On Friday, September 10, 2021, Senate Finance Committee Chairman Ron Wyden released a discussion draft and legislative text that would dramatically change existing partnership tax rules. According to the discussion draft, the proposals are intended to remove unnecessary optionality and ambiguity, close loopholes, and facilitate taxpayer compliance and IRS audits.
The proposals are broad and would have far-reaching effects. It is unclear whether the proposals will be included as part of the ongoing reconciliation process expected to result in legislation enacted this calendar year. While the effective dates of the proposals vary, many would apply as of date of enactment or beginning January 1, 2022.
Taxpayers should carefully consider the potential impact of these proposals on their business arrangements and consider whether transaction documents should be amended or whether restructuring would be advisable.
Summary of Wyden’s Partnership Tax Proposals
The discussion draft proposes numerous changes to the partnership tax rules. Some of the proposals are relatively narrow in scope. Other proposals, such as those relating to allocation of income, gain, loss and deduction; allocation of partnership liabilities; and the tax treatment of publicly traded partnerships (PTPs), would change the partnership tax landscape significantly. The proposals include:
- Repeal the “substantial economic effect” rules for partnership allocations in section 704(b) and require that all allocations satisfy the “partner’s interest in the partnership” (PIP) standard (PIP generally turns on the facts and circumstances associated with the parties’ economic arrangement). The discussion draft assumes that the Treasury Department and IRS would update and simplify existing PIP regulations. Certain partnerships comprised of related persons would be required to allocate partnership items based on the partners’ net contributed capital. These allocation provisions are proposed to be effective for taxable years beginning after December 31, 2023.
- Require that all partnerships apply the “remedial method” under section 704(c) when a partner contributes appreciated property to a partnership and when a partnership “revalues” its property for section 704(b) book purposes. Under existing regulations, partnerships have flexibility to choose a “reasonable” section 704(c) method, including the “traditional method” and “curative method.” The required use of the remedial method generally would accelerate recognition of income and gain with respect to depreciable property contributed to a partnership and would apply to property contributions and revaluation events occurring after December 31, 2021.
- Require that partnerships “revalue” their assets for section 704(b) book purposes when the partners’ economic arrangement changes. Presently, revaluations are permitted, but not required, in certain circumstances enumerated in Treasury regulations. It would appear that the remedial method would be required with respect to “reverse” section 704(c) allocations that result upon a revaluation event. Mandatory revaluations would be required for events occurring after December 31, 2021.
- Repeal the seven-year testing period for the anti-mixing bowl rules so that sections 704(c)(1)(B) and 737 apply to contributions of appreciated property and certain related distributions occurring at any time during a partnership’s life. The amended rules would be effective for property contributed after December 31, 2021.
- Repeal sections 707(c) and 736, which provide rules for certain partnership-to-partner payments. More particularly, the proposal eliminates guaranteed payments (under the proposal, payments to a partner for services or for the use of capital, and which are not distributions, generally would be treated as payments to a non-partner) and rules that apply to certain payments to retiring partners, and would appear to allow a partner to be treated as an employee of the partnership. These changes generally would take effect after December 31, 2021.
- Amend the disguised sale rules of section 707(a)(2), which generally apply to certain transfers between a partnership and partner, to clarify that the disguised sale of partnership interest rules are self-executing and to repeal the exception for reimbursements of capital expenditures. The amendments would apply to services performed or property transferred after the date of enactment.
- Require that all partnership debt is allocated among partners for section 752 purposes in accordance with the partners’ profit shares. Loans to a partnership by a partner (or a person related to a partner) are excepted. Under existing Treasury regulations, recourse debt is allocated to the partner that bears economic risk of loss with respect to the liability and non-recourse debt is allocated based on a three-tiered approach that can take profit sharing into account. Changes to section 752 would apply to taxable years beginning after December 31, 2021, and could result in recognition of taxable gain with respect to negative capital account balances where allocations are based on economic risk of loss or a partner’s share of partnership minimum gain or certain section 704(c) gain under the existing rules for non-recourse liabilities. At the taxpayer’s election, tax liability resulting from the change in law would be payable over an eight-year period.
- Require mandatory adjustments to the tax basis of partnership property under sections 743 and 734 to account for disparities between a partner’s tax basis in its partnership interest and the partnership’s tax basis in property (presently, these basis adjustments are optional except in limited circumstances), and revise the computation of section 734 adjustments to preserve each remaining partner’s gain or loss that would be recognized if the partnership sold all of its property for fair market value. Correspondingly, section 754 would be repealed. Mandatory basis adjustment would be effective for transfers occurring after December 31, 2021.
- Amend the section 163(j) business interest expense limitation rules to provide that a stricter entity-level approach applies to partnerships and S corporations. Current law, in contrast, requires a hybrid approach. Amended section 163(j) would apply to taxable years beginning after December 31, 2021.
- Repeal the exceptions from corporate treatment for PTPs under section 7704. This change effectively would mean that all PTPs would be taxable as corporations. The repeal would be effective for taxable years beginning after December 31, 2022.