The tax treatment of partnership items.

• Author: Martin, M. Jill Lockwood

How to Determine Their Correct Treatment When a Return Is Audited

The majority of tax professionals welcomed the passage of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which required the IRS to conduct audits at the partnership level in order to change the tax treatment of partnership items. Under pre-TEFRA law, a tax professional representing a partner on the audit of the partner's individual tax return was often confronted with an agent proposing changes in the tax treatment of partnership items. All too often, both the tax professional and the individual partnership lacked the information necessary to determine the proper tax treatment of the item. The only response to the agent was that the item had been reported in conformity with the partner's K-1 provided by the partnership.

To solve this dilemma, the TEFRA added Secs. 6221-6232 to the the Code,(1) providing for the audit of partnership items to be conducted during an examination of the partnership rather than during an examination of individual partners' returns. "Partnership items" are income, deductions, gains, losses and credits that are determined by regulation to be more properly determined at the partnership level.(2) Nonpartnership items, on the other hand, are items of income that are properly determined on the individual taxpayer level. The importance of making a distinction between the two is evident. However, this separation of partnership and nonpartnership items is not as easy as it might first appear since there are some items relating to the partnership that can best be determined by the individual and are characterized as nonpartnership items.

In addition to facing the dilemma of which items must be audited at the partnership level and which items must be audited at the individual level, tax professionals are faced with a second dilemma. What happens to an individual taxpayer who receives a Schedule K-1 from a partnership concerning a partnership item and the individual disagrees with the partnership's characterization or treatment of that item? Should the partner report the item as the partnership reported it, believing the treatment is incorrect? Should the partner correct the item, and, if so, is the partner obligated to inform the IRS about the correction?

This article will examine the distinctions between partnership items and nonpartnership items and discuss the procedures to follow when a partner determines that a partnership item is reported incorrectly. The rules affect partnerships formed after Sept. 3, 1982.(3)

Partnership Items vs. Nonpartnership Items

As stated earlier, partnership items are audited at the partnership level; nonpartnership items are audited at the partner level.(4) A partnership item is defined as "any item required to be taken into account for the partnership's taxable year under any provision of subtitle A to the extent [provided by] regulations...."(5) Accordingly, only those items found in subtitle A are considered to be partnership items.(6)

Example 1: On Oct. 3, 1990, the IRS issued a Final Partnership Administrative Adjustment (FPAA) to the A Partnership. The partners filed a petition contesting the FPAA--specifically, the Service's determination that certain items resulted from tax-motivated transactions defined in then applicable Sec. 6621(c). The Service stated that the Sec. 6621 item was not a partnership item since Sec. 6621 is listed in subtitle F. The court agreed, stating that subtitle F "is not within [its] scope of review in a partnership level proceeding."(7)

Not all items found in subtitle A are considered to be partnership items. To be a partnership item, it must be shown that the item is more appropriately determined at the partnership level than at the partner level.(8) The chart on page 565 lists certain partnership items. It must be stressed that this list is not all inclusive; there may be other items that occur in the operation of a partnership that constitute "partnership items." Note that partnership items are those that have an impact on a partnership computation, election or other partnership determination. When deciding whether or not an item is classified as a partnership item, it is important to ask whether the partnership will use the item to make any determination affecting partnership property, partnership income (separately stated or nonseparately stated) or partnership elections. The characterization of an item as a partnership item can best be shown by the following examples.

Example 2: Individual F transfers $20,000 in cash and equipment with a value of $40,000 and an adjusted basis of $30,000 to the ZXC Partnership. The first question the partnership must answer is whether the transaction constitutes a contribution, a sale, a loan or any combination of the three. If the transaction, in whole or in part, constitutes a contribution, the partnership must determine the amount of the contribution and the partnership's basis in any property contributed. To the extent that an item is necessary for the partnership to make the determinations it is required to make, that item is classified as a partnership item; otherwise it is not.

Example 3: In 19X1, the MNB Partnership contributes land and takes a charitable contribution. In 19X3, the land is returned to the partnership. The partnership must recognize income under the tax benefit rule. This determination is made in a partnership level proceeding.(9)

Example 4: The ERK Partnership transfers land to H, one of its partners. The partnership must determine if the transaction is a distribution, a sale or a repayment of a loan. If ERK determines that the transaction is a sale, Sec. 707(a) will apply. The items used by the partnership in its determination that the transaction constituted a sale are characterized as partnership items.

Example 5: Assume the same facts as in Example 4. In addition, H pays for the land by using appreciated stock. H must determine the adjusted basis of the stock in order to determine his gain. However, this information is not needed by the partnership and any item used in H's determination is not considered to be a partnership item.

Warning: Be sure that a partnership item is attributed to the correct partnership.

Example 6: Partnership A incurred certain deductions that it passed to one of its partners, partnership B. A was audited and no one objected to the disallowance of the deductions it claimed. B is subsequently audited and the Service disallows deductions passed to it by A. B's partners object. The items in question are partnership items that must be determined at a partnership proceeding. However, they are A's items. Since no objection was made to their disallowance, all partners, including B and its partners, are bound by the audit of A.(10)

Care must be taken not to confuse "partnership items" with "affected items." "Affected items" " are those that are tied to a partner's adjusted gross income (AGI) and are directly affected by adjustments in partnership items.(11) Nonpartnership items that are...