New Partnership Related-Party Rules May Ease Loss Disallowance
The IRS has issued updated rules relating to the disallowance or deferral of deductions for losses and expenses in transactions between partnerships and related persons. The changes bring the regulations in line with numerous changes to the relevant Code provisions enacted since the prior, outdated regulations were put in place.
The new rules treat a partnership as a single entity instead of an aggregate of its partners. This means that the loss disallowance rules, gain recharacterization rules and income/deduction matching rules will be applied at the partnership level and not the partner level. This change could result in more favorable tax treatment of some transactions between partnerships and related parties.
How the Related-Party Rules Work
Under the related party rules, a taxpayer may not deduct a loss on the sale or exchange of property in a transaction with a related person. In the partnership context, the related party disallowance rules apply to:
- a partnership and a person owning, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership; or
- two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital interest or profits interest.
Additionally, there is a “matching rule” that says a taxpayer may not take a deduction for payments to related parties until the related party payee includes the amount in gross income. Finally, another partnership related-party rule characterizes gains on sales of certain types of property between a partner and a controlled partnership as ordinary income instead of capital gain.
The new rules specify that the related party inquiry should be done at the partnership level, not the partner level. The previous rules treated any transaction between a partnership and a non-partner as occurring between the other person and the members of the partnership separately. This rule led to more partnership transactions being considered related-party transactions, with the resulting loss of tax benefits.
Effective Date a Problem
The proposed rules will not be effective until published as final regulations. The IRS has requested public comments on the regulations by February 26, 2024, and has received two submissions so far. Both comments are concerned about the effective date of the new rules and the treatment of prior transactions in open tax years. For example, Michael Ravnitzky, an attorney in Maryland, observes that because the proposed regulations do not address prior related party transactions, tax years that are currently open could be subject to the existing regulations, causing problems due to the carryover of tax attributes. Ravnitzky along with the second commenter, Monte A. Jackel, Tax Scholar in Residence at the University of Baltimore School of Law and former official in the IRS Office of Chief Counsel, urge the IRS to provide guidance on open years to prevent distortions in the tax system.
“The statutory changes….enacted since 1982 indicate that Congress intended for a partnership to be viewed as an entity, rather than as an aggregate of its partners..,” the IRS explains in its preamble to the regulations. The new regs are a welcome change and clear up a long-standing inconsistency in the tax rules. However, the IRS needs to address the effective date of the rules and provide some kind of transition rule for open years to address the concerns expressed in the expert public comments it has received.