United States

IRS issues final and proposed partnership regulations under section 706


On July 31, 2015, The U.S. Department of the Treasury and the IRS concurrently issued separate final (T.D. 9728) and proposed regulations (REG-109370-10) under section 706. These regulations generally address the allocation of partnership items (income, gain, loss, deduction or credit) among partners in a year in which ownership changes occur.

Final regulations
The final regulations adopt many of the concepts set forth in the 2009 proposed regulations (REG-144689-04), but they also make various changes based on public comments received by the IRS in response to the 2009 proposals. The regulations also clarify that deemed dispositions that occur when, for example, a corporate partner leaves a consolidated group or when a corporate partner's subchapter S status terminates will be treated as a disposition solely for purposes of section 706.

Prior guidance
The 2009 proposed regulations allowed a partnership to choose between the default interim closing method, or alternatively, at the discretion of the partners, the proration method. Under the proposed rules, a partnership could not use a combination of the two methods in any single year. The interim close method was generally seen as more accurate, albeit often more cumbersome to employ, while the proration method was less burdensome for the taxpayer, but could yield skewed results, at least from the IRS vantage point. The 2009 proposed regulations also provided rules covering the treatment of extraordinary items such as capital gains for taxpayers using the proration method.

New guidance
The final regulations lean on the core principles of the proposed regulations, while adding greater flexibility. Favorable changes include: 1) permitting a partnership to use a combination of the interim close and proration methods within the same tax year, 2) adding a monthly close option (in addition to existing daily and semi-monthly options) for partnerships that adopt the interim close method, 3) confirming that a grandfathered publicly traded partnership (PTP) (i.e., one formed prior to the 2009 proposed regulations) does not lose its grandfathered status as a result of a section 708(b)(1)(B) technical termination, and 4) leaving the door open for extraordinary item treatment even if an item is not explicitly listed as such in the regulations.

The regulations also clarify that partnerships must apply the extraordinary item exception even when using the interim close method. Previously, the extraordinary item rule only applied in the proration method context. The change helps eliminate inappropriate allocations when partnerships using the interim closing method use either the semi-monthly or monthly convention to account for extraordinary items. The regulations provide that the timing of extraordinary items must be based on the partners' interest at the time of day the item occurs regardless of the methods or conventions otherwise employed by the partnership.

Several options afforded partnerships under the new rules require "agreement of the partners.” On the surface, logistical issues could accompany the coordination of such decisions. Fortunately, the regulations appear to indicate that a tax matters partner, or other partner with the authority to bind the partnership, can act on the partners' behalf in arriving at and documenting such decisions.

Limited exceptions notwithstanding, the final regulations apply to partnership tax years beginning on or after Aug. 3, 2015. As such, calendar year filers will have to adopt the new rules for their 2016 tax year beginning on Jan. 1, 2016.

Proposed regulations
In addition to the final regulations, Treasury also released new proposed regulations addressing the complications of varying partner interests. The proposed rules provide guidance on determining a partner's distributive share of certain allocable cash basis items and items attributable to an interest in a lower-tier partnership.

With respect to allocable cash basis items, the proposed regulations aim to supplement the statutory language and prevent the shifting of previously incurred partnership expenses to a partner admitted after the item was incurred. In response to concerns about the administrative burden of complying with these rules, the proposed regulations offer a useful de minimis rule.

As with various other partnership tax concepts, tiered entities add a layer of complexity in relation to the varying interest rules. The proposed regulations clarify how and when a partnership takes into account the activity of a lower-tier entity when changes occur among the upper-tier partnership's owners.

These proposed regulations also add two additional extraordinary items for PTPs to the list included in the final regulations. These exceptions allow PTPs to choose to treat certain amounts subject to certain foreign withholding requirements as extraordinary items for the applicable tax year.

Unlike the final regulations discussed previously, these proposed regulations will not be effective until the date on which they are made final. In the meantime, certain PTPs may rely on the extraordinary item provisions mentioned above.

Observations and possible future developments
Unlike the controversial, recently issued proposed regulations affecting fee waivers and disguised payments for services under section 707, the new final regulations under section 706 have been well received because they provide additional flexibility and clarity.

There are still some areas of uncertainty that may require further guidance or clarification in the future. For example, it is unclear whether contingent or success-based fees are subject to the general rules or are properly treated as extraordinary items. In addition, the IRS has acknowledged a possible need for further guidance on the interplay between section 706 and the partnership minimum gain provisions, and between section 706 and the waterfall allocation arrangements found in many partnership agreements.

We also anticipate a need for guidance concerning the interaction between section 706 and sections 704(b) and 704(c), and between section 706(d) and the basis allocation rules under section 755. 


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