The IRS has issued proposed regulations on determining partners’ distributive shares of partnership items of income, gain, loss, deduction and credit when a partner’s interests vary during a partnership tax year (REG-144689-04). The proposed regulations also modify the existing regulations regarding a partnership’s required tax year.
The proposed regulations provide methods for determining a partner’s distributive share of partnership items to take into account the varying interests of the partners in any year in which there is a change in a partner’s interest in the partnership. They also provide that a deemed disposition of a partner’s entire interest under other sections of the regulations is a deemed disposition of a partner’s entire interest for the purpose of IRC § 706(d). Finally, the proposed regulations amend the rules applicable to the determination of the partnership’s tax year in those instances in which partnership interests are held by disregarded foreign partners (as defined in Treas. Reg. § 1.706-1(b)(6)(i)).
Section 706(d)(1) provides that, except as required by sections 706(d)(2) and (d)(3), if there is a change in a partner’s interest in the partnership during the partnership’s tax year, each partner’s distributive share of any partnership item is determined by the use of any method prescribed by the regulations that takes into account the varying interests of the partners in the partnership during the tax year (the varying interests rule). Section 706(d)(1) was added by the Deficit Reduction Act of 1984, PL 98-369 (the 1984 Act), in part, to clarify that the varying interests rule applies to the disposition of a partner’s entire interest in the partnership as well as the disposition of less than a partner’s entire interest, and to authorize the IRS to prescribe methods for determining a partner’s distributive share of partnership items when there is a change in the partners’ interests during the partnership’s tax year.
The existing regulations under IRC § 706 have never been revised to reflect the changes made to section 706(d)(1) by the 1984 Act. The section 706 regulations have also not been revised to reflect a change made to section 706(c)(2)(A) by the Taxpayer Relief Act of 1997, PL 105-34, under which the tax year of a partnership closes with respect to a partner whose entire interest in the partnership terminates by reason of death. The proposed regulations would amend Treas. Reg. § 1.706-1(c) to reflect these changes.
The proposed regulations would not change the provision in Treas. Reg. § 1.706-1(c)(3)(iv) that the sale or exchange of a partnership interest does not include any transfer of a partnership interest that occurs at death as a result of inheritance or any testamentary disposition or the provision in Treas. Reg. § 1.706-1(c)(5) that the transfer of a partnership interest by gift does not close the partnership tax year with respect to the donor. The proposed regulations would add Treas. Reg. § 1.706-4 to provide for the application of the varying interests rule in all cases in which a partner’s interest changes during the tax year, whether by reason of a disposition of the partner’s entire interest in the partnership or a disposition of less than the partner’s entire interest in the partnership.
The proposed regulations amend the minority interest rule in Treas. Reg. § 1.706-1(b)(6)(iii) to provide that partners who are not disregarded foreign partners under Treas. Reg. § 1.706-1(b)(6)(i) (regarded partners) have a minority interest only if each regarded partner has less than a 10% interest in capital and profits, and the regarded partners collectively have less than a 20% interest in partnership capital and profits. This modification means that the interests of foreign partners will be taken into account in determining the tax year of the partnership only if the regarded partners have interests below the stated thresholds in partnership capital and profits, rather than the current rule, which requires only an interest below the threshold in either capital or profits.
