Current developments in partners and partnerships.

• Author: Burton, Hughlene A.

EXECUTIVE SUMMARY

* Several bills in Congress as of this writing would affect partners and partnerships. Sen. Ron Wyden, D-Ore., the chair of the Senate Finance Committee, has proposed changes to partnership allocations.

* Final regulations were issued under Sec. 1061 that provide guidance on the recharacterization of certain net long-term capital gains of a partner that holds one or more applicable partnership interests (carried interests) as short-term capital gains.

* Final regulations provided special rules for how partnerships apply the Sec. 163(j) business interest limitation. Concurrently issued proposed regulations provided additional guidance on the deduction limitation, including on issues with tiered partnerships and dispositions of a partnership interest.

* The IRS issued new international-related Schedule K-2, Partner's Distributive Share Items--International, and K-3, Partner's Share of Income, Deductions, Credits, etc.--International, along with instructions.

* Court rulings addressed sham partnerships, cancellation-of-indebtedness income, theft loss deductions, and disguised sales, among other topics.

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 (Dec. 1, 2020, through Oct. 31, 2021), 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. Also, the courts and the IRS issued various rulings that addressed partnership operations and allocations.

Current proposals

There are several new bills in Congress as of this writing that would impact partners and partnerships.

Build Back Better Act

At the time this is being written, the House and Senate are attempting to finalize President Joe Biden's social safety net proposal known as the Build Back Better Act. (2) The current version of the proposed act contains two provisions that would have an impact on partners and partnerships.

The first provision relates to taxes paid on a partner's share of income. Under current law general partners pay self-employment tax on the full amount of their net trade or business income, subject to certain exceptions such as rents, dividends, capital gains, and certain retired partner income. Likewise, the net investment income tax imposes a 3.8% tax on "net investment income" on individuals that have a modified adjusted gross income over defined thresholds. Other than for guaranteed payments, limited partners and some members of limited liability companies (LLC) are not subject to Self-Employment Contributions Act (SECA) taxes or net investment income tax.

The House's version of the Build Back Better Act would expand the scope of the net investment income tax to cover "specified income" derived in the ordinary course of a trade or business for taxpayers with more than $400,000 in taxable income for single filers and $500,000 for married filing jointly returns. The net investment income tax would not be imposed on income on which Federal Insurance Contributions Act (FICA) tax is already imposed. This change would subject all earnings from passthrough entities to either the 3.8% self-employment Medicare tax or the 3.8% net investment income tax.

The second provision would change the rules related to the amount of losses a partner may deduct on a noncorporate tax return. The TCJA added Sec. 461(l), which limited the amount of business losses a noncorporate taxpayer could deduct each year. Sec. 461(l) is set to expire on Dec. 31, 2026. However, the Build Back Better Act would make this section permanent.

Wyden proposal

At the time of this writing, Sen. Ron Wyden, D-Ore., the chair of the Senate Finance Committee, has proposed some major changes that would affect how income from a partnership is calculated and taxed. Wyden's proposal, released on Sept. 10, 2021, would eliminate or amend a number of sections in Subchapter K.

The first change would impact Sec. 704. The current versions of Secs. 704(a) and 704(b) would be repealed. New Sec. 704(a) would require a partnership to allocate income and loss items based on the partner's interest in the partnership. A partner's interest in the partnership would take into account the partner's contributions to the partnership, the partner's interests in cash flow and other nonliquidating distributions, the partner's entitlement to distributions on liquidation, and the partnership agreement. Under a new Sec. 704(b), if two or more members of a controlled group are partners, the allocations would need to be determined using the consistent-percentage method. In addition to the changes to Secs. 704(a) and (b), the proposal would require that Sec. 704(c) allocations be made using the remedial method for property contributed after Dec. 31, 2021. A new subsection would be added to the Code for revalued property that would be similar to the current rules contained in Sec. 704(c).

In another section of Wyden's proposal, Sec. 707(c) regarding guaranteed payments would be repealed. Instead, partners would have to report income if they had an excess share of the partnership. An excess share of a partnership would occur if the partner's share of the partnership in liquidation exceeds his or her interest in the partnership based on his or her net contributed capital. Likewise, Sec. 736, which governs payments to retiring partners, would be repealed.

The proposal would also change basis adjustments and allocation of liabilities. In the proposal, a basis adjustment would be mandatory when a partnership interest is transferred or when property is distributed to partners under Secs. 734 and 743. The proposal would also change the allocation of debt under Sec. 752. Going forward, all debt, other than debt personally guaranteed by a partner, would be allocated based on the partners' share of partnership profits. The proposal does give some relief for gains that would occur if liabilities are reallocated among partners. In this case, any gain that results from the reallocation of debt would be taxed to the partners over an eight-year period.

Further, Wyden's proposal would change the tax treatment for many publicly traded partnerships (PTPs). The proposal would repeal the exceptions for the treatment of PTPs used by many oil and gas and real estate partnerships. The impact would be that all PTPs would be treated as corporations for tax purposes.

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 contained several provisions that affect partners and partnerships. These include a new limitation on the deduction for business interest and new rules for income from carried interests. In 2021, Treasury issued regulations that explain these provisions.

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 the interest deduction limitation to partnerships, which include:

* The limitation on the deduction for business interest expense must be applied at the partnership level, and a partner's adjusted taxable income must 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)(A)).

* 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)).

* 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)(ii)).

* Rules are provided for the adjusted basis in a partnership of a partner that is allocated excess business interest expense (Sec. 163(j)(4)(B)(iii)).

Final regulations (3) under Sec. 163(j) issued in 2020 provided special rules for how partnerships apply the Sec. 163(j)...