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March 22, 2024

Biden Administration's FY 2025 budget and Green Book proposals address partnership issues relevant to alternative asset management funds and BBA proceedings

The Biden Administration's FY 2025 budget and Treasury General Explanations of Revenue Proposals (Green Book), released March 11, 2024, propose several changes to rules affecting partnerships, such as private equity funds, alternative asset management funds and energy operating partnerships. These include:

  • Eliminating basis shifting among related partners
  • Taxing carried interest as ordinary income
  • Making push-out elections under the partnership audit regimes
  • Eliminating the corporate income tax exemption for fossil fuel publicly traded partnerships (PTPs)

Basis shifting

Under current law, a partnership that has made an IRC Section 754 election can adjust the basis of its remaining property under IRC Section 734(b) when making certain distributions to a partner. If a partner receiving the property recognizes no gain on the distribution, the partnership can increase the basis in its remaining property by the amount its basis in the distributed property exceeds the distributee-partner's basis.

According to the Green Book, the Administration desires to limit the ability for related-party transactions to shift basis from non-depreciable and non-amortizable partnership property to depreciable and amortizable partnership property without economically affecting the parties. Currently, if a distributee-partner takes a stepped-down basis in distributed property, the partnership may take a step-up to depreciable or amortizable property, resulting in depreciation and amortization deductions for the remaining partners even if the distributee-partner holds the distributed property and recognizes no taxable income on the property.

The president's FY 2025 budget proposes a matching rule to prohibit any related partner in a distributing partnership from benefiting from a basis step-up until the distributee-partner disposes of the property received in a fully taxable transaction.

The proposal would be effective for tax years beginning after December 31, 2024.

Implications . Taxpayers and their related parties should note that the proposal would significantly modify long-standing rules on IRC Section 734(b) adjustments, generally considered to be mechanical in nature. These changes could adversely affect partnership distributions that are not intended to achieve a tax benefit.

Incorporate Chapters 2/2A in centralized partnership audit regime proceedings

The Centralized partnership audit regime, as enacted by the Bipartisan Budget Act of 2015 (BBA), currently separates the treatment of Chapters 1 (income tax) and 2/2A (self-employment income tax/net investment income tax) of the Internal Revenue Code for purposes of adjustments, calculations, and assessments. During a BBA proceeding, the IRS must address Chapter 1 liability at the partnership level and generally assess and collect from the partnership taxes resulting from adjustments, whereas Chapters 2/2A taxes resulting from the same BBA proceedings must be collected from the individual partners.

The Administration's proposal would amend the definition of a BBA Partnership-Related Item to include items that affect a person's Chapter 2/2A taxes. The proposal would also apply the sum of the highest rates of tax in effect under IRC Section 1401(b) for the reviewed year to those items. The proposal would be effective after enactment for all open tax years.

Implications. This change would avoid the need for individual partners to be subject to an audit or to extend their own statutes of limitation when a partnership-level audit involves Chapter 2/2A taxes. However, subjecting any adjustments at the partnership level to the highest rates in effect under IRC Section 1401(b) and 1411 may result in more tax being paid than if the adjustments were made at the individual partner level.

Refund of certain adjustments in centralized partnership audit regime

The Administration's proposal is generally same as that in the FY2023 budget (see Tax Alert 2022-0550). 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. Partnerships 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 potentially permanent loss of an overpayment of tax.

Allow partnership to resolve audits earlier

The Administration's proposal would allow a partnership to elect to push out adjustments after the IRS issues a Notice of Proposed Partnership Adjustment (NOPPA) and until 45 days after the issuance of a Final Partnership Adjustment (FPA). The proposal would be effective when enacted.

Currently, the BBA requires the IRS to issue both a NOPPA and FPA before a partnership may elect to push out an adjustment to its reviewed-year partners, even if the partnership agrees with the adjustment.

Implications. This change would improve the efficiency of completing partnership audits where the adjustments are not disputed. Currently, it can take several months for the IRS to issue an FPA, even when the partnership has indicated it agrees with the adjustments and intends to push them out to partners. If the partnership has the option to push adjustments out sooner, audits can be resolved earlier and partners can potentially avoid accruing additional interest on those deficiencies.

Oil and gas PTPs

Among many proposed changes related to fossil-fuel taxation, the Administration proposes repealing the rules that treat PTP qualifying income as including income from exploring for, refining, transporting, marketing and extracting natural resources. PTPs generating such income could no longer rely on such income to avoid classification as a corporation.

The repeal would be effective for tax years beginning after December 31, 2029.

Tax carried (profits) interests as ordinary income

If a partner's taxable income from all sources exceeded $400,000, the partner's share of income on an investment services partnership interest (ISPI) in an investment partnership would be treated as ordinary income (not capital gain), regardless of the income's character at the partnership level. "An ISPI is a profits interest in an investment partnership that is held by a person who provides services to the partnership," the FY25 Green Book notes. The proposal would also repeal IRC Section 1061 for taxpayers with taxable income from all sources exceeding $400,000.

The Administration does not intend this proposal to adversely affect qualification of a real estate investment trust (REIT) owning a profits interest in a real estate partnership, according to the Green Book. The proposal would be effective for tax years beginning after December 31, 2024.

Implications. This proposal is identical to the FY24 proposal. Carried interest reform might be redundant, considering the Administration's proposal to increase capital gains rates to ordinary income rates for high-income taxpayers. If the preference for long-term capital gain ends, the Administration's carried interest proposal would only affect a narrow subset of carried-interest recipients, namely profits-interest holders with taxable income below $1 million (the threshold in the long-term capital gain proposal) and above $400,000 (IRC Section 1061 would still 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:

  • The proposal would convert what is otherwise long-term capital gain into ordinary income (IRC Section 1061 converts certain long-term capital gains into short-term capital gains taxed at ordinary rates)
  • The treatment as ordinary income would apply regardless of the holding period (IRC Section 1061 generally applies to gains on dispositions of assets held for three years or less)
  • Self-employment taxes would apply to this income

Private equity, private capital, and other alternative asset management funds and their professionals could face increased tax liabilities if either the carried interest proposal or the proposal to increase capital gains rates were enacted.

Apply the net investment income tax (NIIT) to high-income taxpayers' pass-through business income

Effective for tax years beginning after December 31, 2023, the proposal would expand the NIIT base to ensure that all pass-through business income of high-income taxpayers is subject to either the NIIT or SECA tax.

To calculate the amount of trade or business income subject to the NIIT, taxpayers would calculate "potential NIIT income" by adding together their:

  1. Ordinary income derived from S corporations for which the owner materially participated in the trade or business
  2. Ordinary business income derived from either limited partnership interests or interests in limited liability companies (LLCs) classified as partnerships to the extent a limited partner or LLC member materially participated in the partnership's or LLC's trade or business
  3. Other trade or business income to the extent it was not subject to NIIT or SECA under current law

A specified percentage of the potential NIIT income would be subject to the NIIT. This specified percentage would be between 0 and 100, increasing as a couple's adjusted gross income (AGI) increased from $400,000 to $500,000 ($200,000 to $250,0000 for married taxpayers filing separately). Material participation standards would apply, generally meaning a taxpayer who worked for a business for at least 500 hours per year materially participated in it.

Implications. This proposal would subject all business income to either the self-employment tax or NIIT. This proposal would ensure that non-passive shareholders of an S corporation and limited partners in a limited partnership will be subject to the NIIT on their passthrough income.

Increase the NIIT rate and the additional Medicare tax rate for high-income taxpayers

Effective for tax years beginning after December 31, 2023, the proposal would increase the additional Medicare tax rate by 1.2 percentage points for taxpayers with more than $400,000 in earnings. This would effectively bring the marginal Medicare tax rate up to 5% for those earning more than $400,000.

The proposal would also increase the NIIT rate by 1.2 percentage points for taxpayers with more than $400,000 in income. For taxpayers with positive net investment income (NII), the NIIT would increase by 1.2 percentage points on the lesser of (1) NII or (2) any excess of modified AGI exceeding $400,000. Both thresholds would be indexed for inflation.

Implications This is identical to a proposal from the FY24 Green Book. When coupled with a top marginal rate of 39.6%, the top rate on ordinary income subject to the NIIT would reach 44.6% if both proposals were enacted.

Repeal gain deferral for like-kind exchanges

The proposal would require a taxpayer to recognize gain from any like-kind exchanges exceeding $500,000 ($1 million for a joint return) during a tax year beginning after December 31, 2024. No changes would be made to the gain deferral for like-kind exchanges up to an aggregate $500,000/$1 million for individual/joint filers.

Implications. Although IRC Section 1031 has been the subject of recent attention by both the Administration and Congress, IRC Section 1031 exchanges have been part of the Internal Revenue Code since 1921. The Congress that passed the TCJA limited IRC Section 1031 and considered eliminating the statute. So, we continue to see attention to like-kind exchanges.

Limiting the benefit of deferral to the extent proposed by the Administration would curtail a time-honored tax-savings strategy whereby a taxpayer exchanges appreciating real estate on a tax-free basis throughout his or her life while borrowing against the value. Upon the taxpayer's death, the heirs would take a stepped-up FMV basis in the real estate, and the appreciation would have escaped taxation completely. In this regard, the proposal to reduce the benefit available from deferral under IRC Section 1031 appears redundant, given the Administration's proposal to also subject the appreciation inherent in one's assets upon death to income tax. In addition, when real estate is evenly exchanged and gain is recognized under the proposal, taxpayers may find themselves facing a tax bill with no corresponding cash generated from the transaction.

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Contact Information

For additional information concerning this Alert, please contact:

Partnerships and Joint Ventures Group

Tax Policy and Controversy

Published by NTD’s Tax Technical Knowledge Services group; Chris DeZinno, legal editor