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In-Depth: IRS Issues Final Regs on Determining Distributive Share When a Partner's Interest Changes.

(Parker Tax Publishing August 24, 2015)

The IRS has issued final regulations regarding the determination of a partner's distributive share of partnership items of income, gain, loss, deduction, and credit when a partner's interest changes during a partnership tax year. T.D. 9728.

Background

In 2009, the IRS issued proposed regulations in REG-144689-04 to conform the regulations to certain provisions of the Taxpayer Relief Act of 1997, and the Deficit Reduction Act of 1984.

The proposed regulations under Reg. Sec. 1.706-4 provided guidance under Code Sec. 706(d)(1), which requires that, 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 the use of any method in the regulations which takes into account the varying interests of the partners in the partnership during such tax year.

Regulations issued in T.D. 9728 (8/3/15) finalize the proposed regulations with modifications. Reg. Sec. 1.706-4(a)(3) now contains a step-by-step process for making allocations under the final regs. In addition, the remainder of Reg. Sec. 1.706-4 has been reorganized into discrete sections addressing the scope of the final regs, exceptions to the final regs, partnership conventions, extraordinary items, and procedures for partnership decisions relating to final Reg. Sec. 1.706-4.

The final regulations generally apply for partnership tax years that begin on or after August 3, 2015. However, the rules for permissible conventions for each variation under Reg. Sec. 1.706-4(c)(3) do not apply to existing publicly traded partnerships (PTPs) formed prior to April 19, 2009). For purposes of the effective date provision, the termination of a PTP under Code Sec. 708(b)(1)(B) due to the sale or exchange of 50 percent or more of the total interests in partnership capital and profits is disregarded in determining whether the PTP is an existing PTP.

Scope of the Final Regulations

Final Reg. Sec. 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, or with respect to a partner whose interest in a partnership is reduced, including by the entry of a new partner. The final regulations clarify that deemed dispositions under Reg. Secs. 1.1502-76(b)(2)(vi), 1.1362-3(c)(1), or 1.1377-1(b)(3)(iv) are treated as a disposition of the partner's entire interest in the partnership.

OBSERVATION: The final regs refer to these changes in a partner's interest in a partnership as "variations."

The final regulations 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 regulations provide that partnerships may make certain decisions under Reg. Sec. 1.706-4 only by an agreement of the partners.

For purposes of selecting the proration method, selecting the semi-monthly or monthly convention, performing regular monthly or semi-monthly interim closings, and selecting additional extraordinary items, the term "agreement of the partners" means either an agreement of all the partners to select the method, convention, or extraordinary item in a dated, written statement maintained with the partnership's books and records, including, for example, a selection that is included in the partnership agreement. The term also includes a selection of the method, convention, or extraordinary item made by a person authorized to make that selection, if that person's selection is in a dated, written statement maintained with the partnership's books and records.

Methods for Applying the Varying Interest Rules: Interim Closing and Proration

In the case of a disposition of a partner's entire interest in a partnership, the partner's distributive share of partnership items for the tax year in which the disposition occurs may be determined by a closing of the partnership's books as of the date of disposition (interim closing method).

Alternatively, the partners, by agreement, may determine the departing partner's distributive share by taking his or her pro rata share of partnership items that would have been included in income had he or she remained a partner until the end of the partnership tax year (proration method).

The proposed regulations required the partnership and all of its partners to use the same method, interim closing or proration, for all variations in the partners' interests occurring within the partnership's tax year. After considering comments, the IRS agreed that partnerships may be more willing to use the interim closing method, which is generally more accurate but more costly, for significant variations if doing so would not require the partnership to use the interim closing method for all variations, regardless of size, that occur throughout the year. Therefore, the final regulations allow a partnership to use different methods for different variations within the partnership's tax year.

For purposes of the interim closing method, the final regulations provide that 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 regulations continue to 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 closings of its books except at the time of any variation for which the partnership uses the interim closing method.

Under the proposed regulations, if the partners agreed to use the proration method, the partnership was required to allocate the distributive share of partnership items among the partners in accordance with their pro rata shares of the items for the entire tax year. Because the final regulations permit partnerships to use both the proration method and the interim closing method in the same tax year, the rules for the proration method are now based upon the items in each segment, rather than the items for the partnership's entire tax year.

Use of Segments and Proration Periods to Account for Changes in Partnership Interests

For purposes of accounting for the partners' varying interests in the partnership, the proposed regulations required the partnership to maintain, for each partner whose interest changes in the tax year, segments to account for such changes. Under the proposed regulations, a segment was a specific portion of a partnership's tax year created by a variation, regardless of whether the partnership used the interim closing method or the proration method for that variation. Although the final regulations continue to rely on the concept of segments, because the final regulations now permit partnerships to use both the interim closing method and the proration method in the same tax year, the final regulations also contain a new concept of proration periods.

Under the final regulations, 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 commences 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 commences 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.

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.

OBSERVATION: The items subject to proration are the partnership's items attributable to the segment containing the proration period.

The final regulations provide that each segment is generally treated as a separate distributive share period. Additionally, the final regulations provide that 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 the effect of any limitation must be apportioned among the segments in accordance with the interim closing method or the proration method.

OBSERVATION: Segments are not treated as separate tax years for purposes of Code Secs. 461(h) and 404(a)(5).

Conventions for Applying the Varying Interest Rules: Calendar Day, Semi-Monthly, and Monthly

For purposes of the final regulations, "conventions" are rules of administrative convenience that determine when each variation is deemed to occur. The regulations provide for three conventions: the calendar day convention, the semi-monthly convention, or the monthly convention.

Under the calendar day convention, each variation is deemed to occur at the end of the day on which the variation occurs.

The semi-monthly convention requires that any variation in a partner's interest occurring during the first through 15th day of the calendar month is deemed to occur at the beginning of the first day of the month, and any variation in a partner's interest occurring during the 16th through the last day of the month is deemed to occur at the beginning of the 16th day of that month.

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.

OBSERVATION: The final regulations require partnerships using the proration method to 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.

The final regulations 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 are not 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 IRS recognizes that the application of the conventions could result in some partners not being allocated any share of partnership items. For example, under the monthly convention, if a new partner buys a partnership interest on or after the 16th day of a month, and sells the entire partnership interest on or before the 15th day of the following month, that partner would not be treated as having been a partner at all for purposes of Reg. Sec. 1.706-4. Accordingly, the final regulations 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. However, this exception does not apply to publicly traded partnerships with respect to holders of publicly traded units.

Exceptions for Contemporaneous Partners and Certain Service Partnerships

The final regulations adopt, with modifications, two exceptions in the proposed regulations for allocations that would otherwise be subject to the varying interest rules of Reg. Sec. 1.706-4: one exception applies to certain partnerships with contemporaneous partners, and the other exception applies to certain service partnerships.

The "contemporaneous partner exception" provided an exception for dispositions of less than a partners' entire interest in the partnership, provided that the variation in the partner's interest is not attributable to a capital contribution or a partnership distribution to a partner that is a return of capital, and the allocations resulting from the modification otherwise comply with Code Sec. 704(b) and its regulations. The final regulations expand the scope of this exception to include allocations of items attributable solely to a particular segment of a partnership's year among partners who are partners of the partnership for that entire segment.

The second exception in the proposed regulations provided that a service partnership may choose to determine the partners' distributive shares of partnership income, gain, loss, deduction, and credit using any reasonable method, provided that the allocations were valid under Code Sec. 704(b). The IRS noted that the definition of "service partnership" in the proposed regulations was too narrow, and expand the scope of the service partnership exception to any partnership for which capital is not a material income-producing factor.

Extraordinary Items

The final regulations provide special rules for the allocation of "extraordinary items" that apply to partnerships using the proration method or the interim closing method. The proposed regulations included a list of nine extraordinary items, including any item from the disposition or abandonment (other than in the ordinary course of business) of a capital asset, any item from assets disposed of in an applicable asset acquisition, and any item from the settlement of a tort or similar third-party liability. The final regulations retain the list, and provide clarifications to five of the items. In response to comments, the final regulations also add two items to the extraordinary item list.

First, the final regulations adopt a recommendation to allow a partnership to treat additional nonenumerated items as extraordinary items for a tax year if, for that tax year, there is an agreement of the partners to treat consistently such items as extraordinary items. However, this rule does not apply if treating that additional item as an extraordinary item would result in a substantial distortion of income in any partner's return.

Second, the final regulations provide that an extraordinary item includes any item identified as an additional class of extraordinary item in guidance published by the IRS.

In addition, proposed regulations under Code Sec. 706 (REG-109370-10) published concurrently with the final regulations propose two additional extraordinary items. Taxpayers may rely on these proposed items until the regulations are finalized. The first proposed extraordinary item provides, in general, that for publicly traded partnerships (PTPs), all items of income that are amounts subject to withholding or withholdable payments occurring during a tax year may be treated as extraordinary items by an agreement of the partners. This proposed rule does not apply unless the PTP has a regular practice of making at least four distributions (other than de minimis distributions) to its partners during each tax year. The second proposed additional extraordinary item would include any deduction for the transfer of an interest in the partnership in connection with the performance of services.

The final regulations require the allocation of extraordinary items as an exception to the proration method, which would otherwise ratably allocate the extraordinary items across the segment, and the conventions, which might otherwise inappropriately shift extraordinary items between a transferor and transferee. The final regulations also provide that 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 regulations, extraordinary items must be allocated in accordance with the partners' interests in the partnership item at the time of day that the extraordinary item occurs, regardless of the method and convention otherwise used by the partnership. Thus, if a partner disposes of its entire interest in a partnership on the same day but before an extraordinary item occurs (e.g. the interest is disposed of in the morning, and the extraordinary item occurs in the afternoon), 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.

However, 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 final regulations also add a small item exception to the extraordinary item rules. Specifically, the final regulations allow a partnership to treat an otherwise extraordinary item as not extraordinary if, for the partnership's tax year, the gain from all extraordinary items in a particular class is less than five percent of the partnership's gross income, and the aggregate amounts of extraordinary items from all classes that are less than five percent of the partnership's gross income do not exceed $10 million for the taxable year. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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