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.
Grant Thornton Insight: This change would represent a major shift in partnership taxation by removing the optionality of drafting allocations to apply the SEE safe harbor versus the PIP standard. Requiring partnership allocations using only the PIP standard would not necessarily represent simplification, given that the PIP standard requires a facts and circumstances analysis that can be complex and potentially lead to disputes among partners if they do not have an agreed upon process for determining their allocations under PIP.
The proposal would amend Section 752 to require that all debt be allocated between the partners in accordance with each partner’s share of partnership profits. An exception is provided in cases where the partner (or a person related to the partner) is the lender and where the IRS identifies opportunities to prevent abuse. The provision would be effective for tax years beginning after Dec. 31, 2021. A transition rule is also provided to allow taxpayers to pay any tax liability that would arise as a result of the enactment of the provision over eight years.
Grant Thornton Insight: This provision would upend longstanding core tenets of partnership taxation, which generally look to the concept of economic risk of loss (EROL) to distinguish between recourse and nonrecourse liabilities to allocate partnership liabilities among partners. Basing partnership liability allocations purely on profit shares could potentially result in significant shifts in existing debt allocations reducing some partners’ bases in their partnership interests, triggering gain in some cases and corresponding partnership basis adjustments under Section 734(b). The provision could affect business decisions concerning the terms of new partnership debt, including whether any person provides a guaranty. Additionally, assuming that under the proposal the concept of sharing debt in accordance with partnership profits does not include or align with the concept of allocating debt based on Section 704(c) built-in gain, the loss of the ability to rely on Section 704(c) minimum gain and the so-called Section 704(c) “kicker” under the current Section 752 nonrecourse debt allocation rules to avert gain recognition at the time of a property contribution might cause some property contributions to result in gain recognition where debt is transferred to the partnership along with the property. Further, the proposal does not address whether the profit share allocation concept applied for debt allocations under Section 752 would also apply for purposes of measuring debt allocations under the disguised sale of property rules under the Section 707 regulations, which currently permit debt allocations to be made by looking to Section 752 EROL concepts. Permitting debt allocations to be made by looking to EROL has enabled some property contributing partners to avert, or reduce the magnitude of, a disguised sale.
Rules concerning contributions of built-in gain property and mandatory revaluations
Wyden’s proposal would require all partnerships to use the “remedial method” for Section 704(c) allocations, eliminating the other allocation methods currently described in regulations (i.e., the traditional method and the traditional method with curative allocations). This provision would be effective for property contributions and revaluation events occurring after Dec. 31, 2021.
Wyden’s bill would also mandate revaluations of partnership property (commonly known as “reverse” Section 704(c) allocations) upon certain events that result in a change in the economic agreement of the partners (e.g.
, as a result of a non de minimis disproportionate contribution of money or property to a partnership in exchange for an interest in the partnership; as a result of a non de minimis
disproportionate distribution; on issuance of a compensatory partnership interest). Under the proposal, any agreement to change the manner in which the partners share any item or class of items of income, gain, loss, or class of items of income, gain, loss, deduction, or credit of the partnership (a so-called recapitalization) would be included as a revaluation event; currently, a recapitalization is merely proposed to be a permitted revaluation event under proposed regulations and has not yet been promulgated in a final regulation. The mixing bowl rules (Sections 704(c)(1)(B) and 737) would not apply to the reverse Section 704(c) allocations unless the Secretary issues regulations to the contrary.
The proposal would also make a revaluation event at an upper-tier partnership be treated as a revaluation event with respect to a lower-tier partnership, where the upper-tier partnership holds more than 50% of the capital or profits interests in the lower-tier partnership. The amendments concerning revaluations would apply to revaluation events occurring after Dec. 31, 2021.
Grant Thornton Insight: This revaluation rule would require partnerships to maintain capital accounts under Section 704(b) and this could prove extremely burdensome for partnerships that have frequent disproportionate contributions, distributions, or issuances of compensatory partnership interests. Additionally, while a revaluation may generally get Section 704(b) capital accounts adjusted to reflect the economic entitlements of partners with regard to their share of unrealized built-in gain or loss of the partnership and to avert the shifting of tax, it is unclear why a revaluation would be needed or relevant in all partnerships. For example, in some professional service partnerships, partners might primarily share in operating income and losses and not in the gains or losses in the partnership’s business assets. Revaluation appears unnecessary in these situations. It is also unclear when an event would qualify as de minimis such that a revaluation would not be required under the proposed legislation.
Mandatory basis adjustments
Wyden’s proposal would make basis adjustments under Section 734 mandatory at the time of a partnership distribution of money or other property. This provision would also revise the calculation of each partner’s basis adjustment to preserve each remaining partner’s gain or loss that would be recognized if the partnership had sold all partnership property at fair market value. This provision would apply to transfers occurring after Dec. 31, 2021. Wyden’s proposal would also make basis adjustments resulting from transfers of partnership interests under Section 743 mandatory. This provision would apply to transfers occurring after Dec. 31, 2021.
Grant Thornton Insight: Generally, with the exception of certain mandatory basis adjustments in certain loss situations, basis adjustments under Sections 734 and 743 have historically been elective (i.e., a valid Section 754 election has to be in effect in order to make the basis adjustment). In some instances, partnerships affirmatively decide not to make a Section 754 election due to the administrative burden of computing and allocating the basis adjustment. Mandatory basis adjustments may create significant additional work that was not intended or desired by parties to a transaction.
Other proposals in Wyden’s bill include the following:
- Amending Section 701 by providing for potential exceptions to the general rule that partnerships are not subject to income tax, and partners are liable only in their individual capacities.
- Grant Thornton Insight: The staff summary of this provision appears to indicate that this change is meant to spur a potential change in the financial statement reporting requirements for partnerships. If partnerships were themselves considered subject to income taxes at the entity level under certain existing code provisions (such as under the partnership audit regime of the Bipartisan Budget Act), it is possible they could be required to reserve for uncertain tax positions under ASC 740. The IRS has also discussed requiring certain partnerships to report uncertain tax positions on the Schedule UTP. The IRS decline to extend Schedule UTP to partnerships in the past because the requirements tied to financial statement reporting that generally did not apply to partnerships.
- Repealing the seven-year time period for the application of the “mixing bowl” rules under Section 704(c)(1)(B) and Section 737 so that the mixing bowl rules would apply to contributed property regardless of the time since contribution, effective on property contributed after Dec. 31, 2021.
- Providing greater flexibility for the determination of outside basis by allowing the alternative rule under Section 705(b) to be applied in scenarios other than partnership terminations. This is proposed to be effective on the date of enactment.
- Repealing Section 707(c) and making Section 707(a) govern any payments by the partnership that are not actual, or in substance, distributions of partnership income under Section 731. Section 707(a) would treat these payments as payments to a partner not acting in its capacity as a partner. The provision would be effective for payments made after Dec. 31, 2021.
- Grant Thornton Insight: Apparently, the repeal of the rule on guaranteed payments is based on Section 707(c) having created confusion and uncertainty. It is unclear whether salary-like payments to partners, which currently are to be reported as guaranteed payments for the provision of services, would be reported as salary payments under Section 707(a). If so, then one might infer that the Wyden proposal would be recognizing the ability of a partner to be treated as an employee for tax purposes. There would be numerous collateral implications from such an inference, such as impact on benefit plans.
- Repealing Sections 736 and 753 “to align payments to retirees and successor-in-interest partners with the general rules of Subchapter K specifically and the IRC generally.” Section 761 would also be amended to provide that a retiring or successor-of-interest partner remains a partner until complete liquidation of the partnership interest. These provisions would apply to successors-in-interests and partners retiring after Dec. 31, 2021.
- Clarifying that the disguised sale rules under Section 707(a)(2)(B) are self-executing.
- Removing the exception from treatment as sale proceeds for certain reimbursements from the partnership to a partner for capital expenditures, thus treating proceeds for reimbursement of capital expenditures as disguised sale proceeds. The provision would apply to property transfers occurring after the date of enactment.
- Clarifying Section 708 by providing that a partnership is not terminated if any part of the business is carried on by a person or persons who was a partner in the prior partnership or by a person related to any of those partners. The provision would be effective for tax years beginning after date of enactment.
- Removing the requirement under Section 751(b) that inventory be substantially appreciated to be treated as ordinary income property. The provision would apply to distributions occurring after the date of enactment.
- Amending Section 163(j)(4) so that the interest limitation rule applicable to partnerships and S corporations would become a “true entity-level limitation.” The proposal provides that excess limitation (i.e., excess business interest income and excess taxable income) cannot be used to deduct interest expense from other sources. The provision would be effective for tax years beginning after Dec. 31, 2021.
- Grant Thornton Insight: This provision is in direct conflict with the tax title approved by the House Ways and Means Committee for the reconciliation bill, which would provide that the Section 163(j) limit is applied only at the partner level.
- Repealing the exception under Section 7704(c) from corporate tax treatment for all publicly traded partnerships (PTPs). The provision would be effective for tax years beginning after Dec. 31, 2022.
- Grant Thornton Insight: This provision is also in conflict with the House bill, which would expand favorable PTP treatment to alternative energy activities.
- Repealing the exception under Section 852(b)(6) for regulated investment companies (RICs), aligning RICs with the general requirement that gain be recognized upon distribution by a corporation of built-in gain property. The repeal would be effective for tax years beginning after Dec. 31, 2022.
- Clarifying that foreign entities are subject to the Section 52 aggregation rules. The provision would be effective for tax years beginning after Dec. 31, 2021.
The staff summary makes clear that the draft bill represents an attack on many aspects of partnership taxation. The introduction acknowledges the original intent of Subchapter K, “to provide flexibility to taxpayer in arranging business affairs,” but makes clear this should be sacrificed in favor of reducing optionality and promoting enforcement. It also promises to make compliance easier, though many of the changes would not necessarily have that intended effect, and in some respects might actually increase compliance burdens. This legislation will likely run into significant opposition, but the breadth and depth of the proposed changes means businesses should analyze the potential impact and continue to follow its legislative progress.
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