This outline is a summary of some of the pertinent provisions of the Wyden partnership proposals.
1. Section 701
A. Allows regulations to treat imputed underpayments under BBA as subjecting the partnership to income tax.
B. This would then subject certain partnerships to the FASB uncertain tax position rules for reserves, etc.
2. Sections 704(a), 704(b) and 707(d)
A. The proposal would require allocations according to PIP except for certain controlled related partnerships where a per capita allocation regime would be required. Deviations from a per capital allocation when required would cause a capital shift among the partners. Requiring a change from SEE to PIP could require very fast rewrite of PIP/section 704(b) regulations by Treasury but that is long overdue anyway.
B. Repealing SEE could require transition rules for tax credit partnerships and for the fractions rule partnerships which relied on SEE for pre-enactment transactions.
C. Consider a “small partnership” exception to those partnerships in applying certain of the changes in the Wyden proposals; specifically, any exceptions for “small partnerships” could be only for mandatory revaluations and mandatory remedials. (One could also consider a similar exception for mandatory application of sections 734 and 743 below). Current section 163(j)(3) references section 448(c) which contains a threshold of $25 Million of gross receipts with aggregation rules. Section 163(j)(3)’s tax shelter exception to the exception should not be adopted for this purpose because it renders the small business exception basically a nullity.
D. The repeal of SEE could be eliminated in final version. But still need a wholesale revision of the section 704(b) regulations to both develop the PIP rules, particularly with respect to waterfall distributions and targeted allocations, and application of various rules, such as DROs, QIOs, minimum gain chargeback, etc., which depend upon SEE for their application but are still included in partnership agreements not relying on SEE.
E. The related party rule should be extended in regulations to at least apply to certain of the related party relationships in section 267(b) and 707(b).
F. Consistent percentage method for controlled partnerships reflects net contributed capital before and after and is a “deeming transaction” like sections 304(a)(1) (acquisition by a related corporation other than a subsidiary of stock of a controlled corporation from a controlling person treated as if the seller of the stock first contributed the stock to the acquiring corporation as a contribution to capital in exchange for stock of the acquiring corporation and the acquiring corporation then is treated as if it had redeemed the stock it was treated as issuing from the seller); and 1361(b)(3)(C)(ii) (termination of Qsub by reason of the sale of stock deemed to be a sale of an undivided interest in the Qsub’s assets and then a section 351 incorporation of the Qsub). Once the capital shift occurs, the regular rules of subchapter K apply.
G. Consequences of capital shift/transfer of capital should result in cost basis to recipient and most likely gain to the transferors equal to FMV of shifted interest less allocable basis of the entire partnership interest. See Rev. Rul. 84-53. No deduction or capital expenditure is allowed to the transferors. The tax basis of the transferors in their partnership interests is also decreased. It is possible that the transferors can avoid gain based on a circular flow of money theory. Capital interest of recipient is increased and of the transferors is decreased. Liabilities are ignored in computing capital interests but liabilities are otherwise taken into account under subchapter K, such as section 752. All other pertinent rules of subchapter K apply.
H. Starting with the formation of the partnership and continuing through each applicable date thereafter, net contributed capital should be increased by later contributions and by allocations of gross income and should be decreased by allocations of losses and deductions and by distributions. Losses are still subject to 704(d) basis limit. The proposed statute should spell this out a bit more.
I. How should taxpayers and the IRS deal with profits interests in a controlled partnership subject to the consistent percentage method? Net contributed capital before and after is zero for profits interests. That would mean that, for controlled partnerships, an allocation to a non-capital partnership interest, such as a profits interest, would trigger the capital shift rule thereby taxing the service partner without a related deduction for the other partners. This is consistent with prior commentary on a pro rata capital allocation scheme where partnership interests granted for services are treated as compensation income.
J. Regulatory carve-outs for this case and others are clearly covered in the statutory grant of regulatory authority. The potential effect of the separate Wyden carried interest proposal should be considered although, technically, that proposal does not impact partnership allocations which operate to increase the invested capital of the partner. The ordinary income treatment and long-term capital loss in the Wyden carried interest proposal occur outside of the subchapter K system.
3. Sections 704(c)(1)(A), 704(c)(1)(B) & 737, 704(f)
A. The proposals would mandate the application of the remedial allocation method for both forward and reverse section 704(c) allocations, delete the five-year requirement of section 704(c)(1)(B), and require revaluations in designated cases and also mandate revaluations through tiers of controlled partnerships.
B. The remedial method needs to be expanded in future regulations to deal with changes in book sharing ratios by either new capital coming in or old capital going out which results in a necessary change to the computation of remedial allocations but is not spelled out in the current regulations. After implementation, current regulations under section 721(c) can be simplified greatly. As noted earlier, certain “small partnerships” should be exempted from this rule.
C. Mandatory revaluations are required through tiers of more than 50% (of profits or capital) controlled partnerships under section 704(f). Need rules for applying these rules through successive lower tier partnerships, brother-sister tiers of partnerships, etc. The proposed statute does not specify whether ownership by upper tier is direct or both direct and indirect or inclusive of constructive ownership with attribution, and how the rule applies to middle tier and lower tier partnerships in these cases. Rules should apply starting from the bottom and working your way up to the top. As noted earlier, certain “small partnerships” should be exempted from this rule.
D. Should sections 704(c)(1)(B) and 737 apply to reverse allocations? If it did, it would accelerate gain to partners whereas the mandatory section 734 Wyden proposal would only preserve the partners’ appropriate economic shares of gain and loss but not accelerate it when a distribution occurs. To the extent that section 704(c)(1)(B) or 737 apply to forwards, gain is accelerated and gain preservation under mandatory section 734 is not necessary.
E. There is a potential glitch in section 704(c)(1)(B) as proposed because it omits the word “loss”. It is believed this is inadvertent. If the change remains, gains would be accelerated but losses will be deferred and preserved under proposed new section 734 but deferred until the property with the loss basis is disposed of.
4. Section 707(c)
A. The proposal would repeal section 707(c).
B. Under current law, guaranteed payments are taken into account by the partner who is the recipient of the payment based on the method of accounting of the partnership and for the year of the partnership in which the year of the partnership ends under section 706(a). In contrast, if section 707(a) applied to the same payment to the partner, section 267(e) would apply section 267(a)(2) matching to all partnership-partner payments. Under this matching rule, the method of accounting of the partner and not the partnership would control because the item is not deductible until the partner includes it in gross income.
C. In Rev. Rul. 69-184, the IRS held without explanation that a partner cannot be an employee in his partnership. As a result, if section 707(a) would have otherwise treated the payment from the partnership as wages and thus compensation income, the revenue ruling precludes that treatment. If section 707(c) continued to apply, the payment would still not constitute wages because of the revenue ruling.
D. The repeal of section 707(c) has long been advocated as a matter of simplification. Current law is confused as to whether a guaranteed payment is real debt or something similar to it or whether it is a distributive share for some purposes. The 1984 blue book at page 233 talked about Treasury being given regulatory power to define who is a partner in a compensatory context but that was never implemented. The Camp proposals from HR1 in 2014 recommended repeal of section 707(c). It is a confusing provision and has arguably been abused in different ways. See pages 375-376 of the Camp 2014 technical discussion.
E. However, there are many provisions in the regulations that reference guaranteed payments and deleting section 707(c) could have potential unintended consequences. Coordinating references should be corrected in future regulations if the repeal is implemented.
F. There may be need for some coordination as a result of the repeal of section 707(c). Right now, section 1402(a)(13) provides for SE tax in case of a guaranteed payment for services to a limited partner. That is not being changed by the proposals. If section 707(c) repeal results in section 707(a) applying, it is unclear how to treat that considering that Rev. Rul. 69-184 does not allow a partner to also be an employee. The section 707(a) payment cannot be wages but it could be compensation to an independent contractor (see Rev. Ruls. 81-300 and 81-301 and Pratt case). Most likely an independent contractor payment.
G. However, if the “twenty factors” indicate an employee status but the payee cannot be an employee because of Rev. Rul. 69-184, what then? Section 707(c) prevented that issue from coming up. If section 707(c) is repealed, it will probably lead to a necessary IRS study of whether a partner can be an employee. For example, RR 81-301 said that section 707(a) applied and the partner was acting as an independent contractor. A conflict with Rev. Rul. 69-184 would have arisen if the facts indicated that the partner was acting as an employee. The repeal of section 707(c) would force this issue on the IRS.
5. Section 736
A. The proposals would repeal section 736. The repeal relates to the fact that after the various law changes to section 736 on recapture and the addition of section 197 relating to goodwill in 1993, section 736 really does not add anything to the tax law anymore but can confuse things. For example, the 2005 notice on section 409A basically deferred covering section 736 except for a very limited provision. Professor Postlewaite was a prime advocate for repeal. See 100 Nw. U.L. Rev. 379 (2006). He argues it is simplification and avoids confusion and inconsistencies with current law.
B. The retiring or successor in interest partner would remain a tax partner until completely liquidated under the proposal. Future payments to this tax-only partner would continue to raise questions about how the payment should be characterized; i.e., as an allocation and subsequent separate distribution, or as a liquidating distribution or a series of payments in liquidation, or as a section 707(a) payment.
C. What to do about section 409A and other provisions outside of subchapter K if section 736 is repealed? There is currently no regulatory guidance on this issue under section 409A.
6. Section 707(a)(2)(B)
A. The proposal would revoke the capital expenditure exception. The revocation of the capital expenditure exception is being made to eliminate what some view as an overinclusive application of this regulatory rule. It was intended to apply to certain property improvements made to the contributed property before the property was contributed to the partnership and then to be reimbursed for those expenditures by the partnership without triggering sales treatment. However, as defined and applied in practice, it extended to many other “capital expenditure” items.
B. Due to the extensive overinclusive application of the rule, this change in law is proposed to be made by statute.
7. Section 708(b)(1)
A. The proposal would add “related parties” to “any of its partners” in determining whether a termination of a partnership has occurred.
B. The proposal would eliminate one planning method currently being used to avoid a partnership termination-only a related party to at least one (or more) of the (presumably) historic partners needs to continue to be a partner to have a partnership continuation.
C. The proposal is arguably incomplete in that there is no indication whether there should be continuity of historic partners like COBE in corporate reorganizations to test for a partnership continuation or termination. If the proposed statutory change remains as is, is there authority to cover COBE for partnerships in regulations?
8. Section 752
A. The proposal is to treat all partnership debt as nonrecourse for section 752 purposes (which includes reg. §1.707-5) based on shares of profits (as set forth in regulation §1.752-3(a)(3)). There is an exception to this rule for partner loans because the partner-lender truly bears the risk of loss. However, guarantees by partners are expressly prohibited from changing the nature of the debt as otherwise nonrecourse. (The proposed change to section 752(c) should not be adopted because it does not add anything substantive). Any taxes due (such as under the disguised sale rules or section 752(b)/731(a)) is allowed an extended payment period over 8 years.
B. This change in law reflects the fact that most partnership debt, even debt that is guaranteed by a partner, will be paid out of partnership profits. It has been recommended for years to treat partnership debt as nonrecourse at least for purposes of the disguised sale rules.
C. From a tax policy perspective, the proposal could have been limited to the disguised sale rules only with a requirement to study whether the rules of the second sentence of section 357(d)(3) should apply to partnership debt under section 752.
D. Current regulation section 1.752-3(a)(2) allocates non-recourse debt secured by contributed section 704(c) property (or reverse section 704(c)) so as to allocate sufficient debt to the section 704(c) partner to avoid gain recognition on the contribution to the partnership based on the excess of non-recourse debt over tax basis. This rule originated in 1988 as part of the section 752 temporary regulations and was carried forward to the final section 752 regulations in 1991. The unstated theory behind this rule was that partnership formations should be encouraged even with outstanding debt on the property contributed because the built-in debt gain would be taxed at a later date as minimum gain under Tufts.
E. This taxpayer favorable rule would be eliminated if all debt, including actual non-recourse debt, is allocated solely based on profits allocated to the partner. The section 752 proposal is based on conforming debt allocations to the partners’ respective economic interests in the partnership and this will cause an acceleration of gain that would most likely be taxed later as minimum gain absent the new rule.
F. The proposal is similar to how encumbered property is treated under section 357(c) on transfers to corporations under section 351 (the excess of debt over aggregated basis is generally subject to tax) although in that case the corporation is a separate tax entity than the shareholder which is not the case for partnership and partners.
G. An additional point to consider is that Rev. Rul. 80-323, which involves a transfer of a partnership interest in a section 351 incorporation, applies the principles of section 752 to that transfer but liability transfers to corporations are now statutorily covered by section 357(d) and no guidance has been issued under the latter provision since adoption in 1999/2000. The latter rules are more oriented towards the actual economics of who will ultimately pay the debt in the real world. Thus, by including section 752 debt allocations in the Wyden proposals and not limiting it to disguised sales only, the rules for transfers to partnerships of encumbered property may be different than transfers of such property to corporations. This can affect partnership interest roll-ups to UPREITs and similar transactions.
H. The proposal will eliminate being able to do basis strips by borrowing money and having a non-distributee partner guarantee the debt because the proposal will allocate the debt based on the overall economic interests of the partners.
I. The proposal relating to section 752(c) should be removed. The key questions relating to section 752(c) pertain to what happens if the FMV limitation applies and there is a later payment on the debt, a sale by the partnership or by a partner, or a reduction or cancellation of the debt. See, e.g., Daniel S. Goldberg, The Tax Lawyer, Vol. 51, No. 1, Fall 1997, pp 41-82.
9. Sections 743 & 6050K
A. Section 743 is made mandatory for all transfers of partnership interests. Information reporting under section 6050K is expanded to cover transfers of all partnership interests not just those with hot asset shares as under current law.
B. Although mandating section 743 can in some cases be burdensome to taxpayers, it is consistent with the new partnership regime that would have mandatory remedials, mandatory revaluations and mandatory section 734 adjustments. The IRS can always provide simplifying assumptions and safe harbors in regulations. As noted earlier, a “small partnership” exception may be warranted here as well.
10. Section 734
A. Section 734 adjustments to basis upon partnership distributions would be made mandatory. Basis shifting among partners would be prevented by ensuring that each partner’s share of built-in forward or reverse gain or loss is preserved after the distribution as compared to the partners’ shares before the distribution. The proposal was included as part of the 2014 Camp proposals in HR1. The approach used essentially incorporates a partial liquidation concept into subchapter K by treating the economic interest being redeemed as a separate partnership interest. As noted earlier, a “small partnership” exception may be warranted here as well.
B. It has been a known problem for many years that subchapter K as it exists today allows, with some limited exceptions, the shifting of gains and losses among the partners. This proposal would eliminate that tax planning and would align the partners’ shares of tax gains and losses with their economic shares of gains and losses.
C. Compared to applying sections 704(c)(1)(B) and 737 to reverses which would accelerate gain, this provision just preserves gain and loss shares, including those of continuing partially redeemed partners.
A. The income exceptions for PTPs would be repealed. The effect would be that all publicly traded partnerships regardless of the industry or income type, would be taxed as a corporation.
B. Proposals over many years have advocated that the changes in the late 1980s allowing partnerships that are publicly traded to be taxed as partnerships was a mistake. Merely being publicly traded is enough under the proposals to cause corporate tax treatment. There arguably should there be an exception to section 7704(f) treatment of assets over on mandatory conversion (such as assets up or interests over).
12. Section 163(j)(4)
A. Effect of changes is to limit application of section 163(j)(4) to that partnership and no other sources of a partner are allowed to offset. This is an improvement to existing law.
B. The House alternative of pure aggregate treatment appears preferable as it will allow a significant simplification to the section 163(j)(4) regulations.
13. Transition Rules may be needed in some cases
A. Changes in the law may warrant extended effective dates to amend partnership agreements, renegotiate contracts and related matters.
B. Change in law for PTPs will affect market pricing and related matters.