Partnerships: 2014 Observations and Updates

The last entry began what might be a series of articles on "Observations and Updates" related to the upcoming tax season. This time I'm dealing with Partnerships. It's been said that one learns most by teaching others, so I hope to learn more about partnerships and upcoming tax issues by telling you what I've discovered since New Year's Day.

Either I missed it or there wasn't much news related to partnerships and partnership taxation. There were several issuances of proposed regulations, but the only final release was interest expense allocations within a partnership. One of the proposals, however, was the source of concern for several opponents. Additionally, there were a few interesting articles on partnerships.

News

Final interest expense allocation rules were made public with the release of Section 1.861-9, regulations that were either proposed or temporary in 1988 and 2012. The amendments in the final regulations generally affect all taxpayers that allocate and apportion interest expense. This affects corporate and limited partners with a 10% share and all general partners, and is based on the value of the partners assets. The value of the partner's assets may either be inside basis for apportionments using tax book value or alternative tax book value, or FMV if using FMV for apportionments. Adjustments may be necessary for 734(b) and 743(b) (basis adjustments), and §1.861-10T(d)(2) (partial year adjustments).

For non-corporate partners (i.e. individuals, trusts, and estates), the interest must be allocated according to Section 1.861-9T(d), which differentiates between trade or business, investment, passive, and personal. These regulations also affect allocating and apportioning interest expense of an affiliated group of corporations.

http://www.journalofaccountancy.com/News/201410543.htm
http://www.aicpa.org/interestareas/tax/newsandpublications/taxnews/pages/20140716.aspx

Current developments (from February 2014)

Other developments in partnership taxation were summarized in a February summary published by AICPA. Since the update was for 2013, I'll forego commentary on that and only provide the link.

http://www.aicpa.org/Publications/TaxAdviser/2014/february/Pages/Burton_Feb2014.aspx

Proposals

Three proposals in the past 10 months affect the operation of partnerships, although one of them has received attention from those concerned with limiting tax planning as a result of  tightening on tax deferrals.

Partnership Basis

Proposals in January would change partnership basis allocations when there are properties with built-in gain or built-in loss. Section 1.704-3 clarifies Section 704(c)(1)(C) from the 2004 American Jobs Creation Act (AJCA). Specifically, the regulations clarify the treatment of built-in gain and built-in loss property, revaluations, and transfers of a partnership interest, particularly built-in loss property. Additionally, the regulation discuss the use of forward and reverse 704(c) allocations and the use of layering in allocating separate items.

In response to the Enron, other provisions (Section 755(c)) address the manipulation of partnership property as a means of avoiding gain. Technical terminations are also considered in the regulations. Additionally, Securitization Partnerships are generally not allowed built-in losses on transfers. Finally, the proposals reflect AJCA changes that lengthen the time for taxing precontribution gain from 5 years to 7 years. 

http://www.accountingtoday.com/news/IRS-Proposes-Changes-Partnership-Basis-Allocations-69331-1.html
https://www.federalregister.gov/articles/2014/01/16/2014-00649/disallowance-of-partnership-loss-transfers-mandatory-basis-adjustments-basis-reduction-in-stock-of-a

Amortize startup expenditures of terminating partnerships

Technical terminations are also the subject of proposed regulations issued in December of 2013. When there is a sale or exchange of at least 50% interest of partnership capitals and profits, there is a technical terminations. Some partnerships consider that as an opportunity to accelerate their startup and organizational expenditures under Sec. 195(b)(2). This regulation simply clarifies that technical terminations are not dispositions and Sec. 195(b)(2) is not available to them.

http://www.journalofaccountancy.com/News/20139211.htm

Liabilities and disguised sales

The proposed regulations in January recommend a hodgepodge of adjustments to limit abuses in partnership taxation. The regulations cover primarily two subjects related to partnerships, subjects that could be intertwined, the allocation of recourse and nonrecourse debt and additional limitations on disguised sales. A third issue covers the deductibility of preformation capital expenditures. Following are the issues as outlined in the proposed regulations.

The proposals for debt-financed distributions add some ordering rules when examining amounts transferred, for example, using debt-financed distributions before something like guaranteed payments.

For preformation capital expenditures, the IRS rules attempt to insure that the 20% if 120% , is treated separately for each property, rather than as an aggregate; that capital expenditures only include those required to be capitalized (not elective); and the dynamics of the assumption of liabilities and disguised sales rules. The best explanation of the last point comes from the regulations

Thus, the proposed regulations provide that to the extent a partner funded a capital expenditure through a borrowing and economic responsibility for that borrowing has shifted to another partner, the exception for preformation capital expenditures should not apply because there is no outlay by the partner to reimburse.

The regulations further discuss qualified liabilities assumed within two years of transfer of assets, and suggests that a liability need not encumber the transferred property. An additional type of qualified liability is being suggested, although a facts and circumstances is required, as well as a disclosure.

The proposed regulations add a 2 year lookback period when determining if an assumption of liability is accompanied by anticipated reduction. Tiered partnerships are also discussed in relation to liability succession, and it is proposed that if a partnership interest is contributed to a partnership it will also be covered by tiered partnerships rules.

Changes in disguised sales rules include netting disguised sales in a merger in the same manner as partnership liabilities in Section 1.752.1(f).

The final issue may be a bit over my head. It seems to indicate that a deemed liquidation may not be necessary to define partner liability, and that additional restrictions may be placed on partners to maintain a level of net worth and meet several other payment obligation factors.

http://www.aicpa.org/Publications/TaxAdviser/2014/October/Pages/Tax_Clinic_08.aspx
http://www.aicpa.org/interestareas/tax/newsandpublications/taxnews/pages/20140129.aspx
http://www.journalofaccountancy.com/News/20149513.htm
https://www.federalregister.gov/articles/2014/01/30/2014-01637/section-707-regarding-disguised-sales-generally

Objections

The objections to these proposed regulations are that partnership tax planning will be severely hampered, particularly by the new recourse debt rules. Proposed regulations under code section 752 would essentially redefine the meaning of recourse for purposes of allocating partnership debt. According to opponents, the changes will limit tax deferral opportunities and restrict the operations of some industries. An article in The Tax Adviser says this will "create planning opportunities," although that probably means it will require careful planning. The BNA website notes that

A partner’s ability to receive tax-free, cash distributions and deduct partnership losses turns upon the partner’s share of recourse and nonrecourse liabilities, as allocated under the rules of section 752.

This issue does need some study, and of course, comments are requested.

http://www.taxlawroundup.com/2014/02/partnership-tax-planning-severely-limited-in-proposed-regulations/
http://www.goodwinprocter.com/Publications/Newsletters/Client-Alert/2014/0203_Proposed-IRS-Regulations-Could-Significantly-Impact-Tax-Deferral.aspx?article=1
http://www.bna.com/proposed-regulations-debt-w17179890165/

Observations

Partnership Losses

Until the above proposed regulations become a reality, we can rely on the AT article, explaining partnership losses. Although this sounds like CPA review material, a quick review may help us realize the consequences of the proposed regulation that received so much attention here. The two primary concerns in deducting partnership losses are basis and at-risk, but in a partnership environment more work is required. Defining at-risk involves distinguishing recourse and non-recourse; non-recourse debt will increase basis, but not at risk amounts.

IRC section 465(b)(4) will not be considered at risk with respect to amounts protected against loss through nonrecourse financing. This limitation also applies to guarantees made by a partner that he may not be responsible for. According to this article, the type of structure and the type of partner will also determine what might be at risk. A limited partner in an LP is not at risk for guarantees, although an LLC member who guarantees a partnership debt would be at risk. Not mentioned in the article is that in addition to basis and at-risk limitations, losses are subject to the passive activity rules of Section 469.

http://www.accountingtoday.com/news/tax_essentials/why-a-partnership-loss-may-not-be-deductible-70927-1.html
http://www.irs.gov/Businesses/Partnerships/Partnership---Audit-Technique-Guide---Chapter-5---Loss-Limitations-(Revised-12-2007)

Partnership Income

While partnership losses may not be a concern, partnership income may be, if you consider recent IRS rulings. In a memorandum from the Chief counsel, the IRS has determined that the distributive share of a partner's income in an LLC may be self-employment income. In general, because these partners were active in a service oriented business, they are subject to self-employment tax. Also, their limited liability doesn't make their income passive.  The limited liability nature of an LLC does not make LLC members limited partners of the partnership.

With this ruling, the IRS also distinguishes LLC partnerships from S Corporations which would be able to avoid self-employment in a similar situation. This was a private ruling, but it does give an insight into how the IRS may treat future cases in the absence of more definitive regulations that have yet to be written.

http://www.forbes.com/sites/anthonynitti/2014/09/10/irs-partners-share-of-llc-income-is-subject-to-self-employment-tax/
www.irs.gov/pub/irs-wd/201436049.pdf

Partners in Disguise

S Corporations and Partnerships are different in another way. It's true that the amount of ownership in a S Corporation can have an impact on some transactions, but it is very possible, maybe even common, to be both a stockholder (owner) and an employee. Apparently not so with a partnership. Although Section 707(a) indicates that a partner could engage in an arms length transaction as other than a partner, that does not include being an employee.

This issue gets the spotlight when a partnership awards a person an equity interest in the partnership for services. Once that happens, that person can no longer be an employee, and treating him like one has consequences, and tax withholding is only one of them. The safe harbor provided by Rev. Proc. 2001-43 insures that - if certain conditions are met. Treating such minority partners as employees also could jeopardize Cafeteria plans, and cause a number of calculations to be incorrect, including FICA, DPAD, taxability of benefits, and health care coverage.

One way to accomplish this is to structure the partnership so that the individual is partner as a separate entity such as a lower level partnership, an S Corporation, or according to Regs. Sec. 301.7701-2(c)(2)(iv), even a disregarded entity operating as a sole proprietorship. Thus the individual can be an employee and an owner of the entity that holds the partership interest.

http://www.journalofaccountancy.com/Issues/2014/Aug/20149676.htm
http://www.aicpa.org/Publications/TaxAdviser/2013/November/Pages/Brock_Nov2013.aspx

Collaboration Agreements an Partnerships

Earning an equity interest is not the only way to make partner. A collaboration agreement could also lead to a partnership. The IRS ruled on a case where two corporations agreed to develop a product. Eventually other agreements were made along the way which lead to fulfilling some of the characteristics of a partnership.

The check-the-box rules allow entities to choose their structure. When they don't, an entity with more than one member is a partnership by default. Among the characteristics that cause a partnership to be formed are:

  • They have a partnership agreement
  • They representing themselves as partners
  • They make contributions to the partnership
  • They share profits and losses
  • They have a right to control income and capital

The OCC, however, used a framework developed by the Tax Court in a separate case. The framework used 8 factors to determine if a partnership exists, and based their decision on all the facts and circumstances. Incidentally, this case was concerned with calculating the DPAD credit, and ruled that the pass-through nature of a partnership required partners to calculate the credit at the partner level.

http://www.aicpa.org/Publications/TaxAdviser/2013/November/Pages/clinic-story-08.aspx

Partnership Capital Accounts

The discussion of 704(b) capital accounts is interesting because one of my instructors in college said most local partnerships don't keep up with capital accounts. I'm not sure how that is done since it should appear on the partner's Schedule K-1, but I can believe that many partnerships don't keep up with everything. While it may be possible to reconstruct a year or two to determine amounts that should be in a capital account, a partnership lasting a lifetime will likely not be able to. On the other hand, many partnerships may operate strictly as a separate business and limit distributions based on the partner's share.

Maintaining capital accounts is important, in part, because the capital account is the amount of each partner's distributive partnership income, gain, loss, deductions, and credits. Other than normal partnership income and loss, key modifications to the capital account occur with the contribution of property with built in gain or loss, and the sharing of depreciation expenses. The traditional method for calculating partner depreciation expenses is textbook, and involves assigning each partner their appropriate share and then assigning the rest to the contributing partner. Two other methods are also allowed that adjust for differences between book and tax depreciation amounts and the ceiling rule for depreciation.

Other modifications may be necessary with the addition of partners to the partnership and are referred to as reverse allocations. These allocations are limited to certain events and have other limitations. Over time there may be multiple revaluations, or allocations, and each 704(c) allocation is a separate account, or layer. There is also a de minimis rule for 704(c) called the Small Disparity Exception in Regs. Sec. 1.704-3(e)(1), that allows partnerships to ignore transactions that differ less than 15% of contributed property basis and less than $20,000.

http://www.aicpa.org/Publications/TaxAdviser/2014/february/Pages/Greenwell_Feb2014.aspx

Partnership Debt Basis

This is not from 2014, but it is worth noting that liabilities can go beyond distinguishing between recourse, nonrecourse, and qualified nonrecourse. In the case of LLCs and LLPs, there may be exculpatory and bifurcated liabilities. An exculpatory debt is one for which the partnership is responsible, but which is nonrecourse for the partners. A bifurcated liability is one for which the partner is only partially responsible, so the recourse amount is less than the total debt. In addition, there is a 10% de minimis rule related to qualified nonrecourse debt if one partner is the lendor or guarantor and a 25% of interest de minimis rule for (nonqualified) nonrecourse debt guaranteed by a partner. Section 1.752-2 (d), (e)(1)

http://www.dbbllc.com/newsletters/focus/jun2012/partnership-tax-rules-%E2%80%93-basis-partnership-liabilities

Auditing challenges

Finally, a Wall Street Journal article discusses the increasing difficulty of auditing partnerships, due to the pass-through nature of the partnership. This is particularly so with the increasing growth in the number of large partnerships. The challenge is in dealing with so many partners, and suggests that the IRS may create some rules to simplify partnership audits.

http://blogs.wsj.com/cfo/2014/09/18/growth-in-partnerships-outrun-tax-auditors/

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