Senate Finance Committee Chair Ron Wyden has released a ‘discussion draft’ of legislation that, if enacted, would dramatically change the tax rules that apply to partnerships. It is key to note that this is only draft legislation and as such, it is difficult to anticipate whether these ideas and proposals will be considered in any ultimate tax legislation. However, it seems likely Senator Wyden will pursue these proposals, and with a $172 billion revenue estimate, it may be safe to assume at least some of these proposals will receive consideration.
Senator Wyden’s ‘discussion draft’ includes an array of changes to Subchapter K of the Internal Revenue Code (IRC) – the major proposals contained therein are discussed in more detail below. In reviewing some of these proposed changes, taxpayers and their advisors may find that the proposals appear quite substantial but are actually more problematic in theory than in practice. Other proposed changes may appear minor, but would completely reshape the way partnerships are formed and operate.
For example, many may find the proposals to limit or prohibit ‘special allocations’ to be the most dramatic of the proposed changes. However, the language itself may not be as far-reaching as it may initially appear. On the other hand, the proposed changes to partnership debt allocations may, at first blush, appear to be of limited impact – indeed, these proposed changes were not even highlighted in Senator Wyden’s summary. However, if enacted, they would dramatically alter the current regime.
The proposed changes include, among other things:
Requiring that partnership debt is allocated in accordance with profit
While some partnerships may already allocate debt in accordance with profit sharing ratios, many utilize allocation methods designed to align tax and economic treatment. If enacted, this proposal would result in a change in debt allocations for certain partnerships, leading to unexpected taxable gains to certain partners.
Mandating revaluations and the use of the ‘remedial’ method under section 704(c)
Several options exist with respect to how and when unrealized gain is taxed when partners contribute appreciated property to a partnership. If enacted, the proposal would mandate the use of the remedial method in all cases.
Moreover, partnerships currently have flexibility regarding whether or not to ‘revalue’ their assets. If enacted, the proposal would eliminate that flexibility, and (as discussed above) require the use of remedial allocations with respect to the ‘reverse’ 704(c) layer.
Eliminate ‘Safe harbor’ and ‘Substantial Economic Effect’ methods of allocating income
Although more complex ‘target’ allocation methods are increasingly common in the middle-market, many taxpayers still utilize ‘safe harbor’ agreements. The proposal targets perceived ‘abuses’ that can arise under this method, and while it is not certain that this change would result in a change in allocations for all partnerships, it may increase the complexity of the required computations and add administrative burdens.
Mandate pro-rata income allocations for partnerships owned by related corporations
The proposal also includes language requiring partnerships owned by two or more corporations under common control to allocate income in relation to each corporation’s share of capital ownership. While this provision appears limited to a very specific subset of partnerships, the proposal also suggests that this group would be expanded further in the future via regulation.
Requiring section 734 and section 743 basis adjustments
Partnerships are generally required to make downward basis adjustments upon the sale or redemption of a partnership interest (and upon the death of a partner) when unrecognized losses above a certain threshold exist. However, if unrecognized gains exist, this basis adjustment is generally optional. The proposal would make these upward adjustments mandatory.
End guaranteed payments for current and retired partners
Payments to partners would either be taxed in a non-partner capacity (e.g. treated as interest, fees, wages, etc.) or as allocable shares of income.
Changes to ‘mixing bowl’ and ‘disguised sale’ rules
The distribution of assets that were previously contributed by a partner can often generate gain, but this rule does not apply if the asset is held by the partnership for more than seven years. The proposal would remove the exception for assets held more than seven years, resulting in the potential for gain any time such an asset is distributed.
Align treatment of inventory in sales and redemptions
Under current law, gains related to partnership inventory are taxed as ordinary income when an interest is sold. In a redemption, ordinary income treatment only applies if the inventory is ‘substantially appreciated’. The proposal would remove the ‘substantially appreciated’ limitation and tax redemptions similar to sales.
Elimination of Publicly Traded Partnership status
Under current law, certain publicly traded companies are allowed to elect to be taxed as partnerships (so-called, publicly traded partnerships or PTPs). The proposed change would repeal this exception for all publicly traded partnerships.