Bipartisan tax package may require amended returns

Congress is currently considering a bipartisan tax package that would significantly increase tax deductions for many businesses. The Tax Relief for American Families and Workers Act of 2024 (TRAFWA) was first announced on Jan. 16, 2024, and passed the House on Jan. 31, 2024. The schedule for consideration in the Senate is yet to be determined, but passage could occur in the coming weeks or months.

TRAFWA proposes a variety of tax relief, but three notable changes are focused on businesses. A more detailed overview of the proposed changes can be found here, but the specific business tax changes include:

• Research & experimentation expenses under Section 174. The first change would restore the deductibility of domestic research and experimentation (R&E) expenditures by modifying existing Sec. 174. R&E expenditures were first required to be capitalized and amortized in tax years beginning after Dec. 31, 2021. TRAFWA would retroactively restore domestic R&E back to that first year. An accounting method change option would be available to obtain the benefit of 2022 deductions in 2023 or a combination of 2023 and 2024.
• Business interest expense deductions. TRAFWA would also return the business interest expense limitation under Sec. 163(j) to previous law. Specifically, this would allow addbacks for depreciation, amortization, and depletion in the calculation of adjusted taxable income (ATI). By increasing ATI, this would increase the capacity of businesses to deduct interest expenses. Such changes would apply to 2024 and 2025. However, taxpayers could elect to apply such changes retroactively to both 2022 and 2023.
• Depreciation. TRAFWA would also restore 100% bonus depreciation for 2023 through 2025. Such change is retroactive, though many 2023 tax returns have been filed and such taxpayers may need to consider how to account for these retroactive changes.

The most notable retroactive changes affecting 2022 tax return filings include changes to Sec. 174 and Sec. 163(j). Unfortunately, partnerships are expected to be presented with different paths to take advantage of such changes. The Sec. 174 changes would allow for either amendments to prior years or the use of accounting method changes. Conversely, the proposed Sec. 163(j) changes seem to indicate that a 2022 amendment would be required for those seeking to benefit from the change in 2023. Partnerships seeking to amend 2022 tax returns to take advantage of these changes may be subject to the BBA Partnership Audit Regime (Bipartisan Budget Act of 2015), and rules related to the Administrative Adjustment Request (AAR) process. These rules may result in a loss of some or all of the anticipated tax benefits.

Overview of the Bipartisan Budget Act Administrative Adjustment Request rules

Partnerships that didn’t elect out of the BBA partnership audit rules for 2022 are required to follow the BBA AAR process for any prior year changes that aren’t made via an accounting method change. Such rules were first introduced after 2017 and provided a dramatically different procedure for partnerships that want to amend their previously filed tax returns.

Central to the AAR regime are the concepts of adjustments and push-outs. If an AAR results in a taxpayer-favorable adjustment (known as a negative adjustment), a partnership is required to “push out” the adjustment to its partners. The tax impact of a push-out adjustment is reflected on the partner’s tax return. If the partnership has a taxpayer-unfavorable adjustment as a result of the AAR, an imputed underpayment of tax (known as an IU) is calculated and paid at the partnership level. However, the partnership is permitted to make an election to push out the adjustment to the partners.

Reporting administrative adjustment request adjustments at the partner level

It’s important to distinguish between the partnership tax year that gives rise to the adjustment (known as the reviewed year) and the year the partner takes the adjustment into account. The partner reflects the tax impact of the adjustment in the “adjustment year.” That is the taxable year that includes the date when the partnership reports its share of the adjustment to the partner. The partner will usually see the tax impact of the adjustment on the partner’s return for the tax year that the AAR was filed. For example, if changes to tax law were enacted in 2024 with retroactive effect, then AARs could begin to be filed in that year. That means that the AAR partners would realize the impact of those AAR adjustments on their own 2024 tax returns.

The partner-level reporting for a pushed-out AAR adjustment requires the partner to recalculate their tax liability for the reviewed year and any other years between the reviewed year and the adjustment year (the intervening years). The revised tax liabilities are compared to the tax liabilities reported on previously filed returns for the same years. If multiple years are recalculated, the tax liability correction amounts are accumulated. When a partner has an overall reduction in tax, the correction amount becomes a negative tax correction in the adjustment year (the negative tax correction amount functions similar to a nonrefundable credit).

AAR negative corrections as nonrefundable tax credits

The treatment of a negative tax correction in the adjustment year will be a significant problem in some situations. In addition to being nonrefundable, the correction amount isn’t eligible to be carried back or forward to a different tax year. As a result, if the partner doesn’t have sufficient tax liability in the adjustment year to absorb the negative correction amount, some or all of the tax benefits from the negative adjustment will be permanently lost. This can be a particularly challenging issue for taxpayers who pay less tax in the adjustment year due to reduced profitability, net operating losses, or other such circumstances. Given that the proposed tax provisions of TRAFWA are likely to result in negative adjustments for partnerships that file AARs, the income tax situation of ultimate partners should be assessed to determine if the benefits of filing the AAR can be fully utilized by the partners. If a partnership has reason to believe that its partners may not be fully able to realize the benefit of the AAR adjustments in the reporting tax year, the partnership may consider alternative strategies to plan into a more desirable tax outcome.

State administrative adjustment request considerations

Like many income tax rules, states vary in their adoption of federal tax law. This applies to both the proposed changes of TRAFWA and the BBA AAR rules themselves. Some states have adopted rules similar to the federal BBA AAR rules. Partnerships should assess their facts and circumstances in determining an approach to correcting state tax filings, if necessary, in response to TRAFWA.

What about 2023 returns?

Given that TRAFWA is still making its way through the legislative process, it’s unknown whether the proposed changes will be enacted and, if so, when. With the passage of the first major filing due date on March 15, 2024, the options available to businesses will depend on whether an extension was filed even if their return was filed by the original due date. Absent an extension, if TRAFWA becomes law after the original due date, any returns that were filed may need to be amended to reflect the changes. This would include deducting domestic R&E costs, redetermining limitations on business interest expense, and utilizing 100% bonus depreciation. However, if an extension was filed, the federal tax return can be superseded to reflect the changes. A superseding return takes the place of the original return when it’s filed by the due date, including extensions. A superseding return eliminates the possibility of a negative correction amount limitation and avoids the timing issues of an AAR.

Key takeaways

The proposed changes of TRAFWA could generate significant tax benefits for the partners of partnerships, but a partner’s tax liability in the adjustment year ultimately drives the benefit, or lack thereof, from a negative adjustment arising from an AAR filing. With the CARES Act legislation in 2020, the IRS in Rev. Proc. 2020-23 provided temporary administrative relief to BBA partnerships to forego filing an AAR, and to use the amended return process instead. However, it’s unclear if the IRS will provide similar relief at this time.