Partners & Partnerships.

• Author: Anderson, Kevin

Impact of business interest expense limitation regs. on partner redemptions

The already considerable challenge of properly characterizing and reporting partnership redemption transactions has only grown more Byzantine due to new basis adjustments under Sec. 163(j).These basis adjustments include those for partners under Regs. Sec. 1.163(j)-6(h), finalized and revised in September 2020 by T.D. 9905 (the final regulations), and those for partnerships under corresponding Prop. Regs. Sec. 1.163(j)-6(h)(5) that were proposed, also in September 2020, under REG-107911-18 (the proposed regulations). This item analyses two related examples of partner redemptions--with and without Sec. 163(j) basis adjustments--to highlight and clarify both the existing and new issues.

Background

The Sec. 163 final regulations provide, in part, that a partner reduces their basis in their partnership interest, but not below zero, by the amount of excess business interest expense (EBIE) allocated to them. Additionally, if a partner disposes of their interest in the partnership, the regulations provide that immediately before the disposition, the partner will get an outside basis addback for the excess, if any, of the previous basis reductions for EBIE over the amounts the partner has been able to deduct as business interest expense paid or accrued.

For partial dispositions, the final regulations adopt a taxpayer-friendly proportionate approach, generally providing that the EBIE addback will be fractionally allowed, based on the ratio of the fair market value (FMV) of the transferred interest over the total predisposition FMV. However, note that in the case of a partner redemption, the final regulations require a complete redemption, as they explicitly state that "a disposition includes a distribution of money or other property by the partnership to a partner in complete liquidation of its interest in the partnership" (Regs. Sec. 1.163(j)-6(h)(3); emphasis added).

On Sept. 14, 2020, the government issued the proposed regulations to address some complex issues that warranted additional study and comments from the public. Prop. Regs. Sec. 1.163(j)-6(h)(5) creates a corresponding partnership basis adjustment upon partner dispositions (partnership Sec. 163(j) basis adjustment). This adjustment ensures inside and outside basis parity. The partnership basis adjustment is generally allocated in the same manner as a Sec. 734(b) basis adjustment to capital gain property, except that the partnership Sec. 163(j) basis adjustment is never depreciable or amortizable, even if the underlying property to which the adjustment is assigned is depreciable or amortizable. If the disposition was the complete redemption of a partner by the partnership, whether via a distribution of money or other property, the partnership Sec. 163(j) basis adjustment is made among the properties only after the partnership has allocated its Sec. 734(b) basis adjustment. While these rules ultimately reflect a taxpayer-favorable result, they do increase the compliance burden on tax practitioners.

PRS's balance sheet FMV Tax basis Depreciation recapture potential Assets Cash $5,400 $5,400 Sec. 1245 property 1,500 - $1,200 Capital asset X 1,500 600 Liabilities Note payable 2,400 2,400 Capital A 2,000 1,200 B 2,000 1,200 C $2,000 $1,200 From a tax perspective, partner redemptions already represent one of the most complex equity transactions a partnership can engage in. Specifically, tax practitioners must navigate the rules for Secs. 731 through 736 and Sec. 751 to properly characterize "redemption" distributions. In general, the rules of Sec. 751(b) apply first to the portion of the distribution that is treated as a sale or exchange of Sec. 751 property (hot assets). Any Sec. 751(b) gain will be ordinary in character and can apply to either the redeemed partner or the partnership, depending on the facts. Additionally, the amounts of Sec. 751(b) gain can vary depending on whether the final or proposed regulations under Sec. 751 are used.

The proposed regulations under Sec. 751 (REG-151416-06) can only be applied before they are finalized through publication in the Federal Register if the relevant time and consistency rules...