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September 16, 2021

Ways & Means Committee releases reconciliation bill with tax provisions that would significantly change partnership rules

Proposed tax provisions in the House Ways & Means (W&M) Committee reconciliation bill (along with the section-by-section summary), released September 13, 2021, would, among other changes:

  1. Revise IRC Section 163(j) so that (i) it applies at the partner or shareholder level for business interest expense incurred by a partnership or S corporation and (ii) disallowed business interest expense expires after five years on a first-in, first-out basis
  2. Expand the list of IRC Section 7704 qualifying income business activities
  3. Provide that a partnership interest worthlessness deduction is capital
  4. Extend the IRC Section 165(g) rules on worthless securities to securities issued by partnerships
  5. Revise IRC Section 1061 to extend the minimum holding period from three years to five for carried interests subject to IRC Section 1061

Unless otherwise indicated, these provisions would apply to tax years beginning after December 31, 2021.

Senate Finance Committee Chair Ron Wyden (D-OR) separately released on September 10, 2021, a discussion draft of legislative text that would significantly revise sections of the Internal Revenue Code governing partnerships (see Tax Alert 2021-1676).

Proposed changes

Business interest limitation: The W&M proposal would amend IRC Section 163(j)(4) to apply IRC Section 163(j) at the partner level and allow carryforwards of disallowed business interest expense to expire after five years.

For a partner with a carryforward excess business interest expense (EBIE) amount under the current rules, a transition rule would treat such EBIE amount as paid or accrued by the partner in the first tax year after the one described in existing IRC Section 163(j)(4)(B)(ii)(II).

Implications: The W&M proposal would significantly modify IRC Section 163(j), changing the regime from one that applies at the partnership level to one that applies at the partner level. Presumably, a partner would take into account its distributive share of partnership interest income, expense and other items to determine how to apply the IRC Section 163(j) limitation at the partner level. Applying the IRC Section 163(j) limitation at the partner level, rather than the partnership level, could introduce more compliance and reporting questions. The partner-level application of IRC Section 163(j) would likely require new and potentially complex reporting considerations, including determining (1) the IRC Section 163(j) items that a partnership would need to report to aid partners in their computations and (2) the level (partner or partnership) at which the various IRC Section 163(j) exemptions and exceptions (e.g., small business taxpayer exemption and the real property trade or business exception) should apply.

The proposed changes also would limit carryforwards of disallowed business interest expense so they would expire after five years; under existing law, disallowed business interest expense may be carried forward indefinitely. Furthermore, existing law allows a partner to increase its basis in its partnership interest immediately before the disposition for any unused EBIE from such partnership. The proposed five-year expiration date on carryforwards of EBIE and the removal of the basis increase could prove to be a significant detriment to many taxpayers.

Publicly traded partnerships: The W&M proposal would increase the list of business activities that generate qualifying income under IRC Section 7704(d), which would expand the types of publicly traded partnerships that could be classified as partnerships and not as corporations for federal income tax purposes. The W&M proposal also would amend IRC Section 871(m) to treat payments pursuant to sale-repurchase agreements and similar payments related to publicly traded partnerships (and, to the extent provided in regulations, other partnerships) as dividend equivalents and would establish withholding rules similar to those under IRC Section 1446(f). The provision amending IRC Section 871(m) would apply to payments made on or after 180 days following enactment.

Implications: In contrast to Wyden's discussion draft, which would require corporate tax treatment for all publicly traded partnerships, the W&M proposal would expand the types of publicly traded partnerships that could be treated as partnerships under IRC Section 7704. The additional business activities that generate qualifying income would largely be related to "green energy" businesses, such as those converting renewable biomass or generating electric power or thermal energy using qualified energy resources.

Worthless partnership interests: The W&M proposal would add a new IRC Section 165(m), providing that if any interest in a partnership becomes worthless, the loss would be treated as arising from the sale or exchange of a partnership interest under IRC Section 741. The W&M proposal also would extend the IRC Section 165(g) rules applicable to worthless securities to securities issued by partnerships.

Implications: By deeming the worthlessness of a partnership to be treated as a sale or exchange, the W&M proposal seems intended to overturn the holding of Revenue Ruling 93-80, under which a loss incurred as a result of a taxpayer's conclusion that its partnership interest is worthless is an ordinary loss if sale or exchange treatment does not apply (which can happen as a result of a deemed distribution under IRC Section 752).

Carried interest: The W&M proposal would make significant modifications to IRC Section 1061.

The W&M proposal would replace the existing mechanism under IRC Section 1061(a) for calculating the long-term-to-short-term recharacterization amount with a new one. Under this new mechanism, a partner's "net applicable partnership gain" with respect to an applicable partnership interest (API) would generally be recast as short-term capital gain, unless an exception applies. "Net applicable partnership gain" would be defined to include (1) net long-term capital gain taking into account only gains and losses with respect to one or more APIs and (2) other amounts includible in the taxpayer's gross income with respect to APIs that are treated as capital gain or subject to tax at the rate applicable to capital gain. The latter clause is apparently intended to pick up items such as IRC Section 1231 gains, qualified dividend income, and the portion of IRC Section 1256 gain otherwise taxable as long-term capital gains, which are not recharacterized as short-term capital gain under existing IRC Section 1061.

The W&M proposal also would add a new "holding period exception" to the above-described general rule. Under the holding period exception, net applicable partnership gain would be determined without regard to any amount realized five years after the latest of:

  1. The date on which the taxpayer acquired substantially all of its API with respect to which the amount is realized
  2. The date on which the partnership in which the API is held acquired substantially all of the assets held by the partnership or
  3. For a partnership described in clause (1) that owns, directly or indirectly, interests in one or more other partnerships, the dates determined by applying rules similar to the rules in clauses (1) and (2) in the case of each such other partnership

The W&M proposal would apply the holding period exception by substituting "three years" for "five years" for (1) taxpayers (other than trusts or estates) with adjusted gross income of less than $400,000 and (2) any income that is attributable to a real property trade or business.

The proposal would also make other amendments, including:

  1. Amending the exception in IRC Section 1061(c)(1) to apply to taxpayers performing services with respect to a business other than an applicable trade or business
  2. Treating a partnership interest as a specified asset if the partnership has a direct or indirect interest in any specified assets (including cash), but allowing the IRS and Treasury to provide otherwise
  3. Amending the corporate exception to IRC Section 1061 by replacing "corporation" with "C corporation"
  4. Replacing the related party transfer rule in existing IRC Section 1061(d) with a rule requiring full gain recognition on any transfer of an API, notwithstanding any other nonrecognition provisions that would normally apply
  5. Directing the IRS and Treasury to issue regulations and other guidance to (i) prevent the avoidance of IRC Section 1061 (e.g., through a carry waiver) and (ii) specify that IRC Section 1061 applies to financial instruments, contracts or interest in other entities to the extent necessary or appropriate to carry out the purposes of IRC Section 1061

The changes would apply to tax years beginning after December 31, 2021.

Implications: The W&M proposals are of significant importance to investment funds and other partnerships. The most obvious major change is that the holding period requirement would be extended from greater-than-three-years to greater-than-five-years, except in the case of (1) individual partners with less than $400,000 of adjusted gross income or (2) income from a real property trade or business.

Less obvious but equally significant, the amendment would appear to radically alter the manner in which the holding period requirement operates. Under existing IRC Section 1061, the holding period requirement generally works in the same way as it does under the normal long-term capital gains rules, with "more than three years" substituted for "more than one year." Thus, subject to certain exceptions, it is generally the holding period of the asset being sold that gives rise to the capital gain in question that will determine whether IRC Section 1061(a) applies. The W&M proposal would replace that mechanism (which has been the existing law for the past 50+ years (see Revenue Ruling 68-79)) with a very different "holding period exception." In effect, the holding period exception would require that holding periods be tested at multiple levels and, if the five-year test is failed at any of those levels, it appears that the holding period exception will not apply. This is a significant departure from existing rules and will likely result in significant additional complexity for partnerships and partners.

Moreover, the proposed holding period exception would appear to lead to counterintuitive results in many cases. For example, where the holding period exception applies, it would appear that the exception would turn off IRC Section 1061 recharacterization even in cases where the capital asset that was sold happens to have been held by the partnership for less than five years. By contrast, it appears that the holding period exception would make long-term capital gains treatment unavailable in certain cases in which assets held for longer than five years are disposed of. For example, it appears that the holding period exception would not apply if a partner who has held his or her API for less than five years is allocated gain from the sale of a fund asset held for more than five years. It seems that the drafters intended this result, although it is different than what the result would be under existing law. As another example, in the case of a hedge fund that regularly turns over substantially all of its assets in less than five years, it is unclear whether any capital gains allocated by the fund to API holders would qualify for long-term capital gains treatment, even if the fund sells certain capital assets after having held them for 15, 20, etc. years. (For similar reasons, it is unclear whether a transfer of an API in such a fund could qualify for long-term capital gains treatment, even if the API had been held for 15, 20, etc. years.)

The application of the holding period exception in tiered structures is also unclear in key respects. For example, consider a situation where an API holder in an upper-tier partnership (UTP) acquired substantially all of his or her API more than five years ago, and UTP acquired substantially all of its assets more than five years ago, but UTP owns an interest in a lower-tier partnership (LTP) that did not acquire substantially all of its assets more than five years ago. It is unclear whether UTP's interest in LTP will cause the API holder to be ineligible for the holding period exception, even in the case of the API holder's share of capital gains of UTP that are unrelated to its interest in LTP. Presumably, this result was not intended by the drafters, but the proposed legislative language is unclear on this point.

The W&M proposal does not provide guidance on what "substantially all" means for purposes of the holding period exception. Previously, proposed regulations under IRC Section 1061, however, would have defined "substantially all" of a partnership's assets as meaning 80% of such assets, excluding cash and certain other assets. See Prop. Reg. Section 1.1061-4(b)(9)(i)(C) (REG-107213-18) (Tax Alert 2020-2026). Other IRC and regulatory provisions contain other definitions of this term. See, e.g., Treas. Reg. Section 1.45A-1(c)(5)(i) (at least 85%).

Amending IRC Section 1061 to apply to non-capital-gain items taxed at long-term capital gains rates would mark a significant expansion of the scope of IRC Section 1061. As noted above, the change would extend IRC Section 1061(a) to apply to items such as IRC Section 1231 gains, qualified dividend income and the portion of IRC Section 1256 gains otherwise taxable as long-term capital gains.

The proposed amendment of IRC Section 1061(d) also would be a significant change. Under the final IRC Section 1061 regulations, IRC Section 1061(d) operates as a gain recharacterization provision, not a gain acceleration provision. See Treas. Reg. Section 1.1061-5(b). The proposed amendment would replace the existing approach with a rule requiring full gain recognition on any transfer of an API, without regard to any nonrecognition provisions that would otherwise apply. It appears that this rule would render fully and immediately taxable transfers of APIs that are made as gifts, charitable contributions or in connection with otherwise nontaxable restructurings. If this provision is enacted into law, taxpayers will need to take great care in connection with transfers of APIs, especially because the holding period exception described above may cause such transfers to be taxed at short-term capital gains rates, even where the interest in question has been held for more than five years.


Contact Information
For additional information concerning this Alert, please contact:
Partnership Transactions Group
   • Jeff Erickson (
   • David Franklin (
   • Todd Golub (
   • Mark Opper (
   • Andrea Whiteway (
   • Ashley Lu (
   • Travis Rose (
   • Lance Parker (
   • John Oldak (