September 15, 2021
Wyden's discussion draft would significantly alter partnership rules
On September 10, 2021, Senate Finance Committee Chair Ron Wyden (D-OR) released (1) a discussion draft of legislative text that would significantly revise sections of the Internal Revenue Code governing partnerships and (2) a summary of those legislative proposals. If enacted, the proposals, among other changes, would:
The House Ways and Means Committee recently released its own tax proposals for partnerships, which will be discussed in a forthcoming Alert. The House Ways and Means Committee release differs significantly from the Wyden discussion draft.
IRC Section 701 entity-level taxation: The summary states that the discussion draft would clarify under IRC Section 701 that partnerships could be subject to entity-level taxation in certain circumstances.
Implications: The proposal appears to codify the fact that a partnership may be required to make an imputed underpayment to the IRS under the centralized partnership audit regime. The codification appears intended to increase partnership-level reporting of uncertain tax positions.
IRC Section 704(b) partnership allocation determination: The discussion draft would remove the "substantial economic effect" (SEE) test for partnership allocations under IRC Section 704(a) and would require applying the PIP standard for all such allocations except for those to which the proposed "consistent percentage method" (CPM) would apply. These changes would be effective for tax years beginning after December 31, 2023.
Implications: The proposal would be a sea change in the application of the IRC Section 704(b) allocation rules, which have been in place for decades. The summary indicates that the SEE rules are complex and that certain simplifying conventions can produce results that divorce tax from economics (for example, due to the value-equals-basis presumption). The PIP factors listed in the discussion draft are taken in part from the existing IRC Section 704(b) regulations, which are difficult to apply in many typical business transactions (which led the IRS to adopt the SEE rules in the first instance). As such, the proposed change could increase the difficulty of applying the IRS Section 704(b) allocation rules for the IRS and taxpayers. If the proposal is enacted, it is unclear to what extent future guidance under IRC Section 704(b) would incorporate into the PIP test elements of the substantial economic effect test (such as substantiality).
The CPM would apply if partners were members of a controlled group and together owned (including by attribution under IRC Section 267(e)(3)) 50% or more of partnership capital or profits. The CPM would require the partnership to consistently allocate all items based on each partner's relative share of net contributed capital. The IRS and Treasury could also extend the CPM to other situations they deemed necessary. Any distribution or right to property not in proportion to contributed capital would result in a deemed transfer, with the partner receiving an "excess share" recognizing gross income and the other partner or partners precluded from deducting or capitalizing any loss or expense under new IRC Section 707(d). The summary states that the IRS and Treasury would issue updated and simplified PIP regulations and new regulations that would apply the new rules to tiered entities.
Implications: The CPM proposal would make another major change in applying the IRC Section 704(b) allocation rules. The summary states that related parties do not have sufficiently adverse interests to justify allocations that are not based on relative capital. The proposed rule, however, seems extremely broad and could apply to many situations in which legitimate business goals lead to economic deals requiring distributions and allocations not proportionate to contributed capital.
How the CPM would work in practice is highly uncertain; implementing the new regime within the existing framework of the partnership rules would be very complex and could lead to arrangements that conflict with the parties' intended economic arrangement (e.g., a preferred and common equity structure). In addition, the proposed rule could apply when unrelated parties own a significant interest in the partnership (up to 50%). It is unclear how the rule would apply if members of a controlled group own 50% or more of the capital or profits of the partnership in some years but not others, depending on the economic results of partnership operations. In addition, it is uncertain how the CPM would apply when partners acquire their interests in a partnership at different times, such that their percentage interests in partnership profits and capital do not correspond to the partners' net contributed capital.
IRC Section 704(c) allocation of built-in gain or loss: The discussion draft would amend IRC Section 704(c)(1)(A) to require all partnerships to use the remedial allocation method on property contributed to a partnership with a built-in gain or loss. The proposal would apply to property subject to a revaluation (commonly referred to as a "book-up") under the IRC Section 704 rules. The proposal would be effective for property contributions and revaluation events occurring after December 31, 2021.
Implications: The proposal would eliminate two of the tax allocation methods allowed under the existing IRC Section 704(c) regulations (i.e., the "traditional method" and the "traditional method with curative allocations"), as well as the use of any other reasonable methods. By utilizing the remedial allocation method, this rule would eliminate the so-called ceiling rule in the current IRC Section 704(c) regulations and require noncontributing partners' allocations of tax items to equal allocations of IRC Section 704(b) items from IRC Section 704(c) property. The proposal would change the way parties analyze the formation of a partnership, as it could result in a contributor of property recognizing income without any cash (or "dry" income). It could also make it more likely that contributing partners would recognize ordinary income as contributed property is depreciated or amortized, as opposed to recognizing gain (potentially capital) on a subsequent disposition of the contributed property. That may adversely affect the contributing partners from both a timing and character perspective. Moreover, any revaluation event could result in unexpected income for existing partners under the remedial allocation method. This change could result in significant additional administrative complexity for many partnerships. It is unclear if such a rule would exempt partnerships that currently use the so-called securities aggregation method (commonly used by hedge funds).
IRC Section 704 revaluations: The discussion draft would add IRC Section 704(f) to make revaluations of partnership property (i.e., reverse IRC Section 704(c) allocations) mandatory upon specified changes in the partners' economic arrangement. The proposal would also require a partnership that must revalue its assets to push the revaluation down to any majority-owned lower-tier partnerships. The proposal would also extend the IRC Section 704(c)(1)(C) rules to built-in losses resulting from revaluations. The proposal would be effective for revaluation events occurring after December 31, 2021.
Implications: In addition to making revaluations mandatory, the proposal states that changes in partnership allocations (for example, a recapitalization of a common interest into a preferred interest) would be a revaluation event, unless the IRS and Treasury provide otherwise. The explanation does not indicate whether the rule regarding changes in partnership allocations is a clarification. Moreover, the summary indicates that the IRS and Treasury could apply the mixing-bowl rules (discussed next) to such revaluation layers. The change to mandatory revaluations would result in significant additional administrative complexity for many partnerships.
IRC Sections 704(c)(1)(B) and 737 taxing pre-contribution gains (mixing-bowl rules): The discussion draft would amend IRC Sections 704(c)(1)(B) and 737(b) to repeal the seven-year period for applying the mixing-bowl rules. The proposal would apply to property contributed after December 31, 2021.
Implications: The proposal would (1) eliminate the ability to make a tax-deferred distribution of contributed built-in gain property (to the extent the contributed property has built-in gain remaining) to a partner other than the contributor; and (2) limit the ability of a property contributor to receive a tax-deferred distribution of other property (to the extent the contributed property has built-in gain remaining). This would significantly change the partnership rules, which are designed to allow for non-recognition treatment of property distributions in most cases. Permanently applying the mixing-bowl rules would significantly burden partnerships because they would have to track the acquisition history of all of their property (whether contributed by current or former partners) and analyze the potential application and consequences of the anti-mixing-bowl rules whenever a property distribution is contemplated.
IRC Section 705 alternative rule for determining partner's basis in interest: The discussion draft would amend IRC Section 705(b) to allow the alternative rule for determining a partner's basis in its partnership interest to apply in more than partnership terminations. The proposal would be effective upon enactment.
Implications: It is not clear what practical effect the proposal would have on partnerships, as the alternative rule in IRC Section 705(b) does not appear to be used very often.
IRC Section 707(a) and (c) partner-to-partnership payments: The discussion draft would repeal the guaranteed payment rule in IRC Section 707(c) and amend IRC Section 707(a) to treat "non-distribution" payments by the partnership as payments to a partner not acting in its capacity as a partner. The proposal would be effective for payments made after December 31, 2021.
Implications: While repealing IRC Section 707(c) has been discussed as a simplification measure, implementing such a change would require considerable work and guidance, including guidance on when a person is acting in a partner capacity. Considerable uncertainty exists in this area; for example , the IRS viewed the situation in Revenue Ruling 81-300 as involving a payment to a partner but the legislative history to the 1984 Tax Reform Act states the payment should be treated as a payment to a non-partner. The IRS and Treasury have yet to issue regulations reflecting the 1984 Tax Reform Act changes to IRC Section 707(a) regarding when a service provider is acting in a partner capacity.
IRC Section 736 payments to retiring and successor-in-interest partners: The discussion draft would remove IRC Section 736 and amend IRC Section 761 to provide that a retiring or successor-in-interest partner remains a partner until complete liquidation of the partnership interest. The proposal would apply to successors-in-interests and partners retiring after December 31, 2021.
Implications: These changes are conforming changes related in part to the repeal of IRC Section 707(c) and the amendment to IRC Section 707(a),they are important because they would preserve the rule that a person remains a partner for federal income tax purposes until its interest is completely liquidated.
The summary states that this change is intended "to align payments to retirees and successor-in-interest partners with the general rules of subchapter K specifically and the IRC generally (such as IRC Section 409A)." It is unclear whether this change is intended to subject all liquidating distributions to partners to subchapter K and the IRC generally, including IRC Section 409A.
IRC Section 707(a)(2) disguised sale of partnership interests: The summary states that discussion draft would clarify that IRC Section 707(a)(2), which addresses disguised sales of partnership interests, is self-executing. The proposal would apply to property transferred after the date of enactment.
Implications: The discussion draft states that no inference should be made on the treatment of property or services provided to a partnership before enactment of the change; in contrast, the IRS views existing IRC Section 707(a)(2) as effective even in the absence of implementing regulations. Implementing such a change would require considerable work and guidance. Treasury previously proposed regulations addressing if and when a disguised sale of partnership interests would occur. Those regulations were controversial and widely viewed as setting forth some unworkable rules. Ultimately, the rules were withdrawn.
IRC Section 707(a)(2) disguised sale of property: The discussion draft would require a capital expenditure reimbursement to be treated as sales consideration under the disguised-sale-of-property rules. The proposal would apply to property transferred after the date of the enactment, subject to a binding contract exception.
Implications: The proposal would effectively repeal the preformation reimbursement rule in Treas. Reg. Section 1.707-4(d). This exception had been commonly used by partners when contributing appreciated property to partnerships, allowing partners to, for example, incur costs in furtherance of the partnership's business before they could transfer the property to the partnership. This change could increase the importance of various other disguised sale exceptions.
IRC Section 708(a) partnership terminations: The summary states that the discussion draft would clarify under IRC Section 708(a) that a partnership is not terminated if any part of the business is carried on by a person who was a partner in the prior partnership or by a person related to any of those partners. The proposal would be effective for tax years beginning after date of enactment.
Implications: The summary states that the proposed change is a clarification, even though it would add that persons related to partners under IRC Sections 267 and 707 are treated as having been partners under IRC Section 708(a). Presumably, this change was designed to prevent related partners from structuring a termination of the partnership. While this change could prevent partners from terminating an existing IRC Section 754 election, the proposed requirement for mandatory basis adjustments under IRC Sections 743 and 734 (discussed later) would nonetheless require the basis adjustments, even without the existence of an IRC Section 754 election.
IRC Section 751 definition of inventory: The discussion draft would amend IRC Section 751(b) to remove the substantially appreciated requirement, thereby treating all inventory (regardless of appreciation) as IRC Section 751 property. The proposal would apply to distributions occurring after the date of enactment.
Implications: The proposal would increase the chances that IRC Section 751(b) would apply to a property distribution for partnerships that hold "inventory." The change could result in additional administrative complexity for many partnerships, especially given the broad definition of "inventory items" for purposes of IRC Section 751.
IRC Section 752 partnership debt allocations: The discussion draft would add IRC Section 752(e) to make all debt, including recourse debt, allocable to the partners in accordance with partnership profits (except for bona fide indebtedness of the partnership to any partner or related person). A transition rule would give taxpayers eight years to pay the tax liability created by the loss of debt allocations. The proposal would be effective for tax years beginning after December 31, 2021.
Implications: The proposal would be another significant change to the taxation of partnerships and would undo much of the existing regulations under IRC Section 752. These regulations use the existing economic-risk-of-loss approach, in part to address Congress's directive in the 1984 Tax Reform Act. Additionally, they are coordinated with other partnership allocation rules, and were just recently amended to address perceived abuses. Implementing the proposal would require considerable guidance from the IRS and Treasury and could be as complicated as the current regime. Partners that are currently allocated liabilities under the "recourse" rules of IRC Section 752 and have negative tax capital could recognize significant gain under IRC Section 731 if the law were changed. In addition, it is unclear whether the proposed change would override certain aspects of the existing IRC Section 752 regulations on nonrecourse liabilities, such as rules that take into account a partner's share of partnership IRC Section 704(c) gain in allocating partnership nonrecourse liabilities among the partners.
IRC Sections 734 and 743 mandatory basis adjustments: The discussion draft would mandate basis adjustments under IRC Sections 734 and 743 for money or property distributions and partnership interest sales or exchanges. The computation of the IRC Section 734 amount would be changed, with the goal of trying to preserve each partner's pre-distribution share of gain or loss in the property remaining in the partnership. The discussion draft would also require that both gain recognized under IRC Section 731(a) and gain in the distributed property be considered in determining the IRC Section 734 amount for a distributee partner that receives a non-liquidating distribution. The proposal would be effective for transfers occurring after December 31, 2021.
Implications: Mandating IRC Sections 734 and 743 adjustments would increase a partnership's required reporting and recordkeeping regarding its tax attributes and its partners' tax attributes; the proposed changes in determining the amount of the IRC Section 734 adjustment would require considerable guidance from the IRS and Treasury. It is unclear if such a rule would exempt partnerships that currently use the so-called securities aggregation method (commonly used by hedge funds) due to the reporting and recordkeeping requirements that mandatory basis adjustments would impose on such partnerships. Moreover, it is unclear how this rule would apply to transfers in the context of multi-tiered partnerships. To the extent the proposed change applied to tiered-partnerships, mandatory adjustments "down the chain" could create compliance and administrative complexities, specifically where certain upper-tier partnerships may not have control of, or visibility into, lower-tier partnerships.
IRC Section 163(j) business interest limitation: The discussion draft would amend IRC Section 163(j)(4) so that partners could not use the partnership's excess IRC Section 163(j) capacity (i.e., excess business interest income and excess taxable income) to deduct interest expense from other sources. The proposal would be effective for tax years beginning after December 31, 2021.
Implications: The proposal is inconsistent with a major part of the IRC Section 163(j) regime, which allows partners to utilize excess IRC Section 163(j) items. Moreover, given the lack of a transition rule, the proposed effective date could adversely affect partners currently invested in partnerships.
IRC Section 7704 publicly traded partnerships: The discussion draft would repeal the IRC Section 7704(c) qualifying income rules and require corporate tax treatment for all publicly traded partnerships. The proposal would be effective for tax years beginning after December 31, 2022.
Implications: The proposal goes beyond simply denying qualifying income status for oil-and-gas-derived income (which is when these rules often apply). In addition to forcing master limited partnerships (MLPs) to convert to C corporation classification, the proposal could affect numerous partnership funds that often rely on having qualifying income from investment activities to maintain partnership classification.