August 11, 2020 Final and proposed regulations under IRC Section 163(j): Partnership-specific provisions On July 28, 2020, the Treasury Department (Treasury) released final regulations (TD 9905) providing guidance for applying the limitations on the deductibility of business interest expense (BIE) under IRC Section 163(j) (the Final Regulations). Accompanying proposed regulations (REG-107911-18) (the Proposed Regulations) would provide additional guidance on several other aspects of the limitation, including specific aspects of the limitation as applied to partnerships. Simultaneously, the IRS also issued Notice 2020-59, which creates a safe harbor allowing taxpayers that manage or operate qualified residential living facilities to be treated as a real property trade or business (RPTB) solely for purposes of qualifying as an electing RPTB. The IRS also released FAQs on the aggregation rules that apply for purposes of the gross receipts test and determining whether a taxpayer is a small business exempt from the IRC Section 163(j) limitation. This Tax Alert focuses on the provisions in the Final Regulations and Proposed Regulations that are of particular interest to partnerships and their partners. The Final Regulations generally follow the same format as the proposed regulations released in 2018 (the 2018 Proposed Regulations), which provide guidance on various aspects of the limitation, including definitions, specific rules for partnerships, and rules for allocating income and expense between "non-excepted" and "excepted" trades or businesses. The Proposed Regulations would provide, among other items, additional guidance related to the following:
The Final Regulations generally are effective and generally apply to tax years beginning 60 days on or after the date the regulations are published in the Federal Register, with special effective dates for certain provisions. Subject to certain requirements, taxpayers generally may apply the Final and Proposed Regulations before their applicability date or may apply the 2018 Proposed Regulations, but generally must apply any set of regulations in their entirety. For details regarding the Final and Proposed Regulations more generally, please see EY Tax Alert 2020-1961 (application to consolidated groups and foreign corporations) and EY Tax Alert 2020-1960 (real estate industry implications). For details regarding the partnership provisions from the 2018 Proposed Regulations, please see EY Tax Alert 2018-2422 (2018 Proposed Regulations implications for partnerships). I. IRC Section 163(j) Final Regulations A. Background IRC Section 163(j) limits the deduction for BIE for tax years beginning after December 31, 2017, to the sum of (1) the taxpayer's business interest income (BII), (2) 30% of the taxpayer's adjusted taxable income (ATI), and (3) the taxpayer's floor plan financing interest. BIE is interest that is paid or accrued on indebtedness that is properly allocable to a trade or business. The IRC Section 163(j) limitation does not apply to certain trades or businesses, including (i) the trade or business of performing services as an employee; (ii) any electing RPTB; (iii) any electing farming business; and (iv) certain regulated utility trades or businesses. In the case of partnerships, the rules of IRC Section 163(j) can apply both at the partnership and partner level. Partnerships deduct BIE arising at the partnership level to the extent allowed by IRC Section 163(j) (the IRC Section 163(j) Limitation). Unlike other taxpayers, however, partnerships do not treat BIE suspended under IRC Section 163(j) for a tax year as BIE paid or accrued by the partnership in the succeeding tax year. Instead, the disallowed amount creates a partner-level tax attribute, excess business interest expense (EBIE). The statute provides that a partnership's EBIE is allocated to each partner in the same manner as the partnership's non-separately stated taxable income or loss and that EBIE allocated to a partner may be deducted by the partner only in succeeding tax years to the extent that partner is allocated excess taxable income (ETI) or excess business interest income (EBII) from the same partnership (the terms EBIE, ETI and EBII are herein collectively referred to as excess IRC Section 163(j) items). ETI is generally a partnership's ATI that is not used to support a partnership-level BIE deduction. Thus, for example, a partner who is allocated EBIE in a particular year that also has ATI from other sources in such year will not be able to deduct any of the EBIE to reduce its taxable income from other sources. Instead, the partner will be able to deduct such EBIE only if and when, in a subsequent year, the same partnership allocates the partner ETI. IRC Section 163(j) requires that a partner perform its own IRC Section 163(j) calculation for BIE it incurs. The statute provides that a partner generally computes its ATI without regard to the partner's distributive share of any items of income, gain, deduction or loss from a partnership. A partner may, however, increase its ATI by the partner's distributive share of a partnership's ETI, which is allocated to each partner in the same manner as the partnership's non-separately stated taxable income or loss. B. Treas. Reg. Section 1.163(j)-1: Common definitions used throughout the Final Regulations Treas. Reg. Section 1.163(j)-1 contains definitions used throughout the Final Regulations. Significant modifications to the 2018 Proposed Regulations include: 1. Definition of ATI Under IRC Section 163(j)(8), the term "ATI" means the taxable income of a taxpayer computed without regard to: (i) any item of income, gain, deduction or loss that is not properly allocable to a trade or business; (ii) any BIE or BII; (iii) net operating losses; (iv) the amount of any deduction allowed under Section 199A; and (v) for tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization or depletion. For tax years beginning on and after January 1, 2022, ATI includes any deduction allowable for depreciation, amortization or depletion. IRC Section 163(j)(8)(B) authorizes the Treasury to provide for additional adjustments to ATI. Whereas the 2018 Proposed Regulations provided that the computation of ATI begins with a taxpayer's taxable income as determined under IRC Section 63, the Final Regulations introduce a new term, "tentative taxable income," which is generally determined in the same manner as taxable income under IRC Section 63, but is computed without regard to the application of the IRC Section 163(j) Limitation, and without regard to any disallowed BIE carryforwards in an effort to avoid creating an iterative loop from taking into account disallowed business interest expense carryforwards more than once. Consistent with the 2018 Proposed Regulations, the Final Regulations require several additions to and subtractions from this initial amount. Notably, in response to comments received, the Final Regulations clarify that the amount of any depreciation, amortization or depletion that is capitalized into inventory under IRC Section 263A during tax years beginning before January 1, 2022, is added back to tentative taxable income as a deduction for depreciation, amortization or depletion when calculating ATI for that tax year, regardless of the period in which the capitalized amount is recovered through cost of goods sold. Furthermore, under Treas. Reg. Section 1.163(j)-1(c)(1), taxpayers that otherwise are relying on the 2018 Proposed Regulations in its entirety for tax years 2018, 2019 and 2020 have the option to choose to follow the Final Regulations' provision that depreciation, amortization, or depletion capitalized under IRC Section 263A can be added back in arriving at ATI. Implications: The change in the Final Regulations that amounts incurred as depreciation, amortization or depletion that are capitalized under IRC Section 263A and included in cost of goods sold may be added back to determine ATI is a taxpayer-favorable reversal from the rule provided in the 2018 Proposed Regulations. Taxpayers have an option to "early-adopt" this particular provision even if the taxpayers are otherwise applying the 2018 Proposed Regulations. 2. Definition of "interest" The Final Regulations narrow the scope of items of income or expense that are specifically defined as interest by excluding from the definition of interest, among other items, commitment fees, debt issuance costs and guaranteed payments for use of capital. In the 2018 Proposed Regulations, guaranteed payments for the use of capital under IRC Section 707(c) were treated as interest expense subject to IRC Section 163(j) at the partnership level. The Final Regulations do not explicitly include guaranteed payments for the use of capital under IRC Section 707(c) as part of the definition of interest. However, the Final Regulations include an example of a situation in which a guaranteed payment for the use of capital is treated, under the interest expense anti-avoidance rule, as interest expense and interest income for purposes of IRC Section 163(j). See Treas. Reg. Section 1.163(j)-1(b)(22)(v)(E), Example 5. Implications: The exclusion of a guaranteed payment for the use of capital as interest in the Final Regulations is a taxpayer favorable modification to the definition of interest for purposes of IRC Section 163(j). Partnerships that had otherwise reconsidered their equity structures following the release of the 2018 Proposed Regulations given the inclusion of guaranteed payments for the use of capital in the definition of interest under the 2018 Proposed Regulations will find this to be a welcome change. Moreover, the anti-avoidance rule (discussed in the next section) generally applies to transactions executed on or after the date of the Final Regulations are published on the Federal Register. Taxpayers can adopt the Final Regulations and treat a current IRC Section 707(c) guaranteed payment for capital as not interest and not subject to the anti-abuse rule. 3. Expanded anti-avoidance rules The Final Regulations provide that, if a principal purpose of structuring a transaction is to reduce an amount incurred by the taxpayer that is economically equivalent to interest expense and would otherwise have been interest expense or treated as interest expense if not for the transaction, such amount will be treated as interest expense for purposes of IRC Section 163(j). For this purpose, an expense or loss is economically equivalent to interest if the item is (1) deductible by the taxpayer, (2) incurred by the taxpayer in a transaction(s) or series of integrated or related transactions in which the taxpayer secures the use of funds for a period of time, (3) substantially incurred in consideration of the time-value of money and (4) not otherwise described in Treas. Reg. Section 1.163(j)-1(b). The determination of whether a taxpayer enters into a transaction(s) with a principal purpose to reduce an amount that would otherwise be characterized as interest expense is based on the facts and circumstances of the transaction(s). However, the taxpayer's business purpose and pre-tax cost of funds are ignored. The Final Regulations also provide that any income realized by a taxpayer in a transaction (or series of integrated or related transactions) is not treated as interest income of the taxpayer if and to the extent that a principal purpose for structuring the transaction(s) is to artificially increase the taxpayer's BII. The anti-avoidance rules apply to transactions executed on or after the date the Final Regulations are published in the Federal Register. 4. Definition of trade or business discussion The terms "BIE," "BII" and "ATI" apply only in the case of tax items that are properly allocable to a trade or business. Thus, the application of IRC Section 163(j) turns on the existence (or absence) of a trade or business. However, the term trade or business is not defined in IRC Section 163(j), and the Code provides no general definition. The Final Regulations provide that the term "trade or business" generally has the same meaning as it does under IRC Section 162. In the Preamble to the Final Regulations, the Treasury and the IRS acknowledge that an entity can conduct more than one trade or business under IRC Section 162 but decline to provide specific guidance under IRC Section 162 on when trades or businesses will be considered separate and distinct. Implications: As stated in the Preamble to the Final Regulations, the determination of whether a single entity has multiple trades or businesses is a factual one. Without further guidance from the Treasury and IRS, taxpayers should continue to weigh various factors set forth in IRC Section 162 case law. C. Treas. Reg. Section 1.163(j)-2: Operative rules and coordination with CARES Act Treas. Reg. Section 1.163(j)-2 makes corresponding changes to reflect modifications to IRC Section 163(j) made by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), and adjusts the ATI limitation to 50% for tax years beginning in 2019 and 2020 (though taxpayers may elect out). For partnerships, the increased 50% ATI limitation does not apply for tax years beginning in 2019. For partnership tax years beginning in 2020, "step 11" of the "11-step process" for allocating excess IRC Section 163(j) items is applied by substituting two for ten-thirds when grossing up each partner's "final ATI capacity excess amount." The "11-step process" for allocating excess IRC Section 163(j) items is described in further detail below and in EY Tax Alert 2018-2422. Similarly, Treas. Reg. Section 1.163(j)-2(b)(3) allows taxpayers to make an election to use ATI for the last tax year beginning in 2019 as the ATI for any tax year beginning in 2020. The provision addresses short tax years in 2020 by allowing the ATI in the last tax year beginning in 2019 to be prorated based on the number of months in the short 2020 year. D. Treas. Reg. Section 1.163(j)-3: Relationship to other provisions affecting interest The Final Regulations confirm the interaction between IRC Section 163(j) and various other Sections of the Code, which also impact the treatment of interest. The Final Regulations generally adopt the 2018 Proposed Regulations regarding the coordination with IRC Sections 465, 469 and 461(l) and continue to reserve on rules regarding discharge of indebtedness under IRC Section 108. For more details on Treas. Reg. Section 1.163(j)-3, see EY Tax Alert 2020-1961. E. Treas. Reg. Section 1.163(j)-4: Application to C corporations and tax-exempt corporations 1. Corporate items are per se trade or business items Consistent with the 2018 Proposed Regulations, all of a C corporation's interest expense and interest income, as well as all items of income, gain, deduction or loss, is allocated to a trade or business (either excepted or non-excepted, as discussed later), regardless of the nature of the corporation's activity. In the case of a corporate partner of a partnership, the partnership's IRC Section 163(d) items (investment interest, investment income, investment expense) and items that are neither trade or business items nor IRC Section 163(d) items, and that are allocated by the partnership to the corporate partner as separately stated items, are allocable to a trade or business of the corporate partner. The Final Regulations retain the general rule from the 2018 Proposed Regulations with respect to the effect of disallowed interest on the earnings and profits of corporate partners. For a detailed discussion, please see EY Tax Alert 2020-1961. F. Treas. Reg. Section 1.163(j)-6: Partnerships and S corporations 1. Overview For partnerships, IRC Section 163(j) can apply at both at the partnership and partner level. As a result, partnerships deduct the BIE arising at the partnership level to the extent allowed by IRC Section 163(j) and the disallowed amount creates a partner-level tax attribute, EBIE. A partner will be able to deduct that EBIE only if and when, in a subsequent year, the same partnership allocates the partner ETI. Treas. Reg. Section 1.163(j)-6 generally provides rules regarding the application of IRC Section 163(j) to partnerships and their partners, including rules on how to calculate the limitation and how to allocate a partnership's deductible BIE and excess IRC Section 163(j) items to its partners. The Final Regulations largely adopt the 2018 Proposed Regulations. Key changes or clarifications of the rules applicable to partnerships and their partners immediately follow below. 2. Allocation of EBIE and ETI (11-step process) IRC Section 163(j)(4) generally allocates partnership EBIE and partnership ETI to each partner "in the same manner as" the "non-separately stated taxable income or loss of the partnership." These terms are not defined by statute or regulations. As a result, it was unclear how to apply the rule to special allocations. The 2018 Proposed Regulations provided an 11-step process that determined the excess IRC Section 163(j) items of a partnership allocable to its partners. For a detailed description of the 11-step process, see EY Tax Alert 2018-2422. The Final Regulations adopt the 11-step process, which, although complex, attempts to preserve the entity-level calculation required in IRC Section 163(j)(4) while also preserving the economics of the partnership, including respecting any special allocations made in accordance with IRC Section 704(b) and its regulations. Notably, the Final Regulations provide an exception from steps 3 through 11 of the 11-step process for partnerships that allocate all items of income and expense on a pro rata basis, because such partnerships by nature "do not make the kinds of allocations the 11-step calculation is designed to address." Instead, these partnerships would allocate all IRC Section 163(j) items in step 2 proportionately. The Final Regulations also confirm that allocations pursuant to the 11-step process satisfy the requirements of IRC Section 704(b). Specifically, Treas. Reg. Section 1.704-1(b)(4)(xi) was added to confirm that the allocation of excess IRC Section 163(j) items will be deemed in accordance with the partners' interests in the partnership. Implications: While partnerships that allocate all items of economic and tax income and expense pro-rata would mechanically achieve the same pro-rata allocation of excess IRC Section 163(j) items after going through the 11-step process, it is helpful for the Final Regulations to formalize the exception and eliminate the need for pro-rata partnerships to have to go through the 11-step process. 3. Partnerships not subject to IRC Section 163(j) Under Treas. Reg. Section 1.163(j)-6(m)(1), BIE allocated by an exempt small business entity to its partners is not subject to IRC Section 163(j) at the partner level. This is a favorable change from the 2018 Proposed Regulations, which would have required such amounts to be tested at the partner level. Implications: The 2018 Proposed Regulations' requirement to test BIE of an exempt small business partnership at the partner level resulted in often difficult and complex disclosures to be issued to partners of an exempt small business partnership. The modification made by the Final Regulations appears more in line with the intent of the statute to provide relief for small business entities from having to deal with the complexities of applying IRC Section 163(j). Treas. Reg. Section 1.163(j)-6(m)(2) provides that, to the extent a partnership is engaged in an excepted trade or business, the IRC Section 163(j) Limitation for BIE allocable to such excepted trade or business does not apply. If a partner is allocated any IRC Section 163(j) item that is allocable to an excepted trade or business of the partnership, such excepted IRC Section 163(j) items are excluded from the partner's IRC Section 163(j) deduction calculation. In addition, if a partner is allocated EBIE from a partnership and, in a succeeding tax year, the partnership becomes an exempt entity (by meeting the small business exception), then the partner treats any of its previously-allocated EBIE from that partnership as BIE paid or accrued by the partner in that succeeding tax year (potentially subject to the IRC Section 163(j) limitation at the partner level). This rule applies only to exempt entities, however. If a partnership is no longer subject to IRC Section 163(j) by reason of becoming an excepted business (e.g., by making a RPTB election), the previously allocated EBIE does not get treated as paid or accrued at the partner level and instead carries forward as EBIE. Implications: The 2018 Proposed Regulations as written were unclear on whether the EBIE of a partnership that is no longer subject to IRC Section 163(j) by reason of becoming an excepted business should be treated as BIE paid or accrued at the partner level in the tax year that the partnership becomes an excepted business. The Final Regulations modify the 2018 Proposed Regulations in a manner that is unfavorable to taxpayers that make an election under IRC Section 163(j)(7) at a later point in time. In particular, partners of partnerships that have a single trade or business, which later makes a RPTB election, will have to carry forward the EBIE indefinitely as such partnerships will no longer generate ETI or EBII once an election under IRC Section 163(j)(7) has been made. 4. Basis adjustments upon partial disposition of partnership interest under IRC Section 163(j)(4)(B)(iii)(II) Under IRC Section 163(j)(4)(B)(iii)(I), a partner's adjusted basis in its partnership interest is reduced (but not below zero) by the amount of EBIE allocated to the partner. If a partner disposes of a partnership interest, IRC Section 163(j)(4)(B)(iii)(II) generally provides for an increase in outside basis for unused carried-forward EBIE. The Final Regulations adopt a proportionate approach to partnership dispositions, allowing for a partial increase to a partner's adjusted basis in its partnership interest being disposed. The basis increase occurs immediately before the disposition in an amount equal to the EBIE allocated to such portion (applying principles similar to Revenue Ruling 84-53). Implications: The partial basis adjustment is a favorable change from the "All-or-Nothing" approach taken in the 2018 Proposed Regulations, which applied only upon the disposition of "all or substantially all" of the partner's interest in the partnership. For purposes of Treas. Reg. Section 1.163(j)-6(h)(3), a disposition includes a distribution of money or other property by a partnership to a partner in complete liquidation of the partner's interest. The Final Regulations also clarify that each partner is considered to have disposed of its partnership interest within the meaning of Treas. Reg. Section 1.163(j)-6(h)(3) if the partnership terminates under IRC Section 708(b)(1). The Treasury and IRS request further comments on whether a current distribution of money or other property by the partnership to a continuing partner as consideration for an interest in the partnership should also trigger an addback and, if so, how to determine the appropriate amount of the addback. 5. Other key provisions The 2018 Proposed Regulations reserve on guidance regarding the application of IRC Section 163(j) to partnership mergers and divisions. The Final Regulations state that the Treasury and IRS will not provide special rules analyzing the consequences of a partnership merger or division in the context of IRC Section 163(j) because, in most situations, a partnership merger or division can be appropriately analyzed under the rules of Treas. Reg. Section 1.708-1(c) and (d). The 2018 Proposed Regulations would include detailed rules to coordinate IRC Section 163(j) with IRC Section 704(d). The 2018 Proposed Regulations would create a special EBIE and BIE loss class, which requires meticulous tracking by partners and partnerships alike. The Final Regulations adopt, without modification, the complex coordination rules with IRC Section 704(d) set forth in the 2018 Proposed Regulations. G. Treas. Reg. Section 1.163(j)-7: Foreign corporations Treas. Reg. Section 1.163(j)-7 provides rules regarding the application of the IRC Section 163(j) limitation to foreign corporations and their US shareholders. IRS and Treasury received comments on the 2018 Proposed Regulations suggesting that IRC Section 163(j) ought not apply to foreign corporations, or should apply in a limited fashion; however, the Final Regulations, relying in part on Treas. Reg. Section 1.952-2, confirm the application of IRC Section 163(j) to any foreign corporation whose income is relevant for US tax purposes, and largely adopt the 2018 Proposed Regulations. The Proposed Regulations, in contrast, would substantially modify the rules applicable to foreign corporations. After reviewing the comments received, Treasury and IRS made modifications intended to reduce the compliance and administrative burdens of applying IRC Section 163(j) to foreign corporations. For a more detailed description of these rules, see EY Tax Alert 2020-1961. H. Treas. Reg. Section 1.163(j)-8: Foreign persons with ECI The IRS and Treasury reserved with respect to final rules on foreign persons with effectively connected income (ECI). As discussed later, the Proposed Regulations provide additional guidance on this topic. I. Treas. Reg. Sections 1.163(j)-9, 1.163(j)-10, and 1.469-9 and Notice 2020-59: Application of IRC Section 163(j) to the real estate industry IRC Section 163(j) does not apply to any "electing real property trade or business" (electing RPTB). An electing RPTB includes any trade or business that is described in IRC Section 469(c)(7)(C) and makes an election under IRC Section 163(j)(7)(B). A trade or business described in IRC Section 469(c)(7)(C) includes any real property development, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. An electing RPTB must depreciate its nonresidential real property, residential rental property and qualified improvement property (QIP) using the alternative depreciation system. Once the election is made, it is generally irrevocable. The Final Regulations answered many of the questions taxpayers had about making the IRC Section 163(j)(7)(B) election (an RPTB election) to be an electing RPTB (Treas. Reg. Section 1.163(j)-9) and how to allocate tax items between excepted and non-excepted trades or businesses (Treas. Reg. Section 1.163(j)-10). The Final Regulations also generally adopt the 2018 Proposed Regulations regarding certain definitions applicable to RPTBs under IRC Section 469(c)(7)(C) (Treas. Reg. Section 1.469-9). Finally, Treasury and the IRS issued Notice 2020-59, which outlines a proposed revenue procedure that would apply to operators and managers of certain residential living facilities to elect to treat those businesses as an RPTB (solely for purposes of qualifying as an electing RPTB under IRC Section 163(j)(7)(B)). 1. Making the RPTB election to be treated as an electing RPTB The Final Regulations clarified that an RPTB election may be made for a RPTB that does not otherwise rise to the level of a trade or business within the meaning of IRC Section 162. The Final Regulations also clarified that taxpayers eligible for the small business exemption can make the RPTB election. The procedure for making the election is largely consistent with the 2018 Proposed Regulations, though the Final Regulations clarify that the election statement must sufficiently describe the RPTB to demonstrate qualification for the election. The Final Regulations retain an anti-abuse rule that provides an RPTB election may not be made for an RPTB if 80% or more of the taxpayer's real property, by fair market rental value, is leased to a related party. However, the Final Regulations limit the scope of this anti-abuse rule by providing two exceptions to the anti-abuse rule that were not included in the 2018 Proposed Regulations, and by modifying an exception previously included for qualified lodging facilities and qualified healthcare properties. First, a new exception provides that a lessor may make the RPTB election if at least 90% of the lessor's real property, determined by fair market rental value, is leased (1) to a related party that uses the real property to operate an excepted trade or business and/or (2) to unrelated parties. Second, another new exception allows a lessor to make a RPTB election to the extent that (1) the lessor leases real property to a related party that subleases the property to an unrelated party or another related party, and (2) each related party sublessee makes the RPTB election. This look-through exception allows the lessor to treat that portion of its real property that is ultimately leased to a third-party or related party who make an RPTB election as an excepted RPTB. Third, the Final Regulations expanded the exception included in the 2018 Proposed Regulations relating to qualified lodging facilities and qualified healthcare properties to exclude partnerships that make the REIT safe harbor RPTB election from the anti-abuse rule. Finally, the Final Regulations expanded the REIT safe harbor RPTB election to allow REITs that hold real property directly or indirectly through shares in other REITs or interests in partnerships to qualify for the election. In addition, the Final Regulations permit certain partnerships that are controlled by a REIT partner to make the REIT safe harbor RPTB election at the partnership level. Implications: The Final Regulations provide taxpayers in the real estate industry with much needed clarification about the application of IRC Section 163(j). In particular, small businesses concerned about meeting the complicated gross receipts requirements to be eligible for the small business exception in IRC Section 163(j) may now make a "protective" RPTB election, if qualification under those requirements is clearer. Additionally, taxpayers concerned that their activities may not rise to the level of a "trade or business" under IRC Section 162 — for example, taxpayers that lease property subject to a triple net lease arrangement — have gained more certainty that they could still be eligible for an RPTB election. Finally, the changes to the REIT safe harbor RPTB election provide much needed clarification to REITs that own shares of other REITs or operate their business through a so-called "operating partnership." 2. Treas. Reg. Section 1.163(j)-10: Allocation rules a) General rules Treas. Reg. Section 1.163(j)-10 provides rules for allocating tax items that are properly allocable to a trade or business (rather than an investment activity) between excepted and non-excepted trades or businesses. The Final Regulations generally allocate a taxpayer's gross income (other than dividends and interest income) to the trade or business that generated the gross income and allocate expenses (other than interest expense), losses and other deductions that are "definitely related" to a trade or business to such trade or business. A deduction is definitely related to a trade or business if the item giving rise to the deduction is incurred as a result of, or incident to, an activity of the trade or business or in connection with property used in the trade or business. The Final Regulations retain the asset-based allocation approach for interest expense and interest income contained in the 2018 Proposed Regulations by allocating such items between a taxpayer's excepted and non-excepted trades or businesses based upon the taxpayer's relative adjusted basis in the assets used in its trades or businesses. A de minimis exception applies to the allocation of interest expense and interest income if at least 90% of a taxpayer's basis in its assets for the tax year is allocable to either excepted or non-excepted trades or businesses for such year. The Final Regulations modify the methodology used to compute asset basis from the methodology of the 2018 Proposed Regulations by permitting taxpayers to compute asset basis by averaging basis as of the beginning and end of the tax year (rather than quarterly), so long as the taxpayer falls within a specified 20% de minimis threshold with respect to changes in the basis of assets used in an excepted trade or business over the course of the tax year. Special rules apply for assets that are used in more than one trade or business. The Final Regulations allow taxpayers to use one of three specified methodologies to allocate interest income and expense among such trades or businesses, so long as the methodology is consistently applied. The Final Regulations clarify that taxpayers are not required to use the same methodology for different classes of assets. The IRS and Treasury have determined that the choice of methodology is not a method of accounting, and they permit a taxpayer to change its methodology after a period of five years without obtaining IRS consent. b) Look-through rule generally For purposes of allocating interest under Treas. Reg. Section 1.163(j)-10(c), a partner's interest in a partnership is treated as an asset of the partner. A partner may generally allocate its adjusted basis in its partnership interest between excepted and non-excepted trades or businesses by looking through the partnership to the partner's share of the inside basis in the partnership assets. A partner must apply the look-through rule if its interest in the partnership is equal to or greater than 80% of the partnership's capital or profits. If a non-corporate partner (e.g., an upper-tier partnership (UTP) or an individual) chooses not, or is not permitted, to look through the partnership, the partner must generally treat its partnership interest as either an investment asset or a non-excepted trade or business asset. If a corporate partner chooses not, or is not permitted, to look through the partnership, the partner must generally treat its partnership interest as a non-excepted trade or business asset. c) Inapplicability of look-through rule to small business taxpayer Under the Final Regulations, a taxpayer may look through a partnership that is eligible for the small business exemption, so long as the partnership has made a RPTB or farming business election. This rule represents a change from the 2018 Proposed Regulations, under which a taxpayer subject to the small business exemption was not eligible to make a RPTB election. Under the 2018 Proposed Regulations, therefore, an interest in a partnership that was eligible for the small business exemption was automatically treated as an investment asset in the hands of a non-corporate partner. The Final Regulations now allow a partner to treat its partnership interest in a partnership eligible for the small business exemption that has made a RPTB election as an excepted business asset by looking through to the assets of the partnership. d) Application of look-through rule to partnership interest The Final Regulations clarify in an example that under the look-through rule, a partner allocates its adjusted basis in its partnership interest between excepted and non-excepted trades or businesses by multiplying its total adjusted basis in its partnership interest by the percentage allocation determined by the partnership with respect to the partnership's inside basis in its assets. Thus, for example, if a partnership's inside basis in its assets is allocable 50% to an excepted trade or business and 50% to a non-excepted trade or business, the partner will allocate 50% of its adjusted basis in its partnership interest to an excepted trade or business and 50% to a non-excepted trade or business. e) Coordination of IRC Section 752 basis reduction rule and investment asset basis reduction rule For purposes of allocating a partner's adjusted basis in its partnership interest between excepted and non-excepted trades or businesses, a partner must reduce (but not below zero) its adjusted basis in its partnership interest by the partner's share of partnership liabilities under IRC Section 752. In addition, the 2018 Proposed Regulations would have required a non-corporate partner to further reduce its adjusted basis in its partnership interest by such partner's share of the partnership's inside basis in investment assets. The combined effect of these two basis reduction rules could be understood as requiring a non-corporate partner to reduce its adjusted basis in its partnership interest twice. The Treasury and the IRS determined that this result would be inappropriate and, therefore, amended the investment asset basis reduction rule in the Final Regulations to use a net, rather than gross, approach to the reduction. The Final Regulations require a non-corporate partner to decrease its adjusted basis in its partnership interest by its share of the excess of (i) the partnership's inside basis in investment assets over (ii) the partnership's debt that is traced to those assets under Temp. Reg. Section 1.163-8T. Thus, to the extent the IRC Section 752 basis reduction rule has already reduced a partner's share of inside basis in an investment asset, the investment asset basis reduction rule applies only to the remaining inside basis in such asset. Conversely, the Final Regulations also require a non-corporate partner to increase its adjusted basis in its partnership interest by its share of the excess of (i) the partnership's debt traceable to the investment assets under Temp. Reg. Section 1.163-8T over (ii) the partnership's inside basis in those assets. Thus, under the Final Regulations, a non-corporate partner may now be required to decrease or increase its adjusted basis in its partnership interest depending on the circumstances. f) Qualified nonrecourse indebtedness An exception to the general asset-based allocation rule applies with respect to qualified nonrecourse indebtedness within the meaning of Temp. Reg. Section 1.861-10T(b). Under this exception, a taxpayer must directly allocate interest expense from the qualified nonrecourse indebtedness to the trade or business incurring that debt. Under the 2018 Proposed Regulations, the full basis of an asset encumbered by qualified nonrecourse indebtedness would be allocated to the trade or business in which such asset was used and disregarded in calculating the taxpayer's relative basis in its assets used in the taxpayer's excepted and non-excepted trades or business. The Final Regulations helpfully change the treatment of directly allocated items by directly allocating and reducing basis (but not below zero) for the purpose of allocation by only the amount of qualified nonrecourse indebtedness, rather than by the entire basis of the property securing the indebtedness. 3. Definitions applicable to RPTBs The Final Regulations generally adopt the 2018 Proposed Regulations in defining the term "real property" for purposes of IRC Section 469(c)(7)(C) and the types of businesses that qualify as "real property trades or businesses." The Final Regulations generally retain the definitions from the 2018 Proposed Regulations for "real property operation" and "real property management" trades or businesses and continue to reserve on definitions of real property development, redevelopment, construction, reconstruction, acquisition, conversion and rental. The preamble to the Final Regulations indicates that businesses involving real property construction, reconstruction, development, redevelopment, conversion, acquisition or brokerage should not necessarily be required to have direct nexus with, or a relationship to, rental real estate in order to qualify as a RPTB under IRC Section 469(c)(7)(C). However, it notes that the end products or final objectives of these businesses should at least have the potential to be used as rental real estate or as integral components in rental real estate activities. Notably, Treasury and the IRS included a statement in the preamble that the operation of a pipeline, bridge, tunnel, toll road or airport may meet the definition of a RPTB under certain and specific facts and circumstances, though the Final Regulations did not include any examples of such facts and circumstances. The Proposed Regulations would include new definitions for "real property development" and "real property redevelopment" including business activities that involve the preservation, maintenance and improvement of forest covered areas (i.e., timberland). Implications: The Final Regulations do not significantly change the definitions of "real property" or the definitions for types of businesses that qualify as "real property trades or businesses" under IRC Section 469(c)(7)(C). However, statements made by Treasury and the IRS in the preamble may provide some relief to taxpayers that own and operate real estate asset classes outside of the traditional rental activities to which IRC Section 469 is often applied. 4. Notice 2020-59 Notice 2020-59, released concurrently with the Final Regulations, outlines a proposed revenue procedure that would allow operators and managers of certain residential living facilities to elect to treat those trades or businesses as an RPTB, solely for purposes of qualifying as an electing RPTB under IRC Section 163(j)(7)(B). To be eligible, the trade or business must: (1) operate or manage one or more residential living facilities with multiple rental dwelling units that serve as a primary residence for customers on a permanent or semi-permanent basis; (2) provide supplemental assistive, nursing or other routine medical services and (3) have an average customer use of the dwelling units of 90 days or more. For this purpose, a "residential living facility" is defined as a nursing home, continuing care retirement community, independent living facility, assisted living facility, memory care facility or skilled nursing facility. For a detailed discussion of the provisions of the Final Regulations, Proposed Regulations and Notice 2020-59 applicable to the real estate industry, including changes to and clarifications of the Proposed Regulations and relevant taxpayer implications, see EY Tax Alert 2020-1960. J. Treas. Reg. Section 1.163(j)-11: Transition rules Tres. Reg. Section 1.163(j)-11 provides rules for applying IRC Section 163(j) to a corporation when it joins a consolidated group whose tax year began before January 1, 2018, and the treatment of carryforwards of disqualified interest. The Final Regulations adopt the transition rules of the 2018 Proposed Regulations without substantive changes. For a discussion of those rules, see Tax Alert 2018-2369. II. IRC Section 163(j) Proposed Regulations A. Prop. Reg. Section 1.163(j)-1(b): Definitions The Final Regulations removed the "lesser of" approach for adjusting ATI with respect to sales or dispositions of depreciable property provided in the 2018 Proposed Regulations. The Proposed Regulations would permit taxpayers to use this approach and extend its application to dispositions of partnership interests and member stock. Specifically, with respect to the sale or disposition of an interest in a partnership, taxpayers choosing to apply the "lesser of" approach would make an adjustment to ATI pursuant to Treas. Reg. Section 1.163(j)-1(b)(1)(ii)(E) in an amount equal to the lesser of (i) the gain recognized on the sale or disposition of such interest, and (ii) the taxpayer's distributive share of allowed or allowable depreciation, amortization or depletion with respect to property held by the partnership at the time of such sale or disposition. Taxpayers choosing to use the "lesser of" approach must do so for all sales or other dispositions otherwise subject to Treas. Reg. Section 1.163(j)-1(b)(1)(ii)(C), (D) or (E). For a discussion of other changes to the definitions, see EY Tax Alert 2020-1961. B. Prop. Reg. Section 1.163(j)-2: Deduction for BIE limited The Proposed Regulations provide rules for making an election under the Final Regulations to use ATI for the last tax year beginning in 2019 as the ATI for any tax year beginning in 2020. For a discussion of changes concerning corporate taxpayers, see EY Tax Alert 2020-1961. C. Prop. Reg. Section 1.163(j)-6: Partnerships The Proposed Regulations include certain modifications to Treas. Reg. Section 1.163(j)-6, relating to the applicability of the IRC Section 163(j) Limitation to partnerships, including proposed rules addressing:
1. Prop. Reg. Section 1.163(j)-6(d)(5) — Election to substitute 2019 ATI for partnership's 2020 ATI Under IRC Section 163(j)(10)(B)(i), in the case of any tax year beginning in 2020, a partnership may elect to determine its IRC Section 163(j) limitation for that year using its ATI for the last tax year beginning in 2019. This elective provision may cause a partnership to have an ATI amount in tax year 2020 that does not match the partnership's net amount of tax items that comprise ATI for such tax year. Accordingly, the Proposed Regulations would modify the rules for determining the partners' allocable shares of ATI under the "11-step approach" by reference to a similar rule that applies to tiered partnerships under Prop. Reg. Section 1.163(j)-6(j)(9) (the -6(j)(9) rule). Specifically, the -6(j)(9) rules provide a method for allocating ATI in a situation where a UTP's amount of tax items that comprise (or have ever comprised) ATI differs from its ATI. The following example illustrates how Prop. Reg. Section 1.163(j)-6(d)(5) modifies the rules for determining the partners' allocable shares of ATI: Assume A and B are equal partners in PRS. In tax year 2019, PRS's ATI is $100. In tax year 2020, PRS only generates $30 of income related to a non-excepted trade or business, which is allocated entirely to A under IRC Section 704(c) principles. PRS has no BIE in tax year 2020. In tax year 2020, PRS elects to use its 2019 ATI of $100 pursuant to Prop. Reg. Section 1.163(j)-6(d)(5). Because PRS has no BIE in tax year 2020, the $100 of "substituted" ATI is $100 of ETI allocable to A and B. PRS uses the -6(j)(9) rule to determine each partner's allocable share of the $100 of ETI. PRS's amount of tax items that comprise ATI before the election is made pursuant to Prop. Reg. Section 1.163(j)-6(d)(5) is $30, which is less than the $100 of "substituted" ATI following the election and thus it is necessary to apply the -6(j)(9) rule. Formulaically, PRS would compute A's and B's allocable share as follows: A's distributive share of gross income/gain items (using pre-election amounts): $30 Less: A's distributive share of gross loss/deduction items (using pre-election amounts): ($0) Add: Product of A's profit share (50%) * PRS's remaining "substituted" ATI ($100 - $30 = $70): $35 A's allocable share of ATI (ETI) $65 A similar approach for B would result in an allocable share of ATI (ETI) for B of $35. 2. Prop. Reg. Section 1.163(j)-6(g)(4) — EBIE allocated in a taxable year beginning in 2019 Under IRC Section 163(j)(10)(A)(ii)(II), a partner may elect to treat 50% of its allocable share of a partnership's EBIE for 2019 as BIE in the partner's first tax year beginning in 2020. Such amount is not subject to the IRC Section 163(j) limitation (-6(g)(4) BIE). The Proposed Regulations clarify that the remaining 50% of the partner's allocable share of the partnership's 2019 EBIE remains subject to the IRC Section 163(j) limitation applicable to EBIE carried forward at the partner level. The Proposed Regulations further provide that if a partner disposes of a partnership interest in the partnership's 2019 or 2020 tax year, the amount of -6(g)(4) BIE is deductible in tax year 2020 by the partner and thus does not result in a basis increase immediately prior to such disposition. However, pursuant to Treas. Reg. Section 1.163(j)-6(h)(3), the remaining 50% of the partner's remaining EBIE increases the partner's basis in its partnership interest immediately prior to the disposition. Moreover, the Proposed Regulations clarify that a partner may elect out of applying this rule and recognize the -6(g)(4) BIE amount in 2019 as part of its basis increase to its partnership interest immediately prior to such disposition in 2019. The Proposed Regulations would provide that the rules and procedures for making such an election are provided in Revenue Procedure 2020-22 and may be further modified through forthcoming guidance. 3. Prop. Reg. Section 1.163(j)-6(h)(5) — Partnership basis adjustments upon partner dispositions Under the statute, if a partner disposes of a partnership interest, IRC Section 163(j)(4)(B)(iii)(II) provides that the adjusted basis of the partner in the partnership interest (the outside basis) is increased immediately before the disposition by the amount of any remaining EBIE that was not treated as BIE paid or accrued by the partner prior to the disposition. The statute does not indicate whether there is a corresponding increase to the basis of the partnership's assets (the inside basis), the absence of which would create disparities between inside basis and outside basis that, according to Treasury and IRS, are inconsistent with the intent of IRC Section 163(j) and subchapter K. To eliminate potential disparities between outside and inside basis, the Proposed Regulations provide that if a partner disposes of its partnership interest, the partnership shall increase its basis in partnership's assets (inside basis) by an amount equal to the increase, if any, to the partner's outside basis in the partnership interest being disposed of by the transferor partner. The Proposed Regulations provide a method for allocating the increase to the inside basis of partnership property similar to the rules under IRC Section 734(b) and provide that the increase in basis is not depreciable or amortizable. 4. Prop Reg. Section 1.163(j)-6(j) — Proposed rules relating to the treatment of EBIE in tiered partnerships The Proposed Regulations provide an "entity approach" with respect to the treatment of EBIE allocated by a lower-tier partnership (LTP) to a UTP. Specifically, the proposed rules would provide that, where LTP allocates EBIE to UTP, UTP does not further allocate such EBIE to the partners of UTP. The entity approach provided in the Proposed Regulations is consistent with the approach taken to partnerships under IRC Section 163(j)(4), which states that IRC Section 163(j) is applied and computed at the partnership level. The Proposed Regulations also provide that a UTP reduces its outside basis in its interest in LTP in connection with the allocation of EBIE by LTP to UTP, but the partners of UTP do not reduce their outside basin in UTP by such amount. In contrast, the IRC Section 704(b) capital account of UTP in LTP and the UTP partners' IRC Section 704(b) capital accounts in UTP are decreased by such amount, treating the EBIE as expenditure item under IRC Section 705(a)(2)(B) for IRC Section 704(b) capital account purposes. Moreover, the Proposed Regulations provide rules to ensure that a reduction in UTP's outside basis in its interest in LTP in connection with the allocation of EBIE by LTP to UTP does not create a disparity between UTP's partners' outside basis in their partnership interests and such partners' respective shares of the adjusted basis of UTP's property following such reduction. These rules effectively create a capital loss asset (UTP EBIE) with tax basis equal to the amount by which UTP reduced its basis in its LTP interest and a fair market value of zero. The example below illustrates the operation of these rules: Assume UTP and X are equal partners in LTP and agree to allocate items of LTP pro-rata. In Year 1, LTP has ATI of $100 and BIE of $40. Y and Z are equal partners in UTP and agree to allocate items of UTP pro rata. In Year 1, UTP has ATI of $0 and no BIE. Based on the above, after applying the IRC Section 163(j) Limitation calculation at the LTP level, LTP's interest expense deduction in Year 1 is $30 ($100 of ATI x 30% limitation). LTP's amount of EBIE is $10. LTP has ETI of $0. Each of UTP and X is allocated deductible interest expense of $15 and EBIE of $5 from LTP. UTP's basis in LTP is decreased by $5 pursuant to IRC Section 163(j)(4)(B)(iii)(I). As provided in Prop. Reg. 1.163(j)-6(j)(3), neither Y's nor Z's outside basis in UTP is decreased by UTP shares of LTP's EBIE. Rather, pursuant to Prop. Reg. 1.163(j)-6(j)(4), UTP creates a non-depreciable and non-amortizable "fictional" capital asset with a basis of $5 and FMV of $0. Pursuant to Prop. Reg. 1.163(j)-6(j)(2), each of Y and Z reduce their IRC Section 704(b) capital account in UTP by their distributive share of the EBIE allocated by LTP to UTP ($2.50 each). Implications: As the 2018 Proposed Regulations reserved on the application of IRC Section 163(j) to tiered partnerships, taxpayers were tasked with interpreting how the rules might apply to their tiered partnership structures. While the Proposed Regulations provide welcome clarity around the application of IRC Section 163(j) to tiered partnerships, the Proposed Regulations create additional complexity and uncertainty. Specifically, taxpayers should carefully consider the future impact of IRC Section 704(c) resulting from reduction to partners' IRC Section 704(b) capital accounts without a corresponding reduction to such partners' tax capital accounts. Moreover, the creation of a "fictional" capital loss asset could create complexities, for example, if the upper-tier partnership is required to subsequently adjust its basis in partnership property under IRC Section 743(b) or 734(b). 5. Prop Reg. Section 1.163(j)-6(n) -Partnership self-charged lending transactions The Proposed Regulations provide that in the case of a lending transaction between a partner (lending partner) and partnership (borrowing partnership) in which the lending partner owns a direct interest (self-charged lending transaction), any BIE of the borrowing partnership attributable to the self-charged lending transaction is BIE of the borrowing partnership for purposes of determining the partnership's IRC Section 163(j) limitation. To the extent the lending partner is allocated EBIE from the borrowing partnership and has interest income attributable to the self-charged lending transaction, the Proposed Regulations provide that the lending partner shall treat such interest income as an allocation of EBII from the borrowing partnership in such tax year, but only to the extent of the lending partner's allocation of EBIE from the borrowing partnership in such tax year. The remaining interest income, if any, is treated as investment income of the lending partner under IRC Section 163(d) if it would otherwise properly be treated as such, unless the lending partner is a C corporation. Consider the following example: X and Y are equal partners of XY and agree to allocate items of XY pro rata. X, an individual, loans $100 to XY with 10% interest accrual annually (i.e., results in $10 of annual interest expense to XY and $10 of interest income to X). In Year 1, XY has ATI of $0 and BIE of $10 which is all attributable to X's loan. X has investment interest income attributable to its loan to XY of $10. Based on the above, after applying the IRC Section 163(j) Limitation calculation at the XY level, XY's interest expense deduction in Year 1 is $0 ($0 of ATI x 30% limitation) and XY's Year 1 EBIE is $10. XY has ETI of $0 in Year 1. Each of X and Y is allocated $5 ($10 x 50%) of EBIE from XY. Because X is allocated EBIE from XY related to the self-charged lending transaction, X is deemed to receive an allocation of EBII from XY of an equal amount ($5) pursuant to Prop Reg. 1.163(j)-6(n). X's share of EBII causes X's share of EBIE to be treated as paid or accrued at X's partner level. X's remaining share of investment interest income ($5) is subject to the limitation under IRC Section 163(d). Y's share EBIE continues to be treated as EBIE and subject to other provisions of IRC Section 163(j) and the regulations thereunder. Implications: The rules related to self-charged lending transactions provided in the Proposed Regulations provide much needed clarification, particularly for partnerships with pre-existing partner-to-partnership lending arrangements that have previously considered various restructuring alternatives to avoid the tax windfall that could have otherwise applied to the lending partner (e.g., where the lender recognizes taxable interest income without a corresponding deduction for related interest expense). 6. Application of IRC Section 163(j) to trading partnerships and publicly traded partnerships a) Trading partnerships The Proposed Regulations would provide guidance requiring a trading partnership to bifurcate its interest expense from a trading activity between partners that materially participate in the trading activity and partners that are passive investors. A more detailed Alert on this guidance is forthcoming. b) Publicly traded partnerships To ensure the fungibility of traded units of a PTP, traded PTP units must have identical economic and tax characteristics. This is generally accomplished through the coupling of the remedial method for allocating IRC Section 704(c) items with basis adjustments under IRC Section 743(b). Consistent with ensuring the fungibility of a PTP's traded units, the Proposed Regulations would provide that, solely for purposes of IRC Section 163(j), a PTP allocates excess IRC Section 163(j) items and items attributable to the PTP's inside basis (gain or loss, and depreciation or amortization) based on each partner's share of IRC Section 704(b) items. In addition, the Proposed Regulations would treat the amount of any IRC Section 743(b) adjustment of a purchaser of a traded PTP unit that relates to a remedial item that the purchaser inherits from the seller as an offset to the related IRC Section 704(c) remedial item. D. Prop. Reg. Section 1.163(j)-8: Considerations for partnerships with ECI allocable to a specified foreign partner Treasury did not receive comments on the 2018 Proposed Regulations under Prop. Reg. Section 1.163(j)-8; however, the IRS became aware of certain distortions that could result under the 2018 Proposed Regulations. Accordingly, Prop. Reg. Section 1.163(j)-8 would revise and re-propose rules for determining deductible BIE and disallowed BIE carryforwards of a nonresident alien, foreign corporation or partnership that are properly allocable to ECI to address these distortions. For a more detailed description of the rules applicable to foreign partners with ECI, please see EY Tax Alert 2020-1961. E. Prop. Reg. Section 1.163-14: Allocation of interest expense among expenditures for pass-through entities Prop. Reg. Section 1.163-14 would require taxpayers to apply a set of complex and mechanical rules in determining the IRC Section 163(j) limitation on interest expense associated with debt-financed distributions made by a passthrough entity and debt-financed acquisitions of an interest in a passthrough entity. Prop. Reg. Section 1.163-14 would augment and modify the proceeds tracing rules under Temp. Reg. Section 1.163-8T and make the application of certain aspects of Notice 89-35 mandatory. 1. Debt-financed distributions Treasury and the IRS provided guidance under Notice 89-35 to address the treatment of (1) passthrough entity debt allocated to distributions by the passthrough entity to its partners (debt financed distributions) and (2) a passthrough entity owner's debt allocated to contributions to, or purchases of interests in a passthrough entity (debt-financed contributions or acquisitions). Under Notice 89-35, regarding the treatment of interest expense on a partnership debt used to make a partnership distribution, a passthrough entity may apply the "optional allocation rule." This rule allows a passthrough entity to first allocate distributed debt proceeds and associated interest expense to one or more expenditures made by such entity during the same tax year. The debt proceeds in excess of partnership expenditures are treated as a debt-financed distribution, where, before the adoption of IRC Section 163(j) by the TCJA, the tax treatment of the interest expense associated with the debt-financed distribution was determined at the owner level and depended on the owner's use of the distributed proceeds. For IRC Section 163(j) purposes, Prop. Reg. Section 1.163-14 would mandate the use of the "optional allocation" rule in Notice 89-35, with some modifications, for debt-financed distributions by a passthrough entity. Under the Proposed Regulations, a passthrough entity would classify the interest expense associated with a debt-financed distribution into the following categories:
The tax treatment of the interest expense for each of the above categories depends on the type of assets to which the interest expense relates. The allocation of expenditure interest expense as investment or business interest for IRC Section 163(j) purposes depends on the type of partnership expenditures to which the debt proceeds are allocated. The tax treatment of the debt-financed distribution interest expense would be made based on the distributee partner's use of the distributed funds. The tax treatment of excess interest expense would be based on the character of the partnership's assets to which the excess interest expense is allocated (e.g., trade or business, investment). The partnership would allocate excess interest expense to its assets based on the relative basis of the partnership assets, determined under one of the two permissible methodologies provided under the Proposed Regulations. Under the Proposed Regulations, a passthrough entity would include the sum of its partners' share of business expenditure interest expense and business excess interest expense in the computation of its IRC Section 163(j) Limitation for the tax year. A partner's share of business debt-financed distribution interest expense is tested at the partner level for IRC Section 163(j) purposes. Investment interest expense attributable to each of the three categories (expenditure interest expense, debt-financed distribution interest expense and excess interest expense) is subject to limitation under IRC Section 163(d). Excess interest expense allocated to trade or business assets is tested at the partnership under IRC Section 163(j). Upon a transfer of an interest in a passthrough entity, Prop. Reg. Section 1.163-14(b)(4) would treat the transferor partner's debt-financed distribution interest expense as excess interest expense in the hands of an unrelated transferee partner. In the case of a related-party transfer of an interest in a passthrough entity, the transferor partner's share of debt-financed distribution interest expense would continue to be treated as debt-financed distribution interest expense for IRC Section 163(j) purposes in the hands of the related transferee partner. Implications: The proposed rules for debt-financed distributions would require categorizing interest expense associated with a debt financed distribution into numerous categories, as each of the three categories of interest expense in the Proposed Regulations must be further allocated between trade or business, investment and personal interest expense, among others. 2. Debt-financed acquisitions Prop. Reg. Section 1.163-14(f) would adopt, with modifications, the rules of Notice 89-35 providing for the tax treatment of interest expense of the owner of the passthrough entity associated with a debt-financed acquisition (either by purchase or contribution) of an interest in a passthrough entity. Under Prop. Reg. Section 1.163-14(f), the owner of a passthrough entity would be allowed to allocate the debt-financed proceeds under two permissible methodologies: (1) in proportion to the relative adjusted tax basis of the acquired entity's assets reduced by any debt allocated to such assets, or (2) based on the adjusted basis of the acquired entity's assets determined in accordance with Treas. Reg. Section 1.163(j)-10(c)(5)(i), reduced by any debt allocated to such assets. Once an owner chooses a method for purposes of this allocation, the owner must consistently apply the same method in all subsequent tax years. F. Applicability Taxpayers and their related parties may choose to apply the Proposed Regulations to tax years beginning after 2017 (for periods prior to their effective date upon finalization), subject to certain exceptions. Taxpayers that choose to apply the Proposed Regulations must consistently apply all of the rules of the relevant section, as applicable. III. Request for comments The Treasury and IRS have requested comments on a number of specific topics, including a number of partnership topics in the Proposed Regulations. IV. Conclusion The Final Regulations adopt substantially all the partnership provisions from the 2018 Proposed Regulations, with certain clarifying exceptions and amendments. Some of the amendments and changes made under the Final Regulations are welcome changes for partnership and small business taxpayers. The Proposed Regulations would provide helpful guidance on the application of IRC Section 163(j) to tiered partnership structures and provide relief for self-charged lending transactions. However, the creation of the inside basis adjustments for tiered partnerships and the requirement to apply the "optional allocation" method to debt-financed distribution interest expense continue to create significant complexity for partners and partnerships. In short, applying IRC Section 163(j) to partnerships continues to be an exercise in mental acuity for taxpayers and tax practitioners alike. ———————————————
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