The IRS has issued final regulations (TD 9728) under IRC §706 dealing with the issue of when partners hold varying interests in a partnership during the year. As well, the IRS issued new proposed regulations, concurrent with these final regulations, that deal with the interplay between the tiered partnership rules and cash basis rules when there is a change in the partners’ interests. (REG-109370-10).
The final regulations are issued to cover the general rule, found at IRC §706(d)(1), that provides:
… [I]f during any taxable year of the partnership there is a change in any partner's interest in the partnership, each partner's distributive share of any item of income, gain, loss, deduction, or credit of the partnership for such taxable year shall be determined by the use of any method prescribed by the Secretary by regulations which takes into account the varying interests of the partners in the partnership during such taxable year.
There are two exceptions to these rules, found at IRC §706(d)(2) and (3) that deal with certain cash basis items in this situation and items that exist in a lower tier partnership. The proposed regulations deal with these issues, as the IRS found that it was not appropriate to attempt to add guidance on those issues to these final regulations in response to comments.
These final regulations, based on proposed regulations issued in 2009, provide for rules for determining a partners’ distributive share of partnership items in a year where there is a change in a partners’ interest in the partnership due to any of the following:
- Disposition of a partner’s entire interest in the partnership
- Disposition of less than a partner’s entire interest in the partnership
- Reduction of a partner’s interest in a partnership due to the entry of a new partner (or partners) [See Reg. §1.706-1(c)(2) and (3)]
There are two exceptions to the applications of these rules.
- “Contemporaneous partners” – the rule does not apply to modifications of distributive shares among partners who were members of the partnership during either a) the entire year or b) the period in which the revised allocation applies so long as:
- Any variation in a partner’s interest is not attributable to a contribution of money or property by a partner to the partnership or a distribution of money or property by the partnership to a partner; and
- The allocations resulting from the modification satisfy the provisions of section 704(b) and the related regulations for respecting allocations.
- Service partnership exception—So long as capital is not a material income producing factor, the partnership can choose to allocate items using any reasonable method that satisfies the provisions of §704(b) and the related regulations regardless of a change in interest. This represents an expansion of this rule compared to the proposed regulations which limited the partnerships qualifying for this rule to only those in specified personal service industries.
For the year in which a change in interest required to be computed under these regulations takes place, the partnership can account for the varying interest using either the interim closing method or the proration method. The partnership must use the interim closing method unless there is an agreement of the partners to use the proration method. However, subject to any restrictions the IRS may later announce, the partnership does not have to use the same method to deal with each separate variation that takes place in the tax year. [Reg. §1.704‑4(a)(3)(iii)]
Except for allocations dealing with extraordinary items the partnership may adopt a separate closing convention period and perform interim closings of the books on a mid-month or monthly basis as opposed to a per day basis. If there is no agreement of the partners then the partnership must use the calendar convention.[Reg. §1.706‑4(c)]
If the monthly convention is used, any change an interest occurring on the first through the 15th day of the month will be treated as occurring as of the end of the preceding month. Those occurring on the 16th day or later will be treated as having occurred at the end of the month in which the variation occurs. [Reg. §1.706‑4(c)(1)(iii)]
If the mid-month convention is used, any change an interest occurring on the first through the 15th day of the month will be treated as occurring as of the end of the preceding month. Those occurring on the 16th day or later will be treated as having occurred on the 15th day of the month in which the variation occurs. [Reg. §1.706‑4(c)(1)(ii)]
Generally the same proration method must be used for all variations during the year in which the partnership uses the interim closing method.
However, regardless of the convention used, all variations within the tax year will be deemed to occur no earlier than the first day of the tax year and no later than the last day of the tax year. If the monthly convention is used, any change an interest occurring on the first through the 15th day of the month will be treated as occurring as of the end of the preceding month. Those occurring on the 16th day or later will be treated as having occurred at the end of the month in which the variation occurs. [Reg. §1.706‑4(c)(2)(i)]
As well, if a person both becomes a partner as the result of one variation and ceases to be a partner as a result of another variation and, under the selected convention, both changes are deemed to occur on the same day, then the variations for that partner’s interest will be treated as occurring on the day the variations actually occurred and not according to the convention. [Reg. §1.706‑4(c)(2)(ii)]
For “extraordinary items” a per day allocation is required—that is, no convention may be used. The extraordinary items, listed at Reg. §1.704‑4(e)(2), are:
- · Any item from the disposition or abandonment (other than in the ordinary course of business) of a capital asset as defined in section 1221 (determined without the application of any other rules of law);
- · Any item from the disposition or abandonment (other than in the ordinary course of business) of property used in a trade or business as defined in section 1231(b) (determined without the application of any holding period requirement);
- · Any item from the disposition or abandonment of an asset described in section 1221(a)(1), (a) (3), (a)(4), or (a)(5) if substantially all the assets in the same category from the same trade or business are disposed of or abandoned in one transaction (or series of related transactions);
- Any item from assets disposed of in an applicable asset acquisition under section 1060(c);
- Any item resulting from any change in accounting method initiated by the filing of the appropriate form after a variation occurs;
- Any item from the discharge or retirement of indebtedness (except items subject to section 108(e)(8) or 108(i), which are subject to special allocation rules provided in section 108(e)(8) and 108(i));
- Any item from the settlement of a tort or similar third-party liability or payment of a judgment;
- Any credit, to the extent it arises from activities or items that are not ratably allocated (for example, the rehabilitation credit under section 47, which is based on placement in service);
- For all partnerships, any additional item if, the partners agree to consistently treat such item as an extraordinary item for that taxable year; 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; any additional 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 taxable year (for example, the limitation for section 179 expenses);
- Any item which, in the opinion of the Commissioner, would, if ratably allocated, result in a substantial distortion of income in any return in which the item is included;
- Any item identified as an additional class of extraordinary item in guidance published in the Internal Revenue Bulletin.
Generally extraordinary items must be accounted for using an interim closing and cannot be accounted for using a proration method. The regulation actually goes so far to look at the time of day that an individual became or ceased to be a partner for purposes of determining the allocation of an extraordinary item. [Reg. §1.706‑4(e)(1)]
However, publicly traded partnerships (PTPs) are allowed to use their conventions to determine who is treated as a partner at the time of occurrence of the extraorindary item. [Reg. §1.706‑4(e)(1)]
The regulations require dividing up the partnership year into segments based on the dates of changes in interest. The regulation outlines the steps the partnership is to take as follows:
- First, determine whether either of the exceptions described above (regarding certain changes among contemporaneous partners and partnerships for which capital is not a material income-producing factor) applies.
- Second, determine which of its items are subject to allocation under the special rules for extraordinary and allocate those items accordingly.
- Third, determine with respect to each variation whether it will apply the interim closing method or the proration method. Absent an agreement of the partners to use the proration method, the partnership shall use the interim closing method. The partnership may use different methods (interim closing or proration) for different variations within each partnership taxable year; however, the Commissioner may place restrictions on the ability of partnerships to use different methods during the same taxable year in guidance published in the Internal Revenue Bulletin.
- Fourth, determine when each variation is deemed to have occurred under the partnership's selected convention.
- Fifth, determine whether there is an agreement of the partners to perform regular monthly or semimonthly interim closings. If so, then the partnership will perform an interim closing of its books at the end of each month (in the case of an agreement to perform monthly closings) or at the end and middle of each month (in the case of an agreement to perform semimonthly closings), regardless of whether any variation occurs. Absent an agreement of the partners to perform regular monthly or semimonthly interim closings, the only interim closings during the partnership's taxable year will be at the deemed time of the occurrence of variations for which the partnership uses the interim closing method.
- Sixth, determine the partnership's segments, which are specific periods of the partnership's taxable year created by interim closings of the partnership's books. The first segment shall commence with the beginning of the taxable year of the partnership and shall end at the time of the first interim closing. Any additional segment shall commence immediately after the closing of the prior segment and shall end at the time of the next interim closing. However, the last segment of the partnership's taxable year shall end no later than the close of the last day of the partnership's taxable year. If there are no interim closings, the partnership has one segment, which corresponds to its entire taxable year.
- Seventh, apportion the partnership's items for the year among its segments. The partnership shall determine the items of income, gain, loss, deduction, and credit of the partnership for each segment. In general, a partnership shall treat each segment as though the segment were a separate distributive share period. For example, a partnership may compute a capital loss for a segment of a taxable year even though the partnership has a net capital gain for the entire taxable year. 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 taxable year will be applied based upon the partnership's satisfaction of the limitation or requirement as of the end of the partnership's taxable year. For example, the expenses related to the election to expense a section 179 asset must first be calculated (and limited if applicable) based on the partnership's full taxable year, and then the effect of any limitation must be apportioned among the segments in accordance with the interim closing method or the proration method using any reasonable method.
- Eighth, determine the partnership's proration periods, which are specific portions of a segment created by a variation for which the partnership chooses to apply the proration method. The first proration period in each segment begins at the beginning of the segment, and ends at the time of the first variation within the segment for which the partnership selects 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 selects the proration method. However, each proration period shall end no later than the close of the segment.
- Ninth, prorate the items of income, gain, loss, deduction, and credit in each segment among the proration periods within the segment.
- Tenth, determine the partners' distributive shares of partnership items under section 702(a) by taking into account the partners' interests in such items during each segment and proration period.
Note that many provisions reference things that can only be done if there is an “agreement of the partners” with regard to the item. The regulations provide for specific requirements for such an agreement and the maintenance of certain records.
Specifically, Reg. §1.706‑4(f) provides:
…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, or a selection of the method, convention, or extraordinary item made by a person authorized to make that selection, including under a grant of general authority provided for by either state law or in the partnership agreement, if that person's selection is in a dated, written statement maintained with the partnership's books and records. In either case, the dated written agreement must be maintained with the partnership's books and records by the due date, including extension, of the partnership's tax return.
The regulations are generally effective for tax years beginning on or after August 3, 2015. However the proration rules found in Reg. §1.706‑4(c)(3) do not apply to publicly traded partnerships in existence prior to April 19, 2009 (the date of issuance of the proposed regulations). For this test, a technical termination of the publicly traded partnership due to a sale or exchange of more than 50% of its interests is disregarded in determining if it was in existence prior to April 19, 2009.