On July 31, 2015, the IRS issued final regulations (T.D. 9728) on the allocation of partnership items when a partner’s interest varies during the partnership’s tax year. The 19-page set of final regulations adopt proposed regulations from 2009, with certain changes, and generally apply to tax years beginning on or after August 3, 2015. The rules apply in any year in which there is a change in a partner’s interest in the partnership, either because the partner disposed of all or part of its interest, or because the partner’s interest in the partnership was reduced as a result of the entry of a new partner or partners.

The final regulations reorganize section 1.706-4 of the regulations, including provisions and rules concerning:

  • Permissible changes among contemporaneous partners,
  • Safe harbor for partnerships for which capital is not a material income-producing factor,
  • Varying interest rule methods (interim closings and proration),
  • Use of more than one method and convention during the same tax year,
  • Optional regular monthly or semi-monthly interim closings,
  • Segments and proration periods,
  • Determining the items in each segment,
  • Determining the items in each proration period,
  • Varying interest rule conventions—calendar day, semi-monthly, and monthly,
  • Conventions for publicly traded partnerships,
  • Use of more than one convention during a tax year,
  • Deemed timing of variations,
  • Exceptions for admission to and exit from the partnership within a convention period, and
  • Extraordinary items.

The regulations also provide two exceptions to the new rules for certain allocations that would otherwise be subject to the final regulations. These are, first, the “contemporaneous partner exception” and second, an exception for certain service partnerships.

Contemporaneous partner exception

The final regulations provide an exception for dispositions of less than a partner’s entire interest in the partnership when the variation in the partner’s interest is not attributable to a capital contribution or a partnership distribution to a partner that is a return of capital. This exception applies where the allocations resulting from the modification otherwise comply with Sec. 704(b) and its regulations (requiring partners’ distributive shares to have substantial economic effect and meet other requirements). In response to comments, the final regulations expanded the scope of the contemporaneous partner exception to include allocations of items attributable solely to a particular segment of a partnership’s year.

However, despite requests from commentators, the final rules do not provide guidance on determining when changes in the allocations among partners are attributable to capital contributions to, and distributions from, the partnership, and which requirements of Sec. 704(b) must be met. The IRS may address these issues in future guidance.

Partnerships for which capital is not a material income-producing factor

The second exception allows certain service partnerships to determine partnership items in years where there is a change in a partner’s interest using any reasonable method. The exception in the proposed regulations limited its application to the performance of services only in specific fields, but in response to comments, the final rules expanded the exception to cover any partnership for which capital is not an income-producing factor. In such cases, the partnership and the partner may choose to determine the partners’ distributive shares of partnership income, gain, loss, deduction, and credit using any reasonable method, provided that the allocations are valid under Sec. 704(b).

Interim closing and proration methods

One other major change to the proposed regulations relates to determining distributive shares. Whenever there is a change in partnership interests, the partnership must account for the change in determining the distribution of partnership items. The partnership can do this by using the interim closing method—allocating its items among the partners in accord with their respective partnership interests during each segment of the tax year—or the proration method—allocating partnership items in accord with the partners’ pro rata shares of the items for the entire tax year. Certain “extraordinary items” are allocated using special rules.

 The final rules allow a partnership to use different methods for different ownership changes in the same year, provided that the overall combination of methods is reasonable based on the overall facts and circumstances. A partnership can therefore use the interim closing method for one change and prorations for another change, provided the use is reasonable. This is a significant change from the proposed regulations, which required the use of either the interim closing method or the proration method. Under the proposed regulations, unless the partners agreed to use the proration method, the partnership was required to use the interim closing method. However, the regulations also permit the IRS to restrict the use of the two methods in future guidance.