When Congress passed the Bipartisan Budget Act of 2015 (BBA), it repealed a previous set of partnership audit rules that had been enacted under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Subsequently, the IRS recently issued temporary regulations regarding qualifying partnerships that wish to elect into a new audit regime established by the BBA.
Under the temporary regulations, the unified audit system under TEFRA has been replaced with new rules where taxes are generally assessed and collected at the partnership level. The new audit regime can be applied by any partnership with a tax year beginning after December 31, 2017, though the IRS notes that early adoption is permitted. Once a partnership makes this election, it cannot be revoked without IRS consent, with the exception of small partnerships that are required to furnish less than 100 K-1 statements.
Taxation in Leveraged Partnerships
Last fall, the IRS and the Treasury Department jointly issued temporary regulations that amended Section 707 (Guidance Relating to Disguised Sales of Property to or by a Partnership) and Section 752 (Allocations of Excess Nonrecourse Liabilities of a Partnership for Disguised Sale Purposes). Under the new regulations, all partnership liabilities are now viewed as nonrecourse for disguised sale purposes. In essence, this change mandates that all partnership liabilities be determined by each individual’s share of partnership profits, and not the full share of the partnership’s debt. This virtually eliminates the opportunity for individuals to engage in tax-favored leveraged partnership transactions, such as receiving cash for contributions of appreciated property. The rule is effective for all transactions of this type taking place on or after January 3, 2017.
Under another significant IRS temporary regulation last May, tax authorities effectively closed a loophole through which partnerships created disregarded entities, and then treated partners as regular employees for tax purposes and thus not subject to self-employment tax on earnings. In this area, the IRS ruled that partners are self-employed for tax purposes, regardless of whether or not they work under a disregarded entity in the partnership.
Additionally, the IRS issued proposed regulations to deal with concerns over investment partnerships and other entities where partners benefit from favorable tax rates. Under these proposed rules, if a partner receives a disguised payment for services, it would be taxed as regular income at the marginal rate. Outside of that definition, any partnership distribution eventually could be taxed at the lower capital gains rate.
Final Debt and Equity Rules
The IRS and Treasury Department also issued final rules last fall that established threshold documentation requirements for certain related party corporate interests to be treated as indebtedness for federal tax purposes. The final Section 385 regulations, which were much narrower in scope than proposed guidance issued earlier in 2016, limited the rule’s applicability to debt instruments issued by U.S. companies, and it defined minimum documentation requirements for expanded group interests (EGIs) of covered entities. Under this standard, an EGI is subject to the so-called “documentation rule” if stock of any member of the expanded group is publicly traded, if the expanded group’s financial statements show total assets in excess of $100 million, or if the expanded group shows total annual revenue of more than $50 million. According to the IRS, those thresholds will eliminate about 99 percent of C corporation taxpayers.
Proposed Rules to Tighten Tax-Free Spinoffs
The proposed Section 355 regulations provide significant, formula-driven rules to evaluate whether a spinoff transaction qualifies as tax-free, including “bright line” standards for the active trade or business test. Under current rules, distributing and controlled entities seeking a tax-free spinoff must be able to show that they have been engaged in an active trade or business for the preceding five years. In this context, “active” is defined as entities with income, expenses, and both management and operations personnel.
Under the proposed standard, entities must calculate a minimum five-year-active-business asset percentage (determined by dividing the fair market value of a corporation’s five-year-active-business assets by the fair market value of its total assets) for each controlled and distributing entity. To meet this threshold calculation for an active trade or business, both the controlled and distributing entities must show five-year active business assets that account for at least 5 percent of total assets.
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February 17, 2017