United States: IRS Proposes Helpful Changes To "Fractions Rule" Tax Regulations

Mark S. Lange is a partner and Alyson K. Pirio is an attorney in Holland & Knight's Atlanta office

HIGHLIGHTS:

  • Proposed income tax regulations recently published by the Internal Revenue Service (IRS) amend the current regulations regarding the application of the "fractions rule" to partnerships that hold debt-financed real property and have one or more (but not all) qualified tax-exempt organization partners.
  • The proposed regulations allow certain allocations resulting from specified common business practices to now comply with the fractions rule under Section 514(c)(9)(E) of the Internal Revenue Code.
  • The new proposed regulations also provide helpful guidance in determining a partner's share of overall partnership income or loss with respect to the fractions rule, including allocations related to preferred returns, partner specific expenditures, unlikely losses and chargebacks of partner-specific expenditures.

Proposed income tax regulations published by the Internal Revenue Service (IRS) on Nov. 23, 20161, amend the current regulations regarding the application of the "fractions rule" to partnerships that hold debt-financed real property and have one or more (but not all) qualified tax-exempt organization partners. The proposed regulations allow certain allocations resulting from specified common business practices to now comply with the fractions rule under Section 514(c)(9)(E) of the Internal Revenue Code.2

Background on the Fractions Rule

In general, Section 511 imposes federal income tax on the unrelated business taxable income (UBTI) of tax-exempt organizations. UBTI includes a specified percentage of gross income derived from debt-financed property. Section 514(c)(9)(A) generally excepts from UBTI income derived from real property acquired or improved through debt financing by certain "qualified organizations" (the real estate exception).

Under Section 514(c)(9)(C), qualified organizations include: 1) an educational organization described in Section 170(b)(1)(A)(ii) and its affiliated support organizations described in Section 509(a)(3); 2) a qualified pension plan (i.e., a trust qualifying under Section 401); 3) a title holding company under Section 501(c)(25); and 4) a retirement income account under Section 403(b) (i.e., an IRA). The types of qualified organizations were added to the Code piecemeal and there does not appear to be any policy rationale for limiting the real estate exception to these particular organizations versus all public charities or all tax-exempt organizations under Section 501(c)(3).3

The real estate exception does not apply if a qualified organization owns an interest in a partnership that holds debt-financed real property unless the partnership meets one of the following requirements: 1) all of the partners of the partnership are qualified organizations; 2) each allocation to a qualified organization is a "qualified allocation" within the meaning of Section 168(h)(6)(B)4; or 3) each partnership allocation has "substantial economic effect"5 under Section 704(b)(2) and satisfies Section 514(c)(9)(E)(i)(l) (the fractions rule).

A partnership allocation satisfies the fractions rule if the allocation of items to any partner that is a qualified organization does not result in that partner having a share of overall partnership income6 for any taxable year greater than that partner's fractions rule percentage. The fractions rule percentage is the partner's share of overall partnership loss7 for the taxable year for which the partner's loss share is the smallest.

Certain allocations are taken into account for purposes of determining overall partnership income or loss only when actually made and do not create an immediate violation of the fractions rule.8 Certain other allocations are disregarded for purposes of making fractions rule calculations.9

The New Proposed Regulations

Many common business practices in real estate partnership deals could run the risk of violating the fractions rule. These include: partnership agreements with "targeted allocations"10, situations in which one investor negotiates a management fee for itself that is lower than that charged to other investors, and agreements involving catch-up allocations for an investor that comes in at a later stage. The proposed regulations were issued in response to these concerns and comments made by tax practitioners requesting specific changes to the existing tax regulations with respect to the fractions rule that would allow certain allocations resulting from specified common business practices to comply with the fractions rule.

The proposed regulations provide helpful guidance in determining a partner's share of overall partnership income or loss with respect to the fractions rule, including allocations related to preferred returns, partner specific expenditures, unlikely losses and chargebacks of partner-specific expenditures.

Further, the proposed regulations simplify one of the examples in the regulations regarding the application of the fractions rule to tiered partnerships. The proposed regulations remove language that could have caused a fractions rule violation in a lower-tier partnership to further infect the receipt of qualified income by an upper-tier partnership. They also provide certain rules regarding changes to partnership allocations as a result of capital commitment defaults or reductions, as well as subsequent acquisitions of partnership interests.

Importantly, these proposed regulations except from the application of the fractions rule certain partnerships in which all of the partners other than qualified organizations own 5 percent or less of the capital or profits interests in the partnership, as long as the partnership's allocations have substantial economic effect.

While most of the changes were made in response to taxpayer comments, some of the changes were initiated by the U.S. Department of the Treasury. Such changes include an increase in the threshold for allocations away from partners that are qualified organizations from $50,000 to $1 million, subject to the overriding limitation that such allocations not exceed 1 percent of the partnership's aggregate items of gross loss and deduction for the taxable year. This is a significant and welcome change that will benefit a meaningful number of qualified organizations that are partners in partnerships holding debt-financed real property.

However, the proposed regulations fail to provide any guidance with respect to targeted allocations. This remains an issue with which practitioners must continue to grapple.

Finally, the proposed regulations introduce a distinction between guaranteed payments and preferred returns. The proposed regulations remain favourable for preferred returns but provide a different rule for guaranteed payments.

Effective Date of the Proposed Regulations

These regulations are proposed to apply to taxable years ending on or after the date the proposed regulations are published as final regulations in the Federal Register. However, a partnership and its partners can apply (and rely on) all of the rules in these proposed regulations for taxable years ending on or after Nov. 23, 2016 (i.e., taxpayers can rely on these new rules now).

Footnotes

1 [REG-136978-12], Federal Register, Nov. 23, 2016.

2 Unless indicated otherwise, all "Section" references are to the Internal Revenue Code of 1986, as amended. References to "§" are to Sections of the Income Tax Regulations ("Treas. Reg. §").

3 The real estate exception for "qualified" organizations was enacted as part of the Miscellaneous Revenue Act of 1980, expanded to include educational organizations as part of the Deficit Reduction Act of 1984 and expanded again to include certain title holding companies in the Tax Reform Act of 1986.

4 The term "qualified allocation" means any allocation to a tax-exempt entity which: (i) is consistent with such entity's being allocated the same distributive share of each item of income, gain, loss, deduction, credit and basis, and such share remains the same during the entire period the entity is a partner in the partnership; and (ii) has substantial economic effect within meaning of Section 704(b)(2).

5 An allocation has "substantial economic effect" within the meaning of Section 704(b)(2) and Treas. Reg. §1.704-1(b)(2) if it satisfies a two-part test that is made as of the end of the partnership taxable year to which such allocation relates. First, the allocation must have "economic effect" within the meaning of paragraph (b)(2)(ii) of such regulations. Second, the economic effect of the allocation must be "substantial" within the meaning of paragraph (b)(2)(iii) of such regulations.

6 Treas. Reg. §1.514(c)-2(e)(1) describes overall partnership income as the amount by which the aggregate items of partnership income and gain for the taxable year exceed the aggregate items of partnership loss and deduction for the year.

7 Overall partnership loss is the amount by which the aggregate items of partnership loss and deduction for the taxable year exceed the aggregate items of partnership income and gain for the year. Id.

8 See Treas. Reg. §1.514(c)-2(b)(2)(i).

9 See, e.g., Treas. Reg. §1.514(c)-2(d) (reasonable preferred returns and reasonable guaranteed payments); Treas. Reg. §1.514(c)-2(e) (certain chargebacks and offsets); Treas. Reg. §1.514(c)-2(f) (reasonable partner-specific items of deduction and loss); Treas. Reg. §1.514(c)-2(g) (unlikely losses and deductions); and Treas. Reg. §1.514(c)-2(k)(3) (certain de minimis allocations of losses and deductions).

10 Targeted allocations, which are also sometimes referred to as forced allocations, are a mechanism used to allocate profits and losses among the partners in a partnership. The fractions rule provides inter alia, that a partnership may incur debt to acquire real property without causing its tax-exempt partners to recognize unrelated business taxable income. The fractions rule requires partnerships to show prospectively that allocations will always comply with its percentage requirements. It has been reported that some tax practitioners have suggested that it's hard to prove compliance with the fractions rule because allocations are not specified in partnership agreements that utilize targeted allocations. These practitioners further note that under such partnership agreements, liquidating distributions are not made in accordance with the partners' positive balances in their capital accounts, and thereby, this may not satisfy the economic effect safe harbor, the first prong of the two-part test for establishing that the allocations have substantial economic effect (see n.5, supra), which could also fail the fractions rule. While practitioners have raised these concerns, the Internal Revenue Service has not yet expressed an opinion on these issues either way. SeeTax Notes, March 19, 2015.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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