The Imputed Underpayment Explained: How the IRS Taxes a Partnership Under BBA

Partnerships are not supposed to pay income tax. That is the whole point of a pass-through. So it comes as a shock when a partnership audit ends with a bill addressed to the partnership itself, calculated at the highest individual or corporate rate, due now.

That bill is the imputed underpayment. It is the default result of an audit under the BBA centralized partnership audit regime, and it is often more than the partners would have owed if the return had been right in the first place.

The rule in IRC 6225

IRC Section 6225(a) says that when the IRS adjusts partnership-related items for a reviewed year:

• If the adjustments result in an imputed underpayment, the partnership pays it in the adjustment year.
• If they do not, the partnership takes the adjustments into account in the adjustment year.

The reviewed year is the year being audited. The adjustment year, under IRC 6225(d)(2), is generally the year the notice of final partnership adjustment (FPA) is mailed, or the year a court decision becomes final if the partnership litigates. For background on the whole system, see our overview of the BBA partnership audit regime.

How the IRS calculates it

IRC 6225(b)(1) says the imputed underpayment is determined by netting all partnership adjustments for the reviewed year and applying the highest rate of tax in effect for that year under IRC Section 1 or 11. Treas. Reg. 301.6225-1 turns that into a process.

Step 1: Group the adjustments

Under Treas. Reg. 301.6225-1(c), each adjustment goes into one of four groupings:

• Reallocation grouping. Adjustments that move an item from one partner to another.
• Credit grouping. Adjustments to items reported as credits, and adjustments to tax or penalties the partnership owes directly.
• Creditable expenditure grouping. Adjustments to items someone could take as a credit, such as qualified research expenses.
• Residual grouping. Everything else, which in most audits means ordinary income and deductions.

If any grouping contains a negative adjustment (for example, a decrease in income or an increase in a deduction), Treas. Reg. 301.6225-1(d) requires the adjustments in that grouping to be subgrouped. IRC 6225(b)(3) requires adjustments to be netted separately within each category of items that must be separately stated under IRC 702(a).

Step 2: Net within each grouping, not across them

Treas. Reg. 301.6225-1(e)(2) allows positive and negative adjustments to offset only within the same grouping or subgrouping. You cannot net one grouping against another, and you cannot net one year against another.

Two statutory limits make the number bigger than you might expect:

• Reallocations are not netted. IRC 6225(b)(2) disregards the part of a reallocation that would decrease the imputed underpayment. If the IRS moves $100,000 of income from Partner A to Partner B, the increase to B counts but the decrease to A does not reduce the bill.
• Limited items may be excluded. Under IRC 6225(b)(4), a decrease that could be subject to an additional limitation, or not allowed against ordinary income, if taken into account by any person is generally disregarded unless the IRS provides otherwise.

If a grouping nets to a negative number, that net negative adjustment is excluded from the imputed underpayment calculation. Under Treas. Reg. 301.6225-1(f), it is treated as an adjustment that does not result in an imputed underpayment and is taken into account by the partnership in the adjustment year.

Step 3: Apply the top rate and add credit items

The net positive adjustments in the reallocation and residual groupings are added together to get the "total netted partnership adjustment." That figure is multiplied by the highest rate in effect for the reviewed year. Net positive amounts in the credit and creditable expenditure groupings are then added dollar for dollar.

A worked example from the IRS

The IRS's page on how to figure an imputed underpayment uses a 2023 reviewed year and a 37% rate. Its example produces these figures:

Item	Amount
Reallocation grouping	$8,000
Residual grouping	$7,100
Total netted partnership adjustment	$15,100
Multiplied by 37%	$5,587
Credit grouping	$500
Creditable expenditure grouping	$0
Total imputed underpayment	$6,087

Notice what the rate assumes. Every dollar of adjustment is taxed as if it landed on a taxpayer in the top bracket. For many small partnerships, that is simply not true of the actual partners.

Interest and penalties on top

Under IRC 6233(a), interest on the imputed underpayment runs from the day after the reviewed year return due date to the adjustment year return due date, or the payment date if earlier. Penalties are determined at the partnership level as if the partnership were an individual and the imputed underpayment were an actual underpayment for the reviewed year.

If the partnership then fails to pay on time, IRC 6233(b) adds interest and the failure-to-pay penalty under IRC 6651(a)(2) measured from the adjustment year. And under IRC 6232(f)(1), if the amount is not paid within 10 days of notice and demand, the interest rate on it increases by two percentage points, because the statute substitutes 5 percentage points for 3 in IRC 6621(a)(2)(B).

Who really pays

The partnership pays, so the economic cost falls on whoever owns the partnership in the adjustment year. New partners can end up funding tax on income that was allocated to people who have since left.

The payment is also not deductible. IRC 6241(4) says no deduction is allowed for any payment a partnership is required to make under the BBA subchapter.

If the partnership does not pay, the IRS has a backstop. IRC 6232(f)(1)(B) lets the IRS assess each partner, determined as of the close of the adjustment year, for a proportionate share of the unpaid amount, including interest and penalties. Under IRC 6232(f)(6)(B), that assessment generally must be made within 2 years after the notice and demand.

How to pay

The IRS's audit process page says a partnership that does not make a push-out election must pay the imputed underpayment. Before assessment, the IRS says to pay through EFTPS or by debit or credit card and apply the payment to Form 1065, and notes that Direct Pay is not available for this payment. IRC 6232(b) generally bars assessment until 90 days after the FPA is mailed and, if the partnership petitions a court, until the decision is final.

Ways to reduce or avoid the imputed underpayment

Modification under IRC 6225(c)

The statute requires the IRS to provide procedures to modify the imputed underpayment. The main ones:

• Amended returns by partners. Reviewed year partners can file returns that take their share of the adjustments into account and pay the tax. The imputed underpayment is then computed without those adjustments. IRC 6225(c)(2)(B) provides an alternative procedure that does not require formal amended returns.
• Tax-exempt partners. IRC 6225(c)(3) removes the portion of an adjustment allocable to a partner that would not owe tax because of its tax-exempt status.
• Lower rates. IRC 6225(c)(4) allows a lower rate for the portion allocable to a C corporation partner, or, for capital gains and qualified dividends, to an individual partner. An S corporation is treated as an individual for this purpose.
• Other procedures. IRC 6225(c)(6) allows the IRS to provide additional modification methods.

Modification requests must be submitted within 270 days after the notice of proposed partnership adjustment is mailed, unless the IRS consents to an extension, under IRC 6225(c)(7). The IRS says the request is made on Form 8980, Partnership Request for Modification of Imputed Underpayment. Under IRC 6225(c)(8), no modification takes effect unless the IRS approves it. We cover the strategy in our guide to reducing an imputed underpayment through modifications.

The push-out election

Under IRC 6226, the partnership can elect within 45 days after the FPA to push the adjustments out to the reviewed year partners. If the election is valid, the partnership is not liable for the imputed underpayment, and each reviewed year partner pays his or her own share, with a higher interest rate. See our full guide to the push-out election under Section 6226.

Contest the adjustments

Within 90 days after the FPA is mailed, IRC 6234 allows the partnership to petition the Tax Court, the district court for its principal place of business, or the Court of Federal Claims. The latter two require a deposit of the imputed underpayment, penalties, and additions to tax first.

Plan before an audit

An eligible partnership that makes a valid election out of BBA on a timely filed return is not subject to the imputed underpayment rules for that year. And a partnership agreement can address how the cost of an imputed underpayment is shared among current and former partners.

The imputed underpayment is the IRS's opening number, not a final verdict. It is built on assumptions the partnership can often rebut with partner-level facts, if it acts inside the deadlines. If your partnership has received a NOPPA or an FPA, call the Law Offices of Darrin T. Mish, P.A. in Tampa, Florida at 813-229-7100.