On October 4, 2017, the Treasury Department released its report detailing actions that it plans to take regarding burdensome regulations, including those regarding the REIT built-in gains tax and recourse partnership liabilities. Treasury acknowledges that the built-in-gain rules may cause too much gain recognition and is considering revisions to narrow the application of the rules. While Treasury also acknowledges issues with the recourse partnership liabilities regulations, no firm action has been determined.

Background

On April 21, President Trump signed an executive order calling for Treasury to review all "significant tax regulations" issued on or after January 1, 2016, and to identify in an interim report those that impose undue financial burden, add undue complexity, or exceed statutory authority. The order further instructed Treasury to submit a final report to the President by September 18, 2017, recommending "specific actions to mitigate the burden imposed by regulations identified in the interim report."

Notice 2017-38 (issued July 7, 2017; see Tax Alert 2017-1086) identified eight specific regulations as unduly burdensome or complex and said, "Treasury intends to propose reforms — potentially ranging from streamlining problematic rule provisions to full repeal — to mitigate the burdens of these regulations in a final report submitted to the President."

Treasury requested comments by August 7, 2017, on whether the regulations described in the Notice should be rescinded or modified, and how they should be modified.

REIT and RIC built-in gains tax regulations

Temporary regulations (T.D. 9770) published on June 7, 2016, amended the built-in gains tax rules contained in Reg. Section 1.337(d)-7 primarily to prevent transactions that could be used to circumvent the new restrictions on tax-free spin-offs involving REITs imposed under Sections 355(h) and 856(c)(8). If a corporation participates in a Section 355 tax-free spin-off as a controlled corporation or the distributing corporation and, during the 10 years following the distribution, engages in a conversion transaction with a REIT (i.e., making a REIT election or transferring assets to a REIT in a carryover basis transaction), Temporary Reg. Section 1.337(d)-7T(c)(6) treats the corporation as having elected to recognize gain and loss as if it sold all of the converted property to an unrelated party at fair market value. This rule applies not only to a corporation that previously participated in a spin-off as a controlled corporation or the distributing corporation, but also to a corporation that was a member of the separate affiliated group of the distributing corporation or the controlled corporation, and to "predecessors" and "successors" of that corporation.

Commenters worried that the rules could result in the over-inclusion of gain in certain situations, such as when a small corporation that engaged in a Section 355 spin-off is acquired by a large corporation that subsequently makes a REIT election.

Treasury and the IRS agreed in the report that the temporary regulations may cause too much gain to be recognized in certain cases and are considering revisions that would limit the potential taxable gain recognized in those situations. Treasury is particularly concerned about situations in which the gain recognition required (because of the application of the predecessor and successor rule in Reg. Section 1.337(d)-7T(f)(2)) exceeds the amount that would have been recognized if a party to a spin-off had directly transferred assets to a REIT.

Treasury will consider revisions that limit gain recognition to the assets of the smaller corporation as well as other technical changes to narrow further the application of the rules.

Temporary partnership regulations

Temporary (TD 9788), and proposed (REG-122855-15) regulations relate to disguised sales of property to or by a partnership under Section 707 and to the treatment of partnership liabilities under Section 752. Among other topics, the regulations address the allocation of liabilities assumed by (or taken subject to) a partnership under the disguised sale rules, the relevance of "bottom-dollar" guarantees for allocating partnership liabilities, and situations in which payment obligations with respect to partnership liabilities may be disregarded for purposes of allocating partnership liabilities. In addition, the regulations address certain deficiencies and ambiguities in the disguised sale rules, mainly with respect to the treatment of preformation capital expenditures.

Commenters stated that the changes to the partnership liability allocation rules for disguised sale purposes were novel, issued without adequately providing time for comments, inconsistent with legislative intent, and internally inconsistent. Treasury is considering revoking the rules and reinstating the prior regulations.

Treasury contends, however, that the bottom-dollar guarantee rules are needed to prevent abuses, as prior rules permitted sophisticated taxpayers to create basis artificially, and thereby shelter or defer income tax liability, and do not meaningfully increase regulatory burdens for taxpayers.

Treasury will continue to study the issue, but does not plan to propose substantial changes to the temporary regulations on bottom-dollar guarantees.

Implications

Reinstating the prior regulations regarding the allocation of partnership liabilities for disguised sale purposes, as considered by Treasury, would permit taxpayers added flexibility in entering into leveraged partnership transactions by respecting recourse liabilities for purposes of Section 707.

Unfortunately, Treasury stated that it has no plan to revoke or amend the changes to the Section 752 regulations that represented a significant departure from rules that had been applied and used by taxpayers for more than two decades. As previously observed, (see Tax Alert 2016-1715), the new final and temporary Section 752 regulations are complex and will require a more detailed analysis, particularly regarding the potential application of the new bottom-dollar payment obligations, to determine the manner in which partnership liabilities are to be allocated both for transactional and compliance purposes. Existing partnerships will need to evaluate the manner in which their existing liabilities are allocated, including their effect on existing deficit restoration obligations, and to consider the new disclosure requirements for bottom-dollar payment obligations.

REITs and their tax advisors will want to be on the look-out for any potential revisions to Reg. Section 1.337(d)-7T to address the concerns noted by Treasury and the IRS. For additional insight on the temporary regulations, see Tax Alerts 2016-1083 and 2013-113.

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