Short answer: Tax returns often have to be filed before every number is final. A fund may still be waiting for an underlying fund's K-1, an invoice, an audit or a valuation, so it uses an estimate. When the final figure arrives and differs, the difference has to go somewhere. That correction is the true-up. The key question is whether the original figure was a reasonable estimate, in which case the difference is usually picked up in the year the final amount is known, or an error, in which case the earlier year has to be corrected. For partnerships under the current audit rules, even corrections to an earlier year usually land in the current year through an administrative adjustment request.

Where estimates come from in funds

  • Late K-1s from underlying funds. A fund-of-funds or feeder often has to file before the funds it invests in have issued their final K-1s.
  • Year-end accruals. Legal, audit and administration fees, interest and other expenses are often accrued before the final invoice arrives.
  • Unfinished accounts. Audited financial statements, valuations and allocations may not be final when the tax return is due.
  • Withholding and estimated tax. Quarterly estimated tax payments and partnership withholding on foreign partners are based on estimates during the year and trued up on the final return.

Rule 1: a reasonable estimate is trued up when the final amount is known

For accrual-method taxpayers, the regulations allow income and deductions to be accrued on a reasonable estimate when the amount cannot yet be fixed exactly. When the exact amount is later determined, the regulations say the difference is taken into account "for the taxable year in which such determination is made." For deductions, the taxpayer deducts the portion of an uncertain liability that can be computed with reasonable accuracy, and adjusts later.

In practice that is the classic true-up: next year's return adds or subtracts the difference, and the earlier return stays as filed.

Rule 2: an error is corrected in the year it belongs to

If a figure was wrong, not just estimated, for example an item left out, double counted or reported in the wrong year, the regulations say the taxpayer should, if still within the statute of limitations, file an amended return and pay any extra tax, or claim a refund if too much was paid. Picking up an error in a later year instead is not the general rule.

The line between an estimate and an error matters. An estimate is reasonable when it is based on the best information available at the time. Ignoring information that was available, or leaving an item out, is an error.

Partnerships under the BBA audit rules

Most partnerships, including most funds, are under the centralised partnership audit regime (often called the BBA rules). They generally cannot file an amended Form 1065 or issue amended K-1s. To correct an earlier year, the partnership files an administrative adjustment request (AAR) instead:

  • When: within three years of the later of the date the return was filed or its due date (ignoring extensions), and never after the IRS has opened an audit with a notice of administrative proceeding.
  • How the correction lands: the adjustment is taken into account in the year the AAR is filed, not the original year. If it produces an imputed underpayment, the partnership either pays it or pushes the adjustments out to the partners who were partners in the year being corrected.
  • Push-out: each of those partners receives a Form 8986 and reports its share on Form 8978 with its return for the year it received the statement, so the partner corrects the past year in its current return. Adjustments that reduce tax are always pushed out to those partners.
  • No amended K-1s. The IRS says a partnership should not provide amended Schedules K-1 or K-3 with an AAR.

So under the BBA rules, even a genuine error in a past partnership return usually becomes a current-year true-up for the partners.

The partner's side

A partner must report partnership items consistently with the partnership's return. If a partner filed using an estimate and the final K-1 shows a different figure, the partner generally corrects its own return. A partner who deliberately reports differently from the K-1 must tell the IRS by filing a notice of inconsistent treatment. This is why many fund investors extend their returns and wait for final K-1s rather than file on estimates.

Book versus tax

Companies see the same issue in their financial statements. The tax provision in the accounts is an estimate made before the return is filed. When the return is finalised, the difference is booked in the next period as a return-to-provision true-up. That is an accounting adjustment, separate from the tax rules above.

Worked examples

1. An accrued expense. A fund using the accrual method accrues $1.2 million of legal fees at year-end, a reasonable estimate before the final bill. In the following year the final bill is $1.0 million. The $200,000 difference is taken into account in the following year, reducing that year's deductions. The earlier return is not amended.

2. A late K-1 under the BBA rules. A fund-of-funds files its 2025 return on time, on extension, using an estimate of $500,000 of income from an underlying fund, because that fund's K-1 has not arrived. In October 2026 the final K-1 shows $560,000. The fund-of-funds must report consistently with the underlying fund's return, so it corrects the $60,000 difference by filing an AAR for 2025. If it pushes the adjustment out, each 2025 partner receives a Form 8986 and reports its share of the $60,000 on Form 8978 with its return for the year it receives the statement.

What this means for funds

  • Document estimates. Keep a record of what was known when each estimate was made. It is the evidence that the figure was a reasonable estimate rather than an error.
  • Track the true-ups. Keep a schedule of estimated items and their final amounts, so the next year's return picks up every difference.
  • Plan the calendar. Extending the return and agreeing K-1 delivery dates with underlying funds reduces the number of AARs.
  • Tell investors. Investors care when a true-up shifts income between years or arrives on a Form 8986, so explain it in the K-1 package.

This explainer is general information, not tax advice.

Sources

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This explainer is analysis and general information, not tax, legal or investment advice.