This article reviews and analyzes recent law changes as well as rulings and decisions involving partnerships. The discussion covers developments in the determination of partners and partnerships, gain on disposal of partnership interests, partnership audits, and basis adjustments.
During the period of this update (Nov. 1, 2019, through Nov. 30, 2020), the IRS issued guidance on the law known as the Tax Cuts and Jobs Act (TCJA), (1) which was enacted at the end of 2017 and made several changes that affect partners and partnerships. The IRS also provided guidance for taxpayers regarding other changes made to Subchapter K over the past few years. The courts and the IRS issued various rulings that addressed partnership operations and allocations.
Guidance on TCJA provisions
The IRS made significant progress during this period toward its goal of issuing substantive guidance on TCJA provisions before the end of 2020, in several areas of special interest to partnerships and partners. These areas include the deduction for qualified business income (QBI), the limitation on the deduction for business interest, rules for income from carried interests, and additional depreciation deductions for qualified property.
QBI
In general, Sec. 199A, enacted by the TCJA, permits a deduction of up to 20% of QBI from partnerships, proprietorships, and S corporations. However, the deduction is limited to taxable income. Taxable income is measured without any QBI deduction and is reduced for any income taxable at capital gain rates, including qualified dividends. (2)
To qualify as QBI, the income must be effectively connected to a trade or business. (3) A separate computation of QBI and other limitations is required for each qualified trade or business. (4) For partners in a partnership, the determination of QBI and any limitations on the deduction apply at the partner level.
In 2019, Treasury issued final regulations (5) to provide taxpayers with computational, definitional, and anti-avoidance guidance on Sec. 199A. During 2020, Treasury issued additional regulations (6) that expand on the treatment of suspended losses and QBI. The 2019 final regulations had provided that previously disallowed losses or deductions under Secs. 465, 469, and 704(d) that are allowed in the tax year are generally taken into account for purposes of computing QBI, except to the extent the losses or deductions are disallowed, suspended, limited, or carried over from tax years ending before Jan. 1, 2018. These losses are used for purposes of Sec. 199A on a first-in, first-out (FIFO) basis.
Proposed regulations in 2019 expanded this rule to provide that previously disallowed losses or deductions, regardless of whether they are attributable to a trade or business and whether they would otherwise be included in QBI, are determined in the year the loss or deduction is incurred. In the 2020 final regulations, Treasury and the IRS determined that it is necessary for the FIFO rule to apply for losses included in tax years beginning on or after Jan. 1, 2018, and that the rule must be applied on an annual basis by category (i.e., Secs. 465, 469, etc.). These final regulations also provide that regulated investment company distributions attributable to income from real estate investment trusts (REITs) are eligible as QBI for REIT shareholders (conduit treatment). However, conduit treatment is not extended to qualified publicly traded partnership (PTP) income.
Limitation on business interest deductions
The TCJA added Sec. 163(j), which limits the amount of business interest an entity can deduct each year. Sec. 163(j)(4) provides special rules for applying Sec. 163(j) to partnerships. Sec. 163(j)(4)(A) requires the limitation on the deduction for business interest expense to be applied at the partnership level and a partner's adjusted taxable income (ATI) to be increased by the partner's share of excess taxable income, as defined in Sec. 163(j)(4)(C), but not by the partner's distributive share of income, gain, deduction, or loss. Sec. 163(j)(4)(B) provides that the amount of partnership business interest expense limited by Sec. 163(j)(1) is carried forward at the partner level. Sec. 163(j)(4)(B)(ii) provides that excess business interest expense (EBIE) allocated to a partner and carried forward is available to be deducted in a subsequent year only if the partnership allocates excess taxable income to the partner. Sec. 163(j)(4)(B)(iii) provides rules for the adjusted basis in a partnership of a partner that is allocated EBIE.
Final regulations (7) under Sec. 163(j) were issued in September 2020. They remove guaranteed payments for the use of capital from the list in proposed regulations of per se interest items. The regulations also add an anti-avoidance rule that allows amounts to be treated as interest if the expense or loss is economically equivalent to interest and a principal purpose is to reduce an amount treated as interest. The anti-avoidance rules in some cases may apply to guaranteed payments. (8) This rule applies to transactions entered into on or after Sept. 14, 2020. (9)
Also included in the final regulations are special rules for how partnerships apply the Sec. 163(j) limitation. Under Sec. 163(j)(1), the business interest expense deduction of partnerships, like that of other taxpayers, is limited to the sum of the partnership's business interest income for the tax year, 30% of ATI for the tax year (zero, if ATI is less than zero), and the partnership's floor plan financing interest expense. (10)
ATI means the taxable income for the tax year, ignoring business interest income or expense. To that amount, the partnership must add back any net operating loss deduction; Sec. 199A deduction; depreciation, amortization, or depletion (through 2021); capital loss carryback or carryover; or deduction/loss from a nonexcepted trade or business. The partnership must also subtract the recapture of depreciation/amortization, including on the sale of a partnership interest (to match the addback and avoid double-counting). The final regulations also add back to ATI depreciation, amortization, or depletion that is capitalized into inventory under Sec. 263A during tax years beginning before Jan. 1, 2022. The final regulations allow taxpayers to apply these rules retroactively to a tax year beginning after Dec. 31, 2017 (including taxpayers who relied on the 2018 proposed regulations). (11)
If any EBIE is in the partnership, the final regulations provide that a partner carries the EBIE forward to future years. Any future excess taxable income partnership allocation will unlock the EBIE carryforward on a dollar-for-dollar basis. The unlocked EBIE is equal to the partner's business interest expense in the year unlocked. A partner can use any ATI to deduct unlocked EBIE.
The regulations provide an 11-step process for allocating excess items from the partnership. (12) This process describes how to handle the allocation of excess items based on the allocation of Sec. 704(b) and Sec. 704(c) items. Partnerships should tentatively allocate excess items based on the allocation of Sec. 704(b) items comprising ATI and interest income and expense. However, if necessary, the partnership should reallocate excess items among the partners to effect the principles set forth by Treasury. If all Sec. 704(b) items (and Sec. 704(c) items other than remedial items) are allocated pro rata, there will be no reallocation of excess items.
Treasury also issued proposed regulations (13) accompanying the final regulations to provide additional guidance on several other aspects of the deduction limitation, including issues with tiered partnerships and dispositions of a partnership interest. These proposed regulations adopt an entity approach where, if EBIE is allocated to an upper-tier partnership (UTP), the UTP's basis in a lower-tier partnership (LTP) is reduced. However, the UTP partners' bases in the UTP are not reduced until the UTP EBIE is treated as paid or accrued by To reflect the reduction in value associated with the LTP's EBIE, the UTP treats any business interest expense paid or accrued by the LTP as a nondeductible, noncapitalizable expenditure solely for purposes of Sec. 704(b). The UTP treats the UTP EBIE as a nondepreciable capital asset with a value of zero and a tax basis equal to the amount of UTP EBIE. A direct or indirect UTP partner that has a Sec. 704(b) capital account reduction because of UTP EBIE is a "specified partner," and UTP EBIE is tracked to each specified partner and its transferees.
If a partner disposes of a partnership interest, the adjusted basis of the partnership interest is increased immediately before the disposition by the entire amount of the partner's remaining EBIE ("basis addback rule"). Partners also may now add back a proportionate basis on partial sales of partnership interests. The proposed regulations require the partnership to create a new block of "inert" basis in the assets equal to the amount added back on the sale or distribution.
Bonus depreciation
The TCJA generally provides for 100% bonus depreciation for qualifying property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023, under Sec. 168(k). The TCJA expands the property eligible for 100% bonus depreciation to include used property that is not acquired from a related party and meets certain other requirements. Sec. 168(k)(7) allows a taxpayer to elect out of bonus depreciation for any class of property for any tax year.
In November 2020, Treasury issued final regulations relating to Sec. 168(k). (14) The final regulations are applicable to depreciable property acquired and placed in service after Sept. 27, 2017, by the taxpayer during a tax year ending on or after Sept. 28, 2017, provided the taxpayer consistently applies all the rules in the final regulations. The taxpayer may alternatively apply the proposed regulations issued in 2019 (15) to...
