IRS Issues Prop. Regs. Regarding Allocable Cash Basis and Tiered Partnership Items.

(Parker Tax Publishing August 23, 2015)

The IRS has issued proposed regulations regarding the determination of a partner's distributive share of certain allocable cash basis items and items attributable to an interest in a lower-tier partnership during a partnership tax year in which a partner's interest changes. REG-109370-10.

Proposed Regulations on Allocable Cash Basis

Code Sec. 706 generally provides rules for the tax years of partners and partnerships.

If during the year a partner's interest in the partnership changes, Code Sec. 706(d)(2) provides rules for determining the partner's distributive share of certain allocable cash basis items. Code Sec. 706(d)(2)(A) provides that if there is a change in any partner's interest in the partnership, then each partner's distributive share of any allocable cash basis item is determined by:

(1) assigning the appropriate portion of such item to each day in the period to which it is attributable, and

(2) allocating the portion assigned to any such day among the partners in proportion to their interests in the partnership at the close of such day.

Code Sec. 706(d)(2)(B) defines "allocable cash basis item" as interest, taxes, payments for services or for the use of property, or any other item specified in regulations, with respect to which the partnership uses the cash method of accounting. Code Sec. 706(d)(2)(C) further provides that if any portion of any allocable cash basis item is attributable to any period before the beginning of the tax year, that portion is assigned to the first day of the tax year. For portions of any allocable cash basis item attributable to any period after the close of the tax year, such portion is assigned to the last day of the tax year.

The proposed regulations provide that the term "allocable cash basis item" generally includes the items of deduction, loss, income, or gain specifically listed in the statute: interest, taxes, and payments for services or for the use of property. The term also includes any allowable deduction that had been previously deferred under Code Sec. 267(a)(2). This provision incorporates the concept of Reg. Sec. 1.706-2T and includes within the meaning of "allocable cash basis item" amounts deferred under Code Sec. 267(a)(2) in the year in which the deduction is allowed. Accordingly, the IRS proposes to withdraw Reg. Sec. 1.706-2T by final regulations issued under Code Sec. 706(d)(2).

In addition, the proposed regulations provide that allocable cash basis items also include any item of income, gain, loss, or deduction that accrues over time and would, if not allocated as an allocable cash basis item, result in the significant misstatement of a partner's income. The IRS believes that items such as rebate payments, refund payments, insurance premiums, prepayments, and cash advances are examples of items which, if not allocated in the manner described in Code Sec. 706(d)(2), could result in the significant misstatement of a partner's income.

Accordingly, the proposed regulations provide that an allocable cash basis item will not be subject to the rules in Code Sec. 706(d)(2) if, for the partnership's tax year:

(1) the total of the particular class of allocable cash basis items (for example, all interest income) is less than five percent of the partnership's gross income, or gross expenses and losses, and;

(2) the total amount of allocable cash basis items from all classes of allocable cash basis items amounting to less than five percent of the partnership's gross income, or gross expenses and losses, does not exceed $10 million in the tax year, determined by treating all such allocable cash basis items as positive amounts.

OBSERVATION: The IRS has issued, simultaneously with the proposed regulations, final regulations in T.D. 9728 under Reg. Sec. 1.706-4 providing general rules for determining partners' distributive shares of partnership items when a partner's interest in a partnership varies during the tax year as a result of the disposition of a partial or entire interest in a partnership, or with respect to a partner whose interest in a partnership is reduced.

Proposed Regulations on Tiered Partnerships

Rev. Rul. 77-311 explains that an upper-tier partnership's distributive share of any items of income, gain, loss, deduction, or credit from a lower-tier partnership is considered to be realized or sustained by the upper-tier partnership at the same time and in the same manner as such items were realized or sustained by the lower-tier partnership. Therefore, in allocating items from a lower-tier partnership, the upper-tier partnership must take into account variations among its partners' interests throughout the year, rather than merely looking to its partners' interests as of the last day of the lower-tier partnership's tax year.

Code Sec. 706(d)(3), enacted in 1984, confirms the analysis of Rev. Rul. 77-311 by providing that if during any tax year of the partnership there is a change in any partner's interest in an upper-tier partnership that is a partner in another partnership (the lower-tier partnership), then each partner's distributive share of any item of the upper-tier partnership attributable to the lower-tier partnership is determined by assigning the appropriate portion of each such item to the appropriate days during which the upper-tier partnership is a partner in the lower-tier partnership and by allocating the portion assigned to any such day among the partners in proportion to their interests in the upper-tier partnership at the close of such day.

With respect to tiered partnerships, the proposed regulations provide that the daily allocation method used for cash basis items applies to all items of the lower-tier partnership if there is a change in any partner's interest in the upper-tier partnership.

The IRS has acknowledged that a lack of information sharing among tiered partnerships may make it difficult to comply with a daily allocation requirement. Thus, the proposed regulations provide an exception from Code Sec. 706(d)(3) if the upper-tier partnership directly owns an interest in less than 10 percent of the profits and capital of the lower-tier partnership ("a de minimis upper-tier partnership"), all de minimis upper-tier partnerships in aggregate own an interest in less than 30 percent of the profits and capital of the lower-tier partnership, and if no partnership is created with a purpose of avoiding the application of the tiered partnership rules of Code Sec. 706(d)(3).

OBSERVATION: The application of this exception is determined at each tier, depending on the interests held by the direct partners at each tier. Thus, in the case of an upper-tier partnership owning an interest in a middle tier partnership, which in turn owns an interest in a lower-tier partnership, it may be the case that the exception applies to the upper-tier partnership's interest in the middle tier partnership, but not to the middle tier partnership's interest in the lower-tier partnership (or vice versa).

If the de minimis upper-tier partnership exception applies, the upper-tier partnership may apply the general rules of Reg. Sec. 1.706-4 in allocating items attributable to the lower-tier partnership. However, as explained in Rev. Rul. 77-311, an upper-tier partnership's distributive share of any items of income, gain, loss, deduction, or credit from a lower-tier partnership is considered to be realized or sustained by the upper-tier partnership at the same time and in the same manner as such items were realized or sustained by the lower-tier partnership.

If the exception applies to an upper-tier partnership using the proration method in Reg. Sec. 1.706-4, the upper-tier partnership may prorate the items from the lower-tier partnership across the upper-tier partnership's segments (or, if the upper-tier partnership has only one segment for its entire tax year, it may prorate the items across its entire tax year). Even if the de minimis upper-tier partnership exception applies, the upper-tier partnership may choose to allocate the items attributable to the lower-tier partnership according to the tiered partnership rules instead. However, the proposed regulations do not impose on lower-tier partnerships an obligation to disclose to upper-tier partnerships the timing of the lower-tier partnership's items.

Coordination with Proposed Partnership Equity for Services Regulations

On May 24, 2005, the IRS published a notice of proposed rulemaking (REG-105346-03), the proposed Partnership Equity for Services regulations, relating to the tax treatment of certain transfers of partnership interests in connection with the performance of services. Those proposed regulations are not effective until finalized.

The proposed Partnership Equity for Services regulations contain two provisions relating to the varying interest rule under Code Sec. 706.

First, proposed Reg. Sec. 1.706-3(a) is intended to provide an exception to the allocable cash basis item rules of Code Sec. 706(d)(2) for deductions for the transfer of partnership interests and other property subject to Code Sec 83. The IRS has concluded that, in the case of a transfer of a partnership interest in connection with the performance of services, no portion of the partnership's deduction should be allocated to the person who performs the services. However, the IRS has also concluded that the scope of the exception to allocable cash basis treatment in proposed Reg. Sec. 1.706-3(a) may have been too broad because it applies to all transfers of property subject to Code Sec. 83. Therefore, the IRS withdraws proposed Code Sec. 1.706-3(a). Instead, the proposed regulations provide an exception to allocable cash basis treatment for deductions for transfers of partnership interests in connection with the performance of services.

Second, proposed Reg. Sec. 1.706-3(b) provides that a partnership must make certain forfeiture allocations upon forfeiture of a partnership interest for which a Code Sec. 83(b) election was made. The IRS anticipates that if the rules for forfeiture allocations in proposed Reg. Sec. 1.706-3(b) are adopted when the proposed Partnership Equity for Services regulations are finalized, those rules will include in Reg. Sec. 1.706-3(b) an additional exception to the general application of the varying interest rule.

Effective Date

The regulations are proposed to apply to partnership tax years beginning on or after the date the regulations are finalized. (Staff Editor Parker Tax Publishing)

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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