Senate Finance Committee Chair Ron Wyden, D-Ore., recently unveiled a sweeping proposal to reform partnership taxation. The proposed rules would significantly modify or eliminate numerous long-standing rules, including allocations of partnership items to partners, allocations of partnership liabilities among partners, and tax allocations relating to property having built-in gain or loss.
The legislation includes dozens of complex provisions that appear to be largely unfavorable to taxpayers, and the bill is meant to raise significant revenue. Wyden also said the effort is aimed at reducing complexity and closing “loopholes.” Wyden unveiled the bill in the hope of including it in a forthcoming reconciliation bill, but many of the provisions are sure to be controversial and raise technical issues. The draft bill is already receiving significant pushback, and it may be difficult for Wyden to gain traction on such complex changes in such a short timeframe. Still, the depth and breadth of the proposed changes are substantial, and taxpayers should analyze the potential impact, as enactment of even just a few of the provisions could have significant impact on partners’ tax liabilities and partnership compliance burdens.
Wyden’s proposal would amend the current partnership allocation rules under Section 704 to remove the substantial economic effect (SEE) safe harbor and, except as provided for certain related taxpayers, would require that all partnership allocations be made in accordance with the partners’ interest in the partnership (PIP) standard. The discussion draft claims that the flexibility accorded to partners under current law, which provides two sets of rules regarding allocations of partnership items (the SEE safe harbor and the PIP standard), has resulted in complexity for taxpayers and the IRS. This provision is apparently aimed at simplifying the administration of partnership allocations (though this may not be the result) and reducing taxpayer flexibility, thereby curtailing perceived abuse.
Wyden’s proposal provides an exception to this general rule for certain situations where partners are not independent and do not have sufficient adverse interests, such that it is not appropriate to rely solely on the purported economic deal between them for the purpose of determining allocations (under PIP or SEE) because, in substance, those partners act in unity and as a single economic person. Under the proposal, if partners are members of a controlled group within the meaning of Section 267(f) and together own more than 50% of partnership capital or profits, the partnership would be required to consistently allocate all items based on partner net contributed capital.
The proposal also contains a provision that would apply when the partners do not allocate partnership items pro rata (i.e., not proportional to net contributed capital). Specifically, any distribution or right to partnership property not proportional to a partner’s net contributed capital would be treated as a transaction directly between partners (i.e., outside the partnerships). The partner receiving such distribution or right would be treated as receiving an interest in the partnership from one or more other partners, while the receiving partner would recognize income or gain and any loss or expense would be nondeductible and noncapitalizable by the other partner(s). This proposal would be effective for tax years beginning after Dec. 31, 2023.
The bill directs the IRS to issue updated and simplified regulations addressing PIP, and to apply the proposal to tiered entities. The provision would be effective for tax years beginning after Dec. 31, 2023.