Individual Addresses Partnership Provisions of Interest Regs

SOME PRELIMINARY COMMENTS ON THE PARTNERSHIP PROVISIONS
OF THE PROPOSED 163(j) PROPOSED REGULATIONS

Monte A. Jackel¹

November 28, 2018

1. Proper Maintenance of Capital Accounts.

A. The proposed regulations state that the 11 step process (the “Process”) for allocating interest expense from a partnership is solely for section 163(j) purposes and does not affect the allocation of tax items under section 704(b) and the computation of partner capital accounts. Presumably, this statement about the exclusivity of the Process to section 163(j) also means that outside tax basis under section 705(a) is also computed without regard to the Process, although the proposed regulations do not explicitly so state².

B. However, current final regulation section 1.704-1(b)(2)(iv)(n), which was not proposed to be amended in the proposed regulations, states in part that:

“[T]he capital accounts of the partners will not be considered to be determined and maintained [properly] unless adjustments to such capital accounts in respect of partnership income, gain, loss, deduction, and section 705(a)(2)(B) expenditures (or item thereof) are made with reference to the Federal tax treatment of such items (and, in the case of book items, with reference to the Federal tax treatment of the corresponding tax items) at the partnership level, without regard to any requisite or elective treatment of such items at the partner level. . . . ”

C. This means that, unless the proposed 163(j) regulations make an express exception to this section 704(b) regulation's rule relating to proper maintenance of capital accounts, the allocations in the Process either (1) will be invalid because not in compliance with the quoted rule under the section 704(b) regulations, or (2) the 704(b) allocations will be invalid because capital accounts will not be properly maintained which, in turn, will thereby invalidate the Process (which makes itself subject to section 704(b)).

2. Proper Computation of Outside Tax Basis.

A. Section 163(j)(4) makes specific reference to only two items to be allocated based on how the non-separately stated taxable income or loss of the partnership is allocated: (1) excess business interest (expense), and (2) excess taxable income. This statute only requires an express outside tax basis adjustment for allocated excess business interest which reduces outside tax basis.

B. Section 705(a)(1)(A) requires that outside tax basis be increased by the allocated taxable income of the partnership, and section 705(a)(2)(B) requires outside tax basis to be decreased by nondeductible noncapital expenditures of the partnership.

C. It is undeniable that if the Process applied in computing outside tax basis, the ending outside basis will be different from what the outside tax basis would have been from the actual allocated taxable income and nondeductible noncapital expenses of the partnership in section 705(a). Thus, it should be made explicit that outside tax basis is not governed by the items allocated under the Process.

D. However, even though the apparent intent in the proposed regulations is to limit the Process solely to section 163(j), this would literally mean that items that the Process creates, such as allocated partnership taxable income and nondeductible expense, have no effect on either outside tax basis or on capital accounts. It may thus be questioned whether the Process creates items that do not have substantial economic effect under regulation section 1.704-1(b). The proposed regulations should add examples illustrating the beginning and ending capital accounts and outside tax basis when applying the Process.

3. Guaranteed Payments As Interest.

A. The proposed regulations treat as interest guaranteed payments on capital (“GPUC”) under section 707(c). Presumably, this also means that the recipient of the GPUC is treated as receiving interest income. Although the proposed regulations define the term “interest” for all purposes of the Internal Revenue Code, this is not clearly stated. The proposed regulations should be clarified to state the intent here.

B. This treatment of the payor and payee can have other significant collateral consequences including, but not limited to (1) withholding on outbound GPUCs under section 1441, and (2) the treatment of the recipient of the GPUC if the recipient is a tax exempt entity or REIT or RIC and the characterization of the GPUC is at issue (meaning, is the GPUC an interest payment or a distributive share and related distribution under sections 704 and 731). These are major points which arguably should have been addressed in the proposed regulations.

C. Also, there may now be huge pressure on the appropriate tax treatment of preferred gross income (and possibly even net income) allocations and related distributions which could be either treated as fee payments or as GPUCs under the appropriate set of facts.

4. Remedial Allocations.

A. The proposed regulations state that remedial allocations are not taken into account in computing the partnership level interest deduction and related 163(j) items under section 163(j) but that such remedial allocations (along with section 743(b) and 704(c)(1)(C) items) is a partner level adjustment to partner adjusted taxable income³.

B. This is technically correct under regulation section 1.704-3(d)(4) which provides that remedial allocations (1) do not affect the partnership's computation of its taxable income under section 703, (2) do not affect the capital accounts of the partners, but (3) do have a direct tax effect on the partners as if they were actual tax items.

C. However, a potential problem with excluding remedial allocations from the partnership level 163(j) computations is that the remedial allocations can change the allocation of tax items from the partnership to the partners and thereby make more difficult the ability of the Process to reach the right result (because of the lack of actual tax items to achieve the intended result).