Current developments in partners and partnerships.

• Author: Burton, Hughlene A.

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, 2018, through Oct. 31, 2019), the IRS issued guidance on the law known as the Tax Cuts and Jobs Act (TCJA), (1) which was enacted at the end of 2017 and made several changes that affect partners and partnerships. The IRS also provided guidance for taxpayers regarding other changes 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. The law included several provisions that effect partners and partnerships. Some of those provisions include a deduction for qualified business income (QBI), a new limitation on the deduction for business interest, new rules for income from carried interest, and the elimination of technical terminations of partnerships. Last year, Treasury provided regulations regarding the QBI deduction and the limitation on the deduction for business interest.

QBI

When Congress reduced the corporate tax rate, it recognized the disparity in the rates between corporations and passthrough entities, such as partnerships. As a way to reduce the effective tax rate for passthrough entities, 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. 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 rules regarding the QBI deduction are quite complex, so Congress granted Treasury specific authority to issue Sec. 199A regulations. In 2018, 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 on Sec. 199A. These proposed regulations contain six substantive sections, each with rules for calculating the Sec. 199A deduction..

Treasury received 335 comments regarding the proposed regulations. Commenters asked that the rules be simplified and clarified. After considering all of the comments, Treasury issued final Sec. 199A regulations (6) adopting many of the rules contained in the proposed regulations. In addition, Treasury added clarifying language and additional examples to make the rules easier to understand.

Limitation on business interest deductions

The TCJA added Sec. 163(j), which limits the amount of business interest an entity can deduct each year. Sec. 163(j)(4) provides special rules for applying Sec. 163(j) to partnerships. Sec. 163(j)(4)(A) requires that the limitation on the deduction for business interest expense be applied at the partnership level and that a partner's adjusted taxable income be increased by the partner's share of excess taxable income, as defined in Sec. 163(j)(4)(C), but not by the partner's distributive share of income, gain, deduction, or loss. Sec. 163(j)(4)(B) provides that the amount of partnership business interest expense limited by Sec. 163(j)(1) is carried forward at the partner level. Sec. 163(j)(4)(B)(ii) provides that excess business interest expense allocated to a partner and carried forward is available to be deducted in a subsequent year only if the partnership allocates excess taxable income to the partner. Sec. 163(j)(4)(B)(iii) provides rules for the adjusted basis in a partnership of a partner that is allocated excess business interest expense.

Proposed regulations issued in 2019 provide guidance regarding Sec. 163(j) partnership deductions and carryforwards. (7) To the extent a partnership is subject to the limitations imposed by Sec. 163(j), the limitation will be applied at the partnership level, and any deduction for business interest expense not disallowed will be taken into account in determining the nonseparately stated taxable income or loss of the partnership. (8) To the extent a partnership's business interest expense is less than or equal to the partnership's Sec. 163(j) limitation, business interest expense will not be subject to further limitations under Sec. 163(j) at the partner level. (9)

Excess business interest expense will retain its character as business interest expense at the partner level. In addition, partner-level adjustments, such as a Sec. 743(b) adjustment, will not be taken into account when the partnership determines its Sec. 163(j) limitation. Instead, partner-level adjustments will be taken into account by the partner in determining his or her adjusted taxable income. However, in keeping with the entity approach taken under Sec. 163(j)(4), a partnership will take adjustments made to the basis of its property under Sec. 734(b) into account for purposes of calculating its adjusted taxable income. (10)

Qualified opportunity funds

The TCJA added Sec. 1400Z, which deals with qualified opportunity funds (QOF). (11) Last year and at the end of 2018, Treasury issued proposed regulations (12) regarding the inclusion in income of gain deferred under Sec. 1400Z-2(a)(1)(A). These rules apply to a QOF owner only until all of the owner's deferred gain has been included in income. The proposed regulations provide, in the case of a partnership that is a QOF or owns an interest in a QOF, that the inclusion rules apply to transactions involving direct and indirect partners of the QOF to the extent of the partner's share of any eligible gain of the QOF. The proposed regulations make clear that Sec. 721 contributions, as long as they do not cause a partnership termination, are not inclusion events and neither is a merger or consolidation under Sec. 708(b)(2)(A). In addition, a distribution of property will be an inclusion event only to the extent that the distributed property has a fair market value (FMV) in excess of the partner's basis in its QOF interest.

Regulations project

In 2017, Trump issued Executive Order 13789 that directed the secretary of Treasury to review all significant tax regulations issued on or after Jan. 1, 2016, and to take concrete action to alleviate certain burdens imposed by the regulations. One of the regulations identified was the proposed regulations concerning the allocation of partnership liabilities in a disguised sale under Sec. 707. (13) Last year Treasury issued final regulations (14) that withdraw the Sec. 707 temporary regulations and reinstate Regs. Sec. 1.707-5(a)(2), which was previously in effect, effective for all transfers occurring on or after Oct. 4, 2019.

Audit issues

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) (15) enacted "unified audit rules" to simplify IRS audits of large partnerships by determining partnership tax items at the partnership level. Any adjustments would then flow through to the partners, whom the IRS would assess deficiencies against. Two issues that arose frequently under TEFRA concerned partnership-level items of income and the statute of limitation for the partners and the partnership.

In an effort to streamline the audit process for large partnerships, Congress enacted Section 1101 of the Bipartisan Budget Act of 2015 (BBA), (16) which amended in its entirety Sec. 6221 et seq. The revised sections instituted new procedures for auditing partnerships, affecting issues including determining and assessing deficiencies, who pays the assessed deficiency, and how much tax must be paid. The BBA procedures replace the unified audit rules as well as the electing large partnership regime of TEFRA. Under the BBA, (17) partnership items generally will be determined in an audit of the partnership at the partnership level. The audit can adjust a partnership's income, gain, loss, deduction, or credit, or any partner's distributive share of these items. On Jan. 2, 2018, Treasury published final regulations under Sec. 6221(b), (18) providing rules for electing out of the centralized partnership audit regime.

A key part of the new audit regime is that the partnership pays tax at the highest individual tax rate. A partnership will pay an imputed underpayment when an audit adjustment results in an increase to income or a decrease to deductions. The payment is borne by the current partners. Adjustments that do not result in an underpayment of tax must be taken into account in the adjustment year. This requirement allows the current partners to benefit from a partnership-favorable audit adjustment related to the reviewed year.

Partners are to be subject to joint and several liability for any partnership tax liability. Partnerships have the option to lower their tax liability if they can prove that the total tax liability would be lower if the adjustments were calculated on a partner-level basis. In addition, partnerships with 100 or fewer partners can elect out of this section if each of their partners is either an individual, a C corporation, any foreign entity that would be treated as a C corporation if it were domestic, an S corporation, or an estate of a deceased partner. Elections out of the regime must be made each tax year. Under this scenario, a partnership...