The Conference Agreement for the "Tax Cuts and Jobs Act" (H.R. 1) was approved by the Senate (December 19, 2017) and the House (December 20, 2017), clearing the way for enactment with the President's signature. Among other things, the Conference Agreement would: (1) codify Revenue Ruling 91-32 (1991-1 C.B. 107); (2) expand when mandatory basis adjustments apply on the transfer of a partnership interest; (3) provide that charitable contributions and foreign taxes paid are subject to the Section 704(d) basis limitations; and (4) provide for a new Section 1061 that recharacterizes gains with respect to certain "carried interests" from long-term to short-term if a three-year holding period is not satisfied.

This Alert discusses certain portions of the Conference Agreement that affect partnerships, other pass-through entities and their holders. For a general discussion of the provisions included in the Conference Agreement, see Tax Alert 2017-2130.

Character of gains allocable to carried interests

Currently, gain or loss recognized on the sale or exchange of a capital asset is characterized as long-term capital gain if the asset was held for more than one year, and such gain allocated by a partnership to a partner retains its long-term capital gain character as if the gain were recognized directly by the partner. Under the Conference Agreement, net long-term capital gains would be eligible for preferential tax rates for individuals, taxed at 20% for individuals in the highest marginal tax bracket of 37%.

The Conference Agreement would add a new Section 1061. That provision would change the one-year holding period under Section 1221 to a three-year holding period for certain capital gains of a taxpayer with respect to carried interests (defined as applicable partnership interests). An applicable partnership interest would be one transferred to (or held by) a taxpayer in connection with the performance of services by the taxpayer or certain related persons in an "applicable trade or business." If the three-year holding period requirement is not satisfied, any capital gain recognized by the carried interest holder would be treated as short-term capital gain, taxable at a partner's marginal income tax rate (e.g., as high as 37%). The provision would not otherwise change the nature or character of the income, and would apply notwithstanding the application of Section 83 to the carried interest or whether a Section 83(b) election was made by the holder with respect to the carried interest.

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The approach to carried interests in the Conference Agreement is more limited than prior legislative proposals. For many types of industries, the new Section 1061 is not expected to result in a significant amount of recharacterization of long-term capital gain into short-term capital gain because most of the capital assets would be held for three years or more in the normal course of business. While the approach to carried interests in the Conference Agreement is also much simpler than prior legislative proposals, the rule contains a number of ambiguities. It is not clear whether the three-year holding period requirement would apply to the underlying assets, the carried interest, or both. It appears that the three-year holding period requirement would apply to the capital asset whose transfer results in capital gain income recognition for the carried interest partner, whether that is the partnership interest or partnership property. There is a special carve-out for partnership interests held by a person who provides service exclusively to another entity that is conducting a trade or business other than an applicable trade or business. The scope of that carve-out is not clear. There is also a carve-out for partnership interests for any capital interest in the partnership that provides the taxpayer with the right to share in partnership capital commensurate with the value of such interest subject to tax under Section 83 upon the receipt or vesting of the interest. The Conference Agreement states that the three-year holding period requirement would continue to apply even where the partner made a Section 83(b) election or recognized income with respect to the grant of the carried interest. Treasury and the IRS will need to clarify the scope of the carve-out where the taxpayer made a Section 83(b) election should the Conference Agreement be enacted. The proposed new Section 1061(d) contains a rule that appears to apply a look-through approach to a transfer of a carried interest to certain persons (family members within the meaning of Section 381(a)(1) and certain persons who performed services in any applicable trade or business within a certain period). This rule appears to require the recognition of gross income even where the transfer is not otherwise a recognition event for US federal income tax purposes, although its scope is not clear.

Partner loss limitation to include charitable contributions and foreign taxes

In applying the Section 704(d) basis limitation on partner losses, current law does not take into account a partner's share of partnership charitable contributions and foreign taxes paid or accrued. The Conference Agreement would modify the basis limitation on partner losses under Section 704(d) to include the partner's share of partnership charitable contributions and foreign taxes.

The provision would be effective for partnership tax years beginning after December 31, 2017.

Implications

This provision would conform the basis limitation that applies to partnerships to the treatment of these items by shareholders in an S corporation.

Mandatory basis adjustments for transfers of partnership interests with built-in losses

The Conference Agreement would expand the scope of the mandatory basis adjustment rules of Section 743(d). In addition to the current requirement that a partnership adjust the basis in its assets upon the sale of a partnership interest if the partnership has a built-in loss of more than $250,000 in its assets, the Conference Agreement would require a basis reduction if the purchaser of the partnership interest would be allocated a loss of more than $250,000 with respect to the purchased interest upon a hypothetical taxable disposition by the partnership of all of the partnership's assets for cash equal to the assets' fair market value, immediately after the transfer of the partnership interest.

The provision would be effective for transfers of partnership interests after December 31, 2017.

Implications

This provision would expand the application of mandatory downward basis adjustments on transfers of partnership interests by taking into account gain and loss allocations to the transferee.

Technical terminations upon sale or exchange of 50% of interests in partnership profits and capital

Under Section 708(b)(1)(B), a sale or exchange of 50% or more of interests in partnership capital and profits within a 12-month period causes a "technical termination" of the partnership. The Conference Agreement would repeal Section 708(b)(1)(B) for partnership tax years beginning after December 31, 2017.

Implications

The most consequential results of partnership technical terminations are generally that the partnership must file two short-period returns, restart depreciation on its Section 168 property, make certain new elections and accelerate many deferred income items such as deferred revenue. In that regard, the repeal of the technical termination rule might be favorable for most taxpayers; however, the repeal of the technical termination rule could limit the ability of partnerships to terminate unfavorable elections or to make a favorable election.

Sales of partnership interests by foreign partners

In Grecian Magnesite (Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (July 13, 2017)),the Tax Court declined to follow Revenue Ruling 91-32, holding the gain recognized by a foreign person on its redemption from a partnership engaged in a US trade or business did not result in effectively connected income (ECI).

The Conference Agreement would effectively reverse that decision, codifying a result similar to that of the ruling, such that gain or loss from the sale, exchange or disposition of a partnership interest by a foreign partner is treated as ECI if the partner's share of the gain or loss from the sale or exchange of the underlying assets held by the partnership would be treated as ECI. In addition, the transferee of a partnership interest subject to the new rule would be required to deduct and withhold 10% of the amount realized on the disposition unless, among other things, the transferor certifies that the transferor is not a foreign person (similar to the operation of the FIRPTA rules applicable to sales of US real estate by foreign owners).

The provision would be effective for sales, exchanges and dispositions on or after November 27, 2017, while the effective date for required withholding on sales of partnership interests would be effective for sales, exchanges, and dispositions after December 31, 2017.

Implications

The IRS recently decided to appeal the Grecian Magnesite decision. As such, taxpayers should continue to monitor the developments in this area. Moreover, it is important to note that the withholding requirements under the Conference Agreement would impose a requirement on the partnership to withhold distributions to the transferee partner to the extent that transferee failed to withhold properly.

Limitation on deductibility of interest

The Conference Agreement would limit the net interest expense deduction for every business, regardless of form, to 30% of adjusted taxable income. The provision would require the interest expense disallowance to be determined at the tax filer level. Adjusted taxable income for purposes of this provision would be a business's taxable income calculated without taking into account: (i) any item of income, gain, deduction or loss which is not properly allocable to a trade or business; (ii) any business interest or business interest income; (iii) NOLs; (iv) the amount of any deduction allowed under Section 199A; (v) in the case of tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion; and (vi) such other adjustments as provided by the Secretary. Adjusted taxable income also would not include the Section 199 deduction, as it would be repealed.

The Conference Agreement would require that a partnership calculate a Section 163(j) limitation at its level and include any allowable interest in the bottom-line amount allocated to each partner. The partner would perform a Section 163(j) calculation with regard to interest at its level, with special adjustments to its income with regard to the partnership to allow the partner to use unused interest limitation for the tax year and to ensure that net income from pass-through entities would not be double-counted at the partner level. It would also include special rules that would require a partner to track its share of any disallowed interest of the partnership.

The provision would be effective for tax years beginning after December 31, 2017.

Implications

The Conference Agreement does not provide rules for applying the pass-through provisions relating to the limitation on interest deductibility to tiered partnerships, and so it is unclear how the pass-through entity provisions would apply in this context. It may be that the partner-level items that are allocated from a partnership under the Conference Agreement (such as "excess taxable income" and "excess business interest"), are simply tiered up a chain of partnerships until an ultimate non-partnership partner is reached. An alternative approach would follow an aggregate theory of partnerships, whereby the tiered partnership structure would effectively be collapsed, and the ultimate non-partnership partners would take into account their share of excess taxable income and excess business interest, as appropriate, from all lower-tier partnerships in which the partner is an indirect owner.

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