Partnership Deals Get Overdue Clarity in IRS’s Tax Rule Proposal

An IRS proposal would bring decades-old sections of the federal tax code relating to deals between partnerships and related persons in line with laws that Congress has passed in recent years.

The proposed amendments to Section 267 and Section 707, released Nov. 24, affect partnerships that enter into transactions with related people 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 different methods of accounting.

If approved and implemented, these changes could provide much longed-for clarity for tax professionals and their clients. To understand how, let’s look at the ambiguity created by the current tax code.

Misaligned Material

Section 267(a)(1) stipulates that a taxpayer generally may not deduct a loss upon sales or exchanges, whether direct or indirect, of property between related persons, as defined in Section 267(b).

Section 267(a)(2) then describes a matching rule providing that a taxpayer (the payor) may not deduct an otherwise deductible expense until the payee has included the amount in their gross income (unless paid), and the parties are related persons, as defined in Section 267(b).

This is relevant when payors and payees have different methods of accounting. It prevents a taxpayer from accruing and taking a deduction in the current year for an amount paid in a later period to a cash basis related party who can defer the income recognition to a later period.

Complicating matters more is when primary source material, including Treasury regulations and laws passed by Congress, doesn’t align with its intent.

Reg. Section 1.267(b)-1(b) reads as though the aggregate theory of partnership taxation applies to loss disallowance rules and the matching rule, but various statutory adjustments issued by Congress over the past 50 years seem to indicate otherwise.

For example, when Section 267(e) was added to the tax code in 1984 to extend the matching rule of Section 267(a)(2), it was drafted in a way that indicated it applied to transactions between partnerships—as an entity—and partners.

These types of conflicting interpretations can confuse practitioners, who must apply the code sections and regulations in practice. Many situations we encounter as tax professionals aren’t black and white and don’t neatly fall within a well-defined framework.

Addressing Inconsistencies

The proposed amendments would remove Reg. Section 1.267(b)-1(b) and add a section to the end of Reg. Section 1.267(a)-1 to clarify that if a partnership loss or deduction governed by Section 267(a) is disallowed or deferred, it will be done at the partnership level and won’t be considered in computing the partnership’s taxable income.

This reading differs from the current interpretation of the regulation, which disallows the loss or defers the deduction at the related partner level instead of by the partnership.

Practitioners can now more clearly advise clients on the impact of any partnership-level deferred or disallowed losses. For example, a practitioner working with a partnership entity client doesn’t always have the full picture to advise on tax matters impacting that entity’s partners unless those partners are also clients of the practitioner.

These proposed regulations, in applying loss limitations at the partnership level, allow practitioners to advise their partnership clients more fully on the impact of such limitations.

Other changes would help align our work with the more natural ways that our clients often view their business dealings, streamlining communication and decision-making. In looking at the changes to Section 267 of the tax code, being able to apply the disallowance of certain losses or deductions at the partnership level is a more straightforward approach than having to apply these rules at the separate partner level.

Outlook

For many taxpayers, the aggregate approach can be a difficult concept to understand. They often view a partnership as its own entity separate and distinct from its partners, so the entity approach to partnership taxation often makes more sense.

For tax practitioners, it can sometimes be challenging to help clients understand the complex concepts of partnership taxation, especially when some concepts are defined under the aggregate approach and others are defined under the entity approach. The lack of consistency and uniformity in applying the tax code can leave taxpayers confused and sometimes questioning the IRS.

Though these proposed regulations only address one small section of the code, it’s a step in the right direction for consistency. It’s also worth noting that taxpayers should be mindful that these changes and clarifications result in more of the loss or expense being limited at the entity level rather than the unrelated persons being able to deduct their share.

Overall, the biggest difference tax professionals would see should these proposals take effect would be reduced ambiguity in applying Section 267. As tax practitioners know, the complexity of the federal tax code increases with each passing year.

Anytime a proposed regulation can serve to provide clarity around a muddy topic, the more this frees up tax practitioners to advise our clients both in that area and in other areas and help them reach their business goals.

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

Kassie Grishaber is a CPA and senior tax manager with FORVIS. She has more than 10 years of experience focusing on flow-through entity taxation and complex, multi-state partnerships.