Don’t Ignore Remedial Allocations in Interest Rules, Firm Says

August 5, 2020

David Kautter, Dept of the Treasury
Michael Desmond, Chief Counsel, Internal Revenue Service
Charles Rettig, Commisioner, Internal Revenue Service
Holly Porter, Associate Chief Counsel (PSI), Internal Revenue Service

Dear Messrs. Kautter, Desmond, Rettig and Porter

This letter is written in response to the recent issuance of final and proposed regulations under section 163(j). As noted in the preamble to the final regulations, we have previously commented on the treatment of so called “remedial allocations” under section 704(c) in applying the “11 step approach” used in allocating a partnership's business interest expense, and excess business interest expense amounts among its partners. We have steadfastly maintained that remedial allocations should be taken into account in determining each partner's share of adjusted taxable income (ATI) and other partnership items in the 11 step program that are intended to reflect the partner's share of partnership items. The preamble indicates that remedial allocations are not taken into account in performing this allocation under the final regulations because of potential inequitable results that could occur because of the one-sided nature of remedial allocations relating to depreciation and amortization prior to 2022 (inclusion of remedial income allocations, but not the effect of remedial “deductions”). We believe this explanation overlooks several critical components of the analysis of the appropriateness of taking remedial allocations into account for these purposes.

First, it is important to note that the one-sided nature of remedial allocations associated with depreciation and amortization is only a short term issue, since the statute would clearly apply to both “legs” of a remedial allocation in tax years beginning after December 31, 2021. The regulations, on the other hand, are 'forever”. For that reason, we believe that any issue relating to the government's concerns about the one-sided nature of certain remedial allocations for the next several years should not dictate the treatment of such allocations for the rest of time. Transitional rules are used all the time in regulations  — this would seem to be an appropriate time for such a rule (i.e., if necessary, suspend the application of remedial allocations with respect to depreciation and amortization in performing the 11 step allocation process until 2022).

Second, it should be noted that the one-sided nature of remedial allocations in years prior to 2022 affects only the allocation of business interest expense amounts among the partners of a partnership, not the total amount of business interest expense that is deductible by the partnership. As a result, there would seem to be no governmental interest in preventing partners from being able to take remedial income into account in determining their allocable share of deductible business interest expense even if no one is taking into account the other “leg”' of the allocation. Neither do we believe that there is a compelling reason why the government should not be willing to take both “legs” of the remedial allocation into account for purposes of applying the 11 step approach in allocating a partnership's allowable interest expense amounts. By way of example, consider a fact pattern where a partnership has ATI of 100, which is allocable 50:50 to each of the partners, before taking into account 50 of remedial allocations, which ultimately result in the partnership's income being allocated 100 to one partner and 0 to the other. If the partnership has 30 of business interest expense, all of this interest will be allowable as a current deduction under 163(j). Under the existing 11 step program, the interest expense would be allocated 15 to each partner. However, if the policy objective of the 11 step program is to align the allocation of such interest expense amounts with the allocation of the partnership's taxable income, the “correct” policy result can be achieved only by taking both legs of the remedial allocation into account for these purposes. Under that approach, the allowable business interest expense amount would be allocated 30:0, to more closely align the allocation to the manner in which the partnership's taxable income is allocated among the partners. We do not believe that anything in the statutory language of 163(j) would prevent the use of depreciation and amortization expense amounts prior to 2022 for these limited purposes, particularly considering that the statute is silent on the allocation of a partnership's allowable business interest expense amounts, making the 11 step program a pure creature of the regulatory process.

Third, we note that remedial allocations come in two flavors — allocations relating to depreciation and amortization and allocations relating to gains and losses upon the disposition of contributed or revalued property. Whatever construction of the statutory language of 163(j) that would lead to the conclusion that remedial allocations of depreciation and amortization cannot be taken into account for any purpose until after 2021 would seem to be wholly inapplicable to remedial allocations of gains and losses upon the disposition of 704(c) property. For example, assume property with 0 basis and 100 value is contributed to a 50:50 partnership, and is subsequently sold for 80. In that situation, if the partnership uses the remedial allocation method, the 80 of partnership level gain would be allocated so that 90 of gain would be allocated to the contributing partner and a 10 loss would be allocated to the other partner. Assume the partnership had 20 of other income, which was allocated 50:50, and 30 of business interest expense. Under the 11 step program, the 10 remedial allocation would be ignored, so that the 30 of business interest expense would be allocated according to the ratio in which the partnership's income would have been allocated without regard to the remedial allocations (i.e. 90:10), so that the deductible interest would be allocated 27:3. However, after taking the remedial allocations into account, the partnership's income is actually allocated 100% to the contributing partner. Thus, the equitable approach would be to allocate all of the deductible interest expense to the contributing partner, so that the deduction would be allocated 30:0.

Finally, we note that the remedial allocation method is not just a good idea, in some situations, it's the law, at least if a partnership applies the gain deferral method in connection with certain contributions of property to a partnership under Reg. Sec. 1.721(c). Given the effectively mandatory application of the remedial allocation method to a broad swath of the partnership community, we believe that it is essential for the regulations to “get this one right”, and not prevent partners in affected partnerships from achieving rational and equitable results. We believe this issue is particularly relevant in the current unprecedented global economic crisis (we're still in the middle of a global pandemic, dammit)., As properties continue to shed value, there is an ever increasing likelihood that properties with built-in gain at the time of contribution will be subsequently sold at a “book” loss, resulting in the need to perform remedial allocations of gains/ losses upon the disposition of contributed property in order to match the tax allocation of such amounts to the allocation of the corresponding economic items.

Based on the foregoing, we strongly recommend that the regulations be modified, perhaps by “re-proposing” the proposed regulations that accompanied the recent release of the 163(j) final regulations, to include the effect of remedial allocations on the allocation of a partnership's taxable income in the application of the 11 step program. In the event this is considered to be too bold of a move in light of statutory constraints on the treatment of depreciation and amortization expense prior to 2022, we recommend that the regulations be modified to take remedial allocations of gain/loss into account immediately, and remedial allocations of depreciation and amortization into account only after 2021.

In making this recommendation, we are mindful of the potential challenges that publicly traded partnerships would encounter in applying the recommended approach and/ or maintaining the fungibility of their units. We are also mindful, however, of the fact that the current regulations, which treat remedial allocations as “partner items”, already create fungibility issues, since such remedial allocations can impact the amount of business interest expense from unrelated activities of a partner that may be deducted under 163(j)). Nonetheless, we suggest that special rules apply to publicly traded partnerships, Specifically, we recommend that something like the following language be used to extend the application of this approach to PTPs: To the extent it can prove to the satisfaction of the Commissioner that the inclusion of remedial allocations in the determination of its partners' shares of ATI will impact the fungibility of its units, a PTP will be permitted to exclude the amount of such remedial allocations from such determinations.

Sincerely,

Glenn E. Dance
Holthouse Carlin Van Trigt LLP
Orange County CA