January 31, 2024
Proposed regulations would apply disallowance and deferment rules at the partnership level for certain transactions
In proposed regulations (REG-131756-11 ), the IRS would apply the rules disallowing or deferring deductions for losses and expenses in certain transactions between partnerships and related persons at the partnership level (i.e., an entity theory).
Importantly, the primary purpose of these rules is to update the present regulations under IRC Sections 267 and 707 to conform with statutory changes made to IRC Sections 707(b)(1)(A) and 267(b)(1) in the 1980s.
The proposed rules would apply to tax years ending on or after the date the final regulations are published in the Federal Register. Comments must be received by February 26, 2024.
IRC Section 267(a)(1) prohibits taxpayers from deducting a loss on the sale or exchange of property with a related person. Under the matching rule of IRC Section 267(a)(2), taxpayers may deduct payments as of the date the payment is includible in the payee's gross income if (1) the payee's chosen method of accounting makes the payment includible in the payee's gross income, and (2) the payment would be deductible at the close of the payee's tax year.
Treas. Reg. Section 1.267(b)-1(b) applies an aggregate theory of partnerships, which deems an IRC Section 267(a) transaction between a partnership and a non-partner to be between the non-partner and the separate members of the partnership, which are related to the non-partner. Therefore, deductions are not allowed to the extent (1) of the partner's distributive share of partnership deductions, losses, expenses or interest, and (2) a related partner acquires an interest in any property sold or exchanged at a loss.
In 1982, Congress added IRC Section 267(b)(10), which applies an entity theory and denies deductions for a partnership or S Corporation if the same persons own more than 50% of the S Corporation's outstanding stock or more than 50% of the partnership's capital or profits interests. The mix of aggregate/entity principles in guidance has led to uncertainty among tax practitioners as to the IRS's overall view of how IRC Section 267 operates in relation to partnerships.
The disallowance rule in IRC Section 707(b)(1) also prohibits a deduction for losses from sales or exchanges of property between a partnership and person owning more than 50% of the capital or profits interests in the partnership or two partnerships in which the same person owns more than 50% of the capital or profits interests.
Updating regulations for congressional intent
The IRS explained in the preamble to the proposed regulations that earlier statutory changes to IRC Sections 267 and 707(b)(1) showed that Congress intended for a partnership to be viewed as an entity, not as an aggregate of its partners, in applying the rules in these sections. As a result, the matching rule of IRC Section 267(a)(2) and the rules relating to certain sales or exchanges of property with respect to controlled partnerships under IRC Section 707(b) should apply at the partnership level and not the partner level. To achieve this, the proposed regulations would:
The proposed regulations would also update an example in the regulations dealing with IRC Section 707(b)(1)(A). Under the updated example, adopting an entity view would prevent both a husband and wife from recognizing a loss on the sale of property to a controlled partnership, even though the wife indirectly owns her interest in the controlled partnership through a trust.
If finalized in their current form, the proposed regulations would make clear that a partnership should be treated as an entity for purposes of IRC Sections 267 and 707(b)and would conform the regulations to statutory law. Many tax practitioners have viewed transactions under an entity view for these purposes since the statutory changes in the 1980s. Thus, finalization of the proposed regulations would solidify a view many have already held for years. Considerations related to implementation of the new rules, for affected taxpayers, can be addressed when the proposed regulations are finalized.