The Treasury Department and the IRS have issued proposed regulations under the so-called fractions rule. The fractions rule provides an exception from the unrelated business taxable income (UBTI) rules for partnerships that hold debt-financed property and have one or more qualified tax-exempt organization partners.

Very broadly, the fractions rule is intended to prevent partnerships owning debt-financed real property from shifting taxable income from taxable persons to certain tax-exempt organizations or to shift taxable losses from those tax-exempt organizations to taxable persons. The existing fractions rule regulations, however, are viewed by many as overbroad in certain respects and difficult to apply. Both tax-exempt and partnership practitioners have long been awaiting new guidance from the government that would simplify and/or clarify many of the difficult and pressing issues under the fractions rule.

Background

The UBTI rules under Section 512 provide that dividends, interest, annuities, royalties, rent from real property, and gain from the sale of property (other than stock in trade or other property properly includible in inventory or property held primarily for sale to customers in the ordinary course of trade or business) are generally excluded from UBTI. One of the exceptions to the general exclusion of such income from UBTI is when the income derives from debt-financed property (i.e., property acquired or improved with "acquisition indebtedness"). Under an exception to this exception, leveraged real estate investments do not generate UBTI as debt-financed property to certain types of exempt investors (e.g., exempt education organizations and pension trusts (a qualified organization or QO)), if the requirements of Section 514(c)(9) are satisfied.

The exemption under Section 514(c)(9)(B)(vi) is allowable to a QO that is a partner in a partnership only if: (i) all the partners in the partnership are QOs, (ii) each allocation to a QO is a qualified allocation, or (iii) the partnership allocations satisfy the requirements for substantial economic effect under Section 704(b) and the "fractions rule" (defined later) under Section 514(c)(9)(E)(i)(I). Many partnerships seeking to satisfy Section 514(c)(9)(B)(vi) have at least one taxable partner and provide for a "carried interest" to the sponsor, which precludes "qualified allocations" and, thus, can qualify only under the fractions rule.

A partnership's allocations satisfy the fractions rule if the partnership's allocations to a QO partner do not result in that partner having a share of overall partnership income for any tax year greater than the partner's share of overall partnership loss for the tax year in which the partner's loss share will be the smallest (the fractions rule). Importantly, a partnership must satisfy the fractions rule on an actual and prospective basis for each tax year beginning with the first tax year that the partnership has a QO as a partner and owns debt-financed real estate.

Certain items are disregarded in applying the fractions rule, including certain guaranteed payments, preferred returns, chargebacks and offsets, partner-specific allocations, unlikely losses and deductions and de minimis allocations of losses and deductions.

Under the existing regulations, a partnership may disregard items of income (including gross income) and gain that may be allocated to a partner for a current or cumulative reasonable preferred return for capital (including allocations of minimum gain attributable to nonrecourse liability, or partner nonrecourse debt, proceeds distributed to the partner as a reasonable preferred return). Similarly, if a partnership agreement provides for a reasonable preferred return with an allocation of what would otherwise be overall partnership income, those items comprising that allocation are disregarded in computing overall partnership income under the fractions rule. The preferred return exception, however, applies only if the allocation for the preferred return is limited to the actual amount distributed currently (or in prior years).

A partnership may provide for chargebacks for disproportionate losses previously allocated to QOs and disproportionate income previously allocated to nonexempt partners. To be disregarded for purposes of the fractions rule, however, any chargebacks cannot be at a ratio exceeding the ratio under which the loss or income was allocated. In addition, the chargeback exception applies to a chargeback of an allocation of part of the overall partnership income or loss only if that part consists of a pro rata portion of each item of partnership income, gain, loss, and deduction (other than nonrecourse deductions, as well as partner nonrecourse deductions and compensating allocations) that is included in computing overall partnership income or loss.

The following partner-specific allocations are excluded in computing overall partnership income or loss for purposes of the fractions rule if they are allocated to the partners to whom they are attributable:

— Expenditures for additional recordkeeping and accounting incurred in connection with the transfer of a partnership interest (including expenditures incurred in computing basis adjustments under Section 743(b))
— Additional administrative costs resulting from having a foreign partner
— State and local taxes or expenditures relating to those taxes
— Expenditures designated by the IRS by revenue ruling or revenue procedure or, on a case-by-case basis, by letter ruling

The existing regulations do not contain any similar exception for the special allocation of management fees to the partners to whom they are attributable.

In computing overall partnership income or loss for purposes of the fractions rule, a partnership may disregard unlikely losses or deductions (other than items of nonrecourse deduction) that may be specially allocated to partners that bear the economic burden of the losses and deductions. The exclusion is not permitted, however, if a principal purpose of the allocation is tax avoidance.

Specific rules are also provided on the acquisition of partnership interests after the initial formation of the partnership, capital commitment defaults, tiered partnerships, and certain de minimis allocations.

Proposed rules

The proposed regulations would expand or create numerous exceptions to the fractions rule for situations that do not implicate the abuse that the fractions rule was intended to address.

The proposed regulations would remove the current distribution requirement under the preferred return exception, effectively replacing it with a priority distribution requirement. In other words, the partnership would be required to make distributions first to the preferred holder to pay accrued, cumulative, and compounding unpaid preferred return (to the extent the preferred return has not been reversed by an allocation of loss prior to distribution). This requirement would be subject to an exception that allows distributions to a partner other than the preferred partner for payment of taxes imposed on the partner's allocable share of partnership income or gain. The exception would apply if the distributions: (i) are treated as an advance against distributions to which the distributee partner would otherwise be entitled under the partnership agreement; and (ii) do not exceed the distributee partner's allocable share of net partnership income and gain multiplied by the sum of the highest statutory federal, state, and local tax rates applicable to that partner.

The existing exclusion for certain partner-specific expenditures would be extended to cover management and similar fees, but not if such fees in the aggregate for the tax year exceed 2% of the partner's capital commitments.

Under the existing regulations, because certain allocations for partner-specific expenditures and unlikely losses are ignored for purposes of the fractions rule, special allocations of income to charge back such losses could cause a fractions rule violation. In order to address this issue, the proposed regulations would disregard special allocations of income made to charge back prior special allocations of partner-specific expenditures or unlikely losses that were disregarded for purposes of the fractions rule.

Under the existing regulations, changes in partnership allocations resulting from transfers or shifts of partnership interests other than between QOs will be closely scrutinized to determine whether the transfer or shift stems from a prior agreement, understanding, or plan or could otherwise be expected given the structure of the transaction, but generally will be taken into account only in determining whether the partnership satisfies the fractions rule in the tax year of the change and subsequent tax years. The proposed regulations provide that, if certain conditions are satisfied, the IRS will not closely scrutinize changes in allocations resulting from staged closings and will disregard, in computing overall partnership income or loss for purposes of the fractions rule, disproportionate allocations of income, loss, or deduction made to adjust the capital accounts when a new partner acquires its partnership interest after the partnership's formation. The conditions would be as follows:

— The changes in partnership allocations and disproportionate allocations to adjust the partners' capital accounts are not inconsistent with the purpose of the fractions rule.
— The new partner acquires the partnership interest no later than 18 months following the formation of the partnership (applicable period).
— The partnership agreement and other relevant documents: (i) anticipate the new partners acquiring the partnership interests during the applicable period, (ii) set forth the time in which the new partners will acquire the partnership interests, and (iii) provide for the amount of capital the partnership intends to raise.
— The partnership agreement and other relevant documents specifically set forth the method for determining any applicable interest factor and for allocating income, loss, or deduction to the partners to account for the economics of the arrangement in the partners' capital accounts after the new partner acquires the partnership interest.
— The interest rate for any applicable interest factor is not greater than 150% of the highest applicable Federal rate, at the appropriate compounding period or periods, at the time the partnership was formed.

The proposed regulations also would contain an exception for changes in allocations due to an unanticipated default on, or reduction in, a partner's capital contribution commitment. The exception would apply only if the changes in allocations are effected under provisions prescribing the treatment of such events in the partnership agreement and are not inconsistent with the purpose of the fractions rule. If the exception applies, the changes in allocations would not be closely scrutinized, and partnership allocations of income, loss, or deduction to partners to adjust the partners' capital accounts as a result of unanticipated capital contribution defaults or reductions would be disregarded in computing overall partnership income or loss for purposes of the fractions rule.

The proposed regulations would remove the requirement that a partnership allocate items from lower-tier partnerships separately from one another. Example 3 in the current regulations would be amended to reflect this change.

The proposed regulations would also alter the de minimis exceptions in the existing regulations. The exception for partnerships in which QOs do not hold interests of greater than 5% of the capital or profits would be modified to require that the QOs not hold such an interest either directly or indirectly through a partnership. In addition, a new exception would apply when persons other than QOs do not own (either directly or indirectly through a partnership) interests of greater than 5% of the capital or profits of the partnership, provided that the partnership's allocations satisfy a modified version of the substantial economic effect safe harbor. The regulations would also modify the exception for certain unplanned allocations of deductions not motivated by tax avoidance by raising the ceiling on such items from $50,000 to $1 million.

The proposed regulations would apply to tax years ending on or after the date they are published as final, but a partnership and its partners may elect to apply them for tax years ending on or after November 23, 2016.

The notice of proposed rule-making also states that the IRS is considering whether to use a "more-likely-than-not" standard in determining whether a loss or deduction is unlikely to occur. Additional comments are requested on this issue.

Implications

In general, the proposed regulations represent a welcome attempt by the government to shield from the fractions rule certain allocations and transactions that do not implicate the purpose behind the rule. Certain aspects of the changes in the proposed regulations, however, may limit their helpfulness.

The elimination of the current distribution requirement from the preferred return exception seems appropriate and likely to make the exception more attractive for partnerships and QOs. One aspect of the proposed exception for tax distributions, however, may prove problematic. For that exception to apply, the tax distributions must not exceed the distributee partner's allocable share of net partnership income and gain, multiplied by the sum of the highest statutory federal, state, and local tax rates applicable to that partner. In practice, partnership agreements often provide for tax distributions to be made based on an imputed tax rate — for example, a specific stated rate, or the highest rate applicable to residents of an identified jurisdiction. This is done for administrative convenience, because it can be burdensome to determine in every case the exact tax rate that should apply. It appears, however, that such tax distribution provisions could cause a partnership to run afoul of the proposed regulations because the tax distribution to a partner may exceed the partner's actual tax liability for its allocable share of partnership income. In addition, partners frequently negotiate tax distributions that are determined without reference to certain partnership items — for example, allocations required under Section 704(c) or items attributable to Section 743(b) adjustments. It is unclear how such tax distribution provisions would fare under the proposed regulations.

The extension of the exception for partner-specific expenditures to management and similar fees seems very helpful, though it is unclear why the government limited the fees for the year to 2% of a partner's capital commitments. In certain situations, this could limit the utility of the exception (e.g., when management fees are based on a percentage of current fair market value).

The exceptions for changes in allocations due to staged closing or defaults on partner's capital commitments are also helpful. Absent further guidance, however, there will likely be uncertainty over the scope of the exceptions. That is because, in addition to imposing specific requirements, both exceptions also impose the more general requirement for changes in allocations not to be contrary to the purpose of the fractions rule. Given the more specific requirements that are already imposed, it is somewhat unclear what additional limitation the more general requirement is intended to impose. In addition, the staged closing exception would not permit the partnership to charge an interest rate in excess of 150% of the applicable federal rate, which is currently significantly less than what is frequently seen in the market.

The addition of an exception for partnerships in which not more than 5% of the capital and profits is held by persons other than QOs appears to be a helpful change. For the exception to apply, however, the partnership's allocations must satisfy a modified version of the substantial economic effect safe harbor. The modified version would disregard: (i) the presumption of a reasonable possibility that allocations will affect substantially the dollar amounts to be received by the partners from the partnership if there is a strong likelihood that offsetting allocations will not be made in five years; and (ii) the presumption that the adjusted tax basis (or book value) of partnership property equals the fair market value of that property. The elimination of these two presumptions may lead to significant additional uncertainty and complexity in the application of the exception.

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