Proposed Regulations on Partnership Allocations When Partners’ Interests
Change During a Taxable Year
April 22, 2009
Partners’ interests in a partnership, such as an investment fund, can change during the course of a year as a consequence of transfers and redemptions of interests and the admission of new partners. The Treasury Department has recently issued proposed regulations that address how a partnership must make allocations for a taxable year in which the partners’ interests change. The proposed regulations prescribe two permissible allocation methods, as well as conventions for determining the date on which the partners’ interests change. Although not addressed in this brief memorandum, the proposed regulations also cover certain other issues such as the determination of the partnership’s taxable year, as well as the treatment of deemed dispositions as actual dispositions.
Background. Section 706(d)(1) of the Internal Revenue Code of 1986, as amended (the “Code”), generally provides that, in making allocations for a taxable year, a partnership must take into account any variation in the partners’ interests in the partnership during that year. This provision is intended to ensure that partnership allocations reflect the partners’ economic interests over the course of the year. For example, Section 706(d)(1) would prevent the allocation of deductible expenses to partners who had not yet acquired their interests at the time the partnership incurred the expenses.
Allocation Methods. The proposed regulations provide that a partnership may account for any variation in the partners’ interests during a taxable year either:
- by an interim closing of the partnership’s books (the “interim closing method”); or
- if the partners agree, by prorating most partnership items across the taxable year (the “proration method”).
A partnership may not elect to prorate “extraordinary items,” however, but rather must allocate any “extraordinary item” in accordance with the partners’ interests at the beginning of the day on which the partnership takes the item into account. “Extraordinary items” include gain or loss from the disposition of certain assets, income from the discharge of indebtedness and various other items for which proration would result in a substantial distortion of income.
Under the proposed regulations, a partnership must divide its taxable year into “segments.” Each segment closes on the day on which the partners’ interests are treated as changing under the convention adopted by the partnership, as described below. If a partnership uses the interim closing method, it will generally treat each segment as if it were a separate taxable year (other than for return filing requirements). For example, the partnership may compute a net capital loss for a segment even though it has a net capital gain for the entire taxable year.
Section 706(d) of the Code provides that, except as provided in regulations, a partnership must use a proration method for certain items for which it uses the cash method of accounting and for its share of items of a lower-tier partnership. The proposed Treasury regulations do not address the application of these provisions.
Conventions for Determining Date of Variation of Interests.
Calendar Day and Semi-Monthly Conventions. If a partnership uses the interim closing method, it may adopt either the “calendar day convention” or the “semi-monthly convention” for determining the date on which the partners’ interests in the partnership change. A partnership that uses the proration method must adopt the calendar day convention.
- Under the calendar day convention, the variation of interests is treated as occurring at the close of the day on which the actual change in interests occurs.
- Under the semi-monthly convention (i) all changes in the partners’ interests that occur on the first day through the 15th day of a calendar month are treated as occurring at the end of the last day of the immediately preceding month, and (ii) all changes in the partners’ interests that occur on the 16th day through the last day of a calendar month are treated as occurring at the end of the 15th day of the month.
Special Rules for Publicly Traded Partnerships. Exceptions to the convention rules apply to publicly traded partnerships (“PTPs”).
- The convention rules will not apply to any PTP that was formed before April 14, 2009.
- Regardless of whether it uses the interim closing method or the proration method, a PTP that was formed on or after April 14, 2009 may:
- treat all transfers of its publicly traded units during a calendar month (other than certain block transfers) as occurring on the first day of the following month, or
- use the semi-monthly convention for transfers of its publicly traded units (other than certain block transfers).
Determining Date of Actual Transfer or Other Change in Interests. Regardless of the convention it adopts, a partnership must determine the date on which a transfer of a partnership interest, or any other change in the partners’ interests, actually occurs. The proposed regulations do not address this issue, thus leaving the determination to common law principles. Under these principles, ownership of an asset for U.S. federal income tax purposes is determined by a practical consideration of all of the surrounding facts and circumstances. A very important factor in determining whether ownership has changed is whether all conditions precedent to a transfer, or other dilutive event, have been satisfied.
Consistency Rule. The proposed regulations generally provide that a partnership must use the same method (either interim closing or proration) and the same convention for all variations in the partners’ interests that occur during a taxable year.
Exceptions to the Rules Set Forth in the Proposed Regulations.
Contemporaneous Partners. The proposed regulations will generally not apply to variations in the interests of partners who have held their interests throughout an entire taxable year, provided that those variations are not attributable to contributions or distributions of money or property. This exception is intended to give effect to Section 761(c) of the Code, under which partners may modify a partnership agreement at any time prior to, or on, the due date for the partnership return for a taxable year.
Service Partnerships. Under the proposed regulations, a “service partnership” may choose any reasonable method to account for the varying interests of its partners during a taxable year. A “service partnership” is a partnership in which substantially all the activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting.
Effective Date. Except as described above with respect to publicly traded partnerships, the proposed regulations generally would be effective after the date on which they are finalized. In no event, however, will they apply to taxable years beginning before January 1, 2010.
Request for Comments. The Internal Revenue Service and the Treasury Department have requested comments with respect to the proposed regulations, including as to (i) whether the proposed regulations should be expanded to include other conventions or methods and (ii) whether any items should be added or removed from the definition of “extraordinary items” that may not be prorated.
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