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Firm Wary of Effects of Proposed Business Interest Deduction Regs

OCT. 26, 2020

Firm Wary of Effects of Proposed Business Interest Deduction Regs

DATED OCT. 26, 2020
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October 26, 2020

Mr. William Kostak
Mr. Anthony McQuillen
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Dear Messrs. Kostak and McQuillen:

Baker Tilly US, LLP, on behalf of our clients, offers the following comments regarding proposed regulations under both §1.163-14 for business interest expense limitations on debt financed distributions, and §1.163(j)-6 for the treatment of business interest expense limitations in tiered partnership structures.

Debt Financed Distributions

Proposed regulation §1.163-14(d) would adopt a rule similar to the “optional” rule provided by IRS Notice 89-35, but essentially make it mandatory. As a result, pass-through entities would have go back to the year the distribution was made and apply the “optional method” under Notice 89-35, regardless of whether they have historically utilized this method.

Our experience indicates that the vast majority of pass-through entities that could benefit by applying the optional method, actually do so in order to avoid debt-financed distribution (“DFD”) treatment. For taxpayers that did not use the optional method, their reporting of DFD interest often goes back many years. Requiring these taxpayers to go several years back to the year of the original distribution, and to re-determine the treatment of DFD interest would be overly burdensome in many situations. If the optional method would have been beneficial at the time of the original distribution, most taxpayers would have used it. As such, this would be a significant administrative undertaking by the partnership and would ultimately have little practical impact on classifying business interest for §163(j) limitation purposes.

In addition to a compliance burden, the optional method can produce harsh results for taxpayers where the DFD occurred during an initial short tax year. For instance, consider a partnership formed in November via the contribution of property. The property is subsequently refinanced and a DFD is made prior to the end of the month. Since under proposed regulation §1.163-14(d)(5)(ii) available expenditures are those made in the same taxable year of the entity as the distribution, this partnership would only have 2 months' worth of expenses to use in the determination of its expenditure interest expense. Accordingly, the partners would have a disproportionately high amount of interest expense allocated to DFD and/or excess interest expense, not as a function of the economic activity of the partnership, but simply a result of the date it was formed.

Therefore, we recommend that requiring the use of the optional method be removed from the final regulations. Further, we recommend that taxpayers not be required to go back to the year of distribution to determine the treatment of any current year business interest expense. For current partners/shareholders who did not receive a DFD, any §163(j) limitation should be based strictly upon current year activities. Lastly, we request that the optional method include a safe harbor whereby partnerships with an initial short-year as described above can determine its available expenditures based on the expenses it incurs in the 12-month period that follows the DFD.

Tiered Partnership Structures

We appreciate the complexity of the task that Treasury and the IRS have been charged with in trying to draft and implement rules for the application of §163(j) in tiered partnership structures. It would certainly make greater sense and be less complicated if any interest limitations carried forward at the partnership level, as they are for S corporations, rather than being allocated as separately stated items to the partners. However, the statute does not provide for that flexibility. While Treasury may have intended to reduce the complexity by having an upper tier partnership (UTP) retain any excess business interest expense (EBIE), we believe the rules being contemplated create undue complexity and produce unfair results.

Under the proposed regulations, when a UTP is allocated EBIE from a lower tier partnership (LTP), the UTP reduces its basis in its LTP partnership interest accordingly. However, the UTP's partners do not reduce their basis in their UTP partnership interests until the EBIE is subsequently deemed paid or accrued, and allocated to the UTP's partners. This can produce an inequitable outcome amongst the partners. Consider the following example:

Partnership A is owned 50% by B, a partnership owned by X and Y, and 50% by Z, an individual. If partnership A has $100 of EBIE in year one, and allocates it to A and Z ratably, partner Z must reduce its basis in A by $50. While B must also reduce its basis in A, neither partner X nor partner Y must reduce their basis in B, possibly allowing them loss utilization that Z is not afforded. This fact pattern could motivate arrangements whereby a partner in Z's situation may look to create a partnership to which it could contribute its interest in A, for no other purpose than to circumvent the rule under the proposed regulations.

While EBIE is not currently deductible for tax purposes, an LTP is considered to have made an economic outlay for the interest expense, meaning that there is a reduction in the LTP's economic value. As such, the UTP and its partners are required to reduce their §704(b) capital accounts to reflect this decrease in value.

Instead of simplifying matters, this requirement results in further complexity by creating §704(b) to tax differences for each year there is an EBIE limitation, which must be tracked and accounted for. Further, in many cases, an LTP's interest expense will be subject to limitation under §163(j) in many subsequent years, if not annually. This means the disparity in §704(b) and tax capital must be continuously adjusted and layered, creating potentially significant compliance and administrative burdens on capital account maintenance.

We appreciate that part of Treasury's and the IRS' calculus in having EBIE carry forward at the UTP level is that generally, compliance with §163(j) is less of a burden on a partnership than its partners. We do not disagree. However, we respectfully submit that adding a §704(b) to tax disparity for allocations of EBIE makes the exercise of maintaining capital accounts more complex, and creates more of a burden on the partnership and its partners.

To avoid the complex, and in some cases, inequitable results of stopping the reduction of tax basis at the UTP level but requiring §704(b) all the way up the tiered structure of the entity, we recommend that the final regulations adopt an aggregate, rather than an entity approach. The final regulations should require that EBIE be allocated through the UTP to its partners. This will ensure that all partners in a tiered structure will be on equal footing with respect to basis reductions, and avoid the creation of §704(b) and tax capital differences that in many cases will need to be adjusted on an annual basis.

We appreciate your time and consideration. If you would like to discuss or have any questions, please do not hesitate to contact me at my direct dial below.

Baker Tilly US, LLP, trading as Baker Tilly, is a member of the global network of Baker Tilly International Ltd., the members of which are separate and independent legal entities.

Very truly yours,

BAKER TILLY US, LLP

Paul H. Dillon
Baker Tilly US, LLP
Tysons, VA

Direct Dial 703 923 8489
paul.dillon@bakertilly.com

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