This article reviews and analyzes recent law changes as well as rulings and decisions involving partnerships. The discussion covers developments in the determination of partners and partnerships, gain on disposal of partnership interests, partnership audits, and basis adjustments. During the period of this update (Nov. 1,2017, through Oct. 31,2018), Congress enacted the law known as the Tax Cuts and Jobs Act (TCJA), (1) which made several changes that affect partners and partnerships, and the Treasury Department and the IRS worked to provide guidance for taxpayers on numerous changes that had been made to Subchapter K over the past few years. The courts and the IRS issued various rulings that addressed partnership operations and allocations.
Tax Cuts and Jobs Act
On Dec. 22, 2017, President Donald Trump signed the TCJA, the first major tax reform in over 30 years. While much of the publicity about the new law focused on the 21% corporate tax rate and the substantial changes to foreign income, the new tax law also included several provisions that will have an impact on partners and partnerships. Some of those provisions include a deduction for qualified business income (QBI), a new limitation on business loss deductions, new rules for income from carried interests, and the elimination of technical terminations of partnerships.
Qualified business income
When Congress reduced the corporate tax rate, it recognized the disparity in the rates between corporations and passthrough entities (PTE), such as partnerships. As a way to reduce the effective tax rate for PTEs, the TCJA introduced a new deduction for QBI under Sec. 199A. In general, the new rule permits a deduction for 20% of QBI from partnerships, proprietorships, and S corporations. It also applies to dividends from real estate investment trusts (REITs), income from publicly traded partnerships (PTPs), and certain payments from cooperatives to their patrons. However, the deduction is limited to taxable income. Taxable income is measured without any QBI deduction and is reduced for any income taxable at capital gain rates, including qualified dividends. (2)
To qualify as QBI, the income must be effectively connected to a trade or business. (3) A separate computation of QBI and other limitations are required for each qualified trade or business. (4) For partners in a partnership, the determination of QBI and any limitations on the deduction apply at the partner level. The deduction is generally 20% of the QBI from a trade or business. However, the allowable deduction may be reduced by several limitations included in the law. The tentative deduction may be reduced by the limitations based on the amount of W-2 wages paid by the PTE and the amount the PTE has invested in tangible depreciable property (e.g., plant, property, and equipment but not land). In addition, the deduction generally is limited where the PTE's business primarily involves the performance of certain specified services (e.g., accountants, lawyers, doctors, and financial advisers).
The limitations are based on the level of taxable income on a taxpayer's individual tax return. The limitation thresholds depend on the individual taxpayer's filing status. In 2019, for married taxpayers filing joint returns, the threshold is $321,400 and the phaseout range is $100,000. For married taxpayers filing separate returns, the threshold is $160,725 and the phaseout range is $50,000. For single and head-of-household taxpayers, the threshold is $160,700 and the phaseout range is $50,000. Thus, when taxable income does not exceed the threshold, "specified service business" income is QBI and the QBI deduction for any trade or business is not limited by reference to the W-2 wages paid or depreciable property held by the business. When taxable income exceeds the threshold plus the phaseout range, specified service income is not QBI and any other QBI is subject to limits based on W-2 wages paid by the business and the basis of property held by the business at the end of the year. When taxable income exceeds the threshold, but is still within the phaseout range, a portion of each rule applies.
When a business produces a loss for the year, the QBI "deduction" may be negative. This amount does not directly add income to the taxpayer's return, but it does offset the QBI deduction that might otherwise be available. If the negative QBI deduction from one business exceeds the positive QBI deduction for all other businesses, the taxpayer must carry the excess loss forward. This carryforward must offset the taxpayer's QBI deduction in the succeeding year. Any loss that enters into the QBI calculations must have already cleared the limits on deductions of partnership basis, amount at risk, and passive activity losses.
The rules regarding the QBI deduction are quite complex, so Congress granted Treasury specific authority to issue regulations regarding the rules of Sec. 199A. Last year, to help taxpayers navigate the new rules, Treasury issued proposed regulations, (5) the purpose of which was to provide taxpayers with computational, definitional, and anti-avoidance guidance regarding the application of Sec. 199A. These proposed regulations contain six substantive sections, each of which provides rules relevant to the calculation of the Sec. 199A deduction. Additionally, the proposed regulations would establish anti-abuse rules under Sec. 643(f) to prevent taxpayers from establishing multiple non-grantor trusts or contributing additional capital to multiple existing non-grantor trusts to avoid federal income tax, including abuse of Sec. 199A.
Excess business losses
Before the TCJA, partners had to clear three hurdles before they were allowed to deduct a loss allocated from a partnership: basis under Sec. 704(d), amounts at-risk under Sec. 465, and passive activity loss under Sec. 469. The TCJA added a fourth hurdle that disallows "excess business losses" for taxpayers other than C corporations. "Excess business losses" means an overall loss in excess of $500,000 for married individuals filing jointly or $250,000 for other individuals. Any excess business loss is treated as a net operating loss (NOL) and carried forward to subsequent years. In the case of a partnership, this provision applies at the partner level and after application of the other three loss limitation rules. Under the new rule, a loss from a partnership may be deductible under Secs. 704(d), 465, and 469 and still be limited on the partner's personal return. This provision is effective for years beginning after Dec. 31,2017, but is set to expire on Dec. 31,2025.
Carried interests are part of a standard compensation package for managers of private-equity (PE) funds. PE funds typically buy entire businesses, operate them for some period (longer than one year), and sell them for a profit (at least that is the hope). In return for making investment decisions for the PE fund and handling all administrative tasks, the manager (profits interest or carried interest holder) is usually compensated with a management fee and a "carried interest." The carried interest is usually equal to 20% of the PE fund's profits, if any, after the return of the capital invested by the limited (capital) partners, plus a return on invested capital. Because the PE fund generally holds each investment (typically classified as a capital asset) for more than one year, and because the character of the income generated by the PE fund is determined at the partnership level, any profit generated by the PE fund on the sale of a portfolio company is normally characterized as long-term capital gain.
Congress acknowledged to a certain extent that income from a carried interest might be better taxed as ordinary income by adding Sec. 1061 to the Internal Revenue Code as part of the TCJA. Sec. 1061 changes part of the carried interest income from a long-term capital gain to a short-term capital gain, which may be taxed as ordinary income. Under new Sec. 1061, for carried interest income to be taxed as a long-term capital gain, the holding period must be three years instead of one.
Executive Order 13789 directed the secretary of the Treasury to review significant tax regulations issued on or after Jan. 1, 2016, and submit a report identifying regulations that impose an undue financial burden on taxpayers, add undue complexity to the federal tax law, or exceed the IRS's statutory authority. Notice 2017-38 identified two partnership regulations that either impose an undue financial burden on taxpayers or add undue complexity to the federal tax law: the temporary regulations under Sec. 752 regarding "bottom-dollar payment obligations" and the temporary and final regulations under Sec. 707 regarding a partner's share of liabilities for disguised-sale purposes. (6) Taxpayers and practitioners have objected to both of these regulations.
On Oct. 2, 2017, Treasury issued a "Second Report to the President on Identifying and Reducing Tax Regulatory Burdens." In it, Treasury and the IRS stated that, upon further review, they believe the Sec. 752 regulations relating to bottom-dollar payment obligations should be retained and that they do not plan to propose substantial changes to them. In 2018, Treasury issued proposed regulations (7) revoking the temporary regulations under Sec. 707 issued in 2016 and reinstating the final regulations that were previously in effect.
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) (8) enacted "unified audit rules" to simplify IRS audits of large partnerships. Under TEFRA, determinations of partnership tax items generally were made at the partnership level. Any adjustments to partnership tax items would then flow through to the partnership's partners, and the IRS would assess deficiencies against and collect them from the partners. Two issues that arose frequently under TEFRA concerned partnerships'...