IRS proposes modernizing partnership-related party loss rules

The IRS has proposed new regulations (REG-131756-11) that would remove certain longstanding but outdated regulations applying Section 267(a) to transactions involving partnerships.

Statutory changes to Sections 267 and 707(b) already superseded much of the targeted regulations, but the actual deletion of these regulations would clarify the application of Sections 267 and 707(b) to partnership transactions. The new proposed regulations might also loosen the restrictions on loss recognition and the timing of certain deductions for transactions between partnerships, their minority partners and related persons.

Section 707(b) provides rules for the disallowance of losses from transactions between partnerships and certain related parties. As originally enacted in 1954, the Section 707(b) rules applied only to transactions between partnerships and their controlling partners and did not contain rules governing transactions between partnerships and persons related to its partners. In 1958, the IRS promulgated Treas. Reg. Sec. 1.267(b)-1(b), which applies an aggregate approach to transactions between a partnership and its partners’ related persons (within the meaning of Section 267(b)). While Section 707(b) generally disallows the entire loss recognized on a transaction to which it applies, Treas. Reg. Sec. 1.267(b)-1(b) disallows only the portion of the loss from the transaction corresponding to the relevant partners’ interest in the partnership. 

Legislative changes in the 1980s updated the list of relationships described in Section 267(b) to include a partnership and a corporation where the same persons own more than 50% of the interests in each and expanded the deduction matching rule in Section 267(a)(2) to cover transactions between partnerships and their partners and related persons. The IRS promulgated temporary regulations (which would also be slated for removal with these proposed regulations) implementing the Section 267(a)(2) matching rule, again, by applying an aggregate approach so that the impact of Section 267(a)(2) fell only with the person transacting with the partnership and its related persons.

The Tax Reform Act of 1986 further expanded the scope of the Section 707(b) loss disallowance rule to cover transactions between partnerships and persons owning more than 50% of the capital interest or profits interest in such partnership (after applying certain constructive ownership rules). After the 1986 amendments, it appears that Treas. Reg. Sec. 1.267(b)-1(b) was out of sync with Section 707(b) in multiple respects. For instance, Section 707(b) takes an “all-or-nothing” approach, completely disallowing losses on transactions partnerships and persons owning greater than a 50% direct or indirect interest, while applying no limitation on losses with persons falling under that threshold. On the other hand, Treas. Reg. Sec. 1.267(b)-1(b) disallows a proportionate share of all losses, whether the related person at issue is above or below the greater than 50% ownership hurdle laid out in Section 707(b).

The proposed regulations would resolve this conflict by deleting Treas. Reg. Sec. 1.267(b)-1(b). The proposed regulations would also delete the temporary regulations noted above applying an aggregate approach to the Section 267(a)(2) matching rule for partnership transactions. The proposed regulations also make other minor conforming changes to Treas. Reg. Sec. 1.707-1(b) and include an example of the application of the constructive ownership rules that apply for purposes of Section 707(b).  The changes to the regulations are proposed to be effective for sales or exchanges in tax years ending on or after the publication of final regulations in the Federal Register.

The statutory total loss disallowance rule provided in Section 707(b) likely already rendered inoperable the proportionate disallowance rules in Treas. Reg. Sec. 1.267(b)-1(b) and the Section 267(a)(2) temporary regulations to the extent they each might apply to a single transaction. However, the proposed removal of these regulations would clarify the ability to claim losses or deductions for transactions between partnerships and persons related to partners owning 50% or less of the partnership.