Income tax

Biden Administration Proposes Partnership Tax Changes – Income Tax

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On March 28, 2022, the Biden administration proposed some limited changes to the taxation of partnerships. In short, the Administration’s proposals (i) would prevent related partners in a partnership that has elected under Section 754 from changing bases to reduce taxable income;1 and (ii) make two useful changes to the partnership audit rules.

I. Prevent rebasing by related partners

Under current law, if a partnership with appreciated non-depreciable assets and depreciable or depreciable assets makes a “section 754 election” and distributes the appreciated non-depreciable assets tax-free to a partner, other partners have the right to “step-up”, or increase, their base in depreciable or depreciable assets. These transactions are known as “basic bumps”.

A section 754 election is an election that allows a partner who acquires an interest in a partnership to adjust its share of the partnership’s “internal” tax base in its fair value assets and allows the partners of a partnership to adjust their internal base of partnership assets when distributing an asset to another partner. The base increase upon distribution of an appreciated asset is generally equal to (i) the beneficiary partner’s gain; or if a Distributor Partner takes a lower base in Distributed Assets than that Partner’s internal base prior to the distribution, (ii) the amount by which the Partnership’s Base exceeds the Distributor Partner’s base in Distributed Assets immediately prior to the distribution.

Two related partners in a partnership can use this rule to generate increased depreciation or depreciation deductions for one of the partners by distributing an appreciated non-depreciable asset to the other. Additionally, these transactions can be used to reduce the gain or generate a loss on the assets that should be sold, while continuing to hold the low-base assets.

The Biden administration has proposed to prevent related parties of a partnership from using this rule to generate deductions by prohibiting any partner related to the beneficiary partner from benefiting from the increase in the base of the partnership until the beneficiary partner disposes of the distributed asset in a fully taxable transaction. In addition, the proposal would authorize the Treasury to issue regulations to implement this matching rule with respect to tied partners. The proposal does not define the term “related” for these purposes.

The proposal has no effect on unrelated partners who use the same strategy to generate increased depreciation or amortization deductions by causing the partnership to distribute appreciated assets to one of the partners.

The proposal would apply to taxation years beginning after December 31, 2022.

II. Amending the Bipartisan Budget Law 2015 Centralized Partnership Audit Regime

a. Authorize the deferral of a tax reduction that exceeds a partner’s tax liability

Section 6225 generally requires a partnership to pay tax attributable to adjustments resulting from an audit on the previous allocation of income, gains, losses, or deductions to partners, unless the partnership persons has made a “rejection” election under Article 6226, in which case the partners who were partners in the tax year subject to the control bear the taxes, interest and penalties attributable to the recovery. For partners who are audited for multiple years or whose adjustments in a single audited year affect their tax liability in subsequent years, Section 6226 allows partners to offset amounts for each year and report either a additional tax, i.e. a tax reduction in the year in which they take into account their share of the adjustments (the “reporting year”). However, if the calculation results in a net decrease, the partners can use the decrease to reduce their reporting year tax obligations to zero and cannot benefit from a refund or deferral.

The Biden administration is helpfully proposing to allow partners who receive a favorable adjustment under Section 6226 (i.e. partners who have paid too much tax) to treat the excess as an overpayment in under section 6401 that can be refunded.

The proposal would enter into force on the date of promulgation.

a. Incorporate Chapters 2/2A into the centralized partnership audit regime

As mentioned above, under the general rule in section 6225, partnership adjustments made as a result of an audit are assessed against the partnership. However, Section 6225 only applies to income taxes and not self-employment or the 3.8% Medicare tax on “net investment income.” Self-employment and taxes on net investment income are subject to the old audit rules (i.e. before the Budget Act of 2015 (the “BBA”) changed the audit rules).

Thus, the IRS conducts an audit procedure under the BBA rules for income taxes and a separate audit procedure under the pre-BBA rules for net investment income and self-employment taxes. Taxpayers may have to amend several returns accordingly.

The Biden administration would usefully include net investment income and self-employment taxes in the BBA’s audit rules that apply to income taxes.

The proposal would come into effect after the date of proclamation for all open taxation years.

Footnotes

1. All section references are to the Internal Revenue Code.

Biden administration proposes changes to partnership taxation

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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