The government stepped back from treating partnership guaranteed payments for capital as interest payments in recently released final regulations.
The final rules (T.D. 9905), released July 28, don’t explicitly treat guaranteed payments for the use of capital as interest in the final section 163(j) business interest limitation regulations, but the antiavoidance rules contain an example of how those payments could still be swept in as interest.
The Tax Cuts and Jobs Act limited the business interest expense deduction under section 163(j) to the sum of business interest income, 30 percent of adjusted taxable income, and floor plan financing interest. Under section 163(j), ATI is computed without regard to nonbusiness income, gain, deduction, or loss; business interest or income; a net operating loss deduction; and the section 199A qualified business income deduction.
The statute provides a more lenient measure for tax years 2018 through 2021 by allowing companies to add back depreciation, amortization, and depletion in determining ATI.
In proposed regulations (REG-107911-18) released the same day, the government also addressed several outstanding issues relating to partnerships and partners. The earlier proposed guidance on section 163(j) didn’t have rules that expanded on the application of reg. section 1.163-8T to passthrough entities. That was further complicated by the fact that Congress applied the interest limits at the entity level for partnerships.
The government responded to concerns by providing guidance specifically tailored to passthrough entities on the topic. For debt-financed distributions, reg. section 1.163-14 provides that when debt proceeds are allocated under reg. section 1.163-8T to distributions to an owner, the debt proceeds and their associated interest expense will be allocated under special rules.
The government proposed adopting the tracing approach in Notice 89-95, 1989-2 C.B. 417, with a few changes.
“First, instead of providing that passthrough entities may use the optional allocation rule, proposed section 1.163-14(d) would generally provide that passthrough entities are required to apply a rule that is similar to the optional allocation rule,” the government said. “Second, instead of providing that the passthrough entity may allocate excess interest expense using any reasonable method, proposed section 1.163-14(d) would generally provide that the passthrough entity must allocate excess interest expense based on the adjusted tax basis of the passthrough entity’s assets.”
Tiered Partnership Insight
The proposed rules also addressed the treatment of section 163(j) in tiered partnerships. The government had asked for feedback on whether, in a tiered partnership structure, excess business interest expense (EBIE) should be allocated through the upper-tier partnership to the ultimate partners. The government also asked for feedback on how and when basis adjustments should apply when a lower-tier partnership has business interest expense limited under section 163(j).
After reviewing comments, the government opted for an entity-level approach for tiered partnerships.
“Accordingly, proposed section 1.163(j)-6(j)(3) would provide that if lower-tier partnership allocates excess business interest expense to upper-tier partnership, then upper-tier partnership reduces its basis in lower-tier partnership pursuant to section 1.163(j)-6(h)(2),” the government said. “Upper-tier partnership partners do not, however, reduce the bases of their upper-tier partnership interests pursuant to section 1.163(j)-6(h)(2) until upper-tier partnership treats such excess business interest expense as business interest expense paid or accrued pursuant to section 1.163(j)-6(g).”
Some practitioners said using an entity approach would result in disparities between an upper-tier partnership’s basis in its assets and the aggregate basis of the upper-tier partners’ interests in the business. The government disagreed, saying EBIE is neither a deduction item nor a section 705(a)(2)(B) expense.
“If an allocation of EBIE from lower-tier partnership results in a reduction of the upper-tier partnership’s basis in its lower-tier partnership interest, there is not a net reduction in the tax attributes of the upper-tier partnership,” the government said. “Rather, in such an event, upper-tier partnership merely exchanges one tax attribute (tax basis in its lower-tier partnership interest) for a different tax attribute (EBIE, which, in a subsequent year, could result in either a deduction or a basis adjustment).”
CARES Act Changes
The proposed rules also shed light on how the recent changes to section 163(j) will work for partnerships.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) modified the net business interest deduction limit from 30 percent of ATI to 50 percent for tax years beginning in 2019 or 2020. For tax years beginning in 2020, businesses may elect to compute the interest expense limitation based on their 2019 ATI, which will likely be higher because of the economic downturn.
This means that if a taxpayer has ATI of $100 in 2019 and $50 in 2020, the net interest deduction limitation would be $50 for both years.
But the section 163(j) changes are more complex for partnerships.
Under the CARES Act, partnership business interest deductions are still limited to 30 percent of ATI for 2019. However, if a partner gets suspended excess interest expense allocated to them in 2019, 50 percent of that suspended interest is treated as freed up in 2020.
The other 50 percent of that suspended interest carryover in 2020 is still limited, meaning it’s deductible only when the partner gets an allocation of excess taxable income or excess business interest income.
The proposed rules provide guidance on how these changes will work, and the government asks in them for comment on whether more guidance is necessary.