team. The IRS did not need to chase the partners for approval. The day to day was also streamlined, as the IRS did not need to notify any non-TMPs of ongoing audit activities.

But while the partnership was binding the partners, the IRS still had to coordinate the amended partner returns. As partnerships (and now LLCs) became larger and more popular, this became an increasingly formidable task.

Knowing this, what would you change to make partnership audits easier?

I would have the partnership itself pay any additional tax resulting from the audit. The partners could settle up as they wish, but the IRS would have moved on.

For the most part, that is the new system - the Bipartisan Budget Act (BBA) centralized audit regime - effective after December 31, 2017.

There are limited exceptions to the BBA regime. For example, a partnership can opt-out of BBA if it has less than 100 partners and every partner is an individual, the estate of an individual, a C or an S corporation. This seems a large exception, but is not. For example, a trust - even a grantor trust - will disallow an opt-out. A disregarded entity (almost every Schedule C is a disregarded entity these days) will also disallow an opt-out.

Fail to opt-out and you are working under BBA rules.

COMMENT: Even if you are in BBA, you can still elect to have the partners rather than the partnership pay tax on any adjustments. This is called a “push-out” election. Mind you, you are still in BBA, but you are electing to use an escape hatch.

BTW the above means that we have two audit regimes (BBA and non-BBA) functioning simultaneously out there. A partnership tax practitioner has to know and be able to work with both.

We will discuss BBA audits only from this point on.

There is an issue with the partnership paying tax on any audit adjustments.

Here is an example:

• You incorrectly reported a $2,000 asset as being placed in service by 12/31/XX.
• This resulted in an incorrect depreciation deduction of $500.
• Self-employment income was understated by $500.
• Qualified Business Income was understated by $500.
• QBI unadjusted asset basis after acquisition was overstated by $2,000.
• You inadvertently understated ending recourse liabilities by $400.

In the old days, the accounting would be straightforward. Say you had two 50:50 partners. The accountant would go back to the original tax returns, substitute the amended numbers for the original numbers and recalculate the tax. The accountant would do this for each partner, and the effect of the audit was the sum of the two changes in final tax.

Intuitive.

However, BBA does not have a tax return like the above. BBA works off the partnership return, which is an information return and does not separately calculate taxable income or arrive at a final tax.

Let’s look at our simple example. What is the change in BBA income from the above?

• $500
• $500 + $2,000
• $500 + $2,000 + $400
• $500 + $2,000 + $400 + ($500 times 20%)
• Something else?

You see the problem: the audit adjustments are divorced from a tax return. You can talk your self into knots over what to include and what to exclude.

So, the BBA created the concept of an Imputed Underpayment (IU). Think of it as a subtotal to which we will apply a tax rate.

Start by separating the adjustments into customary tax pools; income, gain, deduction, loss, and credit.

BBA adds one more pool: non-income items. This pool is the genesis of our problems.

Next separate your adjustments between positive (increase taxable income) and negative adjustments.

Positive adjustments are always included. Negative adjustments are allowed when both the positive and negative adjustments would be reported on the same line of a Schedule K-1. The effect, of course, is to leave many a negative adjustment on the table.

Let’s next look at Reg 301.6225-1(d)(2)(iii):

Got it: gobbledygook.

The hook here is that the customary tax pools (income, gain, deduction, loss, credit) can have both positive and negative sides.

The new BBA pool however – the non-income item – is always positive. The IRS arrives at this conclusion by looking at (d)(2)(ii) above. Since it does not subtract from income, the non-income item is not a negative adjustment. Since it is not negative, (d)(iii) means it must be positive.

Once we are done with positive and negatives, we crunch everything together to arrive at a sum called the Imputed Underpayment (“IU”).

We multiply the IU by the maximum tax rate to arrive at tax due from the BBA audit.

You can see the possible danger from non-income items. Land in this pool – voluntarily or involuntarily – and you can be in trouble. Items in the pool might be indirectly used in calculating tax (say QBI UBIA, for example), but not be directly involved in any tax calculation. You are still paying BBA tax on the pool, however.

Seems to me that someone who could put you in this pool potentially has the power to bankrupt you.

With the above as background, let’s briefly look at the Site Solar Fedok Fund III LLC case.

Site Solar is an Oklahoma partnership that owns, operates, and leases mobile solar generators. It reported a loss of approximately $68 million on its 2018 tax return. It also claimed energy credits on the solar equipment.

The IRS audited the 2018 tax return. It determined that approximately $80 million in depreciable assets were not actually placed in service by December 31, 2018. The IRS reduced depreciation by approximately $63 million. Since assets were not placed in service, the IRS also reduced the solar energy credit by approximately $24 million.

Stopping there and being very liberal with the numbers, we might say that a tentative IU is $104 million ($80 million plus $24 million).

The IRS calculated the IU to be $227 million.

Which translated into tax of approximately $84 million and penalties of $17 million.

How did we get from $104 million to $227 million?

Beats me.

Granted, there are rules to avoid double-counting, more specifically the “subsume rule” of Reg 301.6225-1(b)(4):

COMMENT: The subsume rule is far from perfect. Say for example that the IRS reclassifies an ordinary loss to a capital loss. The ordinary loss is a positive adjustment. The capital loss is a negative adjustment. They will not offset, as they appear on different lines of Schedule K-1. The partnership can wind up with tax due when its taxable income did not change a jot.

Treasury has explicitly stated that an IU is not intended to be the amount of tax that the partners would have owed. It instead is an entity-level calculation, disregarding whether any adjustments would have resulted in an actual tax liability to an actual partner.

Huh?

Maybe we need to regard that last point a bit more, folks. This otherwise is just scribbling numbers on a wall – BBA graffiti if you will.

I understand how this ended up in Court.

The taxpayer had no choice.

Our case this time was Site Solar Fedok Fund III, LLC v Commissioner, U.S. Tax Court Docket 19733-23.

Is A Zero-Return Partnership A Valid Tax Filing?

 

I remember when they were called Chief Counsel Advices. IRS employees – think revenue agents or officers in the field – would reach out to their employer – the IRS – for guidance on an issue.

I am looking at something called a Chief Counsel Email.

Everything changes.

It caught my eye because I was talking with a CPA last week on the very same issue.

And the IRS position is initially disturbing.

Let’s go over this.

A revenue agent (commonly called an auditor) wanted to know if an initial partnership return showing partner information but zeros for activity would constitute a valid tax return.

COMMENT: I have seen this situation many times, including last week. Someone obtains a federal EIN, putting the entity on the IRS radar. The entity then goes on to do … nothing. It never starts or starts a year or two later. Meanwhile the entity is on the IRS Christmas card list. Fail to file a return and the IRS may send a letter asking why you did not file. In response, practitioners usually file an initial return but show zeros as activity because… well because there has been no activity.

Here is the Email:

We agree with the RA’s memo that the initial return showing ownership information, but containing all 0s would most likely be considered invalid under application of the Beard test.

Not good.

To be fair, however, I do not think that it is difficult to work with this Email.

Let’s first talk about Beard.

Beard was a tax protestor.

He found himself in Tax Court over his 1981 return. He received a Form W-2, which he reported on the form 1040. He then inserted a line he described as “Non-taxable receipts” and subtracted his W-2. The result was that he owed – according to him – no taxes and was entitled to a full refund of his withholding.

The IRS wanted tax, of course, and also wanted penalties for failure to file a return. He filed something, but tampering with the forms voided the filing.

Beard responded that he obviously filed a return. The IRS was out of line saying that he had not.

The issue before the Court was: what is a tax return?

The Court presented a four-part test:

1. Does it purport to be a tax return?
2. Is it signed under penalties of perjury?
3. Does it include enough information to calculate a tax?
4. Does it represent an honest effort to satisfy the tax laws?

Beard – a protestor – missed the third test by altering the form.

Here was the Court on the fourth test:

The tampered form here is a conspicuous protest against the payment of tax, intended to deceive respondent’s return-processing personnel into refunding the withheld tax. Since such intentional tampering could go undetected in computer processing, respondent was forced to develop and institute special procedures for handling such submissions. The critical requirement that there must be an honest and reasonable attempt to satisfy the requirements of the Federal income tax law is clearly not met."

Back to our Email.

Numerous tax court decisions have found that a return (typically a 1040) containing all zeros, even if filed on an official IRS form, does not constitute a valid tax return.”

True, but …

However, these are all in the tax protestor context and other cases have held that a zero return may be valid if there is reason to believe that it is an accurate reflection of the taxpayer’s activity.”

Got it.

I will start including a schedule or attachment to the partnership tax return stating the following:

XXX Partnership/LLLC was formed on XX/XX/XX and no business operations occurred during its initial tax year ending XX/XX/20XX.”

Easy.

But it is a trap for a non-tax specialist.

This time we discussed CCA 2026030612260600 a/k/a Chief Counsel Email 202634014.

 

Disregarded, Consolidated And Surly

 

I was reading a consolidated group tax case recently.

It made me think: it has been a moment since I have worked with a consolidated return. It did however remind me a of a favorite tax term.

I consider consolidated groups more the realm of Fortune 500 companies. The reason is that these companies have publicly-traded stock, and publicly-traded stock is a cousin (if not a sibling) to cash. If I am a Fortune 500 and want to buy your company, I am motivated to use my stock to pay for some/all of the purchase price. Why? Because I am not depleting my cash reserves. Since my stock is publicly-traded, however, you are likely to consider it as similar to cash, but being stock there may be tax strategies available to avoid the heavy hand of immediate taxation. It is about as close to a win:win as you can find in the Code.

Let’s take a brief look at this part of the Code.

What is a Consolidated Tax Return?

First of all, we are now talking about corporations. These corporations have sufficient common ownership (that is, are “affiliated”) to combine their separate tax returns into one (“consolidated”) tax return which will be treated as a single unit for tax purposes.

        Code § 1501 - Privilege to file consolidated returns

An affiliated group of corporations shall, subject to the provisions of this chapter, have the privilege of making a consolidated return with respect to the income tax imposed by chapter 1 for the taxable year in lieu of separate returns. The making of a consolidated return shall be upon the condition that all corporations which at any time during the taxable year have been members of the affiliated group consent to all the consolidated return regulations prescribed under section 1502 prior to the last day prescribed by law for the filing of such return. The making of a consolidated return shall be considered as such consent. In the case of a corporation which is a member of the affiliated group for a fractional part of the year, the consolidated return shall include the income of such corporation for such part of the year as it is a member of the affiliated group.

As shorthand, we will refer to the area of the tax Code that deals with consolidated returns as the “15XX Regulations.”

Who Can File a Consolidated Return?

The affiliated group will have at least two corporations connected through a common parent. The corporations (other than the parent) must be at least 80% owned by another corporation (it does not have to be the parent) in the group.

In general, S corporations and foreign corporations cannot be members of an affiliated group. 

BTW you can remain an affiliated group indefinitely and not elect to file a consolidated return.

Like Hotel California, however, once you elect it is not so easy to leave.

Why Would I File a Consolidated Return?

One key advantage is being able to offset the losses from one member of the group against the income of another member.

If one were to file separately, then the profitable member would have taxable income (and pay tax) while the loss member would have a net operating loss that carries over to some future profitable year. It is not the end of the world, but one would probably prefer to use those NOLs now.

How Do Affiliated Corporations Come into Existence?

The first way is organic: the parent creates a subsidiary. In a later year, perhaps the parent creates another subsidiary, or an existing subsidiary creates a new subsidiary.

A second way is to acquire other corporations via mergers and acquisitions.

As shorthand, we will refer to the area of the tax Code that deals with corporate formations, mergers, acquisitions and divisions as the “3XX Regulations.”

Are the Rules Complicated?

You bet.

The 15XX Regulations are some of the most difficult and byzantine rules you will ever work through.

And the 15XX Regulations - just to make it sporting - like to cross-reference the 3XX Regulations.

You will spend time flipping pages, at least until you memorize the citations.

Let’s Look at One Rule: The SRLY

This is pronounced “surly.”

The idea is that a corporation enters the consolidated group with net operating losses. One’s first thought is that the group can immediately use those losses to offset income from other members.

No, it can’t. Congress thought of this, which is how SRLY came into existence.

In general, the SRLY rules will limit the use of net operating losses to future income from the same corporation that brought the losses into the group.

There is a cousin to this rule in 3XX Regulations upon ownership changes, but it does not require an affiliated group. SRLY, on the other hand, is found in the 15XX Regulations and applies to consolidated groups.

Let’s Look at a Recent Case Involving a SRLY

As we have sometimes done before, we will change the names to make this more readable.

Scooby was created pursuant to a reorganization in 2012. Scooby was an S corporation, and it had a subsidiary called Shaggy, itself another S corporation. An S corporation generally cannot have a corporation as a shareholder, so Scooby elected to treat Shaggy as a Qualified Subchapter S Subsidiary (QSSS).

Shaggy in turn acquired a C corporation we will call Daphne. A C corporation (as contrasted to an S corporation) can have a corporation as a shareholder. Daphne was dragging net operating losses behind it.

Shaggy distributed Daphne to Scooby.

At this point we have an S corporation (Scooby) owning a C corporation (Daphne) and an S corporation subsidiary (Shaggy).

COMMENT: We are not there yet, but you see a key piece to a potential SRLY: a C corporation with NOL carryovers. To provoke SRLY, we next need a consolidated group.

In 2018 Scooby revoked its S election.

Scooby elected to treat Daphne as a disregarded entity. For federal tax purposes, Daphne liquidated into Scooby and ceased to exist as a separate entity.

Scooby then formed a consolidated group (which we will call Super Scooby).

Super Scooby was knocking it out of the park. It had group taxable income of $13 million for 2018, $46 million for 2020, and $89 million for 2021, even though Scooby/Daphne had zero (-0-) profit of its own. All the profit was coming from the subsidiaries.

Super Scooby – of course – wanted to use the corporation-previously-known-as-Daphne NOLs. The amount was significant - $108 million.

The IRS said No. Why? Because of SRLY, that’s why.

Off to Tax Court they went.

Super Scooby had a straightforward argument: there was no SRLY because Daphne was disregarded. What was Daphne’s was now Scooby’s, and there is no SRLY rule on the parent of an affiliated group.

True, but there is a “predecessor and successor” rule in the thicket of the 15XX Regulations.

The IRS saw Daphne as a predecessor. Super Scooby did not. Super Scooby argued that Scooby once owned Daphne as a separate corporation. After the S revocation, Daphne ceased to exist, and there remained only Scooby.  Super Scooby was then created upon election to file a consolidated return.

Why the pedantism?

Super Scooby wanted the “lonely parent” exception found in the 15XX Regulations.

COMMENT: I love this term. The idea is that the parent can always drag its NOLs behind it without SRLY restrictions. The idea makes sense if the parent remains the same. It makes less sense if the tax planners restructure the group to result in a new parent, or – as in this case – when a previously existing corporation goes “poof” into the parent.

Do you test the lonely parent before or after the poof?

Super Scooby argued that the test was after the poof.

The IRS of course argued that the test was before.

The Court approached the issue by looking at the predecessor-successor rules in the 3XX Regulations:

In general, a predecessor is any transferor in a Section 381 transaction.”

COMMENT: Section 381 addresses carryovers when corporations acquire corporations.

                

Scooby “acquired” Daphne when it revoked its S election and Daphne liquidated under Section 332. The liquidation triggered Section 381 for any Daphne carryovers, which in turn triggered the “transferor in a Section 381 transaction” requirement for a predecessor-successor.

Daphne was a predecessor.

On to the lonely parent:

Where a member of the group is the successor in a 381 transaction, any net operating loss of the predecessor corporation are considered to have occurred in a SRLY if the predecessor was not a member of the group for each day of such year. The lonely parent rule does not apply in these situations, and the loss carryovers are subject to the SRLY restrictions, despite the fact that the common parent may be the successor corporation in the 381 transaction.”

In recap, the Court reasoned that:

• Daphne was a predecessor.

• Daphne was never a member of the Super Scooby consolidated group.

• The lonely parent rule cannot be extended to predecessors not members of the (consolidated) group.

• Daphne’s SRLYs remained SRLYs.

Super Scooby struck out trying to claim Daphne’s NOLs.

Why was Super Scooby swinging so hard? There was consolidated taxable income of – what? - $13 million, $46 million, $89 million. There appeared plenty of income to go around.

But there wasn’t.

All the consolidated income came from the subsidiaries.

The Daphne SRLY looked only at the income that Daphne (now liquidated into Scooby) brought into the consolidated group.

Scooby/Daphne itself had zero (-0-) income.

Meaning the SRLY was also limited to zero (-0-).

NOTE: The solution to Super Scooby’s problem seems straightforward: why not check-the-box to disregard one (or more) subsidiaries as separate from Scooby? Scooby would then have income to absorb the Scooby/Daphne NOLs. Yes, we still have a SRLY, but we are putting (as much) income (as necessary) into Scooby/Daphne to release some/all of the NOL. Maybe we burn the NOL over several years rather than just one, but that is still a better result than the above.

Our case this time was HBM Holdings Co v Commissioner, 167 T.C. No. 6 (July 27, 2026).