IRS: FINAL REGS ISSUED ON PARTNERSHIP VARYING INTERESTS RULE

FINAL REGS ISSUED ON PARTNERSHIP VARYING INTERESTS RULE

T.D. 9728, 07/31/2015, Reg. § 1.706-1, Reg. § 1.706-4, Reg. § 1.706-5

IRS has issued final regs on the determination of a partner’s distributive share of partnership items of income, gain, loss, deduction, and credit when a partner’s interest varies during a partnership tax year. The final regs also modify the existing regs on the required tax year of a partnership.

For proposed regs issued contemporaneously with the final regs on the interaction of the allocable cash basis item rules and the tiered partnership rules with the rules for determining a partner’s distributive share when a partner’s interest varies, see ¶ 33.

Background on partners’ distributive shares. A partner separately takes into account his distributive share of partnership items of income, gain, loss, deduction, or credit. (Code Sec. 702(a)) Each partner reports his distributive share of the partnership income, deductions and other items (including guaranteed salary and interest payments) for a partnership tax year on his return for his tax year within or with which the partnership tax year ends. (Code Sec. 706(a))

Under Code Sec. 706(d), subject to exceptions, if there is a change in a partner’s interest in the partnership during the partnership’s tax year, each partner’s distributive share of any partnership item of income, gain, loss, deduction or credit for such tax year is determined by using any method prescribed by regs which takes into account the varying interests of the partners in the partnership during the year (varying interests rule). Code Sec. 706(d) was added by the Deficit Reduction Act of ’84 (P.L. 98-369) to clarify that the varying interests rule applies to the disposition of a partner’s entire interest in the partnership as well as the disposition of less than a partner’s entire interest, and to authorize IRS to prescribe methods for determining a partner’s distributive share of partnership items when there is a change in the partners’ interests during the partnership’s tax year. The existing regs have not been revised to reflect these ’84 Act changes.

Under a change made by the Taxpayer Relief Act of ’97 (P.L. 105-34), the tax year of the partnership closes with respect to a partner whose entire interest in the partnership terminates by reason of death. (Code Sec. 706(c)(2)(A)) However, the existing regs do not reflect this ’97 Act change.

In 2009, IRS issued proposed regs for determining partners’ distributive shares of partnership items in any year in which there is a change in a partner’s interest in the partnership, whether by reason of a disposition of the partner’s entire interest or less than the partner’s entire interest, or by reason of a reduction of a partner’s interest due to the entry of a new partner or partners (the 2009 proposed regs, see Weekly Alert ¶ 19 04/16/2009).

Final regs. The final regs finalize the varying interest rules contained in the 2009 proposed regs and include modifications to the proposed regs. Reg. § 1.706-4 provides rules for determining the partners’ distributive shares of partnership items when a partner’s interest in a partnership varies during the tax year as a result of the disposition of a partial or entire interest in a partnership (as described in Reg. § 1.706-1(c)(2) and Reg. § 1.706-1(c)(3)), or with respect to a partner whose interest in a partnership is reduced (as described in Reg. § 1.706-1(c)(3)), including by the entry of a new partner (collectively, a “variation”). The final regs further provide that, in all cases, all partnership items for each tax year must be allocated among the partners, and no items may be duplicated, regardless of the particular provision of Code Sec. 706 which applies, and regardless of the method or convention adopted by the partnership.

The final regs contains two exceptions for allocations that would otherwise be subject to the rules of Reg. § 1.706-4: one exception applies to certain partnerships with contemporaneous partners, and the other exception applies to certain service partnerships. The final regs expand the scope of the former exception as provided in the 2009 proposed regs to include allocations of items attributable solely to a particular segment (see below) of a partnership’s year among partners who are partners of the partnership for that entire segment. Under the contemporaneous partners exception, the general rule with respect to the varying interests of a partner won’t preclude changes in the allocations of the distributive share of items among contemporaneous partners for the entire partnership tax year (or among contemporaneous partners for a segment if the item is entirely attributable to a segment), if: (1) any variation in a partner’s interest isn’t attributable to a contribution of money or property by a partner to the partnership or a distribution of money or property by the partnership to a partner; and (2) the allocations resulting from the modification satisfy Code Sec. 704(b) and its regs. (Reg. § 1.706-4(b)(1))

The final regs apply the service partnership safe harbor exception to any partnership (rather than to service partnership as narrowly defined in the 2009 regs) for which capital isn’t a material income-producing factor. For any tax year in which there is a change in any partner’s interest in a partnership for which capital isn’t a material income-producing factor, the partnership and such partner may choose to determine the partner’s distributive share of partnership income, gain, loss, deduction, and credit using any reasonable method to account for the varying interests of the partners in the partnership during the tax year provided that the allocations satisfy Code Sec. 704(b). (Reg. § 1.706-4(b)(2))

Interim closing and proration. Under the final regs, a partnership takes into account any variation in the partners’ interests in the partnership during the tax year in determining the distributive share of partnership items under Code Sec. 702(a) by using either the interim closing method or the proration method. The regs allow a partnership to use different methods for different variations within the partnership’s tax year. However, the regs provide that IRS may place restrictions on the ability of a partnership to use different methods during the same tax year in guidance published in the Internal Revenue Bulletin. (Reg. § 1.706-4(a)(3)(iii))

A partnership may, by agreement of the partners, perform regular interim closings of its books on a monthly or semi-monthly basis, regardless of whether any variation occurs. The final regs require a partnership using the interim closing method with respect to a variation to perform the interim closing at the time the variation is deemed to occur, and do not require a partnership to perform an interim closing of its books except at the time of any variation for which the partnership uses the interim closing method.

Any partnership using the interim closing method (but not partnerships using the proration method) may use a monthly convention to account for partners’ varying interests. Under the monthly convention, in the case of a variation occurring on the first through the 15th day of a calendar month, the variation is deemed to occur at the end of the last day of the immediately preceding calendar month. And in the case of a variation occurring on the 16th through the last day of a calendar month, the variation is deemed to occur at the end of the last day of that calendar month. The final regs provide that the selection of the convention must be made by agreement of the partners. In the absence of an agreement to use a convention, the partnership will be deemed to have chosen the calendar day convention.

Partnerships using the proration method must use a calendar day convention. Partnerships using the interim closing method have the option of using a semi-monthly or monthly convention in addition to the calendar day convention.

Because the final regs allow partnerships to use both the proration and interim closing methods during a tax year, the final regs provide that the partnership and all of its partners must use the same convention for all variations for which the partnership chooses to use the interim closing method.

The final regs provide that all variations within a tax year are deemed to occur no earlier than the first day of the partnership’s tax year, and no later than the close of the final day of the partnership’s tax year. Thus, under the semi-monthly or monthly convention, a variation occurring on January 1st through January 15th for a calendar year partnership will be deemed to occur at the beginning of the day on January 1. The conventions aren’t applicable to a sale or exchange of an interest in the partnership that causes a termination of the partnership under Code Sec. 708(b)(1)(B); instead, such a sale or exchange will be considered to occur when it actually occurred.

The final regs provide that in the case of a partner who becomes a partner during the partnership’s tax year as a result of a variation, and ceases to be a partner as a result of another variation, and under the application of the partnership’s conventions both such variations would be deemed to occur at the same time, the variations with respect to that partner’s interest will instead be treated as occurring when they actually occurred. Thus, in such a case, the partnership must treat the partner as a partner for the entire portion of its tax year during which the partner actually owned an interest. (Reg. § 1.706-4(c)(2)(ii))

Extraordinary items. The final regs, as the 2009 proposed regs did, provide special rules for the allocation of extraordinary items listed in Reg. § 1.706-4(e)(2) (e.g., items from the disposition or abandonment of certain items, from assets disposed of in an applicable asset disposition, from an accounting method change initiated after a variation occurs, etc.). The final regs provide that the extraordinary item rules apply to partnerships using the interim closing method. Thus, the final regs require the allocation of extraordinary items as an exception to (1) the proration method, which would otherwise ratably allocate the extraordinary items across the segment, and (2) the conventions, which might otherwise inappropriately shift extraordinary items between a transferor and transferee. Extraordinary items continue to be subject to any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership tax year (for example, the limitation for Code Sec. 179 expenses).

Under the final regs, extraordinary items must generally be allocated based on the date and time on which the extraordinary items arise, without regard to the partnership’s convention or use of the proration method or interim closing method. Thus, the allocation of extraordinary items will generally be the same regardless of the partnership’s selected method or convention. If a partner disposes of its entire interest in a partnership before an extraordinary item occurs (but on the same day), the partnership and all of its partners must allocate the extraordinary item in accordance with the partners’ interests in the partnership item at the time of day on which the extraordinary item occurred; in such a case, the transferor will not be allocated a portion of the extraordinary item, regardless of when the transfer is deemed to occur under the partnership’s convention.

Publicly traded partnerships. The final regs provide that a publicly traded partnership (PTP) must use the calendar day convention with respect to all variations relating to its non-publicly traded units for which the PTP uses the proration method. A PTP using a monthly convention generally may consistently treat all variations occurring during each month as occurring at the end of the last day of that calendar month, if the PTP uses the monthly convention for those variations. (Reg. § 1.706-4(c)(2)(iii)) Because PTPs are also allowed to use the semi-monthly and monthly conventions with respect to variations for which the PTP uses the proration method, the final regs provide that PTPs must use the same convention for all variations during the tax year. PTPs may, but are not required to, respect the applicable conventions in determining who held their publicly traded units at the time of the occurrence of an extraordinary item. The exception in Reg. § 1.706-4(c)(2)(ii) does not apply to PTPs with respect to holders of publicly traded units (as described in Reg. § 1.7704-1(b) or Reg. § 1.7704-1(c)(1))

Segments and proration periods. Under the final regs, segments are specific periods of the partnership’s tax year created by interim closings of the partnership’s books, and proration periods are specific portions of a segment created by a variation for which the partnership chooses to apply the proration method. The partnership must divide its year into segments and proration periods, and spread its income among the segments and proration periods according to the rules for the interim closing method and proration method, respectively.

The first segment begins with the beginning of the tax year of the partnership and ends at the time of the first interim closing of the partnership’s books. Any additional segment begins immediately after the closing of the prior segment and ends at the time of the next interim closing. However, the last segment of the partnership’s tax year ends no later than the close of the last day of the partnership’s tax year. If there are no interim closings, the partnership has one segment, which corresponds to its entire tax year. (Reg. § 1.706-4(a)(3)(vi))

The first proration period in each segment begins at the beginning of the segment, and ends at the time of a variation for which the partnership uses the proration method. The next proration period begins immediately after the close of the prior proration period and ends at the time of the next variation for which the partnerships uses the proration method. However, each proration period ends no later than the close of the segment. Thus, segments close proration periods. Therefore, the only items subject to proration are the partnership’s items attributable to the segment containing the proration period. (Reg. § 1.706-4(a)(3)(iii))

The final regs continue to provide that each segment is generally treated as a separate distributive share period. For purposes of determining allocations to segments, any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership tax year will be applied based on the partnership’s satisfaction of the limitation or requirements as of the end of the partnership’s tax year. For example, the expenses related to the election to expense a Code Sec. 179 asset must first be calculated (and limited if applicable) based on the partnership’s full tax year, and then the effect of any limitation must be apportioned among the segments in accordance with the interim closing method or the proration method using any reasonable method. Thus, the segments aren’t treated as separate tax years for purposes of Code Sec. 461(h) and Code Sec. 404(a)(5). Other provisions of the Code providing a convention for making a particular determination still apply; thus, conventions under Code Sec. 168 would apply first to determine when the property is placed in service or when the property is disposed of, and Code Sec. 706 would apply second to determine who was a partner during that segment.

Recordkeeping. Partnerships adopting the proration method, adopting the semi-monthly or monthly convention, choosing to perform semi-monthly or monthly interim closings, or selecting an additional class of extraordinary items, are required to maintain a statement with their books and records. (Reg. § 1.706-4(f))

Effective date. The final regs under Reg. § 1.706-4 generally apply for partnership tax years that begin on or after Aug. 3, 2015; however, the rules of Reg. § 1.706-4(c)(3) do not apply to existing PTPs (i.e., ones formed prior to Apr. 19, 2009). For purposes of this effective date provision, the termination of a PTP under Code Sec. 708(b)(1)(B) due to the sale or exchange of 50% or more of the total interests in partnership capital and profits is disregarded in determining whether the PTP is an existing PTP.

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