IRS Letter 2205-D for a Fund: Imputed Underpayment and Push-Out

What does Letter 2205-D mean for a fund?

Letter 2205-D tells a partnership that the IRS has selected its Form 1065 for exam. The IRS sends one letter for each year under exam, only to the partnership. For tax years beginning after 2017, a fund that did not validly elect out is examined under the centralized partnership audit rules, often called the BBA rules (IRS: BBA partnership audit process).

Under these rules, the fund itself, not each investor, generally owes any tax the exam finds. The tax is computed for the audited year (the reviewed year) but is paid by the fund as it exists today (the adjustment year), unless the fund pushes the adjustments out to the reviewed-year investors.

The first steps after the letter:

1. Call the IRS contact on the letter by the date it gives, to schedule the first exam meeting.
2. Confirm who the partnership representative is for that year, and whether that person is still the right one.
3. Collect the records listed at the end of this page.
4. If the fund knows of an error on the audited return, note that it can file an administrative adjustment request (AAR) only until the notice of administrative proceeding, usually about 30 days after Letter 2205-D.

A case is rarely simple when the fund has many investors, investors who have redeemed since the audited year, tax-exempt or foreign investors, or other partnerships as investors. Each of these changes the tax, who pays it and the forms. A CPA firm can compute the imputed underpayment, prepare the modification request and the push-out statements, and represent the fund in the exam under a power of attorney (Hedge funds and alternative funds).

What happens next in a BBA partnership audit?

The IRS moves through a fixed set of notices.

The partnership representative can request an Appeals conference after the summary report only if at least 18 months remain before the IRS's time limit to make adjustments runs out (see How far back can the IRS go?). If less time remains, an extension of that time limit can be requested (IRS: BBA partnership audit process).

When can the fund no longer file an AAR?

A partnership cannot file an administrative adjustment request (AAR) for a year once the IRS mails the notice of administrative proceeding for that year (26 USC 6227(c)). After the NAP, investors also cannot file returns that are inconsistent with the fund's return for that year. How an AAR works is covered in correcting a filed business return.

Who acts for the fund in the exam?

The partnership representative alone acts for the fund in the exam. The fund and every investor are bound by what the partnership representative does and by any final decision (26 USC 6223).

The partnership representative must have a substantial presence in the United States: a US taxpayer identification number, a US street address, a US phone number, and availability to meet the IRS in person in the United States. If the representative is an entity, such as the general partner or the management company, the fund must also appoint a designated individual who meets the same test. The entity acts only through that person (26 CFR 301.6223-1(b)).

A power of attorney on Form 2848 does not make anyone the partnership representative. A CPA or attorney with Form 2848 can represent the fund, but the partnership representative still makes the binding decisions. The basics of the role are covered in how partnerships are taxed.

Can we replace the partnership representative for the audited year?

Yes. During an exam, the fund can revoke the designation and name a new partnership representative on Form 8979, after the IRS issues Letter 2205-D or the NAP for that year (Instructions for Form 8979).

Form 8979 goes to the IRS employee handling the exam. A revocation must name the successor. A resigning representative cannot name a successor. If no designation is in effect, the IRS gives the fund 30 days from its notice to designate one, and otherwise picks one itself. If the fund sends a second revocation within 90 days of an earlier one for the same year, the IRS may treat the designation as not in effect and choose the representative. If the IRS chose the representative, the fund can revoke that choice only with IRS permission, effective when the IRS confirms it (26 CFR 301.6223-1(d)–(f)).

How is the imputed underpayment computed?

The IRS nets the adjustments for the reviewed year by category and multiplies the net increase by the highest tax rate in effect for that year under section 1 (individuals) or section 11 (corporations) (26 USC 6225(b)). For reviewed years beginning after 2017, the highest individual rate is 37% (26 USC 1(j)).

Interest runs from the due date of the reviewed-year return to the due date of the adjustment-year return, or to the date of payment if earlier. If the imputed underpayment is not paid when due, more interest and a late-payment penalty apply. Penalties are computed at the partnership level (26 USC 6233). The fund cannot deduct any of these payments (26 USC 6241(4)).

Adjustments that only move income from one investor to another are not netted down. A decrease that could be limited on any investor's return, such as a capital loss, generally does not reduce the imputed underpayment. So the IRS figure can be higher than the tax the investors would owe on their own returns.

Can Form 8980 modifications lower it?

Yes. The partnership representative can ask the IRS to lower the imputed underpayment on Form 8980. The request is due within 270 days after the NOPPA is mailed. The IRS can agree to extend this window, but a missed window forfeits the right to request modification (26 USC 6225(c)(7); IRS: BBA partnership audit process).

Sources: 26 USC 6225(c), 26 CFR 301.6225-2(d), About Form 8980.

Do foreign investors count as tax-exempt?

Sometimes. The tax-exempt modification uses a definition that includes foreign persons, but only for the part of the adjustment on which the foreign investor would not owe US tax in the reviewed year (26 CFR 301.6225-2(d)(3)). If the adjustment is income the foreign investor would be taxed on in the United States, that part does not qualify. Whether a given item qualifies depends on the type of income and the investor's facts. This claim is part of the tax-exempt modification (Form 8983); a treaty claim is a separate modification.

Each modification needs documents for each investor. A fund that cannot get tax status forms or cooperation from investors who left may not be able to use the modification for them.

Should the fund pay or make the push-out election (Form 8988)?

A fund can either pay the final imputed underpayment itself or elect to push the adjustments out to the investors of the reviewed year on Form 8988. The election is due within 45 days of the FPA (26 USC 6226(a)). Once made, it can be revoked only with IRS consent.

Interest on pushed-out adjustments runs at the investor level from the due date of the return for the year the increase belongs to (26 USC 6226(c)). Investors that are not pass-through entities (individuals, C corporations, taxable trusts and estates, and tax-exempt investors filing Form 990-T) report their share on Form 8978 with their US income tax return for the year that includes the date the fund furnished Form 8986. Foreign investors do the same (IRS: BBA partnership audit process; Instructions for Form 8978). Investors that are partnerships or S corporations follow the fund-of-funds rules below.

When many audited-year investors have redeemed, paying at the fund level shifts their tax to the investors who remain. Pushing out keeps the cost with the audited-year investors but costs them more interest and needs good investor records. Whether the partnership agreement lets the fund recover a payment from former investors, or requires a push-out, is a question for the fund's counsel.

Which deadlines can't move?

Two deadlines in the push-out route cannot be extended, and missing either one leaves the fund liable for the imputed underpayment. The 270-day modification window is the one that can be extended.

The adjustments are finally determined when the time to petition a court expires or, if the fund petitions, when the court's decision becomes final (26 CFR 301.6226-2(b)). The fund must also wait for the IRS to return a countersigned Form 8988 before sending the push-out statements (IRS: BBA partnership audit process).

To contest the FPA, the fund has 90 days after it is mailed to petition the Tax Court, the federal district court where the fund has its principal place of business (the District of Columbia if that place is outside the United States), or the Court of Federal Claims. Only the Tax Court accepts a petition without payment: the other two require the fund to deposit the imputed underpayment, penalties and additions to tax by the filing date (26 USC 6234; 26 USC 6241(5)).

Our fund of funds received a Form 8986: push out again or pay?

A fund that receives Form 8986 as an investor in another partnership has two choices. It can furnish Form 8986 to its own investors for that year and send Forms 8985 and 8986 to the IRS. Or it can compute and pay an imputed underpayment on the adjustments it received.

Either step is due by the extended due date of the audited partnership's adjustment-year return. The fund uses that date even if the audited partnership did not file for an extension. The date appears in Part II, item F, of the Form 8986 the fund received (26 CFR 301.6226-3(e); Instructions for Form 8986).

If the fund does neither on time, it must pay the imputed underpayment with interest and penalties. A late or missing Form 8985 can also bring the late partnership return penalty under section 6698. These rules apply even if the fund elected out of the centralized rules for its own year (26 USC 6226(b)(4)).

We elected out, but have a GP LLC or trust as a partner: was the election valid?

Not if any partner that year was a partnership (such as a general partner LLC taxed as a partnership), a trust, a disregarded entity or a person holding the interest for someone else. A partnership can elect out only if it must issue 100 or fewer Schedules K-1, counting each shareholder of an S corporation partner, and every partner is an individual, a C corporation, a foreign entity that would be a C corporation if domestic, an S corporation or the estate of a deceased partner. The election must also be made on a timely filed return that lists each partner's name and taxpayer identification number, and the fund must notify each partner within 30 days of making it (26 USC 6221(b); 26 CFR 301.6221(b)-1(c)).

The election binds the fund and its partners until the IRS determines it is invalid. The IRS then notifies the fund in writing and the centralized rules apply to that year (26 CFR 301.6221(b)-1). The fund then needs a partnership representative and faces the full process above. A fund that validly elected out is examined under the general rules, with each investor examined separately. Electing out is covered in how partnerships are taxed.

Which states must we report federal adjustments to?

Many states require a partnership to report final federal adjustments within a set period, and some require it to pay or pass the adjustments to its partners. The Multistate Tax Commission adopted a model statute for reporting federal partnership audit adjustments that states may adopt (Multistate Tax Commission). Each state decides whether to follow it, and forms and windows differ.

Check the rule in every state where the fund filed a return or withheld for nonresident investors for the audited year, starting when the federal adjustments become final. State filings for funds are covered in fund state returns and nonresident withholding.

How far back can the IRS go?

The IRS generally has 3 years from the latest of the filing date, the return due date or the date of an AAR for that year to make adjustments (26 USC 6235). The period is extended:

• to 270 days after everything for a modification request is submitted (plus any agreed extension), if later;
• to 330 days after the NOPPA (plus any agreed extension of the modification window), if later;
• by any written agreement between the fund and the IRS.

The period is 6 years for a substantial omission of income. There is no time limit for a fraudulent return or a year with no return.

Who pays after the fund dissolves?

If the IRS determines that the fund ceased to exist before the adjustments take effect, the fund is no longer liable for the unpaid amounts. Instead, the former partners take the adjustments into account as if the fund had elected push-out (26 CFR 301.6241-3).

• A fund ceases to exist if it has ended because none of its business continues in a partnership (section 708(b)(1)), or if the IRS finds it cannot pay the amount due.
• The determination does not apply if the fund already made a valid push-out election or paid in full within 10 days of notice and demand.
• The former partners are the partners in the adjustment year. If the fund has no adjustment-year partners, they are the partners in the last year the fund filed a return.
• The fund must send statements to the former partners and the IRS within 60 days after the later of the IRS notice or the date the adjustments take effect (when they become final or are settled with the IRS).
• The fund can still request modifications.

If a fund that still exists does not pay within 10 days of the IRS notice and demand, interest rises and the IRS may assess the adjustment-year partners their proportionate share. In general the IRS has 2 years from the notice and demand to do so (26 USC 6232(f)). Closing the fund's books and accounts is covered in winding down a fund.

What records should we gather?

Gather these before the first meeting with the IRS:

• every IRS letter and its envelope date, and the IRS contact's details;
• the audited Form 1065, all Schedules K-1, K-2 and K-3, and the workpapers;
• the partnership agreement, side letters and offering documents;
• the partnership representative designation and any Form 8979 already filed;
• each investor's tax status forms (Forms W-9 and W-8) for the audited year;
• subscription, transfer and redemption records, with current or last known investor addresses;
• the fund's state returns and nonresident withholding filings for the audited year.

Example

Figures are in US dollars and are illustrative only.

Tax-exempt investors lower the bill

The IRS increases a fund's ordinary income for the audited year by $2,000,000. At 37%, the imputed underpayment is $740,000, plus interest. Tax-exempt investors held 25% of the fund that year and would owe no tax on their share of the added income. The fund documents their status on Form 8983 within the 270-day window. If the IRS approves, it removes $500,000 of the adjustment, and the imputed underpayment falls to $555,000.

Most audited-year investors have left

The same fund has seen 60% of its audited-year investors redeem. If it pays, the investors who remain bear the full $555,000. The partnership representative elects push-out on Form 8988 within 45 days of the FPA, then sends Forms 8986 within 60 days after the adjustments become final. Each audited-year investor that is an individual or a C corporation pays its own tax on Form 8978, with interest 2 percentage points above the normal rate.

Different for you?

• You want to correct the return before the IRS notice of administrative proceeding. See correcting a filed business return.
• You need the basics of the partnership representative or electing out. See how partnerships are taxed.
• The fund also received a CP162 or a late-filing penalty. See late filing and payment penalties.
• You are changing preparers before K-1 season. See getting fund tax forms out on time.
• You are an investor with your own IRS notice about fund income. See late fund tax forms.
• The fund is closing or has closed. See winding down a fund.
• The fund has a Letter 2205-D, a NOPPA, an FPA or a Form 8986, and needs the computation, modifications, push-out statements or representation in the exam. See Hedge funds and alternative funds.