April 5, 2022
Biden Administration's FY2023 budget and Green Book renew some partnership-related proposals and add new ones
The Biden Administration's FY2023 budget and Treasury Green Book propose certain changes to the rules affecting partners and partnerships, such as limiting basis shifting between related partners and taxing carried interest as ordinary income. Other proposed changes include:
The 2022 Green Book generally includes in the baseline the revenue provisions of Title XIII of the Build Back Better Act, which passed the House of Representatives on November 19, 2021. This means the Green Book proposals do not repropose any provisions already included in the Build Back Better Act.
Basis shifting between related partners
The Administration's proposal would apply a matching rule that would prohibit any partner that is related to a distributee partner from benefitting from a partnership's step-up in basis until the distributee partner disposes of the distributed property in a fully taxable transaction. The proposal would apply to a partnership's distribution of property that results in a step-up to the basis of the partnership's remaining property. The Treasury Secretary would be authorized to prescribe regulations necessary to implement the matching rule.
Currently, if a partnership distributes property to a partner and the partnership has an IRC Section 754 election in effect, the partnership may, under certain circumstances, increase the basis of its non-distributed property. According to the Green Book, "in partnerships with related-person partners, a partnership basis step-up could be designed to shift basis from non-depreciable, non-amortizable partnership property to depreciable or amortizable partnership property, resulting in immediate increases in depreciation or amortization deductions for remaining partners related to the distributee-partner."
The proposal would be effective for partnership tax years beginning after December 31, 2022.
Comment: The proposal is new in that it requires looking at the distributee partner's use (or disposition) of distributed property to determine if a related partner can enjoy the benefit of an inside basis increase.
The Administration's proposal is generally the same as that in the FY2022 budget (see Tax Alert 2021-1151). The proposal would generally tax as ordinary income a partner's share of income on an "investment services partnership interest" (ISPI) in an investment partnership, regardless of the character of the income at the partnership level, if the partner's taxable income (from all sources) exceeds $400,000. Accordingly, this ISPI-related income would not be eligible for the reduced rates that apply to long-term capital gains. The gain recognized on the sale of an ISPI would generally be taxed as ordinary income, not as capital gain, if the partner is above the income threshold (the Green Book proposes to increase the top marginal tax rate of individuals from 37% to 39.6%). In addition, the Administration's proposal would require partners in investment partnerships to pay self-employment taxes if their income exceeds $400,000.
The proposal would repeal IRC Section 1061 for taxpayers with taxable income (from all sources) over $400,000 and would be effective for tax years beginning after December 31, 2022. The Green Book states that the proposal is not intended to adversely affect the qualification of a real estate investment trust owning a profits interest in a real estate partnership.
Comment: Similar to the proposal in the FY 2022 budget, the Administration's FY2023 proposal also seeks to increase capital gains rates to ordinary income rates for certain high-income taxpayers beginning on the date of enactment (see Tax Alert 2022-0548). If the preference for long-term capital gain ends for certain high-income taxpayers, the Administration's carried interest proposal would only affect a narrow subset of carried-interest recipients, as some or all of the long-term capital gains of taxpayers whose taxable income exceeds $1m would already be taxed at ordinary rates and IRC Section 1061 would continue to apply to those with income from all sources of $400,000 or less. This limited, partial repeal of IRC Section 1061 would lead to new tax complexities and compliance burdens as two different regimes could apply to the same partnership, depending on the income thresholds of the partners.
The Administration's proposal differs from existing carried interest rules (IRC Section 1061 and its regulations) in several ways:
Private equity, private capital and other alternative asset management funds and their professionals could face increased administrative burdens and complexities if they are required to contend with two different carry taxation regimes applying to the same partnership, as well increased tax liabilities for their carry recipient partners if either the carried interest proposal, or the proposal to tax certain capital gains as ordinary income for taxpayers with over $1m of taxable income, is enacted.
Refund of certain adjustments in centralized partnership audit regime
The Administration's proposal is generally same as that in the FY2022 budget (see Tax Alert 2021-1151). Under current law, a partnership subject to audit can either choose to pay any imputed underpayment of tax at the partnership level or elect to "push out" the audit adjustments to its reviewed-year partners. If those adjustments result in a net tax decrease for the reviewed year, the reviewed-year partners may use that decrease to reduce their reporting-year income tax liabilities. The adjustments may not, however, reduce the partner's reporting-year tax liability below zero and may not be carried over to future years. Accordingly, any excess not offset with income tax due in the reporting year appears to be permanently lost.
The same rules apply when a partnership files an Administrative Adjustment Request (AAR) to correct to an originally filed partnership return. In fact, the potential for a permanent loss of a partner-level overpayment is more likely to occur in the AAR context, as partnerships must "push out" favorable AAR adjustments.
The proposal would amend IRC Sections 6226 and 6401 to treat a net negative change in tax that exceeds the income tax liability of a reviewed-year partner in the reporting year as an overpayment under IRC Section 6401 that may be refunded. The proposal would be effective upon enactment.
Comment: This proposal indicates a willingness to address what appears to be an inherent inequity in the current regime. Funds and their partners would welcome this change, as AARs are commonplace and often a necessity (especially in the fund-of-funds space) due to the late receipt of underlying partnership Schedule K-1s. Absent a fix to current law, an AAR that results in an overpayment of tax could result in a potential permanent loss of an overpayment of tax.
The Administration's proposal is generally the same as that in the FY2022 budget (see Tax Alert 2021-1317). The proposal would allow the deferral of gain, up to an aggregate of $500,000, for each taxpayer ($1m for married individuals filing a joint return) each year for like-kind exchanges of real property. Taxpayers would recognize gains from like-kind exchanges exceeding $500,000 during a tax year (or $1m for married individuals filing a joint return) in the year they transfer the real property subject to the exchange.
The proposal would be effective for exchanges completed in tax years beginning after December 31, 2022.
Recapture of gain on IRC Section 1250 property
The Administration's proposal would treat any gain on IRC Section 1250 property held for more than one year as ordinary income to the extent of the cumulative depreciation deductions taken after the proposal goes into effect. See Tax Alert 2022-0533 for a detailed discussion of the current and proposed law.
The proposal would require partnerships and S corporations to determine the character of the gains and losses at the entity level and report to entity owners the relevant amounts for ordinary income, capital gain and unrecaptured IRC Section 1250 gain under both the new law and the old law.
Comment: This proposal, along with other recent changes (e.g., IRC Section 1061 reporting, tax-basis capital reporting, and Schedules K-2 and K-3) would continue to add to the tax reporting complexities and burdens for many partnerships, including private funds.
Fossil-fuel publicly traded partnerships (PTPs)
Among many proposed changes related to fossil fuel taxation, the Administration proposes repealing the qualifying income status of a PTP's income from fossil fuel activities, which would cause a PTP generating such income to be classified as a corporation. The repeal would be effective for tax years beginning after December 31, 2027. Comment: Given the current political climate, the prospects for enacting such a repeal are unclear.