Senator Wyden Releases Far-Reaching Partnership Taxation Proposals

September 2021

BY

Jeff BilskyPartner, National Partnership Taxation Technical Practice Leader

Neal WeberManaging Director, National Partnership Taxation

Senate Finance Committee Chair Ron Wyden, D-Ore., on September 10 unveiled a discussion draft of legislation that would significantly change the way passthrough entities, primarily partnerships, are taxed.

Wyden made the case for the sweeping reforms in a one-page summary of the proposals and a section-by-section summary, arguing that the proposed changes would close loopholes that allow wealthy investors to use partnerships to avoid paying their fair share of taxes, because the partnership taxation rules are too complicated for the IRS to enforce. As a case in point, he cited data concluding that the IRS audited only about 0.03% of the partnership returns filed for tax year 2018.

Calling pass-through entities and partnerships “the preferred tax avoidance tools for those at the top,” Wyden said the rules are “too complex for working people who don’t have armies of lawyers and accountants.” That same complexity, he continued, “allows the wealthiest individuals and most profitable corporations to decide when, and whether, to pay taxes at all.”

The proposed rules should be considered in the context of the Democrats’ ongoing efforts to come up with revenue raisers to offset the expenditures called for in the Biden administration’s $3.50 trillion budget currently being shaped through the reconciliation legislative process.  Wyden's office estimates that the partnership proposals would raise at least $172 billion over 10 years.

It is unclear whether Wyden’s proposals will ultimately be included as part of the budget reconciliation bill, but the draft legislation and accompanying explanations provide valuable insights into Chairman Wyden’s thinking regarding the need for major changes to the partnership tax rules, and the fiscal benefits such changes would entail in the form of raised revenue.

Key provisions addressed in the proposed legislation include:
  • Limiting flexibility in partnership income/loss allocations
  • Making remedial allocations under Internal Revenue Code Section 704(c) mandatory and mandating capital account revaluations
  • Constraining partnership liability allocations under Section 752
  • Modifying the disguised sale rules
  • Expanding application of the anti-mixing bowl rules
  • Modifying the treatment of certain payments between a partnership and a partner
 

Proposed Changes

The 39-page discussion draft includes 18 sections that would introduce the following changes:
  • Require allocations in accordance with a partner’s interest in the partnership. The proposal would eliminate the “substantial economic effect” safe harbor for partnership allocations and require that all partnership allocations be made in accordance with the “partner’s interest in the partnership” standard.
  • Create a special allocation rule for some related-party partnerships. If partners are members of a controlled group and together own 50% or more of the partnership capital or profits, the partnership would be required to consistently allocate all items based on partner net contributed capital.
  • Mandate the use of the remedial method for all Section 704(c) allocations when a partner contributes appreciated property to a partnership, rather than allowing partnerships to choose a “reasonable” method, as provided under the existing regulations. The required use of the remedial method would apply to property contributions that occur after December 31, 2021.
  • Make revaluations of partnership property, commonly known as “reverse” Section 704(c) allocations, mandatory upon a change in the economic arrangement of the partners to prevent partners from shifting built-in gain and loss. This change would eliminate the flexibility the current rules provide by allowing, but not requiring, revaluations.
  • Require that all debt be allocated between partners in accordance with partnership profits. An exception would be made when the partner (or a person related to the partner) is the lender.
  • Repeal the seven-year window for the application of the “mixing bowl” rules. Under current rules, when a partner contributes property with a built-in gain, the partner must recognize gain if the property is subsequently distributed to any other partner within seven years of the original contribution. The revised rules would apply to contributed property regardless of the time since contribution.
  • Repeal Section 707(c) regarding payments by the partnership to a partner that are not distributions and treat those payments as payments to a partner not acting in its capacity as a partner. Also repeal Section 736 to align payments made to retiring partners with other provisions of the Code.
  • Clarify that the disguised sale rules are self-executing thereby affirming potential disguised sales of partnership interests in the absence of regulations and remove the capital expenditure exception, treating proceeds for reimbursement of capital expenditures as disguised sale proceeds.
  • Clarify the current partnership termination rules by providing that a partnership is not terminated if any part of the business is carried on by a person who was a partner in the prior partnership or by a person related to any of those partners.
  • Provide for mandatory basis adjustments in the case of transfers of partnership interests or certain partnership to partner distributions. Under current law, these basis adjustments are generally optional.
  • Alternative basis determination under Section 705(b): The proposed legislation would provide greater flexibility to Treasury and the IRS to prescribe rules for the determination of outside tax basis in scenarios other than partnership terminations.
  • Provide that the business interest deduction limitation is applicable to partnerships and S corporations at the entity-level rather that at both the entity and partner or shareholder levels.
  • Treat all publicly traded partnerships as taxable corporations for tax years beginning after December 31, 2022.
  • Modify existing rules to result in greater ordinary income recognition following certain disproportionate distributions of property.
An in-depth discussion of some of these proposals, and their potential repercussions, follows.
 

Partnership Income and Loss Allocations

Section 704(b) currently provides that allocations are made in accordance with the partner’s interest in the partnership (PIP) unless the allocations pursuant to the operating agreement have substantial economic effect. Existing regulations provide extensive rules used to determine when allocations have substantial economic effect. The proposed legislation would remove the historic substantial economic effect safe harbor and generally mandate use of the PIP standard to determine partner allocations.

The statute, borrowing from existing Treasury regulations, would provide that PIP is determined by considering the partner’s (1) contributions to the partnership; (2) interest in operating cash flow and other non-liquidating distributions; (3) interest in liquidating distributions; (4) the partnership agreement; and (5) any other factor prescribed by Treasury and the IRS.

BDO Observation: In theory, eliminating the substantial economic effect rules should simplify allocations. However, the lack of clarity around PIP does not seem to be addressed in the discussion draft. As it relates to so-called “targeted” agreements, many reporting positions may not change because of these new rules.

The proposed legislation would also create and impose a “consistent percentage” allocation methodology on certain partnerships. Under this methodology, allocations of partnership items would be based solely on partners’ contributions to the partnership. These rules would apply in situations where partners are members of a controlled group under Section 267(f) and together own 50% or more of the partnership capital or profits. Failure to provide for allocations under the consistent percentage method would result in disguised sale/payment transactions between partners.

Observation: These rules appear intended to capture potentially abusive intercorporate planning transactions. However, imposition of these limited allocation rules to unrelated partners seems contrary to the intended purpose.

These rules would be effective for tax years beginning after December 31, 2023.
 

Remedial Allocations under Section 704(c) and Mandatory Capital Revaluations

Section 704(c) currently provides that built-in gains and losses inherent in contributed property are to be allocated back to the contributing partners. Similarly, capital account revaluations create “reverse” Section 704(c) built-in gain and loss layers that are also subject to special allocation. Current regulations generally provide that these built-in gains and losses may be specially allocated under one of three methods: traditional, traditional with curative allocations and remedial.

To prevent perceived abuse, the proposed legislation would mandate use of the remedial allocation method for all Section 704(c) layers. It is not clear whether and how these rules would apply to existing forward and reverse Section 704(c) layers.

Observation: While use of the remedial allocation method often produces reasonable allocations among the partners based on their economic arrangement, this method can be complex to administer and create “phantom” income to partners. Additionally, existing regulations provide anti-abuse rules that generally prohibit use of the remedial method in certain situations. It is not clear how these perceived abusive transactions would be addressed in the proposed legislation.

The proposal to mandate capital account revaluations upon specified events is closely related to the required use of the remedial allocation method under Section 704(c). Currently, Section 1.704-1(b)(2)(iv)(f) provides that partnerships may, but are not required to, revalue partner capital in connection with:
  • A contribution of money or other property (other than a de minimis amount) to the partnership by a new or existing partner as consideration for an interest in the partnership;
  • The liquidation of the partnership or a distribution of money or other property (other than a de minimis amount) by the partnership to a retiring or continuing partner as consideration for an interest in the partnership;
  • The grant of an interest in the partnership (other than a de minimis interest) on or after May 6, 2004, as consideration for the provision of services to or for the benefit of the partnership by an existing partner acting in a partner capacity, or by a new partner acting in a partner capacity or in anticipation of being a partner; or
  • The issuance by the partnership of a noncompensatory option (other than an option for a de minimis partnership interest).
Capital account revaluations are permitted under generally accepted industry accounting practices, provided substantially all of the partnership's property (excluding money) consists of stock, securities, commodities, options, warrants, futures or similar instruments that are readily tradable on an established securities market.

Arguably, this flexibility can create planning opportunities but is often needed to avoid creating complexity in maintaining partner capital accounts and determining income allocations. Thus, the proposed legislation would mandate revaluations in specific situations, thereby creating the potential for multiple reverse Section 704(c) layers.

Specifically, the proposed legislation would require capital revaluations at the following times: (1) any non-de minimis disproportionate contribution/distribution of money or other property; (2) any grant of a non-de minimis interest in the partnership as consideration for services; (3) any non-de minimis issuance by the partnership of a non-compensatory option; (4) except as provided by Treasury and the IRS, any agreement to change (other than a de minimis amount) the manner in which the partners share any partnership item or class of items; and (5) any other event as prescribed by Treasury and the IRS.

Observation: When coupled with required use of the remedial allocation method under Section 704(c), mandatory capital account revaluations have the potential to add significant complexity to annual partnership income and loss allocations.
These rules would be effective for tax years beginning after December 31, 2021.
 

Liability Allocations under Section 752

A partner’s share of liabilities can allow for tax-deferred cash distributions, utilization of loss allocations, avoidance of the disguised sale rules and other planning purposes. Section 752 and the underlying regulations currently provide a wide degree of latitude in determining a partner’s share of liabilities through application of extensive and complex rules. To curtail the perceived abusive planning around partnership liability allocations, the proposed legislation would significantly limit the allocation of liabilities among partners through the following rules:
  • All debt would generally be shared among the partners in accordance with each partner’s share of partnership profits
  • A special rule would specially allocate debt incurred between a partnership and a partner (or person related to the partner)
  • This change would likely result in the immediate recognition of taxable income to partners who have relied on the historic allocation provisions. Recognizing this result, the proposed legislation would allow taxpayers to pay this tax liability over a period of eight years.
Observation: The proposed liability allocation rules would curtail potential transactional planning. However, the principles on which the discussion draft is based are fundamentally sound and consistent with overall economic principles that are foundational to Subchapter K of the Internal Revenue Code.

These rules would be effective for tax years beginning after December 31, 2021.
 

Conclusion

The stated goals of Wyden’s proposals are to remove ambiguity, close loopholes, make compliance easier, allow the IRS to successfully audit taxpayers, and raise revenue. The tradeoff, as the proposal acknowledges, is the loss of taxpayer flexibility and “optionality.”