Treasury’s Long-Delayed Partnership Tax Plan Faces a Tough Road

Tax practitioners might obtain some insight into how the Treasury Department will respond to the end of agency deference by considering how it plans to address certain forthcoming partnership tax regulations.

The Treasury appears ready to target two longstanding issues: defining a “limited partner in a limited partnership” for the purpose of limiting passive losses under Section 469(h)(2) of the tax code, and applying the “disguised sale of a partnership interest” rule under Section 707(a)(2)(B).

Both are areas that the Treasury and IRS have been unsuccessful in reconciling in the face of taxpayer challenges. After the Supreme Court’s decision in Loper Bright Enterprises v. Raimondo, it would seem Treasury faces an even more difficult path.

Loper Bright overturned Chevron v. NRDC, which directed courts to defer to reasonable agency interpretations of ambiguous statues or unclear laws. In doing so, the Supreme Court also eliminated Brand X deference, in which agencies could overrule unfavorable case law by issuing a subsequent contrary regulation. Agencies still play a significant role in determining the law through regulations, but the ultimate job of interpreting the law has been restored to the courts.

Unnecessary and Duplicative?

Despite the loss of deference, Treasury officials intend to finalize regulations proposed in 2011 following a string of judicial losses for applying the general material participation test instead of Section 469(h)(2) to partners and members of other limited liability entities. The Treasury has given no indication that it will modify the 13-year-old proposal in response to Loper Bright.

Expect taxpayer challenges to the final regulations if left unmodified. When it originally proposed the regulations, the Treasury’s task was simpler. Under National Cable & Telecommunications Ass’n v. Brand X Internet Services, the Treasury would have enjoyed Chevron deference to its final regulation.

Now that Loper Bright has eviscerated Chevron (along with Brand X), unfavorable case law no longer can be eliminated by issuing final regulations, which are now open to challenges by taxpayers using the same arguments that were successful against the IRS in three previous cases under Section 469(h)(2): Gregg v. United States; Garnett v. Commissioner; and Thompson v. United States.

Under Loper Bright, taxpayers may argue that the Treasury lacks authority to restrict the definition of a “limited partner in a limited partnership.” As the court in Thompson observed, the purpose of Congress’ grant of regulatory authority under Section 469(h)(2) was to “provide exceptions—not expand upon—the Code’s presumption that limited partners don’t materially participate in their limited partnerships.”

Any attempt to define the term in a restrictive way may be viewed as outside the grant of specific authority.

Courts may not be impressed by the 13-year delay in finalizing its own proposal. They could conclude that the regulations under Section 469(h)(2) are “much ado about nothing,” given that courts previously recognized that the general tests for material participation ensured that limited partners were treated as passive.

Courts may find that any final regulations are unnecessary and duplicative, as the only function of the regulation is to reduce the number of tests that are available to a partner in determining material participation.

Conservative Approach?

It also will be interesting to see whether the Treasury is more conservative in issuing regulations applying the “disguised sale of a partnership interest” rule under Section 707(a)(2)(B). This would provide regulations deeming contributions by, and distributions to, different partners as a disguised sale of a partnership interest.

The IRS was defeated in multiple court cases before receiving a delegation of authority to prescribe regulations from Congress, and regulations issued in 2004 were withdrawn in 2009 following significant criticism. Fifteen years later, the Treasury Department appears ready to try again.

An April Congressional Research Service report estimated that 88% of agency rule drafters either agreed or somewhat agreed that Chevron deference made them willing to adopt “a more aggressive interpretation. Given the significant failure in its previous attempt, the Treasury may attempt to be more conservative in its approach.

Loper Bright means the Treasury may have to compete with the previous courts siding with taxpayers in the marketplace of ideas, given that Congress doesn’t seem to have defined the parameters under which the Treasury received a delegation of authority to issue regulations. If the Treasury simply rehashes arguments made before statutory authority was given, it may find its efforts to regulate wasted.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Brett Bissonnette leads Plante Moran’s tax controversy services practice and frequently represents clients before the IRS. He’s also a leader in the firm’s national tax office.

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