- Longstanding rules regarding partnership tax law may be altered by a new tax proposal.
- Partnership allocations may be required to be made in accordance with a partner’s interest in the partnership (PIP) standard, rather than the firmly established substantial economic effect (SEE) standard.
- Proposed changes to the flexible rules governing the manner in which partnership liabilities are allocated to partners, could trigger gains to certain partners who may have taken losses or distributions in excess of their tax basis capital.
- The new proposal eliminates the optionality of revaluation of partnership property, making revaluation mandatory upon a change in the economic arrangement of the partners.
A new proposal could impact your partnership’s tax plan.
Senate Finance Committee Chair Ron Wyden, D-Ore., has put forth a proposal to alter many longstanding rules regarding partnership taxation. The legislation seeks to raise revenue and simplify the administration of partnerships, by modifying or eliminating rules regarding the allocation of items to partners, allocation of liabilities between partners, and allocations related to property contributions.
In an overview released by the Chairman’s office, Senator Wyden argues that the changes are necessary in order to remove the complexity in current partnership rules by closing loopholes. Interestingly, Senator Wyden also acknowledges that the complexity of the current partnership rules makes them nearly impossible for the IRS to administer and cites recent testimony of the IRS Commissioner that the agency gets “outgunned” by private sector experts in the partnership arena. The proposal is expected to raise significant revenue which could be added to the menu of options needed to fund the Build Back Better Plan. Subchapter K has been largely unchanged for quite some time and this proposal puts forth the most substantial changes seen in decades.
Most of the more meaningful changes relate to decreasing the historical flexibility provided to partnerships. This article will explore some of those changes in depth.
The proposal would amend current allocation rules to remove the substantial economic effect (SEE) safe harbor and would require (with some exceptions) allocations to be made in accordance with the partners’ interest in the partnership (PIP) standard.
The SEE standard was first added to the Internal Revenue Code to preserve flexibility of allocations in partnerships. The proposal argues that the SEE standard has failed to prevent tax-motivated allocations and has, at times, created disconnect between the tax and economics of the partnership. The PIP standard is based on the facts and circumstances of the partnership arrangement and aims to simplify rules surrounding allocation of items to partners.
PIP is a fact and circumstance-based test, which generally requires significant guidance from Treasury to implement. However, there is currently a lack of guidance in how to apply this test, and implementation will likely require a significant amount of additional direction. For this reason, the PIP standard could more appropriately be characterized as a shift to an equally complex regime, as opposed to a simplification of the rules. Some professionals believe this modification will require targeted allocations, which are already utilized by some partnerships. Also note: for members of a controlled group, the proposal would mandate pro-rata allocations.
Mandatory revaluations and property contributions
Upon the occurrence of certain events, such as the issuance of additional ownership interests by a partnership, regulations generally provide an option for the partnership to revalue assets immediately prior to such transactions. Revaluations prevent the shifting of partnership built-in gain/loss away from the partners who have accrued that gain/loss. The proposal eliminates the optionality of revaluation of partnership property, making revaluation mandatory upon a change in the economic arrangement of the partners. This provision would be applicable to revaluation events occurring after December 31, 2021.
When a new equity interest is granted in a partnership, this provision would require a mandatory revaluation of 704(b) capital accounts. While revaluations reflect the economics of the partnership, to make such revaluations mandatory without significant exceptions could be unduly burdensome for taxpayers.
When property is contributed to a partnership or distributed out, the transaction generally does not result in an immediately taxable event for either the partner or the partnership. When property is contributed, the tax basis of the property is often not equal to the fair market value of the contributed property. Section 704(c) attempts to prevent the ability of partners to shift the built-in gain/loss between partners. The rules seek to preserve the variation between the value and basis at the time of contribution when making allocations of taxable income associated with the built-in gain/loss property.
Current law allows significant flexibility in accounting for this variation; three reasonable methods are set out in the regulations. The Wyden proposal eliminates two of those methods and instead requires use of the remedial method — the only one that can fully prevent the shifting of built-in gain between partners. This change would take effect for property contributions and/or revaluations occurring after December 31, 2021.
Mandatory use of the remedial method is another example of reducing the flexibility afforded to partnerships, as well as simplifying the audit process for the IRS.
Generally, the current rules allocate partnership liabilities to the partners based on who shares in the economic risk of loss for the liability, assuming that all of the partnership’s assets are worthless (including cash). Senator Wyden views guarantees and similar arrangements as potentially abusive in determining liability allocations for purposes of providing for loss allocations, avoiding disguised sale rules, and generating tax-deferred cash distributions. Additionally, nonrecourse liabilities are currently allocated under a three-tier approach provided for in the regulations. The Wyden proposal eliminates this flexibility and requires all debt to be allocated in accordance with the partners’ share of the partnership profits. The only exception to this requirement is when the partner (or a person related to the partner) is the lender.
The proposed requirement that all liabilities be allocated in accordance with partnership profits could result in significant shifts of existing debt allocations — which in some cases could trigger gain recognition to the affected partners.
This provision would prevent a partner from increasing their basis in a partnership utilizing partner guarantees of partnership debt. A transition rule provided in the proposal allows any tax liability arising from this rule change to be paid over eight years. We believe the unusual transition rule may exemplify the amount of revenue the IRS expects to generate from this rule change. The current proposal also does not indicate how this change could affect the partner-level at-risk amount.
Mandatory basis adjustments
Currently, a partnership can elect to adjust the basis of partnership property to account for disparities between the partnership’s basis in its property and the partners’ basis in their partnership interests. The Wyden proposal eliminates the elective nature of these adjustments and makes them mandatory.
As a result, where partners recognize gain or loss on distribution — or where a partner takes basis in distributed property different than the basis in the hands of the partnership — the partnership will be required to make basis adjustments at the time of such distribution of money or property under Section 734.
Similarly, transfers of partnership interests by sale or upon death can create disparities between a partner’s outside basis in their partnership interest and the inside basis of the partnership’s assets. The proposal makes these adjustments to account for the difference in basis mandatory under Section 743.
This provision would mandate these adjustments. Although the allowance of these adjustments is typically taxpayer friendly, there are instances where partnerships may intentionally choose not to make a Section 754 election due to administrative burden. This may be the case where the adjustments are de minimis and the costs of making the adjustments outweigh the benefits.
Keep in mind that making the adjustment addresses a timing and character issue. If the election is not made, the benefit is preserved in the partner’s outside basis until the interest is ultimately disposed of.
The proposal lays out several other changes to partnership taxation. We will continue to monitor these changes as it moves through the legislative process. Consult your tax professional to address and plan for potential modifications to partnership taxation.
How we can help
Our team of tax professionals is here to help you understand these potential changes and how they might impact your partnership. We can work with you to develop a strategic tax plan and make sense of complex regulations and rules.