PARTNERSHIP TAXATION: RECENT DEVELOPMENTS

Transcription

1 PARTNERSHIP TAXATION: RECENT DEVELOPMENTS December 2017 BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms.

2 Partnership Taxation Recent Developments BDO Leadership Conference Jeff Bilsky, Partner National Tax Office David Patch, Managing Director National Tax Office Julie Robins, Managing Director National Tax Office November 13, Partnership Taxation: Recent Developments

3 Agenda The New Partnership Audit Rules Sales of Partnership Interests by Foreign Partners (Grecian Magnesite v. Commissioner) Status of Pending Tax Reform Impacting Partnerships Self-Employment Tax Update Proposed Regulations Expanding Fractions Rule Exceptions Proposed and Temporary Regulations Under Section 721(c) Reverse Section 1031 Exchanges (Bartell v. Commissioner) 3 Partnership Taxation: Recent Developments

4 The New Partnership Audit Rules 4 Partnership Taxation: Recent Developments

5 Partnership Audit Rules Current Partnership Audit Rules TEFRA Audits: Partnerships with more than 10 partners are audited at the entity level. IRS flows audit adjustments through to the partners and determines refunds or deficiencies. Electing Large Partnership (ELP) Audits: Partnerships with 100 or more partners that elect to be treated as ELP are subject to a unified audit where resulting exam adjustments are reflected on the partner s tax return for the year the audit is finalized. Small Partnership Audits: Partnerships with 10 or fewer partners (consisting solely of resident individuals, C-corporations or estates of an individual) are audited as part of the partner s separate audit unless the partnership elects to apply the TEFRA rules. 5 Partnership Taxation: Recent Developments

6 Partnership Audit Rules Overview Bipartisan Budget Act of 2015 (the BBA ) significantly changes the way in which partnerships are audited: For tax years beginning after 12/31/2017 all partnerships are subject to the new partnership audit rules. TEFRA and ELP audit rules repealed. Partnership representative is the sole authority to act on behalf of the partners and partnership during an IRS audit. Audits conducted at the partnership level and adjustments are taken into account by the partnership in the year the audit is completed. Unfavorable audit adjustments will result in an imputed underpayment obligation. Default rule requires the partnership to pay the imputed underpayment. Favorable audit adjustments will be allocated out to the partners in the year the audit is completed. Small partnerships may elect out of the new partnership audit rules. 6 Partnership Taxation: Recent Developments

7 Partnership Audit Rules Opt-Out Rules Small Partnerships (those with fewer than 100 eligible partners) may elect out of the new rules In order to elect out, partnerships must make an annual affirmative election and disclose required partner information Eligible Partners: Individuals C-corporations Foreign entities that would be treated as a C-corporation if domestic S-corporations (each shareholder is counted for purposes of determining the 100 partner limit) An estate of a deceased partner. Ineligible Partners: Partnership entities, i.e., upper-tier partnerships Trusts Disregarded entities such as single-member LLCs and grantor trusts Estate of an individual other than a deceased partner Nominee partner 7 Partnership Taxation: Recent Developments

8 Partnership Audit Rules Imputed Underpayment Calculation Step 1: Partnership first groups its adjustments into (i) Reallocation Grouping; (ii) Credit Grouping, or (iii) Residual Grouping Step 2: Partnership adjustments within each grouping/sub-grouping are then netted. Netted amounts resulting in a non-positive adjustment are disregarded for purposes of calculating the imputed underpayment. Step 3: The total netted partnership adjustment calculated in Step 2 is multiplied by the highest effective federal tax rate under section 1 or section 11. Step 4: The product resulting from Step 3 is then reduced, but not below $0 by the net adjustments to partnership credits. Imputed Underpayment = (Net Positive Adjustments * Highest Tax Rate) Adjusted Credits 8 Partnership Taxation: Recent Developments

9 Partnership Audit Rules Imputed Underpayment Calculation Modifications The imputed underpayment obligation can be modified pursuant to Proposed Treasury Regulations: 1. Partner-level amended returns 2. Allocations attributable to tax-exempt partners 3. Application of lower tax rates, e.g., capital gains vs. ordinary rates 4. Certain passive losses of publicly-traded partnerships 5. Other purposes as described in Proposed Treasury Regulations: Number and composition of imputed underpayments Allowable deficiency dividends under section 860 Partner-level closing agreement under section Partnership Taxation: Recent Developments

10 Partnership Audit Rules Imputed Underpayment Obligation Push-Out Election In lieu of the default payment rules the partnership can elect to push-out the imputed obligation to its partners. Reviewed year partners are liable for tax, penalties and interest on their respective shares of partnership adjustments. Reviewed year partners are bound by the election and must take the adjustments into account and report and pay additional tax, penalties and interest. A partnership making the push-out election must furnish statements to the reviewed year partners with respect to the partner s share of the adjustments and file those statements with the IRS. The rate of interest imposed on the underpayment is increased by two percentage points creating a surcharge to use the push-out method. 10 Partnership Taxation: Recent Developments

11 Partnership Audit Rules Partnership Representative The new rules require each partnership to designate a person as the PR who will have the sole authority to act on behalf of the partnership. All partners are bound by the actions of the PR and they have no right to contradict its decisions. This broad authority cannot be limited by state law, the partnership agreement or any other document or agreement. The PR does not have to be a partner but can be any person, including an entity, as long as it has a substantial presence in the United States and the capacity to act. The proposed regulations require a partnership to designate the PR on the partnership s return filed for each taxable year. If a partnership fails to designate a PR the proposed regulations allow the IRS to select a PR. 11 Partnership Taxation: Recent Developments

12 Partnership Audit Rules Administrative Adjustment Requests (AAR) Partnerships subject to the new partnership audit rules cannot file amended returns to correct errors reflected on returns that have been filed but must file an AAR. If a partnership files an AAR and the adjustments result in an imputed underpayment, the partnership must generally compute an imputed underpayment amount. As with the existing rules, a partnership may not file an AAR with respect to a taxable year more than three years after the later of the date the return for that year was filed or the due date of such return determined without regard to extensions. 12 Partnership Taxation: Recent Developments

13 Partnership Audit Rules Financial Accounting Impact Application of ASC 740 (FIN 48) Impact of adjustments on partner tax basis and section 704(b) capital accounts Push-out elections through tiered partnership structures Coordination of push-out rules with partner withholding obligations Look-through ownership of disregarded entities 13 Partnership Taxation: Recent Developments

14 Partnership Audit Rules Unresolved Issues Potential application of ASC 740 (FIN 48) vs. FAS 5 Impact of adjustments on partner tax basis and section 704(b) capital accounts Push-out elections through tiered partnership structures Coordination of push-out rules with partner withholding obligations Look-through ownership of disregarded entities 14 Partnership Taxation: Recent Developments

15 Partnership Audit Rules What does this mean for our clients and the practice? Immediate action is needed to ensure our clients have the authority to manage the partnership and its partners audit risk Risk assessment of existing positions for partner / partnership Plan for increased compliance obligations for all partnership clients Consideration should be given to updating operating agreements to reflect application of new audit rules prior to filing FY18 returns Increased risk to the partners on historical and future positions reported Engagement teams need to plan for increased requirements for partnership clients 15 Partnership Taxation: Recent Developments

16 Sales of Partnership Interests by Foreign Partners Grecian Magnesite 16 Partnership Taxation: Recent Developments

17 Sale of Partnership Interest by Foreign Partners Overview & Relevant Tax Issue A foreign person is subject to US income tax on income that is effectively connected with the conduct of a U.S. trade or business ( ECI ) Gain on the sale of assets used in the conduct of a U.S. trade or business can create ECI Gain on the sale of stock in a U.S. corporation that operates a U.S. trade or business does not create ECI Does the sale of a partnership interest by a foreign person create ECI? Under the Aggregate Theory, the foreign partner would be treated as selling a proportionate interest in assets used in a trade or business. This would generate ECI Under the Entity Theory, the foreign partner sells an interest in a entity that should not generate ECI (similar to the sale of corporate stock) 17 Partnership Taxation: Recent Developments

18 Sale of Partnership Interest by Foreign Partners Revenue Ruling Revenue Ruling adopts the Aggregate Theory and concludes that:... it is appropriate to treat a foreign partner's disposition of its interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States as a disposition of an aggregate interest in the partnership's underlying property for purposes of determining the source and ECI character of the gain or loss realized by the foreign partner Under Rev. Rul , the foreign partner disposing of a partnership interest recognizes ECI to the extent a sale of the underlying assets by the partnership would result in ECI The conclusion in Rev. Rul appears at odds with Section 741 which supports application of the Entity Theory by treating the gain as gain from the sale of a capital asset Notwithstanding its technical flaws, does Rev. Rul reach a correct result from a policy perspective? 18 Partnership Taxation: Recent Developments

19 Sale of Partnership Interest by Foreign Partners Grecian Magnesite v. Commissioner Taxpayer received a liquidating distribution in redemption of its interest in a US partnership Foreign Corporation Multiple LLC Members Gain recognized under Section 731 to the extent cash received exceeded basis in the US partnership Liquidating Distribution (cash) Section 741 provides that gain should be treated as gain recognized on the disposition of a capital asset Section 751 would characterize gain as ordinary only to the extent of the foreign partner s share of hot assets U.S. LLC (partnership) Taxpayer did not recognize ECI on the deemed sale of the US partnership interest. U.S. Trade or Business 19 Partnership Taxation: Recent Developments

20 Sale of Partnership Interest by Foreign Partners Grecian Magnesite v. Commissioner Taxpayer Position Section 741 provides for application of the Entity Theory unless an exception applies, e.g., section 751. Rev. Rul does not provide a technical analysis that is supported by statute or regulations. IRS Position The IRS argued for reliance on the holding in Rev. Rul requesting the court give deference to the IRS administrative rulings consistent with judicial precedent. Tax Court Decision The Tax Court concluded that subchapter K principles mandate treating the gain as capital gain from the disposition of a capital asset. Consequently, no ECI was recognized by the taxpayer. The court refused to provide deference to Rev. Rul due to the ruling s lack of power to persuade. Foreign Corporation Liquidating Distribution (cash) U.S. LLC (partnership) U.S. Trade or Business Multiple LLC Members 20 Partnership Taxation: Recent Developments

21 Status of Pending Tax Reform Impacting Partnerships 21 Partnership Taxation: Recent Developments

22 Tax Reform Impacting Partnerships Pending Legislation Status of Bills The House of Representatives passed their tax reform bill called the Tax Cuts and Jobs Act on November 16, 2017 The Senate passed their tax reform bill also called the Tax Cuts and Jobs Act in the early morning of December 2, 2017 The House and Senate must now reconcile their varying bills Goal is to have the president sign the bill by year end If tax reform is passed, it will likely be passed using budget reconciliation Only a simple majority will be needed in the Senate rather than the 60 votes normally needed to move legislative forward 22 Partnership Taxation: Recent Developments

23 Tax Reform Impacting Partnerships Pending Legislation United Framework Goals Tax relief for the middle class Easing compliance burden Tax relief for businesses, particularly small businesses Ending incentives for businesses to shift capital and revenue to lower tax jurisdictions overseas Broadening the tax base by closing tax incentives and loopholes 23 Partnership Taxation: Recent Developments

24 Tax Reform Impacting Partnerships Pending Legislation Tax Reform Bill - Highlights Lower tax rates Repeal corporate and individual AMT (Senate no longer repeals AMT) Immediate 100% expensing of some capital investments Limitation on interest deductions for businesses Like-kind exchange limitations Net operating loss deduction limitation International (not covered) Move to a territorial system Transition tax on accumulated foreign earnings New anti-erosion rules 24 Partnership Taxation: Recent Developments

25 Tax Reform Impacting Partnerships Pending Legislation Lower Corporate Tax Rates Rate reduced to a flat 20 percent House Bill: Immediate and permanent no phase-in or phase-out Personal service corporations subject to a flat 25 percent tax rate Senate Bill: Is not effective until January 1, 2019 No separate rate for personal service corporations 25 Partnership Taxation: Recent Developments

26 Tax Reform Impacting Partnerships Pending Legislation Lower Individual Tax Rates House Bill: Four brackets with top rate at 39.6%; capital gain & qualified dividend still taxed as lower rates Double standard deduction, repeal personal exemption; expanded child credits Most itemized deductions are to be eliminated except: - Cap on new mortgage interest deductions would be reduced to $500,000; no deduction available for home equity lines of credit or for second homes - Real estate taxes up to $10,000; No other SALT deductions allowed - Charitable contributions limit raised to 60% of AGI Net investment income tax not repealed 26 Partnership Taxation: Recent Developments

27 Tax Reform Impacting Partnerships Pending Legislation Lower Individual Tax Rates Senate Bill: Seven brackets with top rate at 38.5%; capital gain & qualified dividend still taxed as lower rates Double standard deduction; repeal personal exemption; expanded child credits Most itemized deductions are to be eliminated except: - Mortgage interest deductions kept at $1,000,000; no deduction available for home equity lines of credit - Conformed to House Bill allowing real estate taxes up to $10,000; No other SALT deductions allowed - Charitable contributions limit raised to 60% of AGI Net investment income tax not repealed Senate provisions reverse after Partnership Taxation: Recent Developments

28 Tax Reform Impacting Partnerships Pending Legislation Lower Pass-through Business Tax Rates House Bill The portion of an individual s net income from pass-through entities treated as qualified business income ( QBI ) is subject to a maximum 25 percent rate and remaining treated as compensation subject to the ordinary individual rates All net income from a passive business activity would be treated as QBI subject to 25 percent rate - Passive activity as defined in Section 469(c) - excluding Section 469(c)(3), working interests in oil and gas properties, and Section 469(c)(6) which includes expenses for the production of income such as investment expenses in the definition of trade or business Net income from an active business (including any wages received) would determine their QBI by reference to the capital percentage of the net income from such activities 28 Partnership Taxation: Recent Developments

29 Tax Reform Impacting Partnerships Pending Legislation Lower Pass-through Business Tax Rates House Bill (cont.) Determination of capital percentage : - The default capital percentage is 30 percent of the net business income from active business activities or - May elect to apply a facts and circumstances formula to determine a applicable percentage greater than 30 Facts & circumstances formula binding for five years - Applicable percentage based on a rate of return (Federal short-term rate plus 7 percent), multiplied by the capital investments of the business Default capital percentage for certain personal services businesses such as law, accounting, consulting, engineering, financial services, or performing arts would be ZERO - However, election to use facts & circumstances formula if it has an applicable percentage of at least 10 percent 29 Partnership Taxation: Recent Developments

30 Tax Reform Impacting Partnerships Pending Legislation Lower Pass-through Business Tax Rates Senate Bill Taxpayers other than corporations are allowed a deduction equal to 23 percent of domestic qualified business income ( QBI ) of pass-through entities Domestic QBI is defined as all domestic income other than investment income (i.e. dividends, investment interest income, capital gains, etc.) The deduction cannot exceed 50 percent of the W-2 wages paid by the partnership - The W-2 wage limit does not apply to taxpayer with taxable income not exceeding $500,000 married filing joint or $250,000 for other individuals QBI does not include reasonable compensation paid by an S-corporation or any amount that is a Section 707(c) guaranteed payment or a Section 707(a) payment 30 Partnership Taxation: Recent Developments

31 Tax Reform Impacting Partnerships Pending Legislation Lower Pass-through Business Tax Rates Senate Bill (cont.) The deduction is NOT available to QBI from specified services as defined in Section 1202(e)(3)(A) - Section 1202(e)(3)(A) includes the fields of health, law, engineering, accounting, actuarial services, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is reputation or skill of one or more of its employees - Taxpayers whose taxable income does not exceed $500,000 married filing joint or $250,000 for others are excepted and eligible for the 23 percent deduction The provision sunsets on December 31, Partnership Taxation: Recent Developments

32 Tax Reform Impacting Partnerships Pending Legislation Limitation on Business Losses for Taxpayers Other Than Corporations The Senate Bill disallows excess business losses of a taxpayer other than a C Corporation An excess business loss is a taxpayer s net aggregate current year pass-through loss over $500,000 for married filing joint filers and $250,000 for other filers Disallowed losses are carried forward and treated as part of the taxpayer s net operating loss carryforward In the case of a partnership or S corporation, the provision is applied at the partner or shareholder level The provision sunsets on December 31, Partnership Taxation: Recent Developments

33 Tax Reform Impacting Partnerships Pending Legislation Carried Interests Both the House and the Senate Bills impose a three-year holding period requirement for qualification as long-term capital gain with respect to certain applicable partnership interests received in connection with performing services If the holder of an applicable partnership interest is allocated gain from the sale of property held for less than three years, that gain is treated as shortterm capital gain and is subject to tax at the rates applicable to ordinary income This rule does not apply to income or gain attributable to any asset that is not held for portfolio investment on behalf of third party investors 33 Partnership Taxation: Recent Developments

34 Tax Reform Impacting Partnerships Pending Legislation Carried Interests (cont.) The term applicable partnership interest means: Any partnership interest which is directly or indirectly transferred to (or held by) the taxpayer in connection with the performance of substantial services by the taxpayer in any applicable trade or business An applicable trade or business means any activity that consists in whole or part of raising or returning capital, and either investing in (or disposing of) specified assets or developing specified assets Specified Assets include: securities, commodities, real estate held for rental or investment, cash or cash equivalents, or options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership s proportionate interest in any of the foregoing 34 Partnership Taxation: Recent Developments

35 Tax Reform Impacting Partnerships Pending Legislation Repeal of Technical Termination Provisions The House Bill repeals the technical termination rules under Section 708(b)(1)(B) Partnership treated as continuing even if more than 50 percent of the total capital and profits interests of a partnership are sold or exchanged No more related restart of depreciation and No more ability to choose new elections Senate Bill has no similar provision 35 Partnership Taxation: Recent Developments

36 Tax Reform Impacting Partnerships Pending Legislation Modification of the Definition of Substantial Built-in Loss The Senate Bill modifies the definition of a substantial built-in loss in Section 743(d) related to transfers of partnership interests Under current rules, a mandatory basis adjustment is required to partnership assets if there is a substantial built-in loss in partnership assets. The definition is expanded to include that a substantial built in loss exists if the transferee would be allocated a net loss in excess of $250,000 upon a hypothetical disposition of all the assets of the partnership at FMV House Bill has no similar provision 36 Partnership Taxation: Recent Developments

37 Tax Reform Impacting Partnerships Pending Legislation Sale of Partnership Interest by Foreign Partners The Senate Bill essentially codifies the holding in Rev. Rul and overturns the ruling in Grecian Magnesite Gain or loss from the sale of a partnership interest is effectively connected with a U.S. trade or business ( ECI ) to the extent that the transferor would have had ECI had the partnership sold all of its assets at FMV as of the date of the sale or exchange Any gain or loss from the hypothetical asset sale by the partnership must be allocated to the partners in the same manner as non-separately stated income and loss House Bill has no similar provision 37 Partnership Taxation: Recent Developments

38 Tax Reform Impacting Partnerships Pending Legislation Section 704(d) Loss Limitations Changes The Senate Bill changes the basis for loss limitations to include a partner s distributive share of charitable contributions and foreign taxes Under current rules, basis limitations on partner losses do not take into account the partner s share of charitable contributions or foreign taxes paid or accrued House Bill has no similar provision 38 Partnership Taxation: Recent Developments

39 Tax Reform Impacting Partnerships Pending Legislation Interest Expense Limitation Interest expense deduction for every business (regardless of form) will be disallowed if net interest expense is in excess of 30 percent of the business adjusted taxable income House bill allows exclusion of depreciation in calculation of adjusted taxable income House Bill allows disallowed interest to be carried forward five years and applied on a FIFO basis Senate bill allows disallowed interest to be carried forward indefinitely 39 Partnership Taxation: Recent Developments

40 Tax Reform Impacting Partnerships Pending Legislation Interest Expense Limitation (cont.) Disallowance is determined at the filer level (Partnership level determination rather than partner level determination) Special rules will apply to: Allow a pass-through entity s unused interest limitation to be used by the pass-through entity s owners and Ensure that net income from pass-through entities would not be double counted at the partner level 40 Partnership Taxation: Recent Developments

41 Tax Reform Impacting Partnerships Pending Legislation Interest Expense Limitation (cont.) The House Bill exemptions Businesses with average gross receipts of $25 million or less Certain regulated public utilities, and Real property trades or businesses The Senate Bill exemptions Businesses with average gross receipts of $15 million or less Certain regulated public utilities and electric coops, and Electing real-property trades or businesses or farming business provided they use the alternative depreciation system to depreciate applicable property 41 Partnership Taxation: Recent Developments

42 Tax Reform Impacting Partnerships Pending Legislation Immediate Expensing of Capital Investments House Bill 100 percent immediate expensing of qualified property placed in service after September 27, 2017 and before January 1, 2023 Houses Bill does not require the original use of the property to begin with the taxpayer as long as it is the taxpayer s first use and acquired in an arm s length transaction from an unrelated party House Bill provides that qualified property does not include property used in a real property trade or business or by a regulated public utility company 42 Partnership Taxation: Recent Developments

43 Tax Reform Impacting Partnerships Pending Legislation Immediate Expensing of Capital Investments Senate Bill 100 percent immediate expensing of qualified property placed in service after September 27, 2017 and before January 1, 2023 After 2022, the Senate Bill phases down the 100 percent expensing to 80 percent in 2023, 60 percent in 2024, 40 percent in 2025, and 20 percent in 2026 Senate Bill does still requires the original use of the property to begin with the taxpayer Senate Bill provides that qualified property does not include certain public utility property, but does include qualified film, television, and live theatrical productions 43 Partnership Taxation: Recent Developments

44 Tax Reform Impacting Partnerships Pending Legislation Like-kind Exchanges Deferral of gain on like-kind exchanges will ONLY be allowed for real property Effective for transfers after 2017 Transition rule allows like-kind exchanges of personal property to be completed if the taxpayer has disposed of relinquished property or acquired the replacement property on or before December 31, Partnership Taxation: Recent Developments

45 Self Employment Tax Update 45 Partnership Taxation: Recent Developments

46 Self Employment Tax Update General Rules Section 1402(a) Generally provides that the term net earnings from self-employment includes an individual partner s distributive share (whether or not distributed) of income or loss described in section 702(a)(8) (non-separately stated income) from any trade or business carried on by a partnership of which he is a member To the extent not otherwise excluded by Section 1402, separately stated items attributable to any trade or business are included in an individual s net earnings from self-employment (Rev. Rul ) 46 Partnership Taxation: Recent Developments

47 Self Employment Tax Update General Rules Specific Exceptions to SE Taxation Rental from real estate under Section 1402(a)(1); Dividends and interest under Section 1402(a)(2); Capital gains and losses under Section 1402(a)(3) Partnership retirement benefits under Section 1402(a)(10); and The distributive share of income of a limited partner under Section 1402(a)(13) 47 Partnership Taxation: Recent Developments

48 Self Employment Tax Update General Rules Limited Partners Section 1402(a)(13) excludes the income of a limited partner other than guaranteed payments described in section 707(c) (guaranteed payment) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services. When is a partner a limited partner and how is an LLC member treated for purposes of Section 1402(a)(13)? 48 Partnership Taxation: Recent Developments

49 Self Employment Tax Update Recent Authority Renkemeyer, 136 T.C. 137 (2011) Law Firm organized as an LLP Taxpayer argued that the lawyer-owners were not subject to self employment tax under 1402(a)(13) because they are designated as Limited Partners under state law and they each have limited liability Tax Court concluded that the lawyers are not limited partners within the meaning of 1402(a)(13) by looking to legislative intent in defining limited partner. The Court concluded that limited partner meant to exclude earnings of an investment nature and the term does not exclude partners who performed services for a partnership in their capacity as partners. 49 Partnership Taxation: Recent Developments

50 Self Employment Tax Update Recent Authority Riether, 919 F. Supp. 2d (2012) District court found that members of an LLC were subject to SE tax. The court rejected the taxpayer s arguments: 1. That they were employees and not self-employed because the partnership issued W-2s 2. That the income was unearned and therefore not subject to SE tax. The court stated that Plaintiffs are not members of a limited partnership, nor do they resemble limited partners, which are those who lack management powers but enjoy immunity from liability for debts of the partnership. Reiterated that there is no reasonable compensation exception for the SE tax for taxpayers that are do not qualify as a limited partner. 50 Partnership Taxation: Recent Developments

51 Self Employment Tax Update Recent Authority CCA Investment Management LLC excluded distributive share from NESE based on the belief that members received reasonable compensation as wages and members were limited partners for SE tax purposes IRS concluded that: 1) all of the members of Management LLC provided extensive services to the partnership 2) their income was not of the type Congress meant to exclude under section 1402(a)(13), and 3) they are not limited partners within its meaning Section 1402(a) does not distinguish between earned and unearned income of a partner. Management LLC cannot change the character of distributive share by paying reasonable compensation 51 Partnership Taxation: Recent Developments

52 Self Employment Tax Update Castigliola, TC Memo (2017) FACTS: Taxpayers were attorneys and members of a Mississippi Professional Limited Liability Company ( PLLC ). The members were paid guaranteed payments commensurate with local legal salaries, as determined by a survey of legal salaries in the area. They did not dispute that their guaranteed payments were subject to SE tax, but contended that the distributive share in excess of the guaranteed payments was excludable under Section 1402(a)(13). 52 Partnership Taxation: Recent Developments

53 Self Employment Tax Update Castigliola, TC Memo (2017) DECISION: Court noted that no statutory or regulatory authority defines the term limited partner for purposes of Section 1402(a)(13) Tax Court concluded that the primary characteristics of a limited partner common to each State and the history of the Revised Uniform Limited Partnership Act ( RULPA ) are Limited liability and Lack of control of the business The taxpayers in this case were each found to have participated in control of the business of their PLLC and were not limited partners under any version of the RULPA and, therefore, subject to self-employment on their entire distributive share 53 Partnership Taxation: Recent Developments

54 Self Employment Tax Update State Law Limited Partnerships Sands v. Commissioner (Tax Court Docket No ), May 8, 2015 Initially thought to be a test case for the IRS to challenge whether a distributive share of income allocated to a limited partner in a state law limited partnership would be subject to SE tax. Based on the IRS response to a petition filed in May 2015, the IRS acknowledged that it incorrectly assessed SE tax on the distributive share of earnings allocated to a limited partner. What comfort should we take from this response? 54 Partnership Taxation: Recent Developments

55 Self Employment Tax Update 1997 Proposed Regulations Proposed Reg. section (a)-2(h) An individual is treated as a limited partner unless the individual: 1. Has personal liability for the debts of the partnership by reason of being a partner; 2. Has legal authority to contract on behalf of the partnership; or 3. Participates in the partnership's trade or business for more than 500 hours during the partnership's taxable year Issued in 1997, temporary moratorium on finalization imposed by Congress (now expired). 55 Partnership Taxation: Recent Developments

56 Self Employment Tax Update 1997 Proposed Regulations Exceptions Service partners: An individual who is a service partner in a service partnership may not be a limited partner Partner who provides more than de minimis services to or on behalf of the service partnership's trade or business A partnership is a service partnership if substantially all its activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting. 56 Partnership Taxation: Recent Developments

57 Self Employment Tax Update 1997 Proposed Regulations Exceptions Holders of more than one class of interest: Non-LP not subject to SE tax on distributive share attributable to class of units in which LP s hold a substantial, continuing interest Holders of single class of shares Non-LP due solely to participation not subject to SE tax if the class of units he holds are identical to LP interests. 57 Partnership Taxation: Recent Developments

58 Self Employment Tax Update 1997 Proposed Regulations Can we follow the proposed regulations? IRS representatives have recently indicated that the 1997 proposed regulations represent the more reasonable and more recent thinking of the Service and taxpayers can rely on these proposed regulations. See Taxpayers Can Rely on Limited Partner Employment Tax Regs, IRS Official Says, 2010 TNT 10-2; Passthroughs Can Still Rely Safely on Proposed Regs, Official Says, 2011 TNT 89-5; Scope of Self- Employment Tax Exemption Guidance Could Be Broad, 2014 TNT Partnership Taxation: Recent Developments

59 Self Employment Tax Update New Guidance? The Treasury/IRS Priority Guidance Plan contains an item described as guidance on the application of section 1402(a)(13) to limited liability companies. Any significance to use of limited liability company in guidance plan description? See Scope of Self-Employment Tax Exemption Guidance Could Be Broad, 2014 TNT (quoting Craig Gerson, an attorney-advisor in Treasury s Office of Tax Legislative Counsel, as stating, We're hoping to issue guidance on section 1402(a)(13) that will apply to LLCs, because that's the area where guidance is most warranted. That doesn't restrict our ability to apply it more broadly as appropriate. We want to consider the whole landscape. ). 59 Partnership Taxation: Recent Developments

60 Self Employment Tax Update What does this mean for our clients and the practice? Members of an LLC, LLP or LLLP are not automatically excluded from SE tax under Section 1402(a)(13) Each member must analyze their activities in relation to the recent court cases to determine whether or not they may be subject to SE tax under the recent court cases State law limited partners appear to be excluded from SE by the plain meaning of the Section 1402(a)(13) statute at this time Position is not entirely free from risk and may be litigated in the future, or Proposed regulations may be finalized, eliminating the exclusion SE tax issues should be considered when determining choice of legal entity 60 Partnership Taxation: Recent Developments

61 Proposed Regulations Expanding Fractions Rule Exceptions 61 Partnership Taxation: Recent Developments

62 Debt-Financed Income Tax exempt entities are generally exempt from tax on investment income Interest Dividends Rents Such income becomes taxable to the extent it is funded with debt Generally determined by dividing average acquisition indebtedness by the average tax basis of the property and multiplying by investment income Particularly relevant to real estate investments which are typically highly leveraged 62 Partnership Taxation: Recent Developments

63 Section 514(c)(9) Exception Debt-Financed Income from an investment in real property may not be UBTI if certain requirements are met: The partner must be a Qualified Organization Educational organizations and support organizations Qualified pension, profits sharing or stock bonus plans Title holding corporations Retirement income account of a church If held by a partnership then either: All of the members are Qualified Organizations, or Each allocation is a Qualified Allocation, or Allocations meet the Fractions Rule 63 Partnership Taxation: Recent Developments

64 Qualified Allocations The allocations must have substantial economic effect The distributive share of any tax-exempt entity must be the same for each item of income, gain, loss deduction and credit and must never vary 64 Partnership Taxation: Recent Developments

65 Fractions Rule Allocations must have substantial economic effect Partnerships with targeted allocations probably do not qualify A Qualified Organization s share of income in any year cannot be greater than its smallest share of loss in any year the Fractions Rule Many exceptions 65 Partnership Taxation: Recent Developments

66 Current Exceptions Commercially reasonable preferred returns or guaranteed payments based on capital Reasonable guaranteed payments for services Disproportionate allocations of income to reverse prior disproportionately large loss allocations Statutory or regulatory allocations (minimum gain chargebacks, QIOs, prohibited loss allocations) Special allocation of partner-specific items (e.g., administrative costs of a section 743 adjustment) Special allocation of unlikely losses (i.e., casualty losses) 5% QO ownership 66 Partnership Taxation: Recent Developments

67 Proposed Changes Remove current requirement that preferred returns actually be distributed Special allocation of management (and similar) fees Reversal of prior allocations of unlikely losses Allocations to account for staged closings Special allocations due to defaults on capital commitments Clarify treatment of tiered partnerships New exception for partnerships with 5% non-qo ownership Proposed to apply to taxable years ending on or after the date published as final, may be relied for taxable years ending on or after November 23, Partnership Taxation: Recent Developments

68 Action Steps Real estate partnerships that previously did not or could not meet the fractions rule may now be able to qualify, but changes may be needed Consider changes to new fund agreements to meet the requirements and attract investment by qualified organizations Consider changes to existing funds with qualified organization partners Consider whether existing partnerships now qualify Actions can be driven at the fund level or the qualified organization level 68 Partnership Taxation: Recent Developments

69 Proposed and Temporary Regulations Under Section 721(c) 69 Partnership Taxation: Recent Developments

70 Section 721(c) Regulations In general, no gain or loss is recognized on the contribution of property to a partnership (section 721(a)) Section 721(c) authorizes regulations that trigger recognition of gain if when recognized it will be includible in the gross income of a non-us person In Notice , the IRS described regulations to be issued under section 721(c) that would be effective retroactively to contributions on or after August 6, 2015 Temporary and proposed regulations were issued January 19, 2017 Similar but not identical to the regulations described in Notice Partnership Taxation: Recent Developments

71 Section 721(c) Regulations Gain is triggered upon the contribution of Section 721(c) Property to a Section 721(c) Partnership Section 721(c) Property Built-in gain property Contributed to a partnership by a US transferor Excluded property: cash equivalents, securities, property with BIG < $20k, partnership interests holding excluded properties Section 721(c) Partnership A US transferor contributes Section 721(c) Property; and A related foreign person is a direct or indirect partner, and The transferor and related persons own more than 80 percent of the interests in partnership capital, profits, deductions or losses 71 Partnership Taxation: Recent Developments

72 Exceptions The total built-in gain on all Section 721(c) Property contributed to the Section 721(c) Partnership during the year is not >$1,000,000 Deemed transfers as a result of a technical termination The partnership applies the Gain Deferral Method 72 Partnership Taxation: Recent Developments

73 Gain Deferral Method The partnership adopts the remedial method for section 704(c) (except for ECI property) The partnership allocates all items of section 704(b) income, gain, loss and deduction with respect to the Section 721(c) property in the same proportion Exception for gains allocated to the US transferor or loss to other partners Exception for CFTEs Exception for certain regulatory allocations The US Transferor recognizes remaining built-in gain upon an Acceleration Event The partnership satisfies certain procedural and reporting requirements The transferor agrees to extend the statute of limitations period for the contribution year to 8 years from the end of the taxable year Tiered partnership rules are followed, if applicable 73 Partnership Taxation: Recent Developments

74 Acceleration Events Any transaction that would reduce the Built-in Gain (BIG) that the US Transferor would recognize under the Gain Deferral Method, or Any transaction that could defer recognition of the BIG, or Failure of any party to comply with the Gain Deferral Method Consequences Remaining BIG recognized by the US Transferor Corresponding basis adjustments to the Section 721(c) Property and the US Transferor s partnership interest Exceptions / Termination of Applicability Domestic incorporation of a section 721(c) partnership (other than assets up) Transfer of Section 721(c) Property to a domestic corporation Distribution of the 721(c) property to the US transferor Exit of related foreign partners Fully taxable disposition of the Section 721(c) property or entire partnership interest 74 Partnership Taxation: Recent Developments

75 Successor Events Transfer of the Section 721(c) Partnership interest to a corporation in a nonrecognition transaction Transfer of the Section 721(c) Partnership interest between members of a consolidated group Technical terminations Contributions of Section 721(c) property to a partnership controlled by the US transferor (subject to certain requirements) Contribution of a Section 721(c) partnership interest to a partnership (subject to certain requirements) The gain deferral method continues to apply with respect to the transferee 75 Partnership Taxation: Recent Developments

76 Reporting Requirements Reporting of the transfer by the US transferor Statement providing specified information about the Section 721(c) property Statement consenting to extend the statute of limitations Waiver of treaty benefits Information regarding the Section 721(c) partnership Form 8865, if applicable Annual statement Annual reporting by the US transferor Income and deduction items relating to the Section 721(c) property Information about the allocation of such items The remaining built-in gain and amount taken into account A declaration of whether an acceleration event occurred A description of termination or successor events much more. Clients will need assistance meeting these reporting requirements 76 Partnership Taxation: Recent Developments

77 Reverse 1031 Exchanges Bartell v. Commissioner 77 Partnership Taxation: Recent Developments

78 Bartell v. Commissioner (147 TC 5, 8/10/16) In a reverse like-kind exchange, replacement property is effectively acquired before the relinquished property is sold To qualify, the replacement property must be parked with a third party until the exchange can be completed Improvements may be made to the replacement property while it is parked in a so-called build-to-suit exchange Rev. Proc provides a safe harbor in structuring reverse like-kind exchanges under which a facilitator holding title to the replacement property will be respected as the property s owner Reverse exchanges can be accomplished outside of the safe harbor, but it is unclear how a facilitator can establish itself as the owner of the replacement property for this purpose 78 Partnership Taxation: Recent Developments

79 Bartell v. Commissiner Bartell involves a reverse section 1031 exchange pre-dating the safe harbor A facilitator acquired title to replacement property with a loan guaranteed by the taxpayer (Bartell) Bartell indemnified the facilitator against all liabilities Bartell directed and funded construction of replacement property When construction was complete, Bartell sold its relinquished property and took title to the replacement property through a qualified intermediary The process took more than 180 days so it would not have qualified under the safe harbor 79 Partnership Taxation: Recent Developments

80 Bartell v. Commissiner The Tax Court found a valid Section 1031 Exchange The facilitator need not acquire the benefits and burdens of ownership Title is sufficient Support for structuring reverse like-kind exchanges outside the safe harbor? The IRS did not appeal but will not follow the decision (AOD /23/17) The case law cited in Bartell involves transactions that were consummated prior to the issuance of the deferred exchange regulations and Rev. Proc Outside the scope of Rev. Proc the accommodating party must hold the benefits and burdens of ownership of the replacement property until taxpayer transfers the relinquished property 80 Partnership Taxation: Recent Developments

81 The National Tax Office Partnership Group: Jeff Bilsky, Partner Technical Practice Leader (404) David Patch, Managing Director (703) Julie Robins, Managing Director (512) Will Hodges, Senior Manager (404) Katie Pendzich, Senior Manager (414) Partnership Taxation: Recent Developments