Potential partnership guidance

In addition to the recently issued guidance regarding partnership related party basis adjustments (see our Tax Alert for additional details), there are a number of critical areas where Treasury and/or IRS guidance is anticipated in the coming months for various partnership items.

Key takeaways

• The IRS priority guidance plan includes several potentially significant areas that would impact partnerships. Below we discuss several of those items we’re continuing to monitor.
• It is critical to note that in light of the Supreme Court’s overturning of the Chevron doctrine, it is unclear how the IRS’s and Treasury’s pursuit of these guidance projects will unfold.

The IRS priority guidance plan includes several potentially significant areas that would impact partnerships. We continue to monitor the following issues:

Self-employment tax guidance for limited partners and LLC members under section 1402(a)(13)

Guidance on the application of the limited partner exception for self-employment income under section 1402(a)(13) is back on the IRS Priority Guidance Plan after a five-year absence. The IRS has given no official indication of when it will release guidance; unofficially, the IRS has said that it is “working on it.” With the renewed focus on auditing large partnerships, as well as recent court cases in this area, we would not be surprised if guidance is issued sooner rather than later.

With this in mind, we recommend that you review with your Baker Tilly advisor any positions taken utilizing section 1402(a)(13) to exclude flow-through income from net earnings from self-employment in order to be prepared for whatever guidance emerges.

Background and Recent Cases

Section 1402(a)(13) generally excludes a limited partner’s distributive share of partnership income or loss from net earnings from self-employment. Guaranteed payments for services rendered to the partnership are not excluded. The Internal Revenue Code does not define the term “limited partner.” The IRS issued proposed regulations in 1997 that would have imposed functional guidelines for determining limited partner status; however, these regulations were revoked in response to the backlash they received, and Congress placed a one-year moratorium on the issuance of any regulations defining limited partner. No new regulations covering the topic have been issued in the intervening 25+ years.

The Tax Court held in a recent case (Soroban Capital Partners LP et al. v. Commissioner; 161 T.C. No. 12) that the limited partner exception to self-employment tax in section 1402(a)(13) does not apply to a partner who is a limited partner “in name only.” The Court stated that the determination of limited partner status requires an examination of the facts and circumstances regarding the functions and roles of the partner, or a “functional analysis test.”

Note: It is important to mention here that in granting summary judgment, the Tax Court was ruling only on points of law, not the specific facts of the Soroban case.

There have been numerous other court cases over the years on this issue. Most notably, in Renkemeyer (136 T.C. 137) the Tax Court applied a functional analysis test to determine whether the limited partner exception applied to partners in a limited liability partnership (LLP). More recently, there are several pending cases in which fund managers are challenging the IRS’s position on the limited partner exception, including Denham Capital Management LP v. Commissioner (Dkt. No. 9973-23, filed in June) and Point72 Asset Management LP v. Commissioner (Dkt. No. 12752-23, filed in August). The exception is also the subject of a case brought by a consulting firm in 2020 and 2012 (Sirius Solutions LLLP v. Commissioner (Dkt. Nos. 11587-20, 30118-21)).

At a recent conference, a representative from the Office of Chief Counsel said the IRS is drafting proposed regulations that will set out a functional test for determining limited partner status. That guidance is also expected to address:

• Differing organizational structures used by limited partnerships
• How to address the “two hats” issue, and
• How to address different relationships with multiple entities that might be in the structure.

Note: As part of this guidance the IRS may also include final regulations under section 469(h)(2) concerning limited partners and material participation. This topic is also on the IRS priority guidance plan.

Guidance under section 707 on disguised sales.

This guidance package is expected to address both disguised sales for services (section 1.707-2) (fee waiver regulations) as well as disguised sales of partnership interests under section 1.707-7.

Proposed regulations for disguised sales of services were issued in 2015. The proposed regulations indicate that the determination of whether a partner is acting other than in his capacity as a member of the partnership generally is based on all the facts and circumstances. While the proposed regulations set forth a list of facts and circumstances that may indicate an arrangement constitutes (in whole or in part) a non-partner payment for services, they note that the most important factor is whether the payment is subject to significant entrepreneurial risk.

Final regulations regarding the application of section 163(j) to partnerships, S corporations, and their owners. Proposed regulations were published on Sept. 14, 2020.

Under the proposed regulations, when an upper tier partnership (UTP) is allocated excess business interest expense (EBIE) from a lower tier partnership (LTP), the UTP reduces its basis in its LTP partnership interest accordingly. However, the UTP’s partners do not reduce their basis in their UTP partnership interests until the EBIE is subsequently deemed paid or accrued and allocated to the UTP’s partners. This can produce an inequitable outcome amongst the partners. Consider the following example:

Partnership A is owned 50% by B, a partnership owned by X and Y, and 50% by Z, an individual. If partnership A has $100 of EBIE in year one, and allocates it to A and Z ratably, partner Z must reduce its basis in A by $50. While B must also reduce its basis in A, neither partner X nor partner Y must reduce their basis in B, possibly allowing them loss utilization that Z is not afforded. This fact pattern could motivate arrangements whereby a partner in Z’s situation may look to create a partnership to which it could contribute its interest in A, for no other purpose than to circumvent the rule under the proposed regulations.

While EBIE is not currently deductible for tax purposes, an LTP is considered to have made an economic outlay for the interest expense, meaning that there is a reduction in the LTP’s economic value. As such, the UTP and its partners are required to reduce their section 704(b) capital accounts to reflect this decrease in value.

Instead of simplifying matters, this required approach under the proposed regulations results in further complexity by creating section 704(b) to tax differences for each year there is an EBIE limitation, which must be tracked and accounted for. Further, in many cases, an LTP’s interest expense will be subject to limitation under section 163(j) in many subsequent years, if not annually. This means the disparity in section 704(b) and tax capital must be continuously adjusted and layered, creating potentially significant compliance and administrative burdens on capital account maintenance.

Final regulations on the fractions rule under section 514(c)(9)(E). Proposed regulations were published on Nov. 23, 2016.

The proposed regs. also simplify the application of the fractions rule to tiered partnerships and provide insight on how to apply the fractions rule to changes in partnership allocations resulting from capital commitment defaults and subsequent partnership interest acquisitions. Partnerships with qualified exempt partners that own five percent or less of entity capital or profits interests do not have to apply the fractions rule.

The section 514(c)(9)(E) fractions rule is part of an exception to the debt-financed UBTI rules of section 514. The rule provides that a partnership may incur debt to acquire real property without causing its tax-exempt qualified organization partners to recognize UBTI if the partnership doesn't disproportionately allocate income to a tax-exempt partner or losses to a taxable partner

Overturning of Chevron doctrine

As discussed in our recent FAQ article, in light of the Supreme Court’s overturning of the Chevron doctrine, it is unclear how the IRS’s and Treasury’s pursuit of these and other guidance projects will unfold. We continue to monitor these and other partnership-related developments and will issue additional communications as warranted.

Questions? Reach out to your Baker Tilly advisor if you have questions on how this may impact you.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.