The IRS has released proposed regulations regarding income allocation when partnership interests are transferred or partners have varying interests for other reasons.

The long-awaited proposed regulations, issued April 13, principally provide guidance under Section 706(d), a provision added to the Code by the Deficit Reduction Act of 1984. They will take effect upon adoption, but no earlier than the first partnership taxable year beginning in 2010.

Key points in the proposed regulations:

  • Partnerships may use either an interim closing of the books or a proration method to determine partners' distributive shares of income for a taxable year in which they have varying interests.
  • Partnerships electing an interim closing of the books may use a calendar-day convention or a semimonthly convention to determine which segments of the year a change in income allocation applies to.
  • Partnerships electing a proration method must use a calendar-day convention to segment the taxable year, allocating specified "extraordinary items" (such as income from capital transactions and cancellation of debt) within a segment based upon the partners' relative interests as of the beginning of the last calendar day in that segment (and not by proration over the entire year).
  • Partnerships must consistently use the same method and convention during a taxable year, but may elect different methods and conventions for separate taxable years.
  • Partnership interests held by a corporation leaving or entering a consolidated return group, by a corporation terminating its S election, or by an S corporation in which a shareholder has terminated his interest are deemed to be disposed of as of the date the interest-holding corporation closes its books; the partnership must employ either the interim closing of books or proration method in allocating income for its own taxable year to its corporate partner.
  • Partnerships may retroactively change the income allocation among concurrent partners for all segments of a taxable year at any time up to the date the partnership return is due for that taxable year (without extension) -- unless the allocation change stems from a capital contribution by, or return of capital distribution to, a partner of money or other property. Professional service partnerships (such as law and accounting firms) may retroactively change the income allocation for a taxable year at any time up to the date the partnership return is due (without extension) without this limitation.

The IRS has requested comments on whether additions should be made to the list of extraordinary items that require proration as of a specific day and on whether other allocation methods and conventions should be permitted under the regulations.

The IRS also requests comments regarding the application, under the new regulations, of a special consolidated-return regulation rule (Treasury Regulation Section 1.1502-76(b)(2)(vi)(B)). This rule requires, in situations where a consolidated group actually or constructively owns at least 50 percent of a partnership's interests, that the method used in allocating partnership items conform to the method used in allocating consolidated-return items to a departing or entering member. It is likely that the IRS particularly wants guidance on applying the consolidated-return regulation in circumstances where the partnership and the consolidated-return group utilize different taxable years.

In addition, the IRS requests comments concerning whether it should exercise its authority to promulgate legislative regulations on two additional allocation matters under Section 706(d).  The first issue concerns the addition of other periodic expense items (such as property insurance) to the list of cash-basis items for which a cash-basis partnership must always employ the proration method and calendar-day convention. The second issue concerns the creation of exceptions to the statutory rule requiring the mandatory use of the proration method and calendar-day convention for the allocation of all items of a lower-tier partnership whenever there is any change in the interest of a partner in an upper-tier partnership.

The Tax Group of Ballard Spahr Andrews & Ingersoll, LLP is able to assist partnerships and their partners, as well as limited liability companies (LLCs) and other entities taxed as partnerships, in developing and submitting written comments on the proposed regulations. We also will advise partnership entities on revising their capital structures to maintain flexibility in electing allocation methods and conventions if these regulations are adopted in their present form. Please contact Wayne R. Strasbaugh for additional information and assistance at 215.864.8328 or strasbaugh@ballardspahr.com.


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