Proposed Regs Update Rules on Transactions Between Related Persons and Partnerships

(Parker Tax Publishing December 2023)

The IRS issued proposed regulations that update the regulations under Code Secs. 267 and 707 regarding whether persons are treated as related persons who are subject to certain special rules pertaining to transactions with partnerships. The regulations affect partnerships that enter into transactions with related persons that result in gain or loss on a sale or exchange of property or result in a difference in the time at which income and deductions are recognized because of the persons' different methods of accounting. REG-131756-11.

Background

In general, Code Sec. 267(a)(1) provides that a taxpayer may not deduct a loss on the sale or exchange of property with a related person as defined in Code Sec. 267(b). Code Sec. 267(a)(2) sets forth a ''matching rule'' that provides that if because of a payee's method of accounting, an amount is not (unless paid) includible in the payee's gross income, the taxpayer (payor) may not deduct the otherwise deductible amount until the payee includes the amount in gross income if the taxpayer and payee are related persons within the meaning of Code Sec. 267(b) on the last day of the taxpayer's tax year in which the amount otherwise would have been deductible. Code Sec. 707(b)(1) addresses the sale or exchange of property between a partnership and a partner owning, directly or indirectly, more than 50 percent of the capital or profit interest in the partnership.

Reg. Sec. 1.267(b)-1(b) applies an aggregate theory of partnerships to provide that any transaction described in Code Sec. 267(a) between a partnership and a person other than a partner is considered as occurring between the other person and the members of the partnership separately. Specifically, Reg. Sec. 1.267(b)-1(b) provides that if the other person and a partner are within any of the relationships specified in Code Sec. 267(b), no deductions with respect to the transaction between the other person and the partnership will be allowed: (1) to the related partner to the extent of the related partner's distributive share of partnership deductions for losses or unpaid expenses or interest resulting from the transactions, and (2) to the other person to the extent the related partner acquires an interest in any property sold to or exchanged with the partnership by the other person at a loss, or to the extent of the related partner's distributive share of the unpaid expenses or interest payable to the partnership by the other person as a result of the transaction.

According to the IRS, statutory changes to Code Secs. 267 and 707(b) have made Reg. Sec. 1.267(b)-1(b) inconsistent with the statute. In 1982, Congress added Code Sec. 267(b)(10) to disallow a deduction resulting from a transaction between a commonly-controlled partnership and an S corporation. Specifically, Code Sec. 267(b)(10) provides that an S corporation and a partnership were related persons if the same persons owned more than 50 percent of the outstanding stock of the S corporation and more than 50 percent of the capital interest or the profits interest in the partnership. In 1984, Congress added Code Sec. 267(e), which extends the matching rule of Code Sec. 267(a)(2) to transactions between a partnership and a partner or a person related to a partner (within the meaning of Code Secs. 267(b) or 707(b)(1)). Congress also amended Code Sec. 267(b)(10) to include C corporations as well as S corporations.

In 1985, the IRS issued Reg. Sec. 1.267(a)-2T(c) to provide guidance for transactions between related partnerships. The regulations generally apply an aggregate theory of partnerships in deferring deductions according to the partners' aggregate interests in the payor partnership.

In 1986, Congress amended Code Sec. 707(b) in two ways. First, Code Secs. 707(b)(1)(A) and 707(b)(2)(A) were revised to expand the application of those provisions to a person who is not a partner and Code Sec. 707(b)(2) was modified to reduce the thresholds described in that section from more than 80 percent of profits or capital to more than 50 percent of profits or capital for purposes of treating recognized gain between related persons as ordinary income. As amended, the loss disallowance rules of Code Sec. 707(b)(1)(A) and the character of gain rules of Code Sec. 707(b)(2)(A) apply to transactions between a partnership and any person (a partner or nonpartner) who directly or indirectly owns more than 50 percent of the capital or profits interest in the partnership. Second, Congress amended Code Sec. 707(b)(1)(B) to provide that for purposes of the matching rule in Code Sec. 267(a)(2), two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests are treated as related persons within the meaning of Code Sec. 267(b). The related committee reports state that the modifications to Code Sec. 707(b), and in particular to Code Sec. 707(b)(1)(B), were intended to replace Questions and Answers 2 and 3 of Reg. Sec. 1.267(a)-2T(c).

Proposed Regulations

On November 27, the IRS issued proposed regulations that would remove Reg. Sec. 1.267(b)-1(b) and amend Reg. Sec. 1.267(a)-1 to remove the application of Questions and Answers 2 and 3 in Reg. Sec. 1.267(a)-2T(c).

According to the IRS, the statutory changes to Code Secs. 267 and 707(b) enacted since 1982 indicate that Congress intended for a partnership to be viewed as an entity, rather than as an aggregate of its partners, in applying the rules of Code Secs. 267 and 707(b). Therefore, the loss disallowance rules of Code Secs. 267(a)(1) and 707(b)(1), the gain recharacterization rules of Code Sec. 707(b)(2), and the matching rule of Code Sec. 267(a)(2) similarly should be applied at the partnership level and not the partner level. Accordingly, the IRS stated that the rules relating to partnerships in Reg. Sec. 1.267(b)-1(b) and Reg. Sec. 1.267(a)-2T(c), Questions and Answers 2 and 3, do not conform to Congress's view of how Code Sec. 267 should be applied to partnerships.

To conform the regulations under Code Sec. 267 with the current statute, the proposed regulations propose: (1) to remove Reg. Sec. 1.267(b)-1(b); (2) to amend Reg. Sec. 1.267(a)-1 to reflect the rules in Questions and Answers 1 and 4 in Reg. Sec. 1.267(a)-2T(c) as Reg. Sec. 1.267(a) - 1(d)(2) and (3); and (3) to amend Reg. Sec. 1.267(a)-1 to terminate the application of Questions and Answers 2 and 3 in Reg. Sec. 1.267(a)-2T(c). The regulations under Reg. Sec. 1.267(a)-2T(b), which provide questions and answers applying Code Sec. 267(a)(2) and (b) generally, would continue to apply.

The IRS noted that some of the citations in the existing regulations under Code Sec. 267 may be outdated due to subsequent legislative and regulatory changes. However, the IRS stated that the rules in these questions and answers remain substantively accurate. For example, Question 1 under Reg. Sec. 1.267(a)-2T(b) refers to the completed contract method under Reg. Sec. 1.451-3(d). The IRS stated that the substance of this answer remains correct; however, the correct citation to the completed contract method is now under Reg. Sec. 1.460-4(d). The IRS explained that modifications to update incorrect citations in Reg. Sec. 1.267(a)-2T(b) are outside the scope of the proposed regulations. Finally, the proposed regulations also revise Reg. Sec. 1.707-1(b) to conform to the statutory changes made to Code Secs. 267 and 707(b).

The regulations are proposed to apply to tax years ending on or after the date the final rules are published in the Federal Register. Thus, Reg. Sec. 1.267(b)-1(b) would be removed, and the revisions to Reg. Sec. 1.267(a)-1 would apply to tax years ending on or after the date the final regulations are published in the Federal Register. Similarly, the revisions to Reg. Sec. 1.707-1(b) would apply to sales or exchanges of property with respect to controlled partnerships in tax years ending on or after the date the final regulations are published in the Federal Register.

For a discussion of sales or exchanges between a partnership and a controlling partner, see Parker Tax ¶25,240.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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