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News Analysis: The TCJA and Partnerships

Posted on Dec. 17, 2018

While the Tax Cuts and Jobs Act makes only a few revisions directly to subchapter K, it introduces many rules uniquely applicable to partnerships. Guidance in TCJA-related notices and proposed regulations clarifies how partnerships should apply these new provisions. The interest deduction limitation, gain on sales of partnership interests, and international provisions are just a few of the new TCJA rules that require special attention from partnerships.

Section 163(j) Interest Deduction Limit

Section 163(j) of the TCJA (P.L. 115-97) limits the deduction of business interest expense to 30 percent of adjusted taxable income (ATI) plus business interest income plus floor plan financing interest.

For tax years after 2017 but before 2022, ATI is 30 percent of earnings before income tax, depreciation, and amortization. Starting in 2022, ATI is 30 percent of a smaller and less favorable amount — earnings before income tax.

Section 163(j)(4) has special rules for partnerships that apply the interest deduction limit at the partnership level. In other words, interest expense not limited at the partnership level is not re-tested at the partner level. Further guidance on section 163(j)(4) is contained in Notice 2018-28, 2018-16 IRB 492, and proposed regulations (REG-106089-18). Section 1.163(j)-6 specifically applies to partnerships and S corporations, and reserves sections for tiered structures and mergers or divisions. Specific guidance is provided on the intersection of section 163(j) and sections 734, 743, 465, and 469 with respect to partnerships. Section 1.163(j)-6(f)(2) contains an 11-step process used to allocate income and deductions between partnerships and partners for purposes of section 163(j), and section 1.163(j)-6(o) has 17 examples that illustrate the process.

A partner’s future recovery of suspended excess partnership interest expense is deductible only to the extent allocated to excess taxable income from that same partnership in a later year. Excess taxable income not reduced by interest expense in one year does not carry over to future years and isn’t used unless a partner has current interest expense or excess business interest expense.

Because the owner’s ATI is determined without regard to its distributive share of the entity’s items of income, gain, deduction, or loss, the TCJA prevents both partners and S corporation shareholders from double-counting the entity’s ATI when determining the owner’s interest deduction limitation.

Page 388 of the House’s TCJA conference report explains the double counting prevention with Example 1, in which a corporate partner’s ATI is computed without regard to its distributive share of a partnership’s non-separately stated income, which has already taken into account the interest deduction’s limit of 30 percent of the partnership’s ATI.

The TCJA also allows both a partner and an S corporation shareholder to use the entity’s excess taxable income in computing the owner’s business interest deduction limitation. Section 163(j)(4)(C) defines a partner’s excess taxable income as the amount that bears the same ratio to the entity’s ATI as the excess of 30 percent of the entity’s ATI over the amount by which the entity’s business interest expense exceeds the entity’s interest income bears to 30 percent of the entity’s ATI. That excess ATI is allocated in the same way as non-separately stated income and loss.

Example 2 in the conference report explains this rule with a partnership having interest expense that is $20 lower than 30 percent of its ATI. The entity’s excess ATI is the $20, and the 50 percent partner’s distributive share is $10.

Special carryforward rules in section 163(j)(4)(B) apply only to partnerships, not S corporation shareholders. Excess business interest of a partnership is not treated as paid or accrued by the partnership in future tax years. Instead it is allocated to each partner in the same manner as the non-separately stated taxable income or loss of the partnership and is treated as interest paid or accrued by the partner in the next tax year in which the partner is allocated excess taxable income from the partnership — and only to the extent of such excess taxable income. Remaining interest can be carried forward and deducted subject to this limitation.

Moreover, under section 163(j)(4)(B)(iii), a partner’s adjusted basis in its partnership interest is reduced (but not below zero) by the amount of excess business interest allocated to the partner. If a partner disposes of the partnership interest, including in a nonrecognition transaction, the partner’s basis in the partnership interest is increased immediately before the disposition by the excess of: (i) the amount basis was reduced over (ii) the amount of excess business interest allocated to the partner and treated as paid or accrued in a succeeding tax year.

Section 199A 20 Percent Deduction

Section 199A provides a deduction for individuals equal to 20 percent of qualified business income (QBI), which effectively reduces the 37 percent highest marginal individual income tax rate to 29.6 percent if no limitations apply.

A section 199A deduction is not available for many businesses typically held by partnerships:

  • health;

  • law;

  • accounting;

  • actuarial science;

  • consulting;

  • financial and brokerage services;

  • investment management;

  • trading or dealing in securities, partnership interests, or commodities; or

  • any business where the principal asset is the reputation or skill of employees or owners.

The 199A deduction is available for engineering and architecture businesses.

The 199A deduction has limitations tied to Form W-2 wages and the unadjusted bases of qualified property used in the business, which are computed at the partner level. The definition of “W-2 wages” may provide different results for taxpayers that operate a business in an S corporation than for taxpayers that operate as a partnership or sole proprietorship.

Section 199A(f) and proposed regs (REG-107892-18) (specifically section 1.199A-3), contain guidance on the application of section 199A to partnerships, including the effects of sections 751 income, 704(d) losses, and 707 payments on the calculation. Also, section 1.199A-2(c) provides guidance on basis adjustments under sections 734 and 743.

QBI does not include any guaranteed payment described in section 707(c) paid to a partner for services rendered, or section 707(a) payments for services rendered. In other words, QBI does not include service-related income paid to a partner by a partnership, or a payment by a partnership to a partner as compensation or in exchange for services regardless of whether the payment is characterized as a guaranteed payment or as made to a partner acting outside his partner capacity.

Qualified publicly traded partnership (PTP) income is not within the definition of QBI but is separately eligible for the deduction. The definition of “qualified PTP income” in section 199A(e)(5) includes gain on the sale of an interest in a PTP to the extent gain is ordinary income under section 751.

Sections 864(c)(8) ECI and 1446(f) Withholding

The TCJA added two new code sections for taxing gains from the sale of partnership interests. Revenue Ruling 91-32, 1991-20 IRB 20, held that effectively connected income includes gain recognized by a foreign person on its redemption of an interest in a partnership that was engaged in a U.S. trade or business. The Tax Court declined to follow this ruling in Grecian Magnesite Mining v. Comm’r, 149 T.C. 3 (2017), holding that the income was not ECI. The TCJA adopted the IRS view and codified Rev. Rul. 91-32 in section 864(c)(8). (Prior analysis: Tax Notes Int’l, Nov. 12, 2018, p. 759.)

The new look-through rule is similar to the one in section 897(g), part of the 1980 Foreign Investment in Real Property Tax Act that sources gain on the sale of a partnership interest as U.S.-sourced to the extent consideration is attributable to U.S. real property interests held directly or indirectly by the partnership.

The gain or loss from the hypothetical asset sale by the partnership is allocated to interests in the partnership in the same manner as non-separately stated items of income or loss. The amount of gain or loss treated as effectively connected income is reduced by any amount covered by FIRPTA.

Section 1446(f) also requires the transferee of a partnership interest to withhold 10 percent of the amount realized on a sale or exchange of the interest unless the transferor certifies that it is not a foreign person and provides a U.S. taxpayer identification number. If the transferee fails to withhold the correct amount, the TCJA requires the partnership to deduct and withhold the tax, plus interest from distributions to the transferee partner. This makes the partnership responsible for determining whether there was sufficient withholding and the amount realized. (Prior analysis: Tax Notes Int’l, Aug. 27, 2018, p. 888.) Section 1446(f)(6) grants broad regulatory authority to interpret the provisions, including with respect to nonrecognition exchanges.

IRS Notice 2018-8, 2018-4 IRB 352, suspended section 1446(f) withholding only for PTP interests pending release of regulations, but it provided additional guidance and described expected regulations, which are described more fully in IRS Notice 2018-29, 2018-16, IRB 495.

If the amount realized is unknown or gain exceeds cash or property transferred, the withholding amount is limited to the total amount of cash or property transferred. No withholding is required where the partnership’s effectively connected gain would be less than 25 percent of the total gain recognized in a deemed sale of all partnership assets.

Partnerships often have different sharing ratios for operating income and gains from the sale of assets. For these taxpayers, using the ratio of non-separately stated income to determine the amount of gain or loss on the sale of a partnership interest that is ECI could yield results that are different from ECI allocated to the partner from an actual sale of assets by the partnership as set forth in the partnership agreement. Proposed regulations interpreting section 864 are under review by the Office of Information and Regulatory Affairs (OIRA).

Sections 461(l) and 168(k) Deductions

The TCJA expands loss limitations for noncorporate taxpayers. Under new section 461(l), any “excess business loss” is disallowed. Excess business loss is defined as an overall loss above $500,000 for married joint filers and $250,000 for individuals. Any loss exceeding the threshold is treated as an NOL and carried forward to future years under section 172 subject to the new TCJA limits on NOL deductions; that is, they are limited for tax years beginning in 2018 to 80 percent of taxable income, with no carryback and indefinite carryforward. According to section 461(l)(4), the provision applies at the partner level and applies after application of the section 469 passive loss rules.

Section 168(k) addresses full expensing of tangible asset purchases. Additional guidance in proposed regulations (REG-104397-18) addresses the application of the new rules to partnerships. Specifically, section 1.168(k)-2(b) addresses depreciation as applied to remedial allocations and basis recovery and adjustments under sections 704, 732, 734, and 743. Section 1.168(k)-1 addresses contributions to partnerships under section 721. Section 1.168(k)-2(f)(1) addresses technical terminations of partnerships before 2018.

Subchapter K: Sections 704, 708, and 743

Section 708(b)(1)(B) was amended so that technical terminations solely for ownership changes no longer exist after 2017. The repeal can be favorable or unfavorable, depending on the circumstances. Taxpayers will no longer have to file two short-period tax returns for a partnership, but there could be a question on who is responsible for filing the partnership tax return when there is a significant change in ownership. Partnerships may no longer adopt a new section 704(c) method but may also no longer adjust their assets under section 168(i)(7), possibly reducing depreciation deductions. Technical terminations may still be relevant, however, for state tax purposes.

Section 743(d) expands the definition of a substantial built-in loss requiring a mandatory basis adjustment. Under prior law, a partnership with a substantial built-in loss had to decrease the adjusted basis of  partnership property with respect to a transferee by the excess of the transferee partner’s proportionate share of the adjusted basis of the partnership property over the basis of its interest in the partnership under section 743(b). To determine whether there was a substantial built-in loss at the partnership level, one compared the partnership’s adjusted basis in property to its FMV. If the adjusted basis of the property exceeded the FMV by more than $250,000, then there was a substantial built-in loss and the section 743(b) adjustment reduced the basis of the partnership assets with respect to the transferee. The rule prevents the duplication of losses once by the transferor partner on the sale of the partnership interest and again by the transferee partner on the sale of partnership property.

Section 743(b) adds that a substantial built-in loss exists if the transferee would be allocated a net loss above $250,000 on a hypothetical sale of all partnership assets in a fully taxable transaction for a cash price equal to the assets’ FMVs immediately after the transfer of the partnership interest. This new rule focuses on a partner-level determination to ensure that losses aren’t duplicated. The expanded definition transfers a loss in excess of $250,000 to the transferee. Therefore, if the partnership has an overall gain on the sale of its assets, but a transferee would be allocated more than $250,000 in losses, because of its share of gain or loss with respect to particular assets, a section 743(b) adjustment is required.

Finally, in determining outside basis loss limitations, section 704(d) was amended to require that partners take into account charitable contributions and section 901 foreign taxes.

Proposed Section 861 FTC Regulations

The new foreign tax credit regulations under section 1.861-9(e)(8) (REG-105600-18) contain computational and grouping rules relating to the calculation of deemed paid taxes under section 960(a)(b) and (d) and special rules regarding the application of those provisions when a U.S. corporation owns a controlled foreign corporation though a U.S. partnership.

These new FTC regulations eliminate a planning strategy called the “partnership multiplier,” in which a U.S. parent company makes a loan to a foreign related partnership and the income from the loan is foreign-source interest income. The partnership’s interest expense would only be partially allocable to the foreign source income for purposes of calculating the section 904 limitation. (Prior coverage: Tax Notes Int’l, Dec. 3, 2018, p. 1026.)

BEAT, GILTI, and FDII

The base erosion and antiavoidance tax generally only applies to C corporations. Individuals, partnerships, and certain corporations that are taxed on a flow-through basis (regulated investment companies, real estate investment trusts, and S corporations) are not subject to the BEAT.

Although the gross receipts test may not literally include the gross receipts of U.S. or foreign partnerships, U.S. corporate partners may take into account gross receipts earned through partnerships, and foreign corporate partners may include their shares of a partnership’s U.S. ECI.

Determining whether payments are being made to a U.S. or foreign person may be more complex when dealing with U.S. partnerships owned by foreign persons and foreign partnerships owned by U.S. persons. Payments made to a foreign partnership with U.S. partners may be treated differently than payments made to a U.S. partnership with foreign partners. BEAT consequences could be assessed at the partner level considering partnership-level facts — for example, determining whether a payment is eligible for the service cost method. Guaranteed payments to a foreign partner may be subject to BEAT. Answers to some of these questions are in proposed regulations released by the IRS on December 13 (REG 104259-18). The regulations generally use an aggregate approach for applying the gross receipts test and other rules and exceptions, with the related party determination done at the partner level. These rules in section 1.59A-7 prevent taxpayers from avoiding the BEAT by making payments to a U.S. partnership with foreign partners, or payments to foreign partnerships owned by U.S. corporations. The regs contain an exception for partners owning small interests, as well as guidance on the intersection between the BEAT and the section 163(j) interest limitation.

Proposed regulations providing guidance on global intangible low-taxed income contain provisions specifically applicable to partnerships (REG-104390-18). For domestic partnerships, the GILTI proposed rules take a hybrid approach in section 1.951A-5, so that taxpayers cannot avoid GILTI by using a partnership. (Prior analysis: Tax Notes Int’l, Sept. 24, 2018, p. 1299.)

If a partner owns enough of a CFC to be a U.S. shareholder in its own right, then the partnership is treated as an aggregate (like a foreign partnership). If the U.S. partnership is a U.S. shareholder, but the partners all own too little to be U.S. shareholders by themselves, the partnership is treated as an entity and its GILTI is allocated to its partners according to their distributive shares. (Prior analysis: Tax Notes Int’l, Sept. 24, 2018, p. 1368.)

The proposed regs also clarify the rules governing specified tangible property held through a partnership, specifically section 951A(d)(3)’s ambiguous “distributive share of the aggregate of the partnership’s adjusted basis” language. The term “distributive share” is used in subchapter K with respect to income, gain, loss, and credits of a partnership, but not asset bases. A partner of a partnership has a basis in its partnership interest (outside basis), while the partnership has a basis in its assets (inside basis). The proposed regulations therefore use the term “share” (rather than “distributive share”) when referring to the amount of the inside basis of a partnership asset that a CFC partner may include in its qualified business asset investment.

Finally, the proposed GILTI regs address partnership blocker structures. Notice 2010-41, 2010-22 IRB 715, contemplated regulations that would treat a domestic partnership as a foreign partnership for purposes of identifying the U.S. shareholder of a CFC required to report subpart F income. The proposed regulations apply the same rules to identify the U.S. shareholder of a CFC for purposes of section 951A. They treat certain controlled domestic partnerships as foreign partnerships for purposes of identifying a U.S. shareholder for sections 951 through 964.

Foreign-derived intangible income treatment is not available for S corporations, real estate investment trusts, partnerships, limited liability companies, and individuals.

Section 267A Hybrid Rule

This rule disallows a deduction for any disqualified related-party amount paid or accrued pursuant to a hybrid transaction or by or to a hybrid entity. Treasury is expected to issue regulations that apply the provision to branches and domestic entities even if they don’t meet the statutory definition of a hybrid entity. For example, interest or royalty payments to a foreign parent by a U.S. LLC that has elected corporate status could be affected if the parent does not have an income inclusion because the U.S. LLC is treated as a disregarded entity under the foreign parent country’s tax laws. Proposed section 267A regulations are under OIRA review.

Section 1061 Carried Interest

To qualify for favorable long-term capital gain rates on income from carried interest, new section 1061 requires the taxpayer to hold the partnership interest, and the partnership to hold the income-generating asset, for more than three years.

Section 1031 Like-Kind Exchanges

Under the TCJA, the like-kind exchange rules under section 1031 apply only to exchanges of real property. An interest in a partnership that has made a valid election under section 761(a) to be excluded from subchapter K may continue to be treated as an interest in the assets of the partnership and not as an interest in a partnership.

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