Thought-provokinganalysis and opinion on federal tax issues

Some Preliminary Observations on the Partnership Aspects of New Final and Proposed 163(j) Regulations

July 31, 2020

by Monte A. Jackel

Recent regulations under section 163(j) were issued in final form and new regulations were proposed. Some high level highlights reflecting several posts I have on LinkedIn here.

Some post excerpts are below.

“On the proposed 163(j) regulations relating to partnerships, a few questions. First, why don’t the rules address where a partnership lends to a partner? They solely address loans by a partner to the partnership as the partner interest income will almost never be business income. In the reverse case, the partnership may have business income depending on the context and the partner may similarly have business interest expense. Why not addressed? Second…The proposed rules also have a proposed rule that applies either upon some partner dispositions of all or substantially all of the interest or in a tiered partnership where entity treatment is prescribed for the lower tier entity. Without any authority whatsoever other than the general section 7805 authority, the IRS treats excess business interest expense (EBIE) in those cases as a separate non-depreciable asset with a value of zero and a basis equal to the EBIE, namely a built-in loss asset created out of thin air. Prior creations of notional income and loss under reg. 1.704-3(d) remedials had a history dating back to both the 84 tax act and other commentary. The treatment of EBIE has no such support. And the treatment of tiered partnerships is also way too complex, even for experts. Small business tax shelters are in for trouble.”


Relating to the new pro rata exception to the 11 step factor analysis for partnerships, what happens if the pro rata share is thrown out of balance due to the regulatory allocations under the section 704(b) regulations, such as the QIO rules, the minimum gain chargeback rules, etc.? If that can happen, is the exception no longer available? 


“Beautiful math does not carry the day for small taxpayers who are inadvertently trapped into being a tax shelter not eligible for the small partner exception. In justifying the use of the complex 11 step factor, the final regulation preamble states: “the Treasury Department and the IRS have concluded that these computations are not overly burdensome given that the partnerships required to perform these calculations already are experienced with handling the complexities associated with special allocations or section 704(c) allocations.” This statement is demonstrably NOT TRUE when you consider that a taxpayer that would otherwise be exempt from 163(j) under the $25 Million gross receipts test can easily be treated as a “tax shelter” under section 6662 because, in almost any case you can think of, a significant purpose to avoid tax can found by the IRS. The IRS not only failed to provide guidance on this issue in the final and proposed regulations just issued, but section 6662 is not even cited and guidance on the issue is not even promised. On syndicates, only those with actual losses are covered but no passive syndicate investor rule was proposed. In fact, it was flat out ruled out of bounds. Given this state of affairs, the IRS’s justification quoted here is just plain silly.


“The anti-avoidance rule at 1.163(j)-1(b)(22)(iv) is clearly invalid as a matter of law and inconsistent with prior IRS practice. The rule excludes guaranteed payments under 707(c) for the use of capital but example 5 at 1.163(j)-1(b)(22)(v)(E) illustrates a case where a GPUC is treated as interest expense. The regulatory test is whether “a principal purpose” is to avoid 163(j) but a business purpose for the use of funds or that the cost of the funds is cheaper than a straight loan is not relevant. A significant business purpose for the structure of the transaction is stated as a positive factor. This position deviates from common understanding as the Kraft Foods case (232 F.2d 118, 2d Cir. 1956)), Deputy v. DuPont, 308 U.S. 488 (1940) and Rev Rul 95-8, 1995-1 CB 107, as well as the so-called “angel list” under section 7701(o)’s codification of economic substance, say that the choice of equity financing versus debt financing is not an abuse and can be freely chosen and the IRS itself, in the revenue ruling, does not equate a short sale as indebtedness under UBIT based on the Supreme Court case. I submit that there is no authority for this position in the 163(j) regulations.”