A partnership return has been filed, and changes are now needed. To accomplish this, partnerships may have to file an Administrative Adjustment Request (AAR). While many are familiar with the historical process of amending returns, the AAR process is much different and deserves a further look.
Although changing a return may be needed to correct an error, it also may be needed to accomplish a certain goal. Recently, many taxpayers have made legitimate employee retention credit (ERC) claims. Many partnerships will need to file AARs as a result of these claims to reduce wage expense in accordance with the credit. Looking forward, various tax bills may be on the horizon containing legislative changes that could be implemented retroactively. As a result, AARs may be required to take advantage of or comply with these proposals.
When to File an AAR
The Bipartisan Budget Act of 2015 (BBA) was implemented to heighten compliance and transparency in the partnership tax space. Generally applying to tax years 2018 onward, unless the taxpayer can elect out of BBA rules, they may need to file an AAR to change a previously filed return. The options for change are:
- File an AAR using Form 8082: If the previously filed return was e-filed, and the IRS allows returns to be e-filed for the tax year being adjusted. The IRS e-file system only accepts returns for the current and prior two tax years.
- File an AAR using Form 1065-X: If the previously filed return was paper filed, or the return being changed is earlier than three years prior (and was previously e-filed).
- File an amended Form 1065: If elected out of BBA, you may just be able to correct the 1065, file with the “amended” box checked, and include requisite statements according to the instructions. If paper filing, Form 1065-X would be used.
- File a superseded Form 1065: If the period of time is still open to supersede, the partnership can file a superseded return to replace the original return filed.
Who Can Elect Out of BBA
As an overarching rule, eligible partnerships to elect out of BBA must have 100 or fewer partners, all of which must be eligible partners. Unfortunately, if one of these partners happens to be an S corporation, the number of shareholders of that S corporation is included in the partner “count.” If the partnership has a partner listed as an ineligible partner in the below, then they may need to file an AAR:
| Eligible Partners | Ineligible Partners |
|---|---|
| Individuals | Partnerships |
| C corporations | Trusts |
| Foreign entities that would be treated as a C corporation if it were domestic | Foreign entities that would not be treated as a C corporation were it a domestic entity |
| S corporations | Disregarded entities |
| Estates of deceased partners | Estates of individuals other than deceased partners |
| People who hold an interest in the partnership on behalf of another person |
Mechanics & Timing of AARs
Mechanics
Mechanically, AARs are filed by the partnership wishing to change a previous tax return. These changes can be categorized as “net positive” adjustments or “net negative” adjustments. Broadly speaking, net positive adjustments are, in general, changes that increase income, reduce deductions, or reduce credits (and vice versa for net negative adjustments). There is a process of grouping and subgrouping changes, and each subgrouping results in either a “net positive” or “net negative” result. In general, net positive and net negative adjustments cannot be netted.
An AAR can include both net positive adjustments and net negative adjustments. Net negative adjustments must always be passed out to the partners of the year being changed. For net positive adjustments, the partnership has two options. First, the partnership may pay the tax on the net positive adjustments at the entity level. This amount due is called the “imputed underpayment” (IU). Second, the partnership may elect to “push out” the positive adjustments to the partners of the year being changed.
The partnership reports net negative adjustments or pushed-out positive adjustments to the partners using Form 8986 (functioning similarly to a Schedule K-1). If a partner is itself a pass-through (partnership, S corporation, or certain trusts), it must continue to pass along the net negative adjustments from the lower tier AAR to its owners/beneficiaries and has the option to either push out or pay the IU associated with the net positive adjustments. Certain complicating factors with pass-through partners exist but are outside the scope of this article. Reach out to your advisor for more information.
Timing & Partner Treatment
One of the more unique aspects of AARs is their timing and how partners account for adjustments passed out to them. If adjustments are passed out, the partners do not amend their returns for the changes. Instead, they must recompute their Chapter 1 tax liability for the year being changed using the adjustments, and account for the changes in Chapter 1 tax, as either an increase or decrease to the Chapter 1 tax on their tax return that includes the date that the AAR partnership issued its Form 8986s.
For example, a partnership needs to adjust its 2022 tax return (known as the “reviewed year”) to report additional ordinary income. The partnership makes the election to push out the net positive adjustment, and on March 20, 2024, it files the AAR and distributes Form 8986 to Partner A. Partner A is an individual filing a calendar year return. Partner A must recompute its 2022 tax return using the adjustments from Form 8986 and compare the adjusted tax to the tax on its original (or previously amended) 2022 tax return. If there is a change to the 2022 Chapter 1 tax, Partner A reports that change as an increase or decrease to its Chapter 1 tax on its 2024 tax return. 2024 is the “reporting year,” as it includes the March 2024 date that the Form 8986 was distributed to the partners. A reduction in tax from an AAR cannot reduce the reporting year Chapter 1 tax below zero, which may result in a portion of the tax benefit from an AAR being permanently lost under existing rules.
The BBA regime only applies to Chapter 1 taxes (the most common example being income tax). Non-Chapter 1 taxes (self-employment tax, foreign withholdings, etc.) must be adjusted to include adjustments made by the AAR but are not calculated or paid through the AAR or BBA examination process.
The Big Decision: Push-Out Election or IU
Deciding whether to push out the net positive adjustments or to pay an imputed underpayment is the first step in preparing an AAR. Not only are there different forms to fill out and calculations to complete, but there are also differences in potential tax due. Many times, pushing out all adjustments is the favorable option. However, the following discussion weighs the pros and cons of each option.
The Case for the Push-Out Election
- All net negative adjustments must be pushed out.
As discussed above, if there are any net negative adjustments after the grouping process, the taxpayer must push out the net negative adjustment(s) to the partners. Even if there are nine net positive adjustments and one net negative adjustment, the partners must receive a Form 8986 with their portion of the one net negative adjustment. If the partnership pays the tax on the IU, it cannot use the negative adjustments as part of the tax calculation, and thus it may be more tax efficient to push out the positive adjustments to the partners so that the negative adjustments may help reduce the tax paid overall to the IRS. Also, one benefit of paying the IU at the partnership level is that it avoids the partners having to report the adjustments and saves compliance costs. This benefit does not exist if the partners are allocated negative adjustments and still have to recompute their reviewed year tax liabilities and report the change on the reporting year return.
In addition, partners may still have to amend their state income tax returns if the states do not have a similar process as the BBA process.
- IUs require a 37% tax rate (unless modified), while a push-out allows partner characteristics to alter tax due.
By default, IUs are taxed at the highest current marginal tax rate (37% tax rate). This is regardless of the tax classification of the partners, and if the change would have otherwise increased income and tax at the partner level. For example, even if all partners were tax-exempt, the IU would be taxed at 37%. In addition, positive adjustments that can impact the IU calculation can also include changes to an asset or liability balance on the partnership’s tax books and may be taxed at 37% (even though it could simply be a change in a balance sheet item that wouldn’t have impacted taxable income). If the change is to increase capital gain, the “preferential” capital gains rate that individual partners may benefit from is disregarded. That being said, a “modification” process is possible in limited situations to adjust the 37% rate. This modification process can be time-consuming and complicated, especially if there are multiple tiers of pass-through entities in the ownership chain.
A push-out election would allow the partner to calculate the change in tax due using their individual tax situation. For example, if they would have been afforded a 20% capital gains rate on their Form 1040 for the additional income, the 20% rate would apply when determining the change in tax for their Form 8978. Also, a partner may have loss carryovers, e.g., net operating losses or passive losses, that would offset an increase to income from Form 8986.
- Section 199A benefits allowed with push-out election.
Section 199A is a deduction put in place by the Tax Cuts and Jobs Act of 2017 (TCJA) to benefit individual and trust taxpayers who are allocated pass-through income. However, if an IU payment is made, any change to §199A is disregarded. For example, usually, if there is an increase in ordinary income, there is also an increase in §199A income reported to partners. This then provides the opportunity for a higher deduction at the partner level. The same mechanics would be possible with the push-out election, but by paying an IU instead the benefit is lost.
- No “double counting” of changes.
There may be changes that directly result from the “core” adjustment in the AAR. For example, an increase in ordinary income may also affect excess taxable income (ETI) calculated as part of the §163(j) interest limitation within the partnership return. As one changes, so does the other. Each change would be listed as a separate subgrouping for the IU, each taxed at a 37% rate. The taxpayer is taxed twice for effectively the same change. Under Regulation §301.6225-1(b)(4), it may be possible to treat certain adjustments as zero for the IU calculation if one adjustment is reflected in one or more other partnership adjustments (anti-duplication provisions).
- Interest may still be “cut off.”
Even though partners receiving a Form 8986 will account for changes later than the partnership would pay the IU, this does not necessarily mean interest has to accrue on the changes for a longer period of time. Upon receipt of the Form 8986, the partner does not have to wait to pay the additional tax due with the reporting year return but can prepay the additional tax and thus “cut off” the interest accrual on AAR changes.
- Changes in partnership ownership are less complicated with the push-out election.
Let’s say the partnership is adjusting a 2021 tax return via AAR. In 2021, both Partner A and Partner B each owned 50% of the partnership. However, in 2024, the partnership realizes that an AAR should be filed for 2021. In 2023, Partner B transferred its entire interest to Partner C. How is this handled for AARs?
If changes are pushed out, the Forms 8986 are sent to the partners that were present in the reviewed year, i.e., the year being changed. The changes are also allocated according to the operating agreement as in effect for the reviewed year. Therefore, in our example, Partner A and Partner B would receive 50% of the changes on Forms 8986, to be accounted for on their 2024 tax returns via Form 8978.
If the partnership instead chooses to pay the IU, the “economic burden” of 50% of the IU payment is felt by Partner C, as Partner C is the current owner.
- Unexpected items could create an IU.
As discussed previously, there is a grouping process that the changes within an AAR must go through. The result of this grouping process can cause some unusual results if paying the IU:
- Changes to balance sheet items and other “non-income items,” like a partner’s share of partnership liabilities, could create an IU. This can result in the net positive adjustments that are assessed at 37% being much higher than the actual change in income, resulting in a much larger tax liability than if the partners paid the tax at their level on the income changes.
- Reallocating income between partners creates an IU. For example, Partner A was allocated $100 more income than they should have, meaning Partner B was allocated $100 less income than required. To correct this issue, there would be a net positive adjustment with respect to Partner B’s additional income change, and a net negative adjustment with respect to Partner A’s. These changes cannot be netted, even though the partnership’s overall income is unaffected. Without a push-out election, there would be an IU on the net positive change, while the net negative change is pushed out to Partner A.
- An overall reduction in partnership income does not mean all changes will be net negative adjustments. In general, each line of the Schedule K is treated separately and cannot be netted. Therefore, you may pay an IU on an increase in capital gain of $100, while you push out a decrease in ordinary income of $100.
The Case for Paying the IU
- Many partnerships opt to pay the IU if there is a large number of partners or pass-through partners who in turn have many owners. Making an IU payment effectively negates the need for partner involvement at their level.
- If there are no net negative adjustments, and the IU is relatively small, it may not be worth the compliance fees for all partners to account for pushed-out changes on their returns.
- If all partners already expect to pay a 37% rate at their level on the adjustments, then it may make sense to pay the imputed underpayment. However, lost benefit of §199A should also be considered.
AARs can often feel like a burdensome process, and it can take time to complete them correctly. However, with ERC and upcoming possible legislative changes, there may be more and more reasons to file AARs in the coming years. Our knowledgeable tax team can help you through the whole AAR process and answer any questions you may have about your options. For more information, please reach out to a professional at Forvis Mazars.