partnership to push out the adjustment up one tier, where the liability then stops. (Prior coverage (Doc ).)

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1 WARREN: IRS MAY OK TIERED PARTNERSHIP AUDIT PUSH-OUT WITH A COST (Section Partnership Level Tax Treatment) See 2016 TNT Full Text The push-out method or something similar might be made available to tiered partnerships -- but with a cost -- so that they can avoid entity-level collection and pass adjustments on to the partners in the year under audit, according to Clifford Warren, special counsel to the IRS associate chief counsel (passthroughs and special industries). Some commentators have suggested that an upper-tier partnership should be able to file a protective administrative adjustment request (AAR) in case it receives a section 6226 statement from a lower-tier partnership, at which point it might then be allowed to use the AAR process under section 6227 to flow the adjustments from the statement up through the tiers as opposed to being forced to cut a check at the entity level. There are differing views whether the Joint Committee on Taxation's so-called blue book (JCS-1-16 (Doc )) endorses such an interpretation. (Prior coverage (Doc ).) Warren said that the government is thinking about allowing some method of cascading push-outs for tiered partnerships. He spoke July 16 at the New York State Bar Association Tax Section summer meeting in New Paltz, New York. "We are considering it. There may be baggage along with it -- in other words conditions that might have to be required in order to push out. Our concern is at the end of the day if this gets pushed out through 20 tiers to 10,000 partners, how are we going to be able to demonstrate when asked -- and I'm sure we will be -- how much tax we collected?" Warren said. Katherine G. Newman of Apollo Global Management LLC said that "to the extent the cost is more administrative burden, I think that's probably an interesting cost worth looking into." She added, "We are well positioned to accept the administrative challenge and would take that over not being able to push up -- absolutely." Tiering would be a "necessity" in order to look out for Apollo's investors, she said. Diana L. Wollman of Cleary Gottlieb Steen & Hamilton LLP said that in practice the IRS will have to give partnerships additional time to effect a cascading push-out, which could add "a lot of years" to the audit. Warren agreed that providing such needed additional time "will be a significant delay and that's a concern. And then we're a little bit concerned... that the ball will be dropped mid-tier," for example if a statement gets sent to a foreign partnership that has little interest in complying. But Matthew S. Cooper of EY said he's been surprised by the increased interest in the AAR process following enactment of the new partnership audit rules under the Bipartisan Budget Act of 2015 (BBA, P.L (Doc )). "From my experience both in the government and from the taxpayer side, the AAR process can be very burdensome. It's sometimes hard to get responses, because you're just filing amended returns to the service center and [they may not] be processed correctly," he said. Wollman said she suspects that some partnerships are "so desperate" to find a way to avoid the BBA's section 6225 imputed underpayment regime, which assesses and collects any underpayment at the partnership level, that they'll accept any solution no matter how imperfect. The panelists discussed how much weight should be given to the blue book's interpretation of the BBA rules, especially since it clearly states that the section 6226 push-out method allows only a lower-tier

2 partnership to push out the adjustment up one tier, where the liability then stops. (Prior coverage (Doc ).) Even if one thinks the blue book isn't really legislative history because it was written after the BBA's enactment, Wollman said, "I don't know if anyone can think of a time when the blue book said something so definitely and then the regs came out and they were the opposite." She said that if the government decides to allow cascading push-outs for tiered partnerships, "you've got a conundrum on your hands." Allowing cascading push-outs through tiers was one of 11 comments received in response to the new rules and addressed by the panelists in New York. The 11 comments -- identified by Wollman as the most interesting and most frequent -- also included: the regime's rough justice (allowing for the assessment of the wrong amount of tax due by the wrong people), partnership reserves for tax liabilities, and what happens when partners who receive push-out statements don't pay. The NYSBA tax section's report (Doc ), which was principally drafted by Wollman and Meyer H. Fedida of Cleary Gottlieb Steen & Hamilton LLP, addressed some of those issues. Interpretive Flexibility Warren said that every one of the 11 general comments discussed by the panelists "is about simplicity versus fairness. It's really hard to be really fair if you're going to be simple, and part of this rule is to make it simple, certainly for the government." But some of the commentators indicated that investors may be so disturbed by the extent to which the BBA rules will impose another partner's tax burden inappropriately on them that they may seek out other investment vehicles, which Wollman speculated could include regulated investment companies, real estate investment trusts, private managed accounts, and passive foreign investment companies that have made a section 1295 qualified election fund election. Newman said that her firm's investors are largely tax-exempt organizations like pension funds and foreign-government-controlled entities with special tax status like sovereign wealth funds. "When they come into our products, they expect that they will not have any more tax coming in through a partnership form than they would were they investing on their own," she said. "And we have already been receiving in side letters reactions from the [limited partner] community because they're nervous [that these rules might] cause them to have to pay someone else's taxes." Newman said there's a trend among her key clients, including some state pension funds, toward managed accounts. She questioned whether the BBA rules may cause more investors to want to leave commingled products. Warren said that the IRS is sensitive to comments seeking to preserve the special tax treatment of taxexempts. "We have no interest [in collecting tax from an allocation] attributable to a tax-exempt. And I think we hope to get to a place where that's not going to happen probably with one unique exception," he said. The exception is when a partnership has a partnership-level liability and the tax-exempt is buying into it, Warren said. In that case "there's not much we can do. That's kind of like buying into any entity with" an entity-level liability, he said, although he suggested that if BBA liabilities are disclosed under generally

3 accepted accounting principles, at least tax-exempts will have notice. He added that in any case "they should be able to protect themselves though contract." Richard Goldman, deputy associate chief counsel, IRS Office of Associate Chief Counsel (Procedure and Administration), indicated that the IRS has some flexibility in shaping the scope of the BBA rules. "Words can be interpreted in lots of different ways," he said, citing agency struggles with determining the scope of the BBA. "What partner-level issues would be included in that computation of the imputed underpayment? How do you define partners?" "We can be creative and try to interpret the statute in a way that's faithful to its language but achieves fairness as well as as much simplicity as we can get out of the regime," Goldman said. Warren pointed out, however, that there are limits to that flexibility. "Words do have meanings. Increase does not mean decrease," he said. Electing Out Within Tiers Partnerships that don't want to be subject to the section 6225 entity-level imputed underpayment regime may be eligible to elect out (section 6221(b)) if they have 100 or fewer partners -- each of which is either an individual, a C corporation, an S corporation, or an estate of a deceased partner. Commentators have asked the IRS to allow look-through for tiered partnerships, so that a partnership with a partner that's itself a partnership might be able to elect out as long as the total number of ultimate partners isn't greater than 100. Newman said that the investment management community isn't holding out hopes that it will be able to take advantage of the section 6221(b) election out. "Even if 95 percent of the economics is held in a very small group of partners, you are probably going to have at least one partner with a partnership" because of the way Apollo compensates its investment professionals "to have skin in the game in some of these deals." But Newman added that "one could envision" that limited partners with concerns about the BBA rules might want to leave commingled accounts and move to smaller, managed accounts. She said that some limited partners could seek "to structure their relationship with their managers as fees instead of investment allocations so as to avoid some of those tiering issues where you'd fall out of the exception." "When the music stops and we all know what the rules are, people will respond to them," Newman said. Cooper said that practitioners are struggling with whether and how to draft or amend partnership agreements to take into account the evolving rules. He said that his firm is generally recommending that new agreements be drafted with sufficient flexibility to make and change decisions, whereas advisers should generally hold off on making wholesale changes to existing agreements. "Before you see the actual rules, it's hard to say" what the collateral consequences of all the various decisions will be, he said. Newman agreed. She said that Apollo is interested in "maintaining key flexibility in the agreements right now so that we can act as the appropriate fiduciary."

4 Wollman reminded practitioners that when a partnership makes the section 6221(b) election out, "it doesn't mean that the IRS is forced to audit each partner separately." IRS agents "can still audit at the partnership level, provided that they open audits at the upper level and make the assessments before the [partner's] statute closes," she said. Modifying the Imputed Underpayment Partnerships that end up being subject to the section 6225 imputed underpayment regime will likely want to take advantage of the modification rules under section 6225(c), which could allow them to reduce the amount due. For example, section 6225(c)(2) allows for the imputed underpayment amount to be reduced when adjustments are taken into account by partners on amended returns, requiring all partners affected by a reallocation of distributive shares to amend. However, the statute provides that "any modification of the imputed underpayment amount under this subsection shall be made only upon approval of such modification by the Secretary." Newman said that she's interested to see how the modification rules play out. "In reality, it is going to be attractive, and likely many partnerships will go ahead and pay... at the partnership level, so I think we should spend a lot of time on this section and realize that this is the world we'll be living within," she said. In particular, Newman said that she wanted to know what will be required to substantiate the various adjustments. She said that if the partnership is faced with the imputed underpayment regime and the administrative burden that comes along with it, "let's have the opportunity to do it right and to actually identify and to prove out that everyone's been accounted for appropriately." Wollman agreed. "The point of the statute wasn't to completely eliminate the application of the regular tax rules. It was to take away from the IRS that work" of assessing and collecting tax under the old large partnership audit rules under the 1982 Tax Equity and Fiscal Responsibility Act. She said that if the taxpayer is willing to take on that work, "you could see an argument for saying they should be allowed to... get it as right as possible." Warren said that while that argument sounds good, "in practice if we have 10,000 partners that are each claiming 'I'm [alternative minimum tax]' and 'I've got passive losses,' it ultimately could devolve into a TEFRA situation where we'll have to review the submissions to modify" the imputed underpayment. He added, "We don't want this to become TEFRA all over again." Newman said that her industry's investor population is "sensitive about confidentiality issues," so if modifications require disclosing too much sensitive financial information to unaffiliated partnerships within the tier, that could get tricky. "We feel comfortable owning our investor data. We feel comfortable with some of the prescriptions that are laid out, pushing things out, working with our investors, having that role be outsourced to us. But to the extent we're ourselves investing in partnerships, there are a lot of concerns there about how we can do right by our investors without compromising some of their chief concerns around identity," she said. Wollman said, "It's one thing to give identifying information -- this is who I am, and this is where my bank account is. It's another thing to say this is how much leverage I have. These are how many losses I have."

5 Warren said that in his experience some funds would rather just not tell a lower-tier partnership who their investors are "and perhaps pay a little more tax." Newman said, "This will be very tricky, because I don't anticipate investors wanting to share more than they absolutely have to. But to the extent there's an economic cost to that... that's going to be frightening." One aspect of the section 6225 imputed underpayment regime that struck many commentators as unfair is that if the adjustments involve a reallocation of distributive shares of a partnership item from one partner to another, the IRS will disregard any income or gain decreases and any deduction, loss, or credit increases, increasing the likelihood of finding an imputed underpayment. Warren said that the IRS is aware of the issue and that the agency has "no interest in collecting more tax than is due." Wollman said it will be interesting to see if that harsh rule changes behavior "in terms of people being more conservative" when they determine how items are allocated among partners. Newman said that the rule could affect how partnership agreements are drafted, indicating that it may cause partnerships to have second thoughts about using waterfall or targeted allocations. She said that partnerships may decide to be more conservative in "the drafting of a partnership agreement in the first instance trying to make sure that... there's a clear path and a clear suggestion as to how exactly everything is to be allocated." Wollman said that if the general partner is given authority to interpret the agreement to make the allocations right, that may cause a problem. "In the fund context there are allocation decisions that come up from time to time that we feel very good about," Newman said. But she questioned whether funds may nevertheless decide to change partnership agreements "to try to hard-wire things to avoid some of these issues." Wollman pointed out that partnerships can seek to modify the imputed underpayment using section 6225(c) before the clock runs out on deciding to instead go the section 6226 push-out method route. One of the issues raised in the tax section's comments was what issues can be challenged at IRS Appeals and when. The tax section recommended that a partnership get two chances to go to Appeals: The first would be to contest proposed adjustments -- including the initial imputed underpayment computation -- "but not any disagreements over the section 6225(c) decisions." Then partnerships might have a second chance to go to Appeals to contest the section 6225(c) decisions. "You could see an argument for not wanting Appeals to hear all of these issues on the first visit, because a lot of them may become moot" if the partnership ultimately decides to elect the section 6226 pushout method, Wollman said. "But you could also see an argument for not wanting to have repeat visits." Goldman said that "Appeals is definitely considering multiple trips." He said that officials in the IRS Office of Chief Counsel have been in touch with Appeals officials and while many of these questions remain undecided, "Appeals will definitely have a role and it will probably be pre-modification and post" -- so two trips.

6 Reserving for Partnership Liabilities One important open question is whether the BBA rules, and in particular the section 6225 imputed underpayment regime, will require partnerships to account for the GAAP reserve rules, disclosing any potential liabilities in their financial statements under Financial Accounting Standards Board Interpretation No. 48, "Accounting for Uncertainty in Income Taxes," (ASC ), commonly referred to as FIN 48. If the imputed underpayment is considered an income tax liability of the partnership, it would likely be subject to the FIN 48 reserve rules. Cooper said partnerships will either fall under Financial Accounting Standards No. 5, "Accounting for Contingencies" (now codified at ASC ), commonly referred to as FAS 5, or they'll fall under FIN 48. "No one has made any definitive decisions," he said, adding that "it's not clear at least to us without further guidance." He noted that the BBA didn't change section 701, which provides that "a partnership as such shall not be subject to the income tax imposed by this chapter" and that the BBA regime could be viewed as collecting tax from the partnership only as a conduit for the partners' liability. Wollman pointed out that "there is the later-in-time rule" of statutory construction. Cooper said "no one is questioning" that section 6225(a)(1) states that "the partnership shall pay any imputed underpayment." But he added, "We don't think that answers the question directly. I think it comes down to whether it's an income tax liability" of the partnership. Warren said, "FIN 48 doesn't seem to really capture this very well. No -- I would think it's a FAS 5" liability. Chasing Down Partners One area on which the blue book was silent was what happens when a partnership elects the section 6226 push-out method and issues statements (essentially adjusted Schedules K-1) to its partners in the year under audit but the partners fail to pay up. Does the liability fall back on the partnership? IRS Chief Counsel William J. Wilkins has said that he doesn't think so and that if a partnership dispensed with its obligation under the statute, the liability won't fall back on it even if the reviewed-year partners ignore the statements or the partnership made computation errors. (Prior coverage (Doc ).) Goldman said that some of the commentators took the position that Congress, in enacting the BBA, didn't fundamentally change the policy that partnerships aren't liable for tax. "I think that's debatable now with the imputed underpayment... so perhaps there was a fundamental change," he said. Goldman added that the "IRS's remedy should not be so burdensome that we have to run down each partner to make sure that they've complied with their obligations in order to relieve the partnership" of liability. He said, "It's a tough call, but all I can say is that a good-faith effort to furnish those statements is definitely being considered as part of the guidance." Copyright 2016, Tax Analysts