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Is It (Finally) Time? Reforming Subchapter K

Posted on Mar. 29, 2021
Monte A. Jackel
Monte A. Jackel

Monte A. Jackel is of counsel with Leo Berwick.

In this article, Jackel argues that it is way past time for Congress to simplify subchapter K, even if taxpayers lose some flexibility.

I. Background and Introduction

Much scholarly literature has accumulated over the years about the need to reform the federal income taxation of partnerships and partners.1 The reform of subchapter K has been a topic that ebbs and flows with the times, so this isn’t the first time the tax literature has addressed it.2 The hope is that this article will resolve the debate and result in reform legislation that is signed into law as early as possible.

The situation is described nicely in the introduction to an article by Stuart L. Rosow:

Subchapter K needs to be fixed. In its present condition, the statute and regulations promulgated thereunder are simply too complicated for taxpayers to apply or for the IRS to administer. While the goal of providing flexibility to partners in arranging their affairs is admirable, this flexibility comes with substantial costs. Taxpayers seek to exploit the flexibility by arranging transactions that purport to produce results Congress could not have intended. In response, statutory changes and additions to regulations are required to combat these perceived abuses, with the burden of enormous complexity. Yet, despite their complexity, the rules do not prevent taxpayers from inappropriately deferring [or avoiding] income and gain. The net result is that well-meaning taxpayers struggle to comply, usually incurring substantial time and expense, while less scrupulous taxpayers can flout the rules with little or no fear of detection of their aggressive position[s].3

But, one may ask, why is it so urgent to reform subchapter K given that it has been more than two decades since a significant amount of partnership tax reform studies were first published in the NYU Tax Law Review in the early 1990s? Well, it appears that despite numerous warning signs, the IRS and Treasury4 haven’t begun, at least publicly, to seriously try to close the tax gap from past audit history with partnerships. That record hasn’t been good.5

Available evidence and personal experience indicate a huge gap of knowledge and technical competence between the IRS Office of Chief Counsel attorneys who are assigned to the two partnership branches in Passthroughs and Special Industries and the outside tax bar. Further, even though the use and abuse of partnership taxation has accelerated since limited liability companies were granted partnership tax passthrough treatment in the late 1980s, partnership tax at the IRS National Office doesn’t have its own associate chief counsel — unlike corporate tax, international tax, income tax and accounting, and financial instruments and products. The IRS Large Business and International Division, which would audit the large partnerships, appears to be understaffed and behind the curve when it comes to partnership expertise and competence in the review and effective auditing of partnerships. When LB&I hiring is targeted to partnership tax, which I understand has occurred lately,6 I believe the pay is too low to attract any significant long-term talent. I know about budget shortfalls, but the IRS needs to do better on that front even if cuts need to be made elsewhere.

Meanwhile, the published regulations in the partnership area are mostly addressed to an audience that is largely made up of the most sophisticated partnership practitioners and large corporate CFOs, leaving the average CPA, business tax lawyer, and corporate tax company adviser to flounder around trying to understand and comply with the rules. How much more of this can a tax system that relies on self-assessment and efficient tax audits stand?

Time is running out. Subchapter K should be reformed and simplified now. The more time that elapses without reform, the more the treasury is drained of financial resources to fund the government.

To that end, I am setting forth below the key points made in the literature on this reformation and simplification effort. I also offer recommendations on how to proceed. In the interests of keeping the article to a reasonable length, I have assumed that the reader has basic knowledge of how partnerships and partners are taxed under current law.

Also, I don’t spend a great deal of time on the business implications of the suggested reforms. If I did that, no actual reforms would ever occur. I assume that the business concerns of the proposals will be expressed elsewhere in troves.

II. Discussion and Recommendations

Several improvements, clarifications, and changes must be implemented to make subchapter K more reliable and understandable for taxpayers and advisers that apply its provisions and for the IRS to effectively audit those partnerships.

A. Formation of Partnerships

There are two key reforms to consider regarding the formation of partnerships. First is whether a partner should recognize gain or loss upon contribution of property to the partnership. Second, there is the question whether, upon transfer to a partnership, the partnership can freely adopt a new accounting method for federal income tax purposes or is bound by the method used by its predecessor in interest.

1. Gain or loss on formation.

The principal problem and tension about allowing the tax-free contribution of built-in gain or built-in loss property to a partnership,7 and allowing for no partnership entity-level income tax,8 is ensuring that the built-in gain or loss will, at the appropriate time, be taxed or allowed to the contributing partner or a successor. Subchapter K attempts to achieve this result principally through the mandatory application of section 704(c).

However, section 704(c) and its governing regulations are complex and difficult to understand for both practitioners and the IRS. Also, appropriate background information (principally the method of allocation under section 704(c))9 isn’t required to be part of the partnership tax return. Thus, large dollars have escaped the tax net and will continue to do so unless something is done to meaningfully change the situation.

Two principal methods have been proposed in the literature to deal with this problem over the years. First, it has been proposed that a transfer of built-in gain property to a partnership be treated as a taxable deferred sale.10 This would essentially resemble an installment sale by the partner to the partnership in which gain is accelerated upon the occurrence of so-called triggering events (such as the sale of the partnership property by the partnership, the sale by a partner of the partnership interest, and the depreciation of the contributed property). Alternatively, immediate gain or loss recognition of the built-in gain has also been proposed.

As stated in the deferred sale article:

The piecemeal legislative and regulatory efforts to prevent abusive transactions have led to unnecessary complexity and uncertainty in the law of partnership tax. Particularly troubling is the proliferation of anti-abuse rules [including section 704(c)] of indeterminate scope. . . . The time has come for Congress to enact a rule that requires the property contributor to be responsible for the built-in gain or loss in all events. Not only would such a rule achieve more satisfactory tax results than present law, it would also significantly reduce the complexity and uncertainty of current law and make many of the statutes, regulations, and anti-abuse rules unnecessary.

And, regarding the deferred sale method, the article proposed:

We accept the basic premise of section 721-that formation of a partnership should not result in immediate recognition of gain or loss. What we advocate here is the so-called “deferred sale method” of accounting for built-in gain or loss. That method defers recognition of built-in gain or loss until certain triggering events occur. Triggering events include a sale or distribution by the partnership of the contributed property, the sale or liquidation (partial or full) of the contributing partner’s partnership interest, and depreciation of the property. [Footnotes omitted.]

The principal argument against taxing the built-in gain (regardless of whether it is on a deferred basis) is that it would discourage the use of partnerships as a business transaction vehicle, to the detriment of the entire economy. However, this particular partnership tax reform proposal makes sense only if there is parallel reform legislation regarding S corporations (when section 351 wouldn’t apply on transfers of built-in gain property to the S corporation so that transfers to S corporations would also result in gain recognized on the built-in gain) or the S corporation regime is legislatively repealed with appropriate transition rules (the preferable route). Given that neutrality, the lack of an entity-level partnership income tax will still provide a significant benefit to taxpayers as compared with the use of C corporations.

However, there is concern that a deferred sale method would result in more complexity in subchapter K. As explained in T.D. 8501, under which the proposed deferred sale method was eliminated and replaced with the remedial allocation method, the IRS and Treasury explained:

The proposed regulations published by the IRS in the Federal Register on December 24, 1992 (FR 61345) (the original proposed regulations) included the deferred sale method as a reasonable allocation method. The IRS and Treasury included the deferred sale method in the original proposed regulations because it provided a method to eliminate the distortions created by the ceiling rule. In essence, the deferred sale method provided additional cost recovery deductions for the noncontributing partners, which were offset by deferred gain to the contributing partner. In addition, the method prevented the ceiling rule from creating distortions upon the sale of the contributed property due to post-contribution changes in value. . . . After considering the many comments received concerning the deferred sale method and upon further review by the IRS and Treasury, it was determined that the results of the deferred sale method in the original proposed regulations could be achieved using a less complex method. Therefore, the IRS and Treasury have included a revised deferred sale method referred to as the remedial allocation method in these temporary regulations.

Recommendation: The contribution of built-in gain property could be treated as a deferred sale to the partnership by the contributing (selling) partner for all federal income tax purposes.11 This was proposed in the deferred sale article. There were legitimate complaints of complexity in the initially proposed deferred sale method in the 1992 proposed section 704(c) regulations. However, it appears that those complaints should be substantially reduced or eliminated by the other reforms suggested in this article and by a carefully drafted set of regulations.

As an alternative to the adoption of the deferred sale method, the remedial allocation method in the section 704(c) regulations could be made mandatory for all forward and reverse section 704(c) allocations. The key question here, which also is present in the deferred sale method, is at what point should deferral be accelerated (such as by a subsequent section 351 or 721 contribution or partnership distributions).12

If neither alternative is deemed effective or administrable, the default rule should be the taxation of all built-in gain property upon contribution to the partnership. Built-in losses will also be accelerated (recognized) but will continue to be subject to any loss disallowance or deferral provisions elsewhere in the Internal Revenue Code.

2. Adoption of accounting method.

It has been proposed that the carryover of the method of accounting under section 381 be extended to transfers of property to corporations under section 351, as well as to partnerships under section 721.13 Generally, only acquisitive reorganizations are subject to the rules relating to carryover of accounting method.

On that point, the Joint Committee on Taxation stated in its summary of the proposal:

The proposal would extend the application of the rules of section 381(c)(4) (regarding methods of accounting) to section 351 and section 721 transactions. If the transferee is a new corporation or [new] partnership (one that has not yet adopted its methods of accounting), it would be required to use the methods of accounting that were used by the transferring entity [or person]. An existing corporation or partnership could [also] be required to change its methods of accounting to those of the transferring [person] if the transferring [person’s] method of accounting were considered the integrated business’ principal method of accounting.

The JCT then summarized the pros and cons of the proposal. It first stated that a taxpayer that is otherwise unable to obtain the consent of the Treasury secretary for a change in its method of accounting may seek to circumvent the consent requirement by contributing the assets to a new or inactive corporation or partnership in a tax-free transaction under section 351 or 721.

The JCT stated that it isn’t appropriate to allow taxpayers to circumvent the requirement of obtaining the consent of the IRS commissioner for changes in methods of accounting in this manner. The consent requirement, the JCT stated, would support sound tax administration by permitting the IRS to review the proposed accounting method change to ensure that it is the correct method, that no tax abuse will result from the change, and that the change will be made with the appropriate section 481(a) adjustment so that no items of income escape taxation and no items of expense are deducted twice. It was also noted that the consent requirement enables the IRS to ensure taxpayer compliance with the requirement of clear reflection of income. However, the JCT also noted that the IRS could unreasonably withhold consent in some cases when a business restructuring was entered into by the taxpayer to allow for the accounting method change.

The JCT then described areas in which more uncertainty would be introduced into the law by the proposal. The JCT explanation states:

If a single company contributes assets to a new or inactive corporation in a section 351 [or 721] transaction, it is not difficult to determine which methods of accounting would be required under the proposal. If multiple companies contribute several trades or businesses to a joint venture (whether operated as a partnership or a separate corporation), determining which method of accounting is the principal method of accounting under the section 381 regulations may be very complex. The application of the section 381 regulations may result in determining that there is no principal method of accounting, thus necessitating a determination by the Commissioner of which accounting methods will be used. This would introduce an additional level of uncertainty into the transaction. . . . [T]he present section 381 regulations are primarily designed to address the treatment of tax attributes in the tax-free combination of two or more active trades or businesses. . . . It is not clear how the section 381 regulations would be intended to apply if one party to the transaction contributes assets that do not, in and of themselves, constitute a trade or business. If such assets are considered, their contribution to an active trade or business may force that acquiring company to change its methods of accounting to those of the contributing company.

Recommendation: Methods of accounting can become fact intensive. In many cases, less than fully knowledgeable taxpayers and advisers form corporations or partnerships that may or may not constitute an active trade or business either alone or in combination with other corporate or partnership assets. On the other hand, tax-free formations under sections 351 and 721 can be used to change a method of accounting when no real substantive change in a business operation has occurred.

For those reasons, it is recommended that the statute be amended to authorize the IRS to issue regulations or other appropriate guidance to address the circumstances, if any, that would require a carryover of accounting method.

B. Partnership Debt

Partnerships, unlike S corporations, allow the flow-through of debt incurred at the partnership level as if money were contributed to the partnership.14 As parallel treatment, the decrease in the partners’ shares of partnership debt is treated as if money was distributed from the partnership to the partners.15 This treatment provides aggregate treatment for a partnership and its partners, whereas section 721(a) provides entity treatment of the partnership. Were it otherwise, there would be deemed taxable transfers of partnership property between the partners on the transfer of built-in gain or loss property to a partnership.

Partnership debt is treated as nonrecourse unless it is recourse to a partner, including loans made by a partner or a related party.16 Recourse debt is allocated to the partner bearing the ultimate risk of loss on the debt. Complex rules govern whether debt is truly recourse to a partner.17

The treatment of partnership-level debt as if the partners had incurred the debt for tax basis purposes at the partner level and the ability to cause the disproportionate allocation of that debt among the partners (by causing the debt to be recourse to a particular partner) have created complexity, confusion, and sometimes abuse (witness the law regarding partnership disguised sales under section 707(a)(2)(B)).

To eliminate or reduce complexity and potential abuse, two approaches have been proposed. First, deny partners tax basis in their partnership interests because of the incurrence of partnership (nonrecourse) debt.18 This JCT proposal would generally parallel that of S corporations, whereby debt at the S corporation level doesn’t create tax basis at the shareholder level.

The treatment of partnership-level debt flowing up to the partner level ties into the maintenance of partner book and tax capital accounts because, otherwise, aggregate partnership equity (gross and net) wouldn’t match the book and tax capital interests plus shares of partnership debt of all partners. But if the importance of partner book and tax capital accounts was substantially reduced or eliminated by other reforms of subchapter K as noted in this article, this apparent need for the flow-through of partnership debt would be reduced (or even eliminated) in importance and utility under a reformed subchapter K.

Debt-financed distributions would no longer be tax-free to the partners because of the lack of a basis flow-through of partnership debt, but a special rule could be devised for this purpose if found necessary for the feasibility and fairness of the revised subchapter K system. The principal question is whether allowing that technique, which resembles a partial sale of the secured property, should result in a partial acceleration of the deferred sale at contribution of built-in gain property or otherwise be treated as a disguised sale. Simplicity argues for a result paralleling that of subchapter S.

Second, it has been proposed that, to prevent abuse of the recourse debt allocation rules, all debt be treated as nonrecourse for purposes of subchapter K.19 Regarding that topic, the Rosow article stated:

The underlying difficulty with the allocation of recourse debt . . . is that the rules fail to comport with economic reality. Although there may be cases in which a partner expects to use its separate resources to repay partnership debt, the reality is that in almost all situations the debt is expected to be repaid from partnership activities or assets. That expectation is completely at odds with the methodology of the regulations that looks to the person ultimately bearing responsibility if all is lost. The prudent response is to analyze all partnership debt as “nonrecourse.” That view is consistent with the parties’ expectations-that the partnership’s earnings will generally be the source of repayment of the debt. Treating all partnership debt as nonrecourse will have the consequence of preventing much of the manipulation of partnership items and deferral of gain recognition. However, it will place renewed emphasis on the rules governing nonrecourse debt, which are themselves subject to a measure of arbitrariness. [Footnotes omitted.]

Recommendation: All debt incurred by the partnership should be treated as nonrecourse debt for all federal income tax purposes, including sections 752 and 1001. However, this recommendation depends on the authority to treat corporate debt assumptions under section 357(d) as not being exercised so as to provide new rules on the assumption of both corporate debt and the assumption of debt by other entities, such as partnerships under the authority of section 357(d)(3). Otherwise, the treatment of all partnership debt as nonrecourse would be a significant simplification matter.

Basis flow-through of partnership debt should be eliminated, with a possible exception for specific debt-financed distributions, as noted earlier.

C. Allocations to Partners

Partnership allocations to partners have been a continual struggle on the part of both Congress and the IRS to allow businesses some flexibility to separately allocate income from partnership property differently than the partners’ respective capital interests in that partnership property.20 The tax-driven components of these partnership allocations have been principally policed by the substantial economic effect rules of reg. section 1.704-1(b)(2)(ii) and (iii).

Because this is a highly subjective determination, the IRS has issued little guidance on substantial economic effect after the key regulations that were issued in the mid-to-late 1980s. Further, in the past decade or two, partnership distributions on liquidation haven’t been made based on ending capital accounts; rather, they have been based on a waterfall priority of cash distribution scheme in which the allocations generally follow the cash to be distributed and when the partners’ interests in the partnership rule under reg. section 1.704-1(b)(3) govern the allocation of book and tax items among the partners using “targeted allocations.”

A common perception among partnership practitioners is that the IRS is unable to effectively audit these partnership allocations. If it were otherwise, there clearly would have been any number of litigated cases in the three decades since the regulations were first issued. That hasn’t been the case. In fact, the evidence is to the contrary.

One proposal is to eliminate the ability to allocate partnership items differently than the partners’ respective capital interests in the partnership.21 At this point, partnerships would then resemble how S corporation allocations to its shareholders are handled (on a pro rata per share of stock basis), which would provide additional impetus for a legislative phaseout and elimination of subchapter S.

The special allocations article, the special allocations 2 article, and the Rosow article22 all contain proposals to, essentially, eliminate the ability to use special allocations to the partners and to mandate allocations based on proportionate capital interests.

As formulated in the special allocations article:

Special allocations should be eliminated and partners required to allocate all items according to the relative value of their capital accounts. Some items, such as capital gains and losses, charitable contributions, and tax-exempt income, can be separately stated on a partnership return to preserve their character, but they must be allocated in proportion to the relative balances in [the] partners’ capital accounts. This proposed rule eliminates both special item allocations within a year and eliminates special allocations across years. . . . Shares of income allocated to partners cannot change from one year to another unless there is a change in the relative size of [the partners’] capital accounts. [Footnotes omitted.]

And as formulated in the special allocations 2 article:

This article proposes that the Treasury rationalize partnership allocations by transforming the partner’s interest in the partnership into a penalty default rule that requires a partnership to make all tax allocations based on its partners’ relative capital account balances. The adoption of such rule would force partnerships to identify themselves as either simple partnerships or sophisticated partnerships, thereby separating themselves into two categories. Simple partnerships would consider a ratable allocation methodology reasonable and . . . sophisticated partnerships would find a ratable allocation rule impossibly restrictive . . . electing instead to make their allocations pursuant to a revised substantial economic effect safe harbor. [Footnotes omitted.]

Recommendation: Special allocations shouldn’t be permitted, and section 704(b) should be amended to say so. All allocations should be made based on the proportionate capital interests of the partners in the partnership. An exception to this proportionate capital treatment could be allocations related to preferred interests in the partnership. This is because the preferred interest would be given priority regarding distributions under the partnership agreement and local nontax law. As a corollary rule, all partnership allocations in form to service partners should be treated as the payment of compensation by the partnership to the partners for all federal income tax purposes,23 including for employment tax purposes. Appropriate transition rules should be provided.

D. Terminations and Reorganizations

Clear rules should be provided for when a partnership is treated as actually terminated for federal tax purposes under section 708(b)(1).24 The confusion in the law was created when the technical termination statute was repealed. Section 708(b)(1) provides that a partnership shall be considered as terminated only if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership. It is unclear whether the reference to “its partners” means only one or more partners in the partnership before the putative termination event who remain partners after that event or if it merely refers to two or more partners in the partnership whether before, during, or after the putative termination event. In other words, a reform of the statute needs to clarify whether there is a form of continuity of interest on the part of the historic partners to avoid a partnership termination.25

Recommendation: The statute under section 708(b) should provide explicit rules for when a partnership is treated as actually terminated for federal income tax purposes. Sales by preexisting partners of partnership interests to either preexisting historic partners or new partners should be addressed. It should also explain whether there is or should be a continuity of interest on the part of historic partners, much like the continuity of interest rules in section 368 and the regulations thereunder.

Also, the terms “merger” and “division” should be defined in the statute, and the tax attributes that travel with or survive in the merger or division should be addressed by the statute.26 The IRS and Treasury rejected defining those terms in the final merger and division regulations, stating:

The proposed regulations do not define what constitutes a partnership merger or division. Some commentators have requested that these terms be defined in the final regulations. Other practitioners have stated that the selectivity that would be created by attempting to draw lines in such definitions could lead to planning opportunities that would be adverse to the government’s interest. The IRS and Treasury have decided not to provide comprehensive definitions of what is a partnership merger or division in these final regulations.

The IRS and Treasury shouldn’t refuse to provide needed definitions of terms when the public asks for them, no matter how difficult that process may be. At a minimum, Congress should direct that regulations be issued defining those key terms.27

E. Distribution Gain or Loss to Partners

Subchapter K provides separate gain and loss recognition rules for money distributions and property distributions. Proposed reforms on both forms of distribution are described below.

1. Money distributions.

Under current law, partnership distributions of money result in gain to the partners only if the money distributed exceeds the tax basis of the partner’s entire partnership interest.28 This has allowed disproportionate distributions to partners, whereby a partner is permitted to use his entire outside tax basis in the partnership interest to shelter the money distribution from current tax. This is the case even if the distribution represents a distribution to the partner out of another partner’s share of partnership profits or out of another partner’s share of partnership debt proceeds — or even if the distribution represents a distinct economic component interest of the aggregate partnership interest (that is, a partial liquidation).

Thus, it has been proposed that money distributions to the partners be taxed but only when the distribution isn’t out of the partner’s share of profits or debt.29 Alternatively, it has been proposed that partnership distributions of money (or property) be taxed in all cases as if they were taxable sales between the partnership and the partner.30 Treatment as a partial liquidation has also been proposed.31

As stated in the distributions article:

A system [should be adopted that is] more closely tailored to the two reasons for non-recognition that largely avoids the problems of the current system. It has three components: First, a partner would recognize gain on his investment in the partnership upon distributions exceeding his share of accumulated earnings or debt. Gain on an investment in a partnership would be measured by the difference between a partner’s basis in his interest and his capital account. Second, a distribution of assets would be treated as a taxable disposition by the partnership (except to the extent of the [partner’s] pre-distribution interest in the asset). This would extend the rules in sections 704(c) and 751(b), which treat some distributions as sales, to all distributions that alter interests in distributed assets. Finally, gain or loss on assets provisionally is allocated whenever interests in assets are altered as a result of contributions and distributions. This restates the rules in section 704(c) and the section 704(b) regulations requiring allocations of built-in gain or loss when interests in assets shift, but it eliminates the ceiling rule. [Footnotes omitted.]

This approach has been rejected by other commentators because of its complexity.32

Recommendation: Money distributed in excess of the outside tax basis of the partnership interest of a partner that is attributable to the portion of the interest redeemed should be treated as a taxable sale by the partner to the partnership. In applying this rule, the concept of a partial liquidation should be formally incorporated into subchapter K, so that the portion of the outside tax basis that is used to measure gain recognition correlates with the partner’s remaining economic interest in the partnership.33

2. Property distributions.

Property distributions in-kind to partners have been a vexing problem in subchapter K for several years.34 Because of the general rule of nonrecognition on partnership distributions to partners and the absence of a partial liquidation rule for partnerships, built-in gain belonging to one partner can be easily shifted tax-free onto one or more other partners.35

To address these concerns, as well as the optionality of partnership and partner special basis adjustments under sections 734(b) and 743(b), the literature has set forth two basic proposals.

First, to prevent the shifting of built-in gain among the partners, limited gain recognition has been proposed in order to adjust inside and outside tax basis of the various partners to prevent distortions in inside and outside tax basis that would otherwise be caused by the distribution, and to impose gain or loss recognition on the partners to account for the differences in inside and outside tax basis that can no longer be adjusted because the property has left the partnership.36

Second, the alternative proposal would be to repeal nonrecognition under section 731(a) and tax built-in gain on distributions in-kind by the partnership in all cases.

Recommendation: Partners should be treated as selling or buying the appropriate share of distributed or retained partnership property so that inside and outside tax basis can be adjusted so as to not overtax or undertax any partner. This proposal parallels and mirrors the proposals put forth by Dave Camp in 2014. Basis adjustment rules in subchapter K (for example, sections 734(b) and 743(b)) to the extent that they need to be retained, should be made mandatory in all cases, not mostly elective. Partial liquidations should be expressly adopted by subchapter K and incorporated as part of the basis and gain or loss recognition system. And, as noted earlier, character conversion and character shifting, which is policed under current law by the complex rules of section 751(b) and its regulations, will need to be retained in some form because, otherwise, the correct amount of gain or loss could be recognized, but the partners’ shares of recapture and other “hot” assets could be either converted into capital gain or shifted to other partners.37

F. Other Subchapter K Proposals

There are several other provisions in subchapter K that need further study and reform.

1. Tiered partnerships.

The theme of aggregate versus entity predominates the treatment of tiered partnerships under subchapter K. An article by Gary R. Huffman and Barksdale Hortenstine succinctly summarizes the state of the law:

Each partnership in a tiered partnership structure that meets the statutory, regulatory, and judicial standards for entity recognition should be respected as a separate partnership and should not be “collapsed” and treated as part of one or more other partnerships in the tiered structure. As a general matter, the tax law should no more disregard the existence of tiered partnerships than it should ignore the existence of tiered corporations.38

Recommendation: The treatment of tiered partnerships both within and outside subchapter K can be confusing and counterintuitive, yielding apparently inconsistent conclusions based on the provision at issue. There are many instances in which the law is unclear as to whether a lower-tier partnership should be treated as an aggregate of its partners (including the upper-tier partnership partner) or as a separate entity. For example, the ability to revalue property held by a lower-tier partnership if there is an actual revaluation event at the upper-tier partnership is not clear; although it appears that the entity principle most often applies so that a revaluation adjustment in the lower-tier partnership often cannot be made.39

No uniform rule can be drafted that will govern all cases and situations involving tiered partnerships, but Congress should require by statute that the IRS publish regulations or other applicable guidance addressing tiered partnerships in several settings, and set forth guidelines for making that determination in all other unaddressed cases. Current law merely provides for haphazard IRS guidance on a limited number of issues.

2. Single or separate partnerships.

Over the years, a prevalent issue in the organization of partnerships has been whether multiple partnerships under local nontax law should be treated as a single partnership or as multiple partnerships under federal tax law. A closely related issue is whether two or more entities, usually corporations, that have not formed a state law partnership are to be treated as forming a deemed partnership for purposes of federal tax law.40 This analysis is most often based on the so-called Luna factors.41

Recommendation: Congress should set forth by statute the factors that must be considered in determining whether a deemed partnership has been created for federal tax purposes and set forth the factors for determining whether parallel, brother-sister, and other multiple partnership arrangements are to be treated as separate partnerships for federal tax purposes or as part of one federal tax partnership. In doing so, Congress should clarify by statute whether the check-the-box regulations42 have changed the manner of determining who is a partner for federal tax purposes under the case law and regulations.43

At a minimum, Congress should mandate by statute that the IRS and Treasury provide guidance through regulations in these areas.

3. Revocation of the partnership antiabuse regulation.

I and others have advocated for the revocation of the abuse of partnership rule under reg. section 1.701-2(a) through (d) because the regulation has not been applied by either the IRS or the courts in cases in which the common law antiabuse cases do not otherwise apply.44

Recommendation: Congress should by statute direct the IRS to revoke the partnership antiabuse regulation because the IRS apparently is not able or willing to do so. In its place, Congress should direct the IRS and Treasury to issue regulations interpreting and applying the codified economic substance doctrine at section 7701(o).45

G. Proposals Outside Subchapter K

There are several code provisions that are not part of subchapter K but significantly interact with the treatment of partnerships and partners under subchapter K (or are part of subchapter K but their principal meaning lies outside subchapter K). Listed below are some key provisions that could benefit from a review and reform as part of the simplification and reform of subchapter K.

1. Section 163(j).

Section 163(j) imposes a statutory limitation on the amount of business interest expense that can be deducted by a taxpayer, and section 163(j)(4)(A) contains a rule expressly applicable to partnerships. It states that in the case of any partnership, section 163(j) shall be applied at the partnership level, and any deduction for business interest expense shall be taken into account in determining the non-separately stated taxable income or loss of the partnership.

The legislative history of this provision doesn’t state the reason for this determination being made at the partnership level and not at the partner level with the appropriate limitations applied there. However, the statutory text clearly indicates that it was intended to limit the allowance of business interest expense of a partner to each partnership of which he, she, or it is a member and to not allow the aggregation of separate partnerships for this purpose.46

This statutory partnership-level approach has resulted in great complexity in the regulations that were issued to explain and apply section 163(j)(4).47 Even expert practitioners continue to struggle in understanding and applying these rules.

Recommendation: It would greatly simplify the applicable regulations if section 163(j) were amended to apply that statute at the partner level only under the regular rules of sections 702 and 704. In that event, the statutory limitations would apply at the partner level. This approach would limit the deduction by a partner of business interest expense on a partnership-by-partnership basis. Appropriate antiabuse rules would need to be considered by regulation to address aggregation and segregation of partnerships in cases of abuse.

2. At-risk and passive losses.

The at-risk rules of section 465 haven’t been incorporated into final regulations. The regulations that exist have been in proposed form since the late 1970s. During this time, economic arrangements have changed significantly. Taxpayers shouldn’t be penalized because the IRS and Treasury won’t devote resources toward the finalization of those long-proposed regulations.

Recommendation: Congress should direct by statute the reproposal and finalization of the at-risk regulations. Any necessary statutory cleanup should occur at the same time.

The passive activity loss regulations under section 469 are mostly in temporary form because they were issued before Congress amended section 7805(b) to limit temporary regulations to three years. However, part of the section 469 regulations is in final form. Thus, it is difficult to read, follow, and understand those regulations.

Recommendation: The section 469 regulations must be reproposed and finalized as a uniform whole, and Congress should by statute direct this to happen. Otherwise, the status quo will remain, to the detriment of taxpayers who want to comply but cannot understand what they are supposed to comply with.

3. Aggregate-entity.

As discussed at length in the Huffman and Hortenstine article and elsewhere, the general theme of aggregate-versus-entity is predominant both in and outside subchapter K.48 There is even an “abuse-of-entity” rule in the regulations.

Under current law, the IRS’s standard of analysis of an aggregate-versus-entity issue is implemented by concluding, without any foundation (other than that it will raise revenue), that it is appropriate to treat the partnership as an aggregate (or as an entity, as the case may be). The IRS and Treasury never explain why it is appropriate.

Further, statutes outside subchapter K and their legislative histories frequently don’t describe how partnerships and partners are to be treated under them. This allows the IRS to more freely assert the abuse-of-entity rule under reg. section 1.701-2(e).

Recommendation: Congress should add a separate code section to subchapter K that sets forth the factors that must be considered by both taxpayers and the IRS in applying a provision either within or outside subchapter K to this aggregate-versus-entity analysis. Regulations should describe factors that aid in this determination. The abuse-of-entity rule in reg. section 1.701-2(e) should be revoked, principally because it is one-sided and most likely lacked authority for its issuance.

4. Guaranteed payments.

Guaranteed payments on capital are treated sometimes as interest under the IRC and sometimes as a distributive share of income or as payment of a fee.49 Recently, the IRS and Treasury issued a series of regulations under statutes outside subchapter K that treat guaranteed payments on capital as either interest on indebtedness or equivalent to interest, under either general antiabuse regulations or other standards purporting to look at the substance of the transaction.50

Recommendation: Guaranteed payments are clearly set forth in subchapter K at section 707(c), but treatment under subchapter K and under other code provisions isn’t otherwise clearly set forth in regulations. Congress should correct this omission and provide by statute the factors to be applied in determining how guaranteed payments on capital are classified both under subchapter K and elsewhere in the IRC. At a minimum, Congress should mandate by statute that the IRS and Treasury provide that guidance.

5. Section 1245 and other recapture.

Recapture provisions in the IRC, such as section 1245(b)(3) (and (b)(5)), frequently provide that no recapture shall occur in some enumerated sections of the code, such as sections 721 and 731. Similar treatment is also provided for installment obligations under section 453B.51

Recommendation: The nonrecognition exceptions to recapture, disposition of installment sale obligations, and similar items should be statutorily conformed to the ultimate reforms adopted by Congress and as set forth in this article.

6. Partnership and partner holding periods.

Two sections of the IRC deal with holding periods that relate to partners and partnerships. First, section 735(b) provides that “in determining the period for which a partner has held property received in a distribution from a partnership . . . there shall be included the holding period of the partnership, as determined under section 1223, with respect to such property.” Second, section 1223(1) provides, in pertinent part, that

in determining the period for which the taxpayer has held property received in an exchange, there shall be included the period for which he held the property exchanged if . . . the property has, for the purpose of determining gain or loss from a sale or exchange, the same basis in whole or in part in his hands as the property exchanged, and, in the case of such exchanges the property exchanged at the time of such exchange was a capital asset.

Recommendation: There is a long-standing debate about how those two provisions interact: If the holding period of the partner’s outside tax basis in his partnership interest is longer than the inside holding period of the partnership in the property distributed, what is the holding period of the distributed property in the hands of the partner?

For example, assume that partner A has a $100 tax basis in a partnership interest with a 14-month holding period. The partnership distributes an asset, with a $50 tax basis and six-month holding period, to partner A in full redemption of its partnership interest. Partner A has a $100 tax basis in the distributed asset under section 732(b). Does partner A have a six-month holding period (under section 735(b)) or a 14-month holding period (under section 1223(1))? This should be clarified.52

7. Partnership audits.

The statutes governing partnership audits were substantially changed in 2015 when the 1982 Tax Equity and Fiscal Responsibility Act was replaced with a centralized partnership audit system (starting at section 6221). The payment default rule under the new rules is that tax liability attributable to changes to the partnership return is paid by the partnership (known as an imputed underpayment (IU)) under new section 6225.

The regulations offer several alternatives to this approach, the principal one being an election to push out the IU to the partners (section 6226). The regulations also offer several partner and partnership modifications to the IU, the principal one being the filing of amended income tax returns by the partners affected by the audit adjustment.

The regulations governing these new audit procedures are lengthy and complex, even for the most sophisticated tax advisers and taxpayers.

Recommendation: Congress should direct a study by the IRS and Treasury regarding whether the complexity created by the regulations is justified with the effort and time taxpayers and their advisers must take to comply with them. Consideration should be given to providing that the only option is for the partnership to pay the IU (with no push out or modifications) but adjust the tax rate to approximate what would have been paid had there been modifications or a push out.

III. Conclusion

Statutory partnership tax reform isn’t easy to do. Over the years, the ability of “those in the know” to use the rules of subchapter K to their advantage has been prolific and unchecked. There is a strong lobby across a vast expanse of the economy to keep up a good thing. However, statutory partnership reform shouldn’t triumph over legitimate objections that a proposed reform may cause some adverse nonfederal tax consequences of business transactions. A careful balancing act is therefore required.

Now is the time to seriously start that effort.

FOOTNOTES

1 See, e.g., Tax Analysts and Boston College Law School, “Reforming Entity Taxation” (Oct. 10, 2014). Panel 2 of the conference was on passthrough entity reform. During that panel discussion, professor Karen C. Burke of the University of Florida discussed the problems with partnership taxation under current law, saying that “if you dig down, the problem ends up being the nonrecognition rule,” and adding that section 751 is too limiting. “Whatever the policy justifications are for nonrecognition, I’m not sure that they support a rule as broad as the one we’ve got,” she said regarding nonrecognition under section 731(a), “and that’s what’s led to the complexity and that’s what’s led to the abuse.”

2 Several partnership reform articles are discussed in this article, but there are many more. The genesis of many proposals discussed here were first introduced to the public by the American Law Institute study “Federal Income Tax Project, Subchapter K: Proposals on the Taxation of Partners” (1982, 1984); and Philip F. Postlewaite, Thomas E. Dutton, and Kurt R. Magette, “A Critique of the ALI’s Federal Income Tax Project-Subchapter K: Proposals on the Taxation of Partners,” 75 Geo. L.J. 423 (1986). Representative of this literature but not discussed here are Philip F. Postlewaite, “I Come to Bury Subchapter K, Not to Praise It,” 54 The Tax Lawyer 451 (2001); Karen C. Burke, “Partnership Distributions: Options for Reform,” 3 Fla. Tax Rev. 677 (1998); and George K. Yin, “The Future Taxation of Private Business Firms,” 4 Fla. Tax Rev. 141 (1999).

3 Stuart L. Rosow and Rachel A. Hughes, “Reforming Subchapter K: The Partnership Simplification Act of 20___,” 94 Taxes 361 (2016) (Rosow article).

4 Witness the enactment of the centralized partnership audit rules as part of the Bipartisan Budget Act of 2015 (section 6221 and following), with the intention of increasing the IRS audits of partnerships.

5 For an excellent discussion of many of these issues, see Noel P. Brock, “Audits of Partnerships, TEFRA and Partnership Noncompliance: Where We Are and Where We Are Going,” 93 Taxes 171-201 (Mar. 2015). For a very recent study on the tax gap, see John Guyton et al., National Bureau of Economic Research Working Paper 28542, “Tax Evasion at the Top of the Income Distribution: Theory and Evidence,” Mar. 2021.

6 I have heard indirectly that some managers and directors in the partnership groups of the so-called Big Four accounting firms have been targeted to help fill the void.

9 The regulations allow the traditional method, the traditional method with curative allocations, and the remedial allocation method. Reg. section 1.704-3(b), (c), and (d). There is also an antiabuse rule under reg. section 1.704-3(a)(10), the goal of which is to prevent the adoption of a section 704(c) method and its application to the taxpayer from leading to abuse.

10 For a discussion of this method in detail, see Laura E. Cunningham and Noel B. Cunningham, “Simplifying Subchapter K: The Deferred Sale Method,” 51 S.M.U. L. Rev. 1 (1997) (deferred sale article). It should be noted, however, that this method was tried in prop. reg. section 1.704-3 in the early 1990s but was replaced by the remedial allocation method because of the proposed method’s complexity. See Blake D. Rubin and Seth Green, “The Proposed Regulations on Partnership Allocations With Respect to Contributed Property,” Tax Notes, Apr. 12, 1993, p. 257.

11 The character of the gain — that is, ordinary income versus capital gain — is typically front-loaded when the gain is deferred and taken into account over time, which could be the approach in this case.

12 For additional suggestions along these lines, see Ernst & Young, “Analysis of the Administration’s Partnership Proposals,” Tax Notes, July 5, 1999, p. 103 (EY study paper), part IV.

13 See Joint Committee on Taxation, “Summary of Tax Provisions Contained in the President’s Fiscal Year 2001 Budget Proposal,” JCX-13-00, at 27 (Feb. 7, 2000); JCT, “Description of Revenue Provisions Contained in the President’s Fiscal Year 2001 Budget Proposal,” JCS-2-00, at part II.C.13 (Mar. 6, 2000) (“deny change in method treatment in tax-free transactions”).

16 Reg. section 1.752-1 and -2.

17 See Monte A. Jackel, “A Brief Tour of Recent Changes to the Partnership Liability Regs,” Tax Notes Federal, Nov. 4, 2019, p. 797.

18 See JCT, “Options to Improve Tax Compliance and Reform Tax Expenditures,” JCS-02-05, at 161-168 (Jan. 27, 2005) (reform of minimum gain allocations under reg. section 1.704-2 and exclusion of nonrecourse debt from the outside basis of the partners).

19 See the Rosow article, which discusses this concept extensively.

20 Any attempt to achieve the same result outside the partnership context would almost always run afoul of the assignment of income common law doctrine.

21 See detailed discussions in Mark P. Gergen, “Reforming Subchapter K: Special Allocations,” 46 Tax L. Rev. 1 (1990) (special allocations article); and Andrea Monroe, “Too Big to Fail: The Problem of Partnership Allocations,” 30 Va. Tax Rev. 465 (2011) (special allocations 2 article). The Rosow article also has an extensive discussion of these issues.

22 Supra note 21.

23 This should make section 736 more or less a nullility and result in its effective or actual repeal. There would also need to be rules relating to valuing a non-capital profits interest because current law generally follows a hypothetical liquidation approach to value the profits interest (usually resulting in a zero value), whereas actual fair market value should govern if this proposal is enacted into law.

24 Jennifer Ray and Dina Wiesen, “Partnership Continuations After the Tax Cuts and Jobs Act,” Tax Notes Federal, Aug. 19, 2019, p. 1215.

25 See Rev. Rul. 66-264, 1966-2 C.B. 246; Jackel and Robert N. Crnkovich, “Partnership Conversions: Making Something Out of Nothing,” Tax Notes, July 20, 2009, p. 275; Alan Kennard, “Continuation of a Partnership: Avoiding Adverse Tax Consequences,” Tax Notes, Sept. 15, 2003, p. 1421; and Philip Gall, “Nothing From Something: Partnership Continuations Under Code Sec. 708(a),” 95 Taxes 167 (2017).

26 T.D. 8925, preamble part V.

27 For example, reg. section 1.708-1(c) (merger) and -1(d) (division) don’t indicate whether ownership by pre-merger or pre-division persons references indirect ownership through another entity or whether only direct ownership is taken into account. The regulations reference only the term “own.” Depending on the resolution of this issue, the terms “merger” and “division” can be either very broad or very narrow.

29 Gergen, “Reforming Subchapter K: Contributions and Distributions,” 47 Tax L. Rev. 173 (1991) (the distributions article).

30 Monroe, “Taxing Reality: Rethinking Partnership Distributions,” 47 Loy. L.A. L. Rev. 657 (2013) (the distributions 2 article). Deferred sale treatment on exit of the partner from the partnership isn’t administratively feasible because the property will have left the partnership. Query, is that necessarily true?

31 See discussion of the partial liquidation proposal in the EY study paper.

32 See the deferred sale article.

33 Character conversion and character shifting, which is policed by the complex rules of section 751(b) and its regulations, will need to be retained in some form because, otherwise, the correct amount of gain or loss could be recognized, but the partners’ shares of recapture and other “hot” assets could be either converted into capital gain or shifted to other partners.

34 See William D. Andrews, “Inside Basis Adjustments and Hot Asset Exchanges in Partnership Distributions,” 47 Tax L. Rev. 3 (1991).

35 See, e.g., Howard Abrams, “The Section 734(b) Basis Adjustment Needs Repair,” 57 Tax Law 343 (2004); Abrams, “Partnership Book-Ups,” Tax Notes, Apr. 26, 2010, p. 435; and Abrams, “Partnership Inequalities: The Consequence of Book/Tax Disparities,” 92 Taxes 111 (2014); Burke, “Partnership Inside Basis Adjustments and Remedial Allocations,” Tax Notes, Mar. 19, 2001, p. 1683; Jackel and Shari Fessler, “The Mysterious Case of Partnership Inside Basis Adjustment,” Tax Notes, Oct. 23, 2000, p. 529; and EY study paper.

36 See the 2014 tax reform proposal by then-Rep. Dave Camp (the Tax Reform Act of 2014, H.R. 1). The provision was never introduced as proposed legislation. See also Noel B. Cunningham, “Needed Reform: Tending the Sick Rose,” 47 Tax L. Rev. 77 (1991).

37 With adoption of all or most of the proposals in this article, the rules needed to police character conversions and character shifting should be much simpler than the current morass of complexity. See Jackel and Avery I. Stok, “Blissful Ignorance: Section 751(b) Uncharted Territory,” Tax Notes, Mar. 10, 2003, 1557.

38 Gary R. Huffman and Barksdale Hortenstine, “Tiers in Your Eyes: Peeling Back the Layers on Tiered Partnerships,” 86 Tax Mag. 179 (2008).

40 This concept is sometimes referred to as a contractual alliance. See, e.g., Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, 943 F.3d 49 (1st Cir. 2019) (refusing to deem a partnership between two related and controlled entities); and Jackel, “Sun Capital Could Have Implications Beyond ERISA,” Tax Notes, Apr. 25, 2016, p. 529.

41 Luna v. Commissioner, 42 T.C. 1067 (1964).

42 Reg. section 301.7701-1, -2, and -3.

43 See Jackel, “Entity Recognition and Tax Avoidance Transactions,” Tax Notes Federal, Mar. 8, 2021, p. 1533 (summarizing the state of the law on this issue and clarifications that are needed).

44 See Jackel, Alison L. Chen, and James M. Maynor Jr., “Time to Revoke the Partnership Antiabuse Regulation,” Tax Notes, Jan. 29, 2018, p. 669; and Jackel, Chen, and Maynor, “Proving That the Partnership Antiabuse Reg Has No Place,” Tax Notes, May 14, 2018, p. 1027.

45 With very limited exceptions relating mostly to LB&I and National Office procedures, the IRS and Treasury have adamantly refused to provide that guidance under section 7701(o), essentially rendering it a nullity. They should be directed to provide that guidance.

46 See generally the TCJA.

48 See Jackel, “Summaries of Aggregate and Entity Authorities” (July 25, 2017); Jackel, “Subchapter K Under the TCJA International Regs,” Tax Notes Federal, Oct. 21, 2019, p. 457; and Jonathan S. Brenner and Josiah P. Child, “I’m Looking Through You, You’re Not the Same: Partnership-Held CFCs,” Tax Notes Federal, Oct. 7, 2019, p. 21.

49 The most comprehensive article on this topic is Sheldon I. Banoff, “Guaranteed Payments for the Use of Capital: Schizophrenia in Subchapter K,” 70 Taxes 820 (1992).

50 See Jackel, “Saying Anything That Gets the IRS the Answer It Wants,” Tax Notes Federal, Oct. 5, 2020, p. 117.

51 Reg. section 1.453-9(c); prop. reg. section 1.453B-1(c); REG-109187-11; and Jackel, “The Proposed Installment Sale Disposition Regulations,” Tax Notes, Feb. 2, 2015, p. 641.

52 Rev. Rul. 55-68, 1955-1 C.B. 372, implies that the holding period for outside basis partnership interest should control. However, the ruling was issued under the 1939 code, so it isn’t definitive on this point.

END FOOTNOTES

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