Senate Proposal Would Overhaul Partnership Tax Rules

Senate Finance Committee Chair Ron Wyden (D-Ore.) is working on a draft of legislation that would substantially change some tax rules on partnerships. The National Association of Home Builders has come out against the legislation, arguing that the changes “would restrict the ability of partnerships to allocate income and deductions unless those allocations are in line with the partners’ ownership percentages.”

The new proposal is in line with many others coming from either Democrats in Congress or the Biden White House. They include eliminating step-up basis, the additional 20% deduction for pass-through businesses, carried interest, and the 1031 exchange break as well as increasing the capital gains tax rate.

The following “examples of partnership tax loopholes” and the suggested change come from committee document:

• Contributions and distributions of appreciated (or depreciated) property are generally tax free. Partnerships are supposed to allocate built-in gains and losses on contributed property in a way that limits abuse, but they get to choose among three or more allocation methods. Only one—the “remedial method”—actually prevents tax from being shifted between the partners. The discussion draft would require partnerships to use the remedial method making sure gain, and the related tax liability, cannot be shifted. 
• Upon a change in the interests of the partners, a partnership can elect—but is not required—to revalue its assets to prevent the shifting of built-in gain and loss. The discussion draft would require such revaluations. 
• The partnership tax rules afford tremendous flexibility in the allocation of partnership income and losses among partners. The discussion draft would remove optionality and in doing so, simplify administration and curtail abuse. For certain related-party partnerships, the discussion draft would require all income and loss to be allocated pro-rata.

“The draft proposal would remove the Substantial economic effect of safe harbor and generally require most partnership allocations to be made based on Partners’ interest in the partnership,” John Blake, a partner in the real estate and construction group of accounting and advisory firm Klatzkin, tells GlobeSt.com. “This would undoubtedly simplify partnership filings, but it would remove some of the flexibility afforded commercial real estate partnerships in the past.”

Blake also notes that mandatory revaluation of property on a change in ownership “would keep any deferred gains or losses with the current partners and not allow any income shifting that had previously been done to alleviate potential built-in gains on assets.”

“Under existing partnership tax rules, ‘taxes follow economics,” Steve Good, a director at Fennemore Law, tells GlobeSt.com. “A partner who enjoys the economic benefits associated with the partnership’s operations will ultimately pay tax on the gain or income associated with those benefits. Likewise, a partner who suffers economic losses from the partnership’s operations is ultimately entitled to the associated tax loss.” Although the changes would be unlikely to shift tax benefits and burdens, because “sophisticated taxpayers already take those items into account when negotiating their economic deal,” they could affect the timing of benefit and burden realizations.

Currently, though, any legislation is theory. 

“Changes in the tax law have a really high legislative barrier to get accomplished,” Stephen Bittel, founder and chairman of Terranova Corporation, tells GlobeSt.com. “We have a 50-50 Senate. That’s an incredibly high barrier. The more technical the changes, the easier to get stuck in committee and never see the light of day.” And despite all the proposals that have come out of the current administration, “none of them seem to get a lot of momentum,” he adds. “The question is whether the administration asked for everything in hopes of getting something, because they have great legislative experience.”