Treasury Finalizes Regulations on the Varying Interests Rule Under Section 706
On August 3, 2015, the U.S. Department of Treasury (Treasury) and the Internal Revenue Service (IRS) issued final regulations under Section 706(d), providing rules for determining the partners’ distributive shares of partnership items when a partner’s interest varies during the taxable year. Concurrently, Treasury and the IRS issued proposed regulations addressing allocations of certain cash basis items and allocations when interest shifts occur in a tiered partnership structure.
Under Section 706(d) of the Internal Revenue Code (Code), subject to certain exceptions, if a partner’s interest in a partnership changes during the year, each partner’s distributive share of partnership items for such year must be determined pursuant to any method prescribed by Treasury in regulations that take into account the varying interests of the partners in the partnership during such year. This varying interests rule generally was intended to prevent a partner from joining a partnership during the year and receiving a retroactive allocation of tax losses or other benefits. However, under what is known as the contemporaneous partner exception, the varying interests rule does not apply to shifts among partners who are partners for the entire taxable year, as long as such shifts are not, in substance, attributable to the influx of new capital.
2009 Proposed Regulations
Proposed regulations released in 2009 (the 2009 proposed regulations) generally provided that in determining a partner’s distributive share of partnership items under the varying interests rule, the partnership must divide its taxable year into segments. Each segment corresponds to the period of time during which the partners’ interests remain unchanged. The partnership must then allocate its items to each segment under either the interim closing method or proration method. Unless the partners agree to use the proration method, the partnership was required to use the interim closing method.
The interim closing method is generally viewed as more cumbersome, but more accurate. Under the interim closing method, the partnership must calculate partnership items for each segment as if the segment was a separate distributive share period, and then allocate the items of each segment among the partners in accordance with their respective partnership interests during such segment. Under the proration method, the partnership is simply required to allocate all items for the year among the segments on a pro rata, per-day basis. The 2009 proposed regulations did not allow extraordinary items (such as gains from the disposition of property) to be prorated; instead, such items generally must be allocated to the partners based on their interests as of the beginning of the day on which the item is taken into account (the beginning of day rule). The 2009 proposed regulations contained a list of nine types of extraordinary items.
The 2009 proposed regulations adopted certain conventions that would treat any change in any partner’s interest during a particular month as occurring on one or more specified days in the month. (The IRS had previously approved a semimonthly convention in a 1984 news release.) Partnerships that used the interim closing of the books method could use either the calendar day convention or the semimonthly convention. Under the calendar day convention, a segment closes at the end of any day on which a variance occurs, and the next segment commenced on the following day. Under the semimonthly convention, if the variance occurs between the first day and the 15th day of the month, the variance is treated as occurring on the last day of the preceding calendar month, resulting in a new segment commencing on the first day of the month. If the variance occurs between the 16th day and the last day of the month, the variance would be treated as occurring at the end 15th day of the month, and a new segment would commence as of the following day. A partnership using the proration method must use the calendar day convention.
The final regulations generally adopt the framework of the proposed regulations with minor modifications, clarifications and options providing additional flexibility. Key provisions of note are:
The 2009 proposed regulations required a partnership to use the same method for variations occurring within the partnership’s taxable year, whether resulting from a complete or partial termination of a partner’s interest, or the entry of a new partner. In response to comments, the final regulations allow a partnership to use different methods for different variations within the partnership’s taxable year.
As noted above, the 2009 proposed regulations contained certain conventions for partnership utilizing the interim closing method under which a variance is treated as occurring as of a specified date of a calendar month. The final regulations add a monthly convention. Under this convention, a variation that occurs on the first through the 15th day of the calendar month is treated as occurring on the last day of the preceding calendar month. Otherwise, the variation is treated as occurring on the last day of the calendar month. The selection of the convention (calendar day, semimonthly or monthly) must be made by agreement of all partners. In the absence of an agreement, the partnership will be deemed to have chosen the calendar day convention. As with the 2009 proposed regulations, the final regulations require partnerships that use the proration method to utilize the calendar day convention.
The 2009 proposed regulations did not require partnerships using the interim closing method to separately account for extraordinary items. Treasury became concerned that partnerships that used either the semimonthly or monthly convention could shift tax consequences of extraordinary items to partners who were not partners in the partnership when the partnership incurred the extraordinary item. As a result of these concerns, the final regulations provide that the extraordinary items rules also apply to partnerships that use the interim closing method. Accordingly, the special allocation of extraordinary items is an exception to not only the proration method, which would otherwise ratably allocate the extraordinary items across the segment, but also the conventions, which might otherwise shift extraordinary items between a transferor and transferee.
The 2009 proposed regulations would have allocated extraordinary items in proportion to the interests of the partners as of the beginning of the day on which the item is taken into account. The final regulations rejected requests by commentators to adopt a “next day rule” (similar to what is provided in the consolidated return rule for when members join or leave a consolidated group). In addition, the final regulations tweaked the timing rule to provide that an extraordinary item 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.
The final regulations add two items to the extraordinary item list. First, a partnership may treat as an extraordinary item any non-enumerated item if there is an agreement among the partners to consistently treat such items as extraordinary items. Second, the final regulations provide that an extraordinary item includes any item identified as an additional class of extraordinary item in published guidance from the IRS.
The above changes are generally welcome additions to the regulations applying the varying interests rule. In many cases, taking advantage of certain exceptions from default rules will require an agreement among the partners. Fortunately, the final regulations generally permit the selection of methods, conventions or additional extraordinary items to be made by a person authorized to make that selection under state law or in the partnership agreement.
Subject to certain exceptions, the final regulations are effective for partnership taxable years that begin on or after August 3, 2015.
New Proposed Regulations
New proposed regulations issued concurrently with the final regulations propose to add two additional items to the extraordinary item list. The first one allows publicly traded partnerships to treat items of income that are amounts subject to withholding as extraordinary items. The second one would require deductions attributable to the transfer of partnership equity in connection with the performance of services as an extraordinary item. The new proposed regulations would treat such deduction as occurring immediately before the transfer or vesting of the compensatory partnership interest. Accordingly, no portion of the deduction would be allocated to the person who performs the services.
The new proposed regulations provide rules supplementing Section 706(d)(2) on the allocation of “allocable cash basis items,” including adding a de minimis rule to ease the administrative burden of compliance. In addition, the new proposed regulations provide narrow guidance on tiered partnership structures (i.e., how an upper-tier partnership takes into account items from a lower-tier partnership when a variance occurs at the upper-tier level). Specifically, the proposed regulations provide that the daily allocation method used for cash basis items applies to all items of a lower-tier partnership if there is a change in any partner’s interest in an upper-tier partnership. Lastly, the proposed regulations request comments on several complex issues that arise when applying the varying interests rule in a tiered partnership structure.
The new proposed regulations are proposed to be effective for partnership taxable years beginning on or after the date of publication of the regulations in final form.