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Partnership Tax Reform: The Wyden Proposals and Budget Reconciliation Legislation

By: John V. Aksak Ross J. Valenza Matthew John McNally Kristen Slusarczyk Jason Carter |

Congress is currently working on legislation designed to enact the agenda laid out by President Biden in his State of the Union address and the budget for Fiscal Year 2022, which was forwarded to Congress in the spring.  After enacting pandemic-relief legislation in early 2021, Congress then moved on to infrastructure legislation, which was approved in the Senate in August and is awaiting final action in the House.

The major legislation in 2021 with proposed tax law changes is the budget reconciliation bill, which may contain key Biden agenda items, including provisions targeting large corporations and high-income individuals, middle-class tax relief, tax incentives and new spending on traditional infrastructure projects and “human” infrastructure initiatives, as well as proposals to address climate change.  Negotiations between the White House and Democratic leadership in the House and Senate are ongoing with a target of completing the legislation by the end of the year.

The Senate Finance Committee has not yet held a committee markup of draft budget reconciliation legislation or announced that such a markup will occur.  Over the past several months, however, Senator Wyden (D-OR), who is the Chair of the Senate Finance Committee, has released a series of proposals on key tax issues including pass-through entity tax rules, international tax rules, carried interest, derivatives, a mark-to-market proposal, and a stock buyback excise tax proposal. All of these proposals are being considered for inclusion in the Senate tax title of the budget reconciliation legislation.

This True Insight will focus on the proposals released by Chair Wyden in early September that would make changes to the rules applicable to pass-through entities, primarily in the rules governing partnerships in Subchapter K of the Internal Revenue Code (Code).

Status and Timeline for the Budget Reconciliation Legislation

The House Committee on Ways & Means approved the tax title of the Build Back Better Act, which includes a significant package of business and individual provisions such as increased tax rates on corporations, individuals, and capital gains; changes to outbound and inbound international tax provisions; and several other provisions affecting high-income individuals, pass-through businesses, and estates and trusts.  On October 28th, President Biden released a new “framework” for the Build Back Better bill, which dropped many of the key proposals that were included in the Ways & Means Committee-approved tax title. A final version of the legislation is being negotiated within the House Democratic Caucus before House Floor consideration in order to ensure that there are enough votes to pass the bill.

The new framework was offered in order to resolve key differences among Democrats in the House and Senate about the size of the bill and specific provisions to be included on both the tax incentive side and the revenue offsets. Revised legislative language was posted on the House Rules Committee website on October 28th, but changes are still being made prior to House Floor consideration. Democratic leadership in the House and Senate hope to complete action on both the infrastructure legislation and the budget reconciliation legislation in the next few days.  If they do, the infrastructure bill would go to the President for signature, and the budget reconciliation legislation would go to the Senate for consideration, where it is likely to be revised with the possible addition of some of Chair Wyden’s proposals.

There is no new deadline for completion of the budget reconciliation legislation, but Democratic leadership have suggested a deadline of the Thanksgiving Congressional recess. The current continuing resolution, which was approved to fund the government past the October 1st deadline for a Fiscal Year 2022 budget, expires on December 3, 2021, could also serve as a convenient deadline for the budget reconciliation bill if the legislation has not been enacted.

Senator Wyden’s Discussion Draft on Pass-Through Entity Reform

On September 10, 2021, Senate Finance Committee Chair Wyden (D-OR) released a Discussion Draft of legislation that would significantly revise the treatment of partnerships and partners under Subchapter K of the Internal Revenue Code (“Discussion Draft”).  The materials included in the release were draft legislative language, a one-page summary, and a 10-page section-by-section summary of the proposed changes.  The proposals are estimated by the Joint Committee on Taxation to raise $172 billion over ten years.

These proposals are broad and could potentially have far-reaching effects on partnerships and their partners as well as exchange-traded funds (ETFs), mutual funds, and their managers and investors.  Some of the proposals are narrow in scope, while others make significant changes including those related to allocations of income and deductions; allocations of partnership liabilities; and the tax treatment of publicly trade partnerships (PTPs).  This partnership tax reform is intended to remove unnecessary optionality and ambiguity, close loopholes, and facilitate taxpayer compliance and IRS audits.

The Senate Finance Committee has not held hearings on these issues, nor have they held a markup session on a tax title to be included in budget reconciliation spending and tax legislation.  Therefore, these materials are the best source of insight into possible changes to partnership taxation that might be included in the revenue section of the budget reconciliation legislation.

The Ways & Means Committee has approved a tax title to be included in the budget reconciliation legislation when it is considered on the House Floor.  There are several provisions in that tax title that would have an impact on partnerships and their partners, but there is very little overlap with the proposals covered in the Wyden Discussion Draft.

The Biden Administration and Congressional Democratic leadership have stated that they do not intend to have the revenue-raising proposals included in the budget reconciliation legislation impact taxpayers with less than $400,000 of income.  This policy position will have to be factored into any decisions on the proposals discussed in this True Insight.

Why Reform the Partnership Tax Rules?

The Wyden Discussion Draft is designed to “reform major areas of tax law that are abused by sophisticated taxpayers by removing ambiguity and closing tax loopholes for pass-through entities, primarily partnerships, that allow investors and corporations to pick and choose when to pay tax.”  The Overview document states that the “complexity and ambiguity of the partnership tax rules make them nearly impossible for the IRS to administer, to the detriment of taxpayers who play by the rules and to the benefit to wealthy individuals and mega-corporations.”

The Section-by-Section summary explains the intent of the proposed changes:

The provisions of the discussion draft, in removing ambiguity and closing loopholes, will make compliance easier for well-meaning taxpayers, allow the IRS to more successfully audit aggressive taxpayers, and raise revenue in a progressive manner.

The discussion draft also includes changes that remove existing areas of uncertainty and align the language and policy of existing IRS provisions.  Subchapter K has remained largely untouched for decades, with well-known oversights unaddressed and long-standing questions unanswered.  More recent changes to the taxation of partnerships have given rise to new questions.  Legislative changes to remove uncertainty and better effectuate policy ends, at the cost of some optionality, will assist both taxpayers and the IRS.

This summary of the proposals follows the organization of the Section-by-Section summary of the Discussion Draft.

Section 1 – Code Section 701 – Partnership’s Subject to Tax Under New Audit Rules

The Discussion Draft would make a technical amendment to Section 701 that follows the enactment and implementation of the centralized partnership audit regime established by the Bipartisan Budget Act of 2015, under which partnerships can, at times, be subject to entity-level taxation.  The change is intended to allow the IRS to enhance reporting requirements of partnership tax positions by aligning tax reporting with Financial Accounting Standards Board (FASB) reporting, which may require the reporting of uncertain tax positions that could trigger an entity-level liability.

Section 2 – Code Sections 704(a) and 704(b) – Profit Allocations and Substantial Economic Effect

Current law provides two sets of rules for the allocation of partnership items, specifically the “partners interest in the partnership” (PIP) standard and the “substantial economic effect” (SEE) safe harbor.  Both are based on the general principle of economic substance and are intended to align tax allocations with the underlying economic arrangement.  The Discussion Draft states that the flexibility of current law has resulted in complexity for taxpayers and the IRS, and that the new provisions would simplify the administration of partnership allocations.

The Discussion Draft would eliminate the SEE test under Section 704(b) and mandate that PIP be the general rule for testing partnership allocations.  The PIP standard generally depends on the facts and circumstances associated with the parties’ economic arrangements, e.g., each partner’s contributions and rights to distributions.  Certain partnerships where related persons own 50% or more would be required to allocate items consistently based on partner net contributed capital.

The changes related to Section 704(b) allocations would have a delayed effective date and would apply to partnership tax years beginning after December 31, 2023.  The Treasury Secretary is authorized to provide transition rules and to provide exceptions to the general rule and to issue updated regulations reflecting the changes.

TPC Insight:  The SEE safe harbor has become a linchpin within the framework of partnership taxation because it provides a more objective standard than PIP.  Many partnership agreements with special allocations rely on the SEE safe harbor, so the impact of this change will be widespread.  However, it appears that the “targeted allocation” model, which has been growing in popularity in recent years—particularly amongst private equity firms—would not be impacted by this provision because those allocations are tied to distributions based on capital accounts and thus would be respected under PIP.

The Discussion Draft contemplates that the IRS will issue additional regulations to further clarify how the PIP standard should be applied after the SEE safe harbor is removed.  One can expect that many partnerships would need to amend their agreements in order to ensure their allocations meet the PIP standard  This could be why the effective date for this provision is 2 years later than others in this proposal.

Section 3 – Code Section 704(c)(1)(A) – Mandatory use of the Remedial Method

Generally, property can move into and out of partnerships tax-free under Sections 721 and 731.  Section 704(c) attempts to prevent the shifting of built-in gains or losses (“NUBIG”) on contributed property (i.e., the difference between the tax basis and fair market value when the property is contributed) between the contributing and non-contributing partners.  The regulations governing section 704(c) provide for three methods of allocating tax items related to contributed property to account for NUBIG:  the traditional method; the curative method; and the remedial method.  The Discussion Draft concludes that only the remedial method fully prevents shifting of NUBIG between partners in all cases.

The Discussion Draft would require the use of the remedial method for all Section 704(c) allocations, effective for property contributions and revaluation events occurring after December 31, 2021.

TPC Insight:  All taxpayers who are considering transactions in 2022, including contributions of property or formation of a new partnership, should consider the December 31, 2021 effective date of this provision.  Mandatory use of the remedial method could result in unexpected consequences, including income recognition with respect to contributed property, the timing and amount of which will depend on numerous factors such as the character and tax life of the property with NUBIG.  This could also impact future tax distributions that may be necessary to cover the remedial allocations.

Section 4 – New Code Section 704(f) – Mandatory Revaluations

The Discussion Draft states that under current law, there is an opportunity to shift NUBIG in connection with a change in a partner’s interest in a partnership (e.g., as a result of a contribution of money or other property in exchange for a partnership interest or the issuance of a profits interest in the partnership).  Revaluations (or “book-ups”) prevent the shifting of partnership NUBIG away from the partners who accrued such economic gain or loss, but under Treas. Reg. sec. 1.704-1(b)(2)(iv)(f), these revaluations are currently optional.

The Discussion Draft would create a new Section 704(f) that would make revaluations of partnership property, which are known as “reverse” Section 704(c) allocations, mandatory upon a change in the economic arrangement of the partners.  This would prevent partners from having the option to shift NUBIG that exists under current law.  The Discussion Draft would also treat a revaluation event of an upper-tier partnership (“UTP”) as a revaluation event for any lower-tier partnership (“LTP”) if the UTP owns 50% or more of the capital or profits interest in the LTP.  The provision would apply to revaluation events occurring after December 31, 2021.

TPC Insight: The time, complexity, and cost of complying with mandatory revaluations would likely increase for partnerships that are not booking up assets under current law but have periodic revaluation events, including the issuance of compensatory partnership interests.  This change would also be particularly burdensome on tiered partnership structures that have multiple tax preparers working on different entities throughout the organizational structure who would need to coordinate and track multiple 704(c) layers across the different tiers.  Furthermore, since a revaluation event of a UTP would also trigger a revaluation event for a 50%-owned LTP, this may have unexpected consequences on the LTP’s profit and loss allocations, which could include pushing a fund manager into a carried interest position in an earlier tax year.

Section 5 – Code Sections 704(c)(1)(B) and 737 – Mixing Bowl Transactions

Under current law, when a partner contributes property with a built-in gain, the partner must recognize gain if such property is: (1) subsequently distributed to any other partner within 7 years of the original contribution, or (2) other property is distributed to the contributing partner within 7 years of the original contribution.  Collectively, these two rules are known as the “mixing bowl” rules and are designed to prevent taxpayers from engaging in tax-free exchanges of property through contributions and related distributions to and from a partnership.  The Discussion Draft finds partnerships are able to avoid these rules by waiting more than 7 years to make the subsequent distribution.

The Discussion Draft would repeal the seven-year limit for “mixing bowl” transactions under Section 704(c)(1)(B) and Section 737, so that the rules would apply to contributed property regardless of the time since contribution.  The provision would apply to property contributed after December 31, 2021.

TPC Insight:  Any taxpayer considering a transaction that involves contributing property to a partnership in 2022 should consider the potential effect of this provision, including M&A transactions involving the use of rollover equity as compensation to legacy owners.

Section 6 – Code Section 705(b) – Partner’s Outside Basis

The Discussion Draft would give greater flexibility to the Treasury Secretary to prescribe rules under Section 705 for the determination of outside basis by allowing the alternative rule under Section 705(b) to be applied in scenarios other than partnership terminations.  This change would be effective on the date of enactment.

Section 7 – Code Sections 707(a), 707(c), 736, 753, and 761 – Guaranteed Payments, Liquidating Distributions, and other Transactions Between Partners and the Partnership

A partner’s distributive share of partnership income can be considered compensation for the partner’s services on the partnership’s behalf as well as for the use of the partner’s capital.  However, a partner can also receive a payment from the partnership in addition to its distributive share.

Under current law, such payments are generally considered to be a guaranteed payment (i.e., a payment between the partnership and one who is not a partner) under section 707(c) to the extent that the payment is: (i) either for services or the use of capital, and (ii) determined without regard to the partnership’s income.  The Discussion Draft states that Section 707(c) has created “confusion and uncertainty,” allowing the taxpayer to choose how to treat the payments.

The Discussion Draft would repeal the partnership-to-partner payment rules in Section 707(c).  Section 707(a) would govern any payments by the partnership that are not actual or in substance distributions under Section 731, treating them as payments to a partner not acting in its capacity as a partner.  The provision would be effective for payments made after December 31, 2021.

The Discussion Draft also notes that a partnership may structure payments to withdrawing or retiring partners in a variety of ways and states that some partnerships selectively choose the rules that will apply so that their tax liability is minimized.  Thus, the Discussion Draft would repeal Section 736 to align payments to retirees and successor-in-interest partners with the general rules of subchapter K specifically and the Code generally (including Section 409A).  Section 761 would be amended to provide that a retiring or successor-in-interest partner would remain a partner until complete liquidation of the partnership interest.

TPC Insight:  Eliminating the rules for guaranteed payments could impact the timing and character of income related to these payments.  Moreover, this rule change could prompt the IRS to issue new (and arguably long-awaited) guidance clarifying when and how such payments should be treated.  For example, there has long been confusion about how to determine whether allocations of preferred returns based on a percentage of the partner’s invested capital should be treated as standard allocations under section 704(b) or as guaranteed payments for the use of capital (“GPUCs”), as well as how GPUCS should be classified for federal tax purposes (see e.g., the discussion in the preamble to the final 163(j) regulations about whether such amounts should be classified as interest payments for purposes of section 163(j)).  The elimination of section 707(c) could accelerate the timeline for the IRS to issue such guidance.

Sections 8 and 9 – Code Section 707(a)(2) – Disguised Sale Rules

Under current law, partners are generally allowed to contribute property to, and receive distributions from, a partnership without recognition of gain.  The current rules include a number of anti-abuse provisions intended to prevent taxpayers from using a partnership to exchange one type of property for another (including cash) without recognition of gain, including, for example, the mixing bowl transactions discussed above.

Section 707(a)(2)(B) was enacted to prevent such abuses by directing the Treasury Secretary to identify circumstances under which a contribution and related distribution should be characterized as a sale of property or a partnership interest, known as the “disguised sale” rules.  The Discussion Draft includes two provisions that “correct two asserted ambiguities that may limit the effectiveness of these rules.”

The first provision would clarify that the disguised sale rules are “self-executing.”  This change is necessary because some taxpayers have taken the position that sales of partnership interests that take the form of a contribution by one partner and a related distribution to another partner are not considered sales of partnership interests because the Secretary has not yet issued regulations.

The current regulations provide an exception from treatment as sale proceeds for certain reimbursements from the partnership to a partner for capital expenditures.  The Discussion Draft provision would repeal this exception, thereby treating proceeds for reimbursement of capital expenditures as disguised sale proceeds.

Both provisions would apply to services performed or property transferred after the date of the enactment.

TPC Insight:  With regards to the first provision that the disguised sale rules are self-executing, many taxpayers and tax preparers already take the position that there can be a disguised sale of a partnership interest.  This change would only impact taxpayers that are taking the opposite position based on the lack of a specific regulation stating that fact.

All taxpayers who rely on tax-free reimbursements of pre-formation costs or expenses related to contributed property, particularly taxpayers in capital intensive industries like real estate and private equity, should monitor the development of the second provision and have discussions with their tax advisor about how it may impact the structure of future investments.

Section 10 – Code Section 708 – Partnership Terminations

Under current law, a partnership is considered to be terminated if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.  Some taxpayers have taken the position that Section 708(a) incorporates a continuity of partner requirement, which would appear to allow taxpayers to structure into a termination, even if the business is still operating.

The Discussion Draft would clarify that a partnership is not terminated under Section 708 if any part of the business is carried on by a person who was a partner in the prior partnership or by a person related to any of those partners.  The provision would be effective for tax years beginning after the date of enactment.

Section 11 – Code Section 751(b) – Distributions and Substantially Appreciated Inventory

Under current law, section 751(b) acts as another anti-abuse rule to prevent partners from using partnerships to avoid taxes.  Section 751 generally governs the treatment of the partnership’s inventory and unrealized receivables—also known as “hot assets”—both of which are property that produce ordinary income.  Section 751(b) was enacted to prevent partners from avoiding tax by exchanging their percentage interest in hot assets into cash or an interest in other property that generates lower-taxed capital gains (“cold assets”).

Under these rules, if a partnership makes a disproportionate distribution of property to a partner that has the effect of shifting any partners’ percentage interest in the partnership’s hot assets and cold assets (i.e., shifts their right to receive future allocations of ordinary income to capital gains, or vice versa), such distribution may be reclassified as a sale or exchange of the property between the partner and the partnership.  Inventory, however, is only treated as a hot asset to the extent it is “substantially appreciated,” meaning the fair market value exceeds 120% of the inventory’s adjusted tax basis.

The Discussion Draft would eliminate the requirement that inventory be “substantially appreciated” to be treated as ordinary income property.  The provision would apply to distributions occurring after the date of enactment.

TPC Insight:  This is another potential rule change that could have unexpected tax consequences for sellers in M&A transactions who will receive rollover equity if part of the transaction structure would also involve receipt of a non-pro rata distribution of assets that includes unrealized receivables.

Section 12 – Code Section 752 – Allocations of Partnership Debt

Under current law, there are rules for determining whether a partnership has recourse debt under Section 752.  Those rules assume that all partnership property is worthless, regardless of its actual value, and that the partner will fulfill any obligation, regardless of the partner’s ability to do so.  The Discussion Draft comments that in practice, “a lender typically expects that credit extended to a partnership will be repaid with partnership profits.”  The Discussion Draft concludes that the “flexible recourse debt” rules of current law permit partnerships to manipulate a partner’s basis in the partnership, manipulate the allocations of losses, avoid disguised sale rules, and generate tax-deferred cash distributions.  It states that the rules are also “enormously complex, difficult to administer, and rife with abuse.”

The Discussion Draft would modify Section 752 to require that all debt be shared between the partners in accordance with partnership profits.  There is an exception to this provision for cases where the partner (or a person related to the partner) is the lender.

The provision would be effective for tax years beginning after December 31, 2021.  There is a transition rule that allows taxpayers to pay any tax liability that arises as a result of the enactment of the provision over eight years.

TPC Insight:  This provision of the proposal would not only change the debt allocation rules such that all future allocations of a partnership’s third-party recourse debt would be treated as if it was nonrecourse, it would also change the fundamental rules for allocating nonrecourse debt by aligning it with each partner’s percentage of the partnership’s profits.  The allocation rules would no longer consider factors such as which partner guarantees the debt or whether a contribution of property with nonrecourse debt in excess of basis would trigger gain.

If enacted as written, these changes could have a widespread impact on any partner invested in a partnership if their allocations of debt are not equal to their allocations of profits. Partners who rely on the basis from existing debt allocations to support deductions or distributions could have immediate tax consequences, including gain recognition and corresponding basis adjustments, which would be payable in installments over 8 years.

Given the effective date of December 31, 2021, it’s unclear how partners and partnerships will be able to prepare for and implement these new debt allocation rules before tax consequences are triggered.  The rules for determining a partner’s percentage of the partnership’s profits are already unclear when applied to certain allocation structures (e.g., whether GPUCs and other preferred returns should be included in that percentage), and other changes in this proposal (e.g., the elimination of guaranteed payments) will add further complexity. Furthermore, it will take time for the IRS to develop regulations that sufficiently address most of the open questions, and many partnerships will be required to make payments (e.g., tax distributions) or execute transactions with uncertainty about the tax consequences before guidance is issued.

Section 13 and 14 – Code Sections 734, 743, and 754 – Mandatory Basis Adjustments

Under current law, a partnership can elect to adjust the basis of partnership property for disparities between the partnership’s basis in its property and the partners’ basis in their partnership interests.  The Discussion Draft includes two provisions that make these basis adjustments mandatory rather than elective, “limiting opportunities for tax planning through deferral and shifting of tax liability.”

Also under current law, a partnership is only required to adjust basis in partnership assets to correct a disparity in the case of substantial basis reductions under Section 734(d) and 743(d).  Otherwise, basis adjustments are optional, which the Discussion Draft states leads to tax planning opportunities.  The provision would make basis adjustments mandatory at the time of a partnership distribution of money or other property.  It would have the effect of aligning the partners’ shares of tax gain or loss with their economic shares of book gain or loss in the partnership, according to the Discussion Draft.

Sales of partnership interests can create disparities between the inside and outside tax basis of a partner when a transferee partner has basis in its partnership interest that is different than the transferee partner’s proportionate share of basis in partnership assets.  Under current law, a partnership can elect to adjust basis in partnership assets with respect to the transferee partner, but those basis adjustments are only mandatory in the case of a “substantial” built-in loss with respect to the transfer of an asset.  The Discussion Draft provision would make basis adjustments resulting from transfers of partnership interests mandatory to prevent deferral of tax liabilities.

Section 754 would be deemed to be obsolete and repealed.  The provisions would be effective for transfers occurring after December 31, 2021.

TPC Insight:  Many partnerships currently avoid making a 754 election because of the administrative burden, and thus the compliance costs for those partnerships would likely increase if this proposal is enacted.  The changes to section 734 could also have unintended consequences on any disproportionate distributions.  Taxpayers that are considering making non-pro rata distributions in 2022 should consider the impact of these rule changes before announcing that they will make those distributions.

Section 15 – Code Section 163(j) – Partnership’s Business Interest Expense

The deduction for business interest under Section 163(j) is limited to the sum of (1) business interest income, (2) 30% of the adjusted taxable income, and (3) floor plan financing interest.  The amount of business interest not allowed as a deduction for any taxable year is treated as business interest paid or accrued in the succeeding taxable year.

For partnerships, this limitation is only partially applied at the partnership level.  Under special rules, a partner is allowed to use its share of excess partnership limitation to deduct business interest from other sources.

The Discussion Draft would amend Section 163(j)(4) to make the business interest limitation fully apply at the entity level for partnerships (and S corporations).  Thus, excess limitation cannot be used to deduct interest expense from other sources.

The provision would be effective for tax years beginning after December 31, 2021.

Note that the House Ways & Means Committee-approved tax title to be included in the budget reconciliation bill would apply Section 163(j) only at the partner level.

TPC Insight:  It’s unclear if this provision would be enacted due to the conflict with the House budget reconciliation bill.  However, if enacted, taxpayers will need to consider whether they should move debt to another entity within their organization structure in order to avoid trapping excess business interest expense carryforwards within an entity that will not generate sufficient adjusted taxable income to utilize those attributes.

Section 16 – Code Section 7704(c) – Elimination of the Exception for Publicly Traded Partnerships

Under current law, certain publicly traded companies are allowed to opt into partnership status, thereby creating an exception to being taxed at the corporate level. The Discussion Draft would eliminate the exception from corporate treatment for publicly traded partnerships (PTPs) under Section 7704. 

The Discussion Draft states that PTPs often have hundreds of thousands of partners and that it is nearly impossible for the IRS to properly administer them.  Because these entities do not pay corporate taxes, they “erode the corporate tax base.”

This change requiring PTPs to be taxed as corporations would be effective for tax years beginning after December 31, 2022.

Section 17 – Code Section 852(b)(6) – Distributions of Appreciated Property by RICs

Under current law, corporations must recognize gain when distributing appreciated property to their shareholders.  Regulated Investment Companies (RICs) are exempt from this rule when they distribute property in kind to a redeeming shareholder.

The Discussion Draft states that this exception has led to a significant rise in the distribution of assets with built-in gain in redemption of a shareholder in order to significantly reduce the future tax burden of current and future shareholders.  It posits this case as an example. Typically, a firm will make a strategic investment in a mutual fund with the intention that it will be redeemed with appreciated assets.  The investment and related redemptions permit the fund to eliminate unrealized gain on the distributed assets completely tax free, allowing the mutual fund’s shareholders to defer economic gains until they liquidate their investments in the mutual fund.

The Discussion Draft would revise Section 852(b)(6) to repeal the exception for RICs so that RICs would be required to recognize gain upon distribution by a corporation of built-in gain property. 

The repeal would be effective for tax years beginning after December 31, 2022.

TPC Insight:  While it may have a broader impact, this provision appears to be primarily targeting ETFs that are taxed as RICs, many of whom redeem shareholders by making property distributions in order to avoid or minimize the amount of capital gains recognized at the fund level.

Section 18 – Code Section 52 – Aggregation of Gross Receipts

Under the current Code, certain business entities are aggregated when testing for various limitations, such as the gross receipts limitation in the use of the cash method of accounting under Section 448(c) and the exemption from interest deductibility limitations under Section 163(j).  Section 52(a) covers corporate entities, and Section 52(b) has similar rules for corporate and non-corporate entities.  The Discussion Draft states that Section 52(b) refers to “trades or business (whether or not incorporated)” and that the treatment of certain for-profit activity is unclear.

The Discussion Draft would revise Section 52 to provide that any taxpayer engaged in an activity in connection with a trade or business or for-profit activity, including a foreign entity, is subject to the aggregation rules under Section 52.  The provision would be effective for tax years beginning after December 31, 2021.

TPC Insight:  The proposed change to section 52 would clarify the existing aggregation rules, although it could result in fewer businesses claiming the small business exception to avoid the limitation on business interest deductions under 163(j) limitation.  This includes certain portfolio companies owned by private equity funds that currently take the position that they are eligible for the exception (i.e., that their average annual gross receipts in the previous 3 years was less than $25 million) because they are excluding the gross receipts of the fund and its other portfolio companies when computing their 3-year average.

Conclusions

Significant changes to the partnership tax rules appear to be possible with the enactment of budget reconciliation legislation if Senator Wyden successfully negotiates with the House for inclusion of some of his proposals in the Discussion Draft.  Businesses are well advised to monitor reports on the negotiations between Congress and Treasury related to these proposals.

If you have questions about any of the information in this True Alert, please contact a member of your TPC engagement team.