June 8, 2009

New Proposed Regulations under Section 706 Address Varying Partnership Interests


On April 14, 2009, the IRS issued Proposed Regulations addressing the determination of partners’ distributive shares when a partner’s interest in the partnership changes during the partnership’s tax year (the “Proposed Regs”). The Proposed Regs would update existing regulations to reflect a 1997 amendment to Code Section 706(c) that added death of a partner to the list of events that close the partnership’s tax year with respect to a partner whose entire interest terminates. The Proposed Regs also consolidate, clarify, and in some cases restrict the methods available for dividing partnership income and other items between a partner whose interest terminates (or is reduced) and the partner or partners whose interests increase. The corresponding rules under current law are scattered among the Code, legislative history, regulations, rulings and other administrative pronouncements, and are collectively referred to as the “varying interests rule”. Finally, the Proposed Regs narrow the circumstances under which the tax year of a “disregarded foreign partner” must be taken into account in establishing a partnership’s tax year. This summary focuses on how the Proposed Regs affect the more commonly-encountered aspects of the varying interests rule.

Under current law, the default method for dividing partnership items between periods of different ownership involves an interim closing of the partnership’s books. This “interim closing” method divides the partnership’s tax year into two short periods –one before and one after the change in ownership. As an alternative, the partners may agree to use the “proration” method. That method prorates income and other items for the partnership’s full tax year between the pre-change and post-change periods based on the elapsed portion of the year or another reasonable method. The Proposed Regs retain a choice between these methods (as modified) and confirm that they apply to a full disposition, partial disposition, or other reduction of a partner’s interest. Under a new consistency requirement, the partnership must apply the same method and (if applicable) convention to all changes in partners’ interests during the same tax year.

Perhaps the most notable change to the varying interests rule is the requirement that a partnership using the proration method allocate “extraordinary items” among partners in proportion to their interests at the beginning of the day on which the item is taken into account. Thus, for example, gain from disposition of a capital asset (other than in the ordinary course of business) cannot be prorated over the partnership’s entire tax year but must be assigned to the date of recognition. The term “extraordinary items” also encompasses Section 1231(b) property, items arising from the discharge or retirement of debt, certain bulk sales, and other listed items. For purposes of this definition, Section 1231(b) property is identified by disregarding the requirement of a holding period, and is subject to an exception for sales in the ordinary course of business. If the Commissioner determines that proration of an unlisted item would result in a substantial distortion of income, then it too is considered an extraordinary item. Although many partnerships today voluntarily distinguish between operating and capital items in applying the proration method, the new “extraordinary item” requirement and the breadth of that defined term will greatly diminish the usefulness of the proration method as a planning tool. If this proposed rule becomes final, the proration method will mainly be useful to avoid the administrative burden associated with an interim closing of the books. In light of this and the new consistency requirement, it is likely that many partnerships will specify in the partnership agreement the method to be used in applying the varying interests rule.

Under the Proposed Regs, a partnership using the interim closing method may adopt a semi-monthly convention. In general terms, that convention calls for the interim closing to take place either at the end of a month (in cases where the ownership change occurs during the first 15 days of the following month) or on the 15th day of the month of change (in all other cases). In 1984, the IRS approved use of a semi-monthly convention in more limited circumstances. See IRS News Release 84-129 (December 13, 1984).

Certain “service partnerships” would enjoy a safe harbor in the Proposed Regs that allows use of “any reasonable method” to account for varying interests, provided that the resulting allocations are valid under Section 704(b). In general terms, this means that the allocations must either comply with the substantial economic effect test or reflect the partners’ interests in the partnership. For purposes of the safe harbor, a service partnership is one in which substantially all activities involve services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting. Largely preserving an existing exception, the Proposed Regs provide that the new rules do not preclude changes in allocations among partners who were partners for the partnership’s entire tax year, provided that the change in interests is not attributable to a capital contribution or a return of capital, and further provided that the resulting allocations comply with Section 704(b) and corresponding regulations. Under Section 761(c) generally, such modifications to a partnership agreement may be made until the deadline for filing the partnership’s return (disregarding extensions).

In most cases, the Proposed Regulations are proposed to apply to partnership tax years that begin after the date of publication of final regulations (but not to partnership tax years that begin before January 1, 2010). Special effective date rules are provided for certain partnerships with foreign partners and for existing publicly traded partnerships.

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Contributed by Glenn Madere, Esq. Glenn Madere is the Editor of The Readable Code and Regs: Partnerships (Blue Bell, PA: Readable Press, 2009).