Proposed Regulations Issued on Varying Interest and Partnership Taxable Years

REG-144689-04, 74 Fed. Reg. 17119 (4/14/09): Proposed regulations issued on determination of distributive share when partner's interest varies during partnership taxable year and on required taxable year of partnership.

Discussion: Varying Interests Rule. The preamble to the proposed regulations explains that, under §706(c)(1), the taxable year of a partnership—except in the case of a termination of a partnership and except as provided in §706(c)(2)—does not close as the result of the death of a partner, the entry of a new partner, the liquidation of a partner's interest in the partnership, or the sale or exchange of a partner's interest in the partnership. The preamble notes that under §706(c)(2)(A), however, the taxable year of a partnership does close with respect to a partner whose entire interest terminates (whether by reason of death, liquidation, or otherwise), while under §706(c)(2)(B) the taxable year of a partnership does not close (other than at the end of a partnership's taxable year) with respect to a partner who sells or exchanges less than the partner's entire interest in the partnership or with respect to a partner whose interest is reduced (whether by entry of a new partner, partial liquidation of a partner's interest, gift, or otherwise).

The proposed regulations would amend Regs. §1.706-1(c) to reflect §706(c)(2)(A), which requires that the taxable year of a partnership close with respect to a partner who dies. The proposed regulations would not change the provisions in Regs. §1.706-1(c)(3)(iv), that the sale or exchange of a partnership interest does not include any transfer of a partnership interest occurring at death as a result of inheritance or any testamentary disposition, or in Regs. §1.706-1(c)(5), that the transfer of a partnership interest by gift does not close the partnership taxable year with respect to the donor.

The preamble also explains that, under §706(d)(1) (except as required by §706(d)(2) and (d)(3)) if there is a change in a partner's interest in the partnership during the partnership's taxable year, each partner's distributive share of any partnership item of income, gain, loss, deduction, or credit for that taxable year is determined by the use of any method prescribed in regulations that takes into account the varying interests of the partners in the partnership during the taxable year (the “varying interests rule”). Section 706(d)(1), the preamble notes, was added by the Deficit Reduction Act of 1984 (P.L. 98-369), in part to clarify that the varying interests rule applies to the disposition of a partner's entire interest in the partnership as well as the disposition of less than a partner's entire interest.

The proposed regulations would add Regs. §1.706-4to provide for the application of the varying interests rule in all cases in which a partner's interest changes during the taxable year, whether by reason of a disposition of the partner's entire interest in the partnership or a disposition of less than the partner's entire interest in the partnership.

Methods and Conventions. The preamble notes that under Regs. §1.706-1(c)(2)(ii) a partnership may use the interim closing method, or the partners may by agreement choose to use the proration method, in determining distributive shares. Under the proration method, the partnership's income and losses may be prorated based on the portion of the taxable year that has elapsed prior to the date upon which the partners' interests varied, or “under any other method that is reasonable” (i.e., under a “convention”). In 1984, the preamble explains, the IRS issued news release IR-84-129 announcing that partnerships using the interim closing method are permitted to use a semi-monthly convention, under which partners entering during the first 15 days of the month are treated as entering on the first day of the month, and partners entering after the 15th day of the month (but before the end of the month) are treated as entering on the 16th day of the month (except to the extent that §706(c)(2)(A) applies). The news release provided that, until regulations were issued, partnerships using the proration method must use a daily convention.

Prop. Regs. §1.706-4 would provide that: (1) if a partner's interest changes during the partnership's taxable year, the partnership must determine the partner's distributive share using the interim closing method unless the partners agree to use the proration method; (2) a partnership must take into account any variation in the partners' interests during the taxable year by determining the distributive shares under §702(a) for each “segment” (as defined) of the taxable year, using an interim closing of the books method (unless the partners agree to use the proration method) and by allocating the items among the partners according to their respective interests during the segment; (3) each partner whose interest changes in the partnership's taxable year must maintain segments to account for the changes; (4) a partnership using the interim closing or proration method must use a special accounting method; (5) a partnership using the proration method must allocate “extraordinary items” (as defined in the regulations) among the partners in proportion to their interests at the beginning of the day on which they are taken into account; (6) a partnership using the interim closing method can use either a “calendar day convention” or a “semi-monthly convention,” but a partnership using the proration method must use the calendar day convention; and (7) a partnership must use the same method and convention for all variations in partners' interests during the partnership's taxable year.

Change in Allocations Among Contemporaneous Partners.
The preamble mentions that the 1984 Act amended §706, in part, to clarify that the varying interests rule applies to any change in a partner's interest, and that legislative history of the resulting §706(d)(1) reflects Congress's intention that §706(d)(1) not overrule §761(e) (which provides that a partnership agreement includes any modifications of the partnership agreement made before, or at, the time prescribed for filing the partnership return).

Prop. Regs. §1.706-4 would clarify that the varying interests rule does not preclude changes in allocations among contemporaneous partners resulting from amendments to the partnership agreement made no later than the due date of the partnership return for the taxable year (excluding extensions). The exception, however, would not apply to changes in interests attributable to contributions of money or other property or resulting from capital distributions.

Safe Harbors for Service Partnerships and Publicly Traded Partnerships. Prop. Regs. §1.706-4 would also allow “service partnerships” (as defined) to allocate items relating to the provision of services among the partners whose interests vary during the year using any reasonable method (as long as the allocations are valid under §704(b)), and would provide that §7704(b) publicly traded partnerships may treat all transfers of its publicly traded units during a calendar month as occurring on the first day of the following month under a consistent method adopted by the partnership or may use the semi-monthly convention. Block transfers of units, however, would not qualify for this safe harbor.

Deemed Dispositions. Regs. §1.706-1(c) would be amended to treat a deemed disposition of a partner's entire interest in the partnership pursuant to Regs. §1.1502-76(b)(2)(vi), Regs. §1.1362-3(c)(1), or Regs. §1.1377-1(b)(3)(iv) as a disposition of the partner's entire interest for purposes of §706.

Taxable Years of Partnerships. The preamble notes that a partnership must determine its taxable year under §706(b)(1)(B) unless the partnership establishes to the satisfaction of Treasury a business purpose for a different year. In general, the preamble continues, the required taxable year of a partnership is determined by reference to the taxable year of its partners. If partners owning a majority interest in a partnership have the same taxable year, the partnership is required to have the same taxable year as the majority interest owners (“majority interest taxable year”). If a taxable year for the partnership cannot be determined under the majority interest taxable year rule, the taxable year of the partnership shall be the taxable year of all of its principal partners (“principal partner taxable year”). If there is not taxable year described under the majority interest taxable year rule or principal partner taxable year rule, then the partnership is required under the regulations to have the taxable year that results in the least aggregate deferral of income.

Under Regs. §1.706-1(b)(6)(i), the preamble continues, an interest held by a “disregarded foreign partner” is not taken into account in determining the taxable year of the partnership. (A foreign partner is a “disregarded foreign partner” unless the partner is allocated gross income that was effectively connected with the conduct of a trade or business of the partnership within the United States and taxation of that income is not otherwise precluded under any U.S. income tax treaty.) However, the preamble states, the interest of a disregarded foreign partner is taken into account in determining the taxable year of the partnership if the partners that are not disregarded foreign partners (“regarded partners”) hold a “minority interest” in the partnership (the “minority interest rule”). Regarded partners hold a “minority interest” for this purpose if each regarded partner holds less than a 10% interest in capital or profits of the partnership and the regarded partners in the aggregate hold less than a 20% interest in the capital or profits of the partnership.

The proposed regulations would amend the minority interest rule to provide that regarded partners have a minority interest only if each regarded partner has less than a 10% interest in capital and profits and the regarded partners collectively have less than a 20% interest in partnership capital and profits.

Proposed Effective Date. The proposed regulations would apply to partnership taxable years beginning after the date on which the final regulations are published but—to ensure a transition period in accord with the legislative history of §706(d)—not before taxable years beginning after 2009.