- The basic rule
- Computing accuracy and fraud penalties on the IU
- Negative adjustments and penalty ordering
- The substantial understatement test
- Reasonable cause and partner-level defenses
- Penalties after a push-out election
- Supervisory approval and reporting
- Penalties outside the BBA computation
- Questions practitioners ask
The basic rule
IRC 6221(a) makes the applicability of any penalty, addition to tax or additional amount relating to a partnership adjustment a partnership-level determination. IRC 6233(a)(3) sets the computation: “Any penalty, addition to tax, or additional amount shall be determined at the partnership level as if such partnership had been an individual subject to tax under chapter 1 for the reviewed year and the imputed underpayment were an actual underpayment (or understatement) for such year.” The partnership pays the penalties with the IU unless it pushes out (IRM 20.1.5.22.2).
Interest on an IU runs from the day after the reviewed-year return due date to the adjustment-year return due date, or earlier payment (IRC 6233(a)(2)). Separately, if the partnership fails to pay the IU when due, IRC 6233(b) imposes interest and the failure-to-pay addition under IRC 6651(a)(2) as if the IU were an adjustment-year underpayment. The IRM notes the same failure-to-pay rule applies to pass-through partners that elect to pay an IU and to partnerships filing an AAR (IRM 4.31.9.9.3.3). General failure-to-pay rules are on the failure-to-pay penalty.
Computing accuracy and fraud penalties on the IU
Treas. Reg. 301.6233(a)-1(c)(2) gives the method for penalties under IRC 6662, 6662A and 6663. The partnership is treated as an individual for the reviewed year and the IU is treated as the underpayment or understatement (IRM 20.1.5.22.2). Each penalty is shown, by code section and amount, on Form 14791, Form 14792 or Form 15027, with a separate Form 886-A for each penalty (IRM 4.31.9.9.3.3).
The IRM's six steps (IRM 20.1.5.22.2.1.1):
- Total the adjustments subject to a particular penalty, excluding credit and creditable expenditure adjustments.
- Multiply by the highest rate used in computing the IU.
- If the IU was rate-modified, repeat steps 1 and 2 for each rate used.
- Add the results of steps 1 to 3.
- Net the credit and creditable expenditure adjustments and add or subtract them under the ordering rules.
- Multiply by the penalty rate. The result is the penalty for that category.
The IRM's first example assumes a 40 percent highest rate for illustration: a $100 ordinary income adjustment subject to the 20 percent negligence penalty and a $300 capital gain adjustment with no penalty. Only the $100 portion is subject to penalty: $100 x 40% = $40 of IU, and $40 x 20% = an $8 penalty. When the IU is modified, the penalty follows the modified IU; in the IRM's modification example, a $400,000 adjustment produced a $160,000 IU and a $32,000 penalty, and after approved modifications for a tax-exempt partner and an amended-return partner removed $200,000, the IU became $80,000 and the penalty $16,000.
Fraud has its own rule: “If any part of an IU is attributable to fraud, the entire IU shall be treated as attributable to fraud unless the taxpayer establishes (by a preponderance of the evidence) such portion of the underpayment is not attributable to fraud.” The 75 percent rate applies to the portion attributable to fraud (IRM 20.1.5.22.3.1). For IRC 6662A, the portion of the IU attributable to a reportable transaction is treated as a reportable transaction understatement. Penalty basics are on the accuracy-related penalty and the civil fraud penalty.
Negative adjustments and penalty ordering
When a grouping or subgrouping contains both negative adjustments and positive adjustments subject to penalties, the negative adjustment is used first against positive adjustments with no penalty, then against those with the lowest penalty rate, and so on upward: none, 20 percent, 30 percent, 40 percent, 75 percent (Treas. Reg. 301.6233(a)-1(c)(2)(iii); IRM 20.1.5.22.2.1.1). Adjustments that do not result in an IU, and adjustments excluded from the IU by modification, are disregarded for penalty purposes. All credit and creditable expenditure adjustments are treated as one credit grouping for this purpose, and net negative credit adjustments offset the unpenalized portion of the IU first. Examiners must refer cases with negative adjustments and penalties to a BBA point of contact (IRM 4.31.9.7.2).
An example from IRM 20.1.5.22.2.1.1 (again assuming a 40 percent rate): a $100 ordinary income adjustment subject to the 20 percent negligence penalty, a $300 long-term capital gain adjustment subject to the 40 percent gross valuation misstatement penalty, a $10 credit reduction subject to the 20 percent penalty, and a $50 ordinary deduction subgrouped with the $100. The $50 offsets the $100 first, leaving $50 at the 20 percent rate; the $300 is penalized at 40 percent; and the IRM totals the penalties at $54.
The ordering rule favors the partnership: a deduction the examiner allows is applied to unpenalized income first, which minimizes the penalized portion of the IU.
The substantial understatement test
For IRC 6662(d), the IU is the understatement. To decide whether it is substantial, the “tax required to be shown” is computed by treating the partnership's net income or loss as adjusted as taxable income under IRC 1(c), the unmarried individual schedule, without IRC 1(h) (Treas. Reg. 301.6233(a)-1(c)(2)(iv)(B)). The IRM cautions: “The calculation of the amount of tax required to be shown on the return is based on the brackets and not using the highest rate as a flat rate.”
The IRM's example for a 2018 reviewed year, using the Rev. Proc. 2018-18 rate table for unmarried individuals:
| Item | Amount |
|---|---|
| Net ordinary loss reported | $(500,000) |
| Partnership adjustments | $1,200,000 |
| Taxable income as adjusted | $700,000 |
| Tax required to be shown: $150,689.50 + 37% of the excess over $500,000 | $224,689.50 |
| Threshold: greater of $5,000 or 10% of tax required to be shown | $22,468.95 |
| Understatement (the IU) | $444,000 |
| Penalty at 20% | $88,800 |
Because $444,000 exceeds $22,468.95, the understatement is substantial. The IRS uses a job aid for these calculations (IRM 4.31.9.9.3.3).
Reasonable cause and partner-level defenses
At the partnership level, “A partner-level defense may not be raised at the partnership level.” (IRM 4.31.9.9.3.3). In applying IRC 6664(c) and Treas. Reg. 1.6664-4, the partnership is the taxpayer and only its facts count (IRM 20.1.5.22.3.4). A reasonable cause defense for the partnership therefore has to be built on facts and circumstances applicable to the partnership itself; partners' personal circumstances do not defeat the partnership-level penalty. See reasonable cause.
Partners keep personal defenses only in a narrow way: “Partners can only challenge penalties with partner-level defenses by first paying the penalty and then filing a claim for refund for the reporting year.” Those defenses are limited to ones personal to the reviewed-year partner, such as a partner's own reasonable cause (Treas. Reg. 301.6226-3(d)(3)). See refund claims and suits.
Penalties after a push-out election
If the partnership pushes out, the reviewed-year partners become liable for the penalties on their shares (IRC 6226(c)(1)). The partnership-level determination still decides which penalties apply, and Forms 8986 tell partners which penalty provisions apply to which adjustments. Each partner then computes the penalty on its own return: if it has no understatement, or one below its threshold, no penalty is due (Treas. Reg. 301.6226-3(d)(2)). As the IRM puts it, “The reviewed year partners calculate the penalty using their own personal thresholds.” Pass-through partners that pay an IU instead of pushing further compute penalties as if the amounts were IUs for their first affected year (Form 8985 instructions). See the push-out election.
Supervisory approval and reporting
The IRM applies IRC 6751(b) to BBA penalties: “Managers, including immediate supervisors or for LB&I examinations, the immediate supervisor or a designated higher-level official, must review and approve in writing whether any penalties should be imposed as part of the examination.” Penalty computations must appear in the summary report package, the 30-day letter package and the NOPPA package. The PR can protest penalties to Appeals with the substantive issues, and a court reviewing an FPA has jurisdiction over the applicability of penalties for which the partnership may be liable (IRC 6234(c)). Approval rules are covered on supervisory approval under IRC 6751(b).
Penalties outside the BBA computation
- Late partnership return (IRC 6698). “The IRC 6698(a) penalty is not on an adjustment to a PRI.” It is assessed against the partnership outside BBA, does not appear on Forms 14791 or 14792, and also applies to a late or incomplete Form 8985 partnership adjustment tracking report (IRM 4.31.9.9.3.3). See the IRC 6698 penalty.
- Push-out statements (IRC 6722). A failure to furnish correct push-out statements is subject to the IRC 6722 penalty (Treas. Reg. 301.6226-2(a)).
- Math error assessments on partners. A partner who reports inconsistently without notice is assessed tax, penalties and interest through math error procedures under IRC 6222 (IRM 4.31.9.8.2.3).
Questions practitioners ask
Can the partnership raise a partner's reasonable cause to avoid a BBA penalty?
No. Only the partnership's facts count at the partnership level, and partner-level defenses cannot be raised there. A partner with a personal defense pays the penalty and files a refund claim for the reporting year.
Is the substantial understatement threshold computed at the 37 percent flat rate?
No. The IRM says the tax required to be shown is computed using the IRC 1(c) brackets for the reviewed year, not the highest rate as a flat rate. The IRM's 2018 example uses the Rev. Proc. 2018-18 table.
Does the penalty shrink if the IU is modified?
Yes. The penalty is computed on the modified IU. The IRM's example shows the penalty falling from $32,000 to $16,000 when approved modifications halved the IU.
Who pays penalties if the partnership pushes out?
The reviewed-year partners. The partnership-level determination decides which penalties apply, but each partner computes them on its own return using its own thresholds.
Is the IRC 6698 late filing penalty part of the imputed underpayment?
No. It is not a penalty on an adjustment to a partnership-related item, so it is assessed separately and does not appear on the BBA reports.