Attorneys Comment on Proposed Partnership Allocation Regs

We respectfully submit these comments to proposed regulations under section 704(b) of the Internal Revenue Code of 1986, as amended (the "Code"), relating to the testing of allocations for substantiality. We wish to commend the Internal Revenue Service (the "Service") and the Treasury Department for their efforts in drafting proposed regulations that seek to clarify an otherwise complicated area of partnership tax law.

This letter will discuss a number of issues raised by the proposed regulations, including the difficulty in obtaining all of the necessary tax attributes of indirect partners of a partnership through potentially multiple tiers of pass-through entities, as well as the complexity involved in ascertaining how these attributes will interact with the partnership's items over an extended period of time. After discussing these issues in detail, this letter suggests some clarifications and solutions that are intended to reduce the burden of compliance on taxpayers and to simplify the administration of these regulations by the Service.

I. PROPOSED REGULATIONS

1. Reasonable Possibility Test -- The regulations provide that the economic effect of an allocation is substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. For example, original allocations of profit and loss that are followed by special offsetting allocations of profit and loss that are designed to produce the same economic result that would occur in the absence of such special allocations would generally not satisfy this test. The regulations provide a presumption that a reasonable possibility exists that allocations will affect substantially the dollar amounts to be received by the partners if there is a strong likelihood that offsetting allocations will not, in large part, be made within 5 years after the original allocations are made (determined on a first in, first out basis).¹ This presumption is discussed in greater detail below.

2. After-Tax Economic Test -- The regulations provide that, notwithstanding whether the reasonable possibility test is met, the economic effect of an allocation will not be substantial if the allocation does not satisfy the after-tax economic test. The 5-year presumption applicable to the reasonable possibility test does not apply to the after-tax economic test. This test, which is the focus of this letter, requires that:

(a) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation were not included in the partnership agreement, and

(b) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation were not contained in the partnership agreement.

C. Attributes Considered in Determining Substantiality

In making the determination pursuant to the after-tax economic test, the partnership must take into account each partner's tax attributes that are unrelated to the partnership. Moreover, Prop. Treas. Reg. § 1.704-1(b)(2)(iii)(a)(2)(i) provides that:

Thus, in order to comply with the proposed regulations, a partnership (an "Operating Partnership") must examine not only the attributes of its partners but, if a partner is a look-through entity or a member of a consolidated group, the attributes of the direct or indirect owners of the look-through entity or the attributes of the consolidated group and the members thereof. For example, if a partner of an Operating Partnership is itself a partnership (an "Investment Partnership"), the Operating Partnership must determine and take into account the tax attributes of the partners of the Investment Partnership.

II. DISCUSSION OF ISSUES PRESENTED UNDER THE PROPOSED REGULATIONS

A. Impracticality of Discovering Attributes of Multiple Tiers of Partners and of Predicting Interaction of These Attributes Over an Extended Period of Time

In light of the business realities, we believe that the substantiality requirement of the proposed regulations would be very difficult, if not impossible, for a significant number of Operating Partnerships to satisfy, and would be equally difficult for the Service to administer. An ever increasing number of investments in Operating Partnerships are being made through funds that are established as limited partnerships and limited liability companies that are taxed as partnerships, each of which is a separate Investment Partnership. Many of these Investment Partnerships have one or more tiers of partnerships that are owners of the Investment Partnerships, with each tier itself representing additional Investment Partnerships having multiple partners. Under the proposed regulations, the Operating Partnership would be required to identify through the tiered Investment Partnership structure the ultimate partners in the Operating Partnership, determine the tax attributes of each of these ultimate partners, and try to predict how the allocations from the Operating Partnership would interact with these tax attributes over time.

In many cases neither the Operating Partnership nor the Investment Partnership will have access to such information. As a practical matter, the manager of a significant Investment Partnership will not have the necessary information. Moreover, even if the manager made the required inquires, it is unlikely that each partner would be able or willing to ascertain and divulge such information, particularly in light of the fact that such information has no apparent relevance to the performance or operation of the Investment Partnership. In short, placing such a requirement on an Operating Partnership would impose a heavy burden to acquire information that may not be available in any event.

In our experience, the tax attributes of the partners of Investment Partnerships have no bearing on the determination of how the allocation provisions of an Operating Partnership are structured. Specifically, a significant number of partners in an Investment Partnership that has a direct or indirect interest in an Operating Partnership will have a relatively small interest in the underlying Operating Partnership, making it unlikely that they will be known to or otherwise considered by the Operating Partnership when allocating profit and loss. In this case, the fact that the Investment Partnership itself must meet the substantiality requirement should be sufficient to ensure that the substantiality requirement is satisfied.

The inherent problems associated with requiring an Operating Partnership to determine the tax attributes of all of its direct and indirect partners and to predict how these attributes will interact with the items of the Operating Partnership is greatly exacerbated by the lack of any time period over which such interaction must be predicted. It will generally be impossible to engage in any meaningful prediction of this interaction over an extended period, particularly if the Operating Partnership and its partners are engaged in an active trade or business. The profit and loss realized by an active Operating Partnership several years in the future will generally be speculative. In addition, the utilization of a partner's tax attributes over a period of years, and thus the availability of these attributes throughout this period, will be extremely difficult to predict. Because of the inherent difficulty in predicting the items and attributes of the Operating Partnership and its indirect partners, respectively, not to mention the additional task of understanding how these items and attributes will interact over time, we believe that a presumption or safe harbor that sets forth a specific time period beyond which such prediction would not be necessary would assist taxpayers and the Service in the administration of the proposed regulations.

The proposed regulations also require the tax attributes of partners that are members of a consolidated group of corporations to be taken into account. Like any other partner, such attributes become very difficult to predict with any degree of accuracy over an extended period of time, a problem that is intensified in the consolidated group context because of the numerous rules and provisions that limit or eliminate the ability of a member corporation to use attributes of the consolidated group.² This in our view produces unnecessary uncertainty with respect to the substantiality requirement, as it would require the Operating Partnership to have a detailed understanding of the consolidated tax attributes of a consolidated partner and apply the consolidated return rules with respect to the allocation of the profit and loss of the partnership.

In summary, the proposed regulations would require the Operating Partnership to have an expansive knowledge of the partners of the Investment Partnership and their attributes in order to make the necessary substantiality determinations thereunder. However, this information is often unattainable or otherwise unknown. Moreover, even if such information is otherwise obtained, the Operating Partnership would in effect be required to predict the profit and loss of the Operating Partnership and how this profit and loss will interact with the partners' attributes over time. In a significant number of cases, the likely result of such a burdensome, complicated, and subjective requirement would either be noncompliance or an application amounting to speculation.

B. Application of Aggregate Concept to Substantiality Requirement

The proposed regulations do not make it clear that the aggregate concept should be applied in making the substantiality determination. We would suggest a clarification, as described below.

III. POSSIBLE SOLUTIONS

As drafted, the proposed regulations would likely be very difficult if not impossible for many taxpayers to administer, particularly given the increased use and size of investment funds. However, the purpose of the regulations -- namely, to discourage taxpayers from implementing special allocations that have no after- tax economic impact in order to enable the partners to utilize their tax attributes and thereby reduce their overall net tax liability -- is a legitimate one. We believe there are solutions available that could minimize or even eliminate some of the issues discussed above.

A. Presumption or Safe Harbor With Respect to the Duration of an Allocation

One solution that would address the difficulty and complexity inherent in determining the partners' tax attributes and predicting the interaction of these attributes with the items of an Operating Partnership over time would be to apply the 5-year presumption in Treas. Reg. § 1.704-1(b)(2)(iii)(c) to the after-tax economic test as well as to the reasonable possibility test. Although Treas. Reg. § 1.704-1(b)(2)(iii)(c) currently contains a 5-year presumption, this presumption relates only to the transitory allocation rules of that section and to the reasonable possibility test. Specifically, this presumption states that:

Notwithstanding the foregoing, the original allocation(s) and the offsetting allocation(s) will not be insubstantial (under this paragraph (b)(2)(iii)(c)) and, for purposes of paragraph (b)(2)(iii)(a), it will be presumed that there is a reasonable possibility that the allocations will affect substantially the dollar amounts to be received by the partners from the partnership and that there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement if, at the time the allocations become part of the partnership agreement, there is a strong likelihood that the offsetting allocation(s) will not, in large part, be made within five years after the original allocation(s) is made (determined on a first-in, first-out basis).

Adopting such a presumption would be consistent with the other changes made by the proposed regulations. As with removing the presumption that all partners own an equal amount of a partnership on a per capita basis for purposes of determining a partner's interest in a partnership, adding a presumption with respect to the after-tax economic test will serve the purpose of making the proposed regulations more in tune with "real world" economics.

For purposes of this paragraph (b)(2)(iii), in determining the after-tax economic benefit or detriment to any partner that is a look-through entity, the tax consequences that result from the interaction of the allocation with the tax attributes of any person that owns an interest in such a partner, whether directly or indirectly through one or more look-through entities, must be taken into account as if such person were a partner in the underlying partnership, and, in determining the after-tax economic benefit or detriment to any partner that is a member of a consolidated group (within the meaning of § 1.1502-1(h)) the tax consequences that result from the interaction of the allocation with the tax attributes of the consolidated group and with the tax attributes of another member with respect to a separate return year must be taken into account.

If you have any questions or comments, please do not hesitate to contact Philip Tingle at 305.347.6536 or Justin Mead at 305.347.6512.

² For partners who are members of an affiliated group filing a consolidated return, numerous provisions can affect the use of tax attributes, including Code sections 382, 384, 269, and Treas. Reg. §§ 1.1502-19, -13, -35, -20, -21, and -11.