What the statute says
IRC 6225(a) splits adjustments into two outcomes. If the adjustments result in an imputed underpayment, the partnership pays it in the adjustment year. If they do not, the partnership takes them into account in the adjustment year. Under IRC 6225(b)(1) the IRS determines the IU by “appropriately netting all partnership adjustments with respect to such reviewed year” and “applying the highest rate of tax in effect for the reviewed year under section 1 or 11”. Three limits shape the netting:
- Reallocations between partners are not netted to reduce the IU (IRC 6225(b)(2)).
- Adjustments are netted only within categories that must be separately stated under IRC 702(a) or other provisions (IRC 6225(b)(3)).
- A decrease that could be limited or restricted in any person's hands, or not allowed against ordinary income, is not taken into account except as the IRS provides (IRC 6225(b)(4)).
The reviewed year is the year being adjusted; the adjustment year is the year the court decision becomes final, the AAR is filed, or the FPA is mailed (IRC 6225(d)). For an agreed case, the IRM treats the year the IRS countersigns Form 14792 as the adjustment year.
The IRM tells examiners to expect objections: “An imputed underpayment may reflect an amount that is larger than the cumulative amount of tax the partners would have paid as a result of the partnership adjustments.” It explains why: “The partners’ individual tax circumstances are not taken into account when computing the imputed underpayment under IRC 6225.” Partner facts come in only through modification or are avoided entirely by a push-out election.
The formula
IRM 4.31.9.9.2.1 and the IRS's IU page state it the same way:
| Component | What goes in |
|---|---|
| Reallocation grouping | Net positive adjustments only |
| + Residual grouping | Net positive adjustments only |
| = Total netted partnership adjustment (TNPA) | Groupings that net to zero or less are left out |
| x Highest rate | IRC 1 or IRC 11 rate for the reviewed year |
| + Creditable expenditure grouping | Net decreases in creditable expenditures, treated as positive credit adjustments |
| + Credit grouping | Net decreases in credits; net increases only if the IRS allows |
| = Imputed underpayment |
A positive adjustment is anything that is not a negative adjustment. A negative adjustment is a decrease in income or gain, an increase in loss or deduction, an increase in credit or creditable expenditure, a decrease in a chapter 1 tax or penalty the partnership owes, or a decrease to an IU the partnership computed (IRM 4.31.9.9.2.1).
The seven steps
- Group. Put each adjustment in one of four groupings. Reallocation: any adjustment that moves a PRI to or from particular partners, other than a credit or creditable expenditure. Credit: adjustments to items the partnership reports or could report as a credit, plus adjustments to a chapter 1 tax or penalty the partnership owes and to an IU the partnership computed on an AAR. Creditable expenditure: items a person could take as a credit, such as qualified research expenses or creditable foreign taxes. Residual: everything else, including balance sheet items such as liabilities.
- Subgroup. Sort each adjustment by how it would have to be separately stated under IRC 702(a), the forms or instructions. Generally each Schedule K or K-1 line is its own subgroup, and a line with components that must be stated separately (two trade or business activities on line 1, several types of other income on line 11) splits further. Any adjustment that could be subject to a preference, limitation or restriction goes in its own subgroup. The regulations require subgrouping only when a grouping contains a negative adjustment, but the IRM has examiners subgroup every adjustment because the IUA calculator needs it.
- Net. Sum adjustments within each subgroup. “Positive adjustments and negative adjustments may only be netted against each other if they are in the same grouping or subgrouping.” Also, “Adjustments from one tax year may not be netted against adjustments from another tax year.”
- Compute the TNPA. Add the net positive results in the reallocation and residual groupings. Net negative results are excluded.
- Find the rate. Use the highest rate in effect for the reviewed year under IRC 1 or IRC 11.
- Add credits. Add net positive adjustments in the credit and creditable expenditure groupings. A net negative credit adjustment reduces the product only if the IRS decides it is appropriate, which requires a BBA point of contact referral at the field level.
- Compute the IU. TNPA x rate, plus or minus the credit results.
Special recalculation rules apply to partnership years ending on or after November 20, 2020 when a net negative adjustment to a partnership chapter 1 tax or penalty, or to an IU the partnership computed, drives the IU to zero or less. The IU is recomputed without that negative adjustment, and the result determines whether the excluded amount reduces the IU to zero and how the other adjustments are treated (IRM 4.31.9.9.2.7.1).
Worked example from the IRS
The IRS's IU page works an AAR for a reviewed year it assumes is 2023, with a highest rate of 37%. The adjustments and results:
| Adjustment | Grouping and subgroup | Treatment |
|---|---|---|
| $8,000 qualified nonrecourse liability reallocated from partner A to partner B (two legs) | Reallocation | Both legs are positive because a liability is not an income item; one leg ($8,000) treated as zero as duplicative. Net positive $8,000 |
| $3,000 decrease in rent expense (page 1) | Residual, Schedule K line 1 | Net positive $3,000 |
| $5,000 increase in gross rents and $1,500 increase in rental expenses (Form 8825) | Residual, Schedule K line 2 | Netted in the same subgroup: $3,500 |
| $600 increase in interest income | Residual, Schedule K line 5 | Net positive $600 |
| $400 decrease in royalty income | Residual, Schedule K line 7 | Net negative: does not result in an IU; pushed out on Forms 8986 |
| $6,500 increase in QBI tied to the line 1 and line 2 changes | Residual, line 20c code Z | Treated as zero as duplicative |
| $500 decrease in the research credit | Credit | Net positive $500 |
TNPA = $8,000 + $7,100 = $15,100. At 37%, that is $5,587. Adding the $500 credit adjustment gives an IU of $6,087. The IRS notes that adjustments treated as zero for the IU computation are not adjustments that fail to produce an IU: if the partnership pushes out, the full $8,000 liability leg and the $6,500 QBI adjustment still go on the push-out statements.
The IRM adds a subgrouping lesson. A $100 increase in gross receipts and a $30 increase in cost of goods sold from a single activity net to $70 on Schedule K line 1. If the receipts belong to Activity A and the COGS to Activity B, and the activities are separately stated, they cannot net: the IU base is $100, and the $30 is an adjustment that does not result in an IU (IRM 4.31.9.9.2.8).
Zero adjustments and recharacterizations
Treas. Reg. 301.6225-1(b)(4) lets the IRS treat an adjustment as zero, solely for computing the IU, when its effect is already reflected in another adjustment, and generally treats one of two related positive adjustments as zero. IRM 4.31.9.9.2.9 reads that discretion broadly: the zeroed adjustment need not be the same amount or character, multiple adjustments can be zeroed, and simultaneous reviewed years can be considered together. But the IRS cannot zero the only positive adjustment in a report, and IRS job aids require some items to stay in. The IRM's IRC 199A example: the QBI disclosure can be zeroed as duplicative of the underlying income adjustments, but the W-2 wage and UBIA disclosure adjustments stay in the IU, unless the examiner reviews a material percentage of affected partners' returns and finds those items have no or immaterial effect.
A recharacterization (ordinary to capital, active to passive, deductible to nondeductible) generally creates two adjustments in separate subgroups: a negative leg reversing the wrong character and a positive leg applying the right one. The negative leg does not offset the positive leg, which is why recharacterizations can produce an IU even when total income does not change. Nondeductible expense adjustments, for example, show as a positive adjustment in the residual grouping that creates an IU and a negative adjustment taken into account in the adjustment year (IRM 4.31.9.6).
Adjustments that do not result in an IU
Net negative adjustments, and all adjustments when the IU computes to zero or less, are adjustments that do not result in an IU. In an exam, “A net negative adjustment does not result in an IU; thus, such adjustment must be taken into account by the partnership in the adjustment year.” The partnership reports them on its adjustment-year return as separately stated or non-separately stated items under IRC 702, and reallocation negatives go to adjustment-year partners who were also reviewed-year partners (IRM 4.31.9.9.2.10).
Exceptions: if the partnership elects push-out for the IU, it must also push out the associated adjustments that do not result in an IU; certain modifications can reach them under IRC 6225(c)(9); and if there is no IU at all, push-out is not available. On an AAR the rule reverses: a partnership filing an AAR must push out adjustments that do not result in an IU to its reviewed-year partners. See administrative adjustment requests.
General and specific imputed underpayments
Normally an exam produces one general IU per year. The IRS may determine one or more specific IUs for adjustments allocated to a particular partner or group of partners with similar characteristics or transactions (IRM 4.31.9.9.2). A partnership usually asks for this through a modification request on the number and composition of IUs after the NOPPA. A specific IU matters because the push-out election can be made for one or more of the IUs in an FPA (Treas. Reg. 301.6226-1(a)), and a petition in district court or the Court of Federal Claims requires a deposit of each IU to which the petition relates (IRM 8.19.14.7.4).
Challenging the computation
The IU is reported to the PR on a separate Form 886-A that shows the TNPA, the rate, each grouping's result and any recalculation, with the IUA workbook's computation and adjustment summary tabs. During the exam, the PR can propose different subgrouping or netting, but the IRM requires it in writing: “PR must provide a written request detailing the appropriate facts and circumstances to support such request.” Partner-level facts, such as showing that a negative adjustment is not actually limited for any partner, support those requests. Otherwise, the IU can be protested to Appeals after the 30-day letter, modified after the NOPPA, and contested in court after the FPA (the IU is itself a partnership-related item under IRC 6241(2)(B)). Interest and penalties on the IU are covered on penalties in a BBA examination.
Questions practitioners ask
Why is the imputed underpayment higher than what the partners would have owed?
Because IRC 6225 applies the highest individual or corporate rate to the netted adjustments and ignores each partner's own rate, losses and limitations. The IRM says partners' individual tax circumstances are not taken into account. Modification or push-out is how partner facts come in.
Can a deduction we missed offset income the IRS found?
Only if both adjustments land in the same grouping and subgrouping. A negative adjustment in a different subgroup, such as a capital loss against ordinary income, does not reduce the IU and is instead taken into account in the adjustment year.
Which rate applies for a 2023 reviewed year?
The highest rate in effect for the reviewed year under IRC 1 or 11. The IRS's own example for a 2023 reviewed year uses 37%. A partnership can request a lower rate for C corporation partners, or for individuals on capital gains and qualified dividends, through rate modification.
Is the imputed underpayment the same as a deficiency?
No. It is assessed and collected as if it were a tax for the adjustment year, but deficiency procedures do not apply (IRC 6232(a)). The IRS assesses it after the FPA period runs or the court decision becomes final.
Do adjustments treated as zero disappear?
No. They are zero only for computing the IU. If the partnership pushes out, the actual amounts go on the push-out statements, as the IRS's example shows for the liability and QBI adjustments.