September 15, 2021 / North America
On Friday, Senate Finance Committee Chairman Wyden released a discussion draft of potential changes to partnership tax law intended to reduce taxpayer flexibility, simplify Internal Revenue Service enforcement of partnership tax law, and increase the federal tax liability imposed on businesses operating in partnership form. If the proposal is enacted as currently drafted, it could have catastrophic effects on how businesses operate and how they are set up. As a result, although this is merely a discussion draft, we thought it is important to note several of the key provisions of the draft as Democrats are searching for revenue raisers to support their potential $3.5 trillion budget resolution.
1. Allocate all partnership debt, regardless of whether it is recourse or nonrecourse, based on each partner’s share of partnership profits, unless the partner or a related person to the partner was the creditor.
In general, a partner’s basis in its partnership interest is relevant when it sells the interest, is allocated losses or deductions, and when it receives a distribution. A partner’s basis increases, not only for a contribution or being allocated income or gain, but also for its allocable share of partnership debt. The proposal would dramatically change decades-old rules for allocating debt among partners and could result in partners recognizing gain if their current share of partnership profits does not equal or exceed those prior partnership distributions or losses. The discussion draft recognizes the potential for significant current tax liabilities and permits taxpayers to spread them over eight years. To add insult to injury, the gain resulting from this change in partnership debt allocation would likely be subject to tax at new, higher tax rates on capital gains and ordinary income expected to be adopted as part of the Democrats’ budget reconciliation process.
2. Require partnerships to book-up partnership assets – which creates reverse section 704(c) allocations – any time the partners change their economic agreement or admit a new partner to the partnership. Additionally, partnerships must use the remedial method for built-in gains with respect to contributed property or property that is revalued under reverse section 704(c) allocation rules.
Section 704(c) and the remedial allocation method is a particularly technical area of partnership tax law. Distilled to their essence, these proposals would render all contributions of appreciated property to a partnership as an income recognition event for the contributing partner. Further, any change to a partnership’s economic arrangement or admission of a new partner would become an income recognition event for the existing partners. The extent and the timing of the income recognition would depend on how much the contributing or historic partners shifted ownership to others and on the depreciable or amortizable lives of the partnership property.
The purpose of section 704(c) is to prevent the shift of built-in gain (the difference between the tax basis and the fair market value of partnership property) with respect to contributed or revalued property among partners. Statutorily, partners are permitted to defer gain recognition on contributed or revalued property if the asset is non-amortizable. In addition, even if the asset is amortizable, built-in gain could be shifted to another partner depending upon the tax basis of the property. Currently, the existing regulations under section 704(c) provide taxpayers some optionality (through various methods for taking into account section 704(c) amounts) in non-abusive situations. One method would allow taxpayers to report consistent with the statute. Alternatively, the taxpayer could elect the remedial method, which requires the built-in gain to be amortized over time even if the asset is otherwise non-amortizable. It also requires a non-contributing partner to be allocated deductions as if the tax basis of the asset was its fair market value. The remedial method accomplishes this effective re-allocation of income among the parties, to the extent necessary, by creating and allocating notional allocations of income and deductions.
The proposal, which would generally prohibit partnerships from operating a business at a low tax cost, would make the adoption of the remedial method mandatory in all cases. This would have the effect of accelerating the reporting of built-in gain associated with contributed or revalued non-amortizable assets, as well increasing the taxable income allocated to contributing (or deemed contributing) partners with respect to low basis amortizable assets.
3. Replace the primary partnership income allocation regulations based on substantial economic effect with a facts and circumstances test based on each partner’s interest in the partnership.
In general, under current law, if a partnership’s allocations do not otherwise satisfy the substantial economic effect safe harbors, they must be made based on a partner’s interest in a partnership. However, that determination is a facts and circumstances test. But the proposal to repeal the substantial economic effect rules instead of making more targeted changes to those rules creates significant uncertainty for taxpayers by eliminating a major component of the established partnership allocation regulations with which both taxpayers and the IRS are familiar, which the discussion draft acknowledges. Additionally, it is unclear what would be considered an allocation based on a partner’s interest in the partnership: would targeted income allocations that are common in the market be acceptable, or would more restrictive allocations be required?
A&M Insight: One complication with the discussion draft is how a change in partners’ relative rights to partnership profits, either over time or after the partnership achieves a specified rate of return, would fit within this new proposed allocation regime. These arrangements are popular among numerous sectors, including renewable energy tax credit investment partnerships. It would be befuddling if the Democratic budget reconciliation, which has as one of its stated goals increasing investment in renewable energy, would contain tax provisions that could significantly alter certain transaction structures that the market commonly uses to facilitate funding renewable energy investments by creating uncertainty regarding the partnership allocation rules.
Further, as the draft acknowledges, the Treasury Department and the IRS would have to review all partnership regulations as a result of this change, and many other partnership rules would likely need to be modified. As a result, taxpayers might be unable to comply with rules because it is unclear which ones would be left in force after the government’s review of the existing regulations. As a practical matter, at least until new regulations are issued, there would be few, if any, safe harbors to apply when determining whether a partnership’s allocation of partnership income would be respected if this proposal were adopted into law.
4. Require partnerships between members of the same consolidated corporate group (and other partnerships identified in future Treasury regulations) to apply a new “Consistent Percentage Method” that requires all partnership allocations to be pro rata based on partner capital contributions.
If members of a consolidated corporate group own at least 50 percent of partnership capital or profits, the discussion draft would require all partnership allocations to be made using a new “Consistent Percentage Method.” Under that method, allocations must be pro rata based on contributed capital, such that each partner receives the same percentage allocation of each item of partnership income or loss. As a result, partnerships required to apply the Consistent Percentage Method would be prohibited from making any special allocations, issuing profits interests, having preferred equity, or using other common allocations to reflect economic arrangements. Additionally, if a partnership attempts to allocate income in a non-ratable method, the proposal would treat such allocation as a transfer of interests among partners, which will result in gross income to the recipient of non-pro rata income. However, the proposal would prohibit the other partners from capitalizing the transfer or deducting a loss.
A&M Insight: While the application of the Consistent Percentage Method is currently limited to so-called controlled partnerships within a consolidated group, the proposal also allows Treasury to identify other partnerships that would be required to apply this new allocation method (i.e., it could potentially apply to related-party partnerships, ownership by tax-indifferent partners, and ownership by intermediaries). As a result, the Consistent Percentage Method could become more of the standard, as opposed to being the exception to the rule.
5. Eliminate the current seven-year period of limitations that applies to the so-called partnership mixing bowl rules.
Partnership tax law requires a partner that contributed built-in-gain property to recognize any remaining built-in gain if either (1) that contributed property was distributed to a different partner within seven years or (2) different property is distributed to the contributing partner within seven years. The discussion draft would eliminate this seven-year period and trigger the built-in gain for the contributing partner if the contributed property were ever distributed to another partner or the contributing partner ever received a distribution of other property. Removing this seven-year limitation creates a significant administrative burden for partnerships because every partnership distribution would have to be analyzed forever to determine whether it triggered built-in gain for a partner. In addition, the longer contributed property remains in a partnership, the more integrated that property becomes into the business and the more difficult it becomes to separately distribute to each partner only the property that the partner contributed to the partnership instead of using a blended property approach. For example, if a partner receives a distribution of a partnership interest that contains the property that it contributed plus other assets that developed while the property was part of the partnership, that partnership interest is generally considered blended property and arguably is not a distribution of only the property that the partner had previously contributed to the partnership.
A&M Insight: Removing the time limitation of the mixing bowl rules seems to be more of an attack on the general partnership principle that property distributions are not taxable events than it is a an attempt to limit abusive mixing bowl transactions. The current seven-year holding period requirement in the mixing bowl rules is already a significant deterrent to tax avoidance transactions.
6. Clarify that partnership entities are subject to tax in certain circumstances.
Amending the statute to clarify that a partnership entity can be subject to tax in certain circumstances does not sound controversial. Indeed, it simply recognizes reality in light of the new centralized partnership audit rules. However, according to the discussion draft’s explanation, the intent is to expand partnership reporting requirements, which could include requiring disclosures of uncertain tax positions as part of their annual tax returns. When corporations were required to start disclosing uncertain tax positions, it was a controversial requirement and corporate tax teams made significant time investments relating to those disclosures. A&M would expect similar amounts of controversy and increased partnership compliance costs if this statute were adopted and the IRS were to require partnerships to disclose uncertain tax positions.
A&M Insight: The discussion draft notes that the IRS has a low audit rate for partnership tax returns and that auditing such returns can involve difficult tax questions. Requiring disclosure of uncertain tax positions is one way that the IRS could seek to increase the efficiency of its audit process for partnerships.
7. Change how the section 163(j) business interest expense limitation applies to partnerships and Subchapter S corporations.
Section 163(j) limits the amount of business interest expense that a taxpayer is allowed to deduct in the current year. Under both the current law and the discussion draft, the section 163(j) limitation rules apply at the partnership and Subchapter S corporation level and any disallowed business interest expense or excess business interest income or taxable income is allocated to the partners or shareholders, as applicable. However, under the discussion draft, the partner or shareholder cannot use any of its distributive share of partnership items (including excess business interest income or taxable income) to determine its section 163(j) limitation, which could significantly impact common partnership financing structures. In particular, it is common in tiered partnership structures for third-party financing to be held in a partnership that is one or more levels above the operating partnerships in the business’s organizational chart. This type of arrangement may not be economically feasible if the discussion draft is adopted because an upper-tier financing partnership may not be able to use excess taxable income that is allocated to it from a lower-tier operating partnership to support its interest expense deduction. While the intended scope of the provision in the discussion draft is unclear, it could significantly impact how businesses arrange their operations.
A&M Taxand Says:
The discussion draft that the Senate released on Friday would represent a significant change to partnership tax law, and would likely cause some disruption as the market adapts to the changes that these new requirements would impose on commonly used transaction structures. It remains to be seen whether these proposals gain traction as part of the Democrats budget legislation. On Monday, September 13th, Democrat members of the House Ways and Means Committee released a framework of potential tax changes that they are considering as part of their committee process (discussed here). Unlike the Senate’s discussion draft, the House’s proposal makes minor changes to the current carried interest rules that apply to certain private equity partnerships. Indeed, the explanation released with the House’s proposal expressly states that certain provisions were intended to encourage Subchapter S corporations to convert to partnerships. Thus, it appears that Democrats in the House and Senate have very different views regarding the need for fundamental changes to partnership tax law as part of the reconciliation process. It remains to be seen which side’s view will ultimately prevail.