IRS has retroactively removed a de minimis rule in the partnership regs because it may have resulted in unintended tax consequences. The rule had provided that, for purposes of determining substantiality of a partnership allocation, the attributes of de minimis partners (those owning less than 10% of capital and profits and who are allocated less than 10% of each partnership item) need not be taken into account. IRS will study alternative approaches suggested by commentators.
Background. Under Code Sec. 705(b), a partner’s distributive share of income, gain, loss, deduction, or credit (or item thereof) is determined in accordance with the partner’s interest in the partnership (determined by taking into account all facts and circumstances) if the allocation to a partner under the partnership agreement of income, gain, loss, deduction, or credit (or item thereof) does not have substantial economic effect. The determination of whether an allocation of income, gain, loss, or deduction to a partner has substantial economic effect involves a two-part analysis that is made as of the end of the partnership tax year to which the allocation relates. (Reg. § 1.704-1(b)(2)(i)) (1) The allocation must have economic effect within the meaning of Reg. § 1.704-1(b)(2)(ii); and (2) the economic effect of the allocation must be substantial within the meaning of Reg. § 1.704-1(b)(2)(iii).
In general, for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners. This means that, if there is an economic benefit or burden that corresponds to the allocation, the partner to whom the allocation is made must receive such economic benefit or bear such economic burden. In general, the economic effect of an allocation (or allocations) is substantial if there is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences.
Removed de minimis partner rule. Under the de minimis partner rule, for purposes of applying the substantiality rules, the tax attributes of a de minimis partner did not need to be taken into account. A de minimis partner was any partner, including a lookthrough entity, that owned, directly or indirectly, less than 10% of the capital and profits of a partnership, and who is allocated less than 10% of each partnership item of income, gain, loss, deduction, and credit.
IRS says that commentators agreed with it that the de minimis partner rule was too broad, was easily abused, and/or was not consistent with sound tax policy. Accordingly, the rule has been removed from the final regs.
Alternative approaches. The preamble to the proposed regs requested comments on how to reduce the burden of complying with the substantial economic effect rules, with respect to lookthrough partners, without diminishing the safeguards the rules provide. In response to this request, IRS received a number of comments. Some commentators requested that future guidance in regs amend the de minimis rule, while others suggested alternative approaches for de minimis partners and look-through partners. IRS says it needs more time to consider these comments and may address them in future guidance.
Effective date. Whether an allocation is considered to be substantial is generally determined at the time the allocation becomes part of the partnership agreement. The final regs provide that the de minimis partner rule does not apply to allocations that become part of the partnership agreement on or after Dec. 28, 2012. (Reg. § 1.704-1(b)(2)(iii)(e)(1))
With respect to preexisting allocations, IRS agreed with one commentator who suggested that the de minimis partner rule was sufficiently flawed that it should not continue to apply to allocations that became part of the partnership agreement before its removal. Accordingly, the final regs are effective, and the de minimis partner rule is no longer applicable, for all partnership tax years beginning on or after Dec. 28, 2012, regardless of when the allocation became part of the partnership agreement. Thus, the substantiality of all partnership allocations, regardless of when they became part of the partnership agreement, must be retested without the benefit of the de minimis partner rule. For allocations in existing partnership agreements, the retest has to be as of the first day of the first partnership tax year beginning on or after Dec. 28, 2012. (Reg. § 1.704-1(b)(2)(iii)(e)(2); T.D. 9607)
References: For partnership allocations, see FTC 2d/FIN ¶ B-2400 ; United States Tax Reporter ¶ 7044 ; TaxDesk ¶ 586,100 ; TG ¶ 2162 .
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