Section 1.514(c)–2(d)(1) and (2) of the existing regulations disregard in computing overall partnership income for purposes of the fractions rule items of income (including gross income) and gain that may be allocated to a partner with respect to a current or cumulative reasonable preferred return for capital (including allocations of minimum gain attributable to nonrecourse liability (or partner nonrecourse debt) proceeds distributed to the partner as a reasonable preferred return) if that preferred return is set forth in a binding, written partnership agreement. Section 1.514(c)–2(d)(2) of the existing regulations also provides that if a partnership agreement provides for a reasonable preferred return with an allocation of what would otherwise be overall partnership income, items comprising that allocation are disregarded in computing overall partnership income for purposes of the fractions rule.

Section 1.514(c)–2(d)(6)(i) of the existing regulations limits the amount of income and gain allocated with respect to a preferred return that can be disregarded for purposes of the fractions rule to: (A) the aggregate of the amount that has been distributed to the partner as a reasonable preferred return for the taxable year of the allocation and prior taxable years, on or before the due date (not including extensions) for filing the partnership’s return for the taxable year of the allocation; minus (B) the aggregate amount of corresponding income and gain (and what would otherwise be overall partnership income) allocated to the partner in all prior years. Thus, this rule requires a current distribution of preferred returns for the allocations of income with respect to those preferred returns to be disregarded.

The Treasury Department and the IRS have received comments requesting that the current distribution requirement be eliminated from the regulations because it interferes with normal market practice, creates unnecessary complication, and, in some cases, causes economic distortions for partnerships with QO partners. The preamble to the existing final regulations under section 514(c)(9)(E) responded to objections regarding the current distribution requirement by explaining that if the requirement were eliminated, partnerships might attempt to optimize their overall economics by allocating significant amounts of partnership income and gain to QOs in the form of preferred returns. The preamble explained that these allocations “would be a departure from the normal commercial practice followed by partnerships in which the money partners are generally subject to income tax.” TD 8539, 59 FR 24924. A recent commenter explained that the vast majority of partnerships holding debt-financed real property (real estate partnerships) with preferred returns to investing partners (either the QO or the taxable partner) make allocations that match the preferred return as it accrues, without regard to whether cash has been distributed with respect to the preferred return. Instead of requiring distributions equal to the full amount of their preferred returns, taxable partners generally negotiate for tax distributions to pay any tax liabilities associated with their partnership interest.

The Treasury Department and the IRS have reconsidered the necessity of the current distribution requirement to prevent abuses of the fractions rule. So long as the preferred return is required to be distributed prior to other distributions (with an exception for certain distributions intended to facilitate the payment of taxes) and any undistributed amount compounds, the likelihood of abuse is minimized. Therefore, the proposed regulations remove the current distribution requirement and instead disregard allocations of items of income and gain with respect to a preferred return for purposes of the fractions rule, but only if the partnership agreement requires that the partnership make distributions first to pay any accrued, cumulative, and compounding unpaid preferred return to the extent such accrued but unpaid preferred return has not otherwise been reversed by an allocation of loss prior to such distribution (preferred return distribution requirement). The preferred return distribution requirement, however, is subject to an exception under the proposed regulations that allows distributions intended to facilitate partner payment of taxes imposed on the partner’s allocable share of partnership income or gain, if the distributions are made pursuant to a provision in the partnership agreement, are treated as an advance against distributions to which the distributee partner would otherwise be entitled under the partnership agreement, and do not exceed the distributee partner’s allocable share of net partnership income and gain multiplied by the sum of the highest statutory federal, state, and local tax rates applicable to that partner.

Section 1.514(c)–2(f) of the existing regulations provides a list of certain partner-specific expenditures that are disregarded in computing overall partnership income or loss for purposes of the fractions rule. These expenditures include expenditures attributable to a partner for additional record-keeping and accounting costs including in connection with the transfer of a partnership interest, additional administrative costs from having a foreign partner, and state and local taxes. The Treasury Department and the IRS are aware that some real estate partnerships allow investing partners to negotiate for management and similar fees paid to the general partner that differ from fees paid with respect to investments by other partners. These fees include the general partner’s fees for managing the partnership and may include fees paid in connection with the acquisition, disposition, or refinancing of an investment. Compliance with the fractions rule may preclude a real estate partnership with QO partners from allocating deductions attributable to these management expenses in a manner that follows the economic fee arrangement because the fractions rule limits the ability of the partnership to make disproportionate allocations.

The Treasury Department and the IRS have determined that real estate partnerships with QO partners should be permitted to allocate management and similar fees among partners to reflect the manner in which the partners agreed to bear the expense without causing a fractions rule violation. Accordingly, the proposed regulations add management (and similar) fees to the current list of excluded partner-specific expenditures in § 1.514(c)–2(f) of the existing regulations to the extent such fees do not, in the aggregate, exceed two percent of the partner’s aggregate committed capital.

It has been suggested to the Treasury Department and the IRS that similar partner-specific expenditure issues may arise under the new partnership audit rules in section 1101 of the Bipartisan Budget Act of 2015, Public Law No. 114–74 (the BBA), which was enacted into law on November 2, 2015. Section 1101 of the BBA repeals the current rules governing partnership audits and replaces them with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level as an imputed underpayment. Some have suggested that the manner in which an imputed underpayment is borne by partners potentially could implicate similar concerns as special allocations of partner-specific items. As the Treasury Department and the IRS continue to consider how to implement the BBA, the Treasury Department and the IRS request comments regarding whether an imputed underpayment should be included among the list of partner-specific expenditures.

Similar to § 1.514(c)–2(f), § 1.514(c)–2(g) of the existing regulations generally disregards specially allocated unlikely losses or deductions (other than items of nonrecourse deduction) in computing overall partnership income or loss for purposes of the fractions rule. To be disregarded under § 1.514(c)–2(g), a loss or deduction must have a low likelihood of occurring, taking into account all relevant facts, circumstances, and information available to the partners (including bona fide financial projections). Section 1.514(c)–2(g) describes types of events that give rise to unlikely losses or deductions.

The Treasury Department and the IRS have received comments suggesting that a “more likely than not” standard is appropriate for determining when a loss or deduction is unlikely to occur. Notice 90–41 (1990–1 CB 350) (see § 601.601(d)(2)(ii)(b)), which preceded the initial proposed regulations under section 514(c)(9)(E), outlined this standard. The commenter explained that the “low likelihood of occurring” standard in the existing regulations is vague and gives little comfort to QOs and their taxable partners when drafting allocations to reflect legitimate business arrangements (such as, drafting allocations to account for cost overruns). The Treasury Department and the IRS are considering changing the standard in § 1.514(c)–2(g) and request further comments explaining why “more likely than not” is a more appropriate standard than the standard contained in the existing regulations, or whether another standard turning upon a level of risk that is between “more likely than not” and “low likelihood of occurring” might be more appropriate and what such other standard could be.

Because allocations of partner-specific expenditures in § 1.514(c)–2(f) and unlikely losses in § 1.514(c)–2(g) are disregarded in computing overall partnership income or loss, allocations of items of income or gain or net income to reverse the prior partner-specific expenditure or unlikely loss could cause a violation of the fractions rule. For example, a QO may contribute capital to a partnership to pay a specific expenditure with the understanding that it will receive a special allocation of income to reverse the prior expenditure once the partnership earns certain profits. If the allocation of income is greater than the QO’s fractions rule percentage, the allocation will cause a fractions rule violation.

Section 1.514(c)–2(e)(1) of the existing regulations generally disregards certain allocations of income or loss made to chargeback previous allocations of income or loss in computing overall partnership income or loss for purposes of the fractions rule. Specifically, § 1.514(c)–2(e)(1)(i) disregards allocations of what would otherwise be overall partnership income that chargeback (that is, reverse) prior disproportionately large allocations of overall partnership loss (or part of the overall partnership loss) to a QO (the chargeback exception). The chargeback exception applies to a chargeback of an allocation of part of the overall partnership income or loss only if that part consists of a pro rata portion of each item of partnership income, gain, loss, and deduction (other than nonrecourse deductions, as well as partner nonrecourse deductions and compensating allocations) that is included in computing overall partnership income or loss.

The Treasury Department and the IRS understand that often a real estate partnership with QO partners may seek to reverse a special allocation of unlikely losses or partner-specific items with net profits of the partnership, which could result in allocations that would violate the fractions rule. Such allocations of net income to reverse special allocations of unlikely losses or partner-specific items that were disregarded in computing overall partnership income or loss for purposes of the fractions rule under § 1.514(c)–2(f) or (g), respectively, do not violate the purpose of the fractions rule. Accordingly, the proposed regulations modify the chargeback exception to disregard in computing overall partnership income or loss for purposes of the fractions rule an allocation of what would otherwise have been an allocation of overall partnership income to chargeback (that is, reverse) a special allocation of a partner-specific expenditure under § 1.514(c)–2(f) or a special allocation of an unlikely loss under § 1.514(c)–2(g). Notwithstanding the rule in the proposed regulations, an allocation of an unlikely loss or a partner-specific expenditure that is disregarded when allocated, but is taken into account for purposes of determining the partners’ economic entitlement to a chargeback of such loss or expense may, in certain circumstances, give rise to complexities in determining applicable percentages for purposes of fractions rule compliance. Accordingly, the Treasury Department and the IRS request comments regarding the interaction of disregarded partner-specific expenditures and unlikely losses with chargebacks of such items with overall partnership income.

Section 1.514(c)–2(k)(1) of the existing regulations provides special rules regarding changes in partnership allocations arising from a change in partners’ interests. Specifically, § 1.514(c)–2(k)(1) provides that changes in partnership allocations that result from transfers or shifts of partnership interests (other than transfers from a QO to another QO) will be closely scrutinized (to determine whether the transfer or shift stems from a prior agreement, understanding, or plan or could otherwise be expected given the structure of the transaction), but generally will be taken into account only in determining whether the partnership satisfies the fractions rule in the taxable year of the change and subsequent taxable years. Section 1.514(c)–2(k)(4) of the existing regulations provides that § 1.514(c)–2 may not be applied in a manner inconsistent with the purpose of the fractions rule, which is to prevent tax avoidance by limiting the permanent or temporary transfer of tax benefits from tax-exempt partners to taxable partners.

The Treasury Department and the IRS have received comments requesting guidance in applying the fractions rule when additional partners are admitted to a partnership after the initial formation of the partnership. The commenter explained that many real estate partnerships with QO partners admit new partners in a number of rounds of closings, but treat the partners as having entered at the same time for purposes of sharing in profits and losses (staged closings). A number of commercial arrangements are used to effect staged closings. For example, the initial operations of the partnership may be funded entirely through debt financing, with all partners contributing their committed capital at a later date. Alternatively, later entering partners may contribute capital and an interest factor, some or both of which is then distributed to the earlier admitted partners to compensate them for the time value of their earlier contributions.

Under existing regulations, staged closings could cause violations of the fractions rule in two ways. First, when new partners are admitted to a partnership, shifts of partnership interests occur. Changes in allocations that result from shifts of partnership interests are closely scrutinized under § 1.514(c)–2(k)(1) of the existing regulations if pursuant to a prior agreement and could be determined to violate the fractions rule. Second, after admitting new partners, partnerships may disproportionately allocate income or loss to the partners to adjust the partners’ capital accounts as a result of the staged closings. These disproportionate allocations could cause fractions rule violations if one of the partners is a QO.

The Treasury Department and the IRS have determined that changes in allocations and disproportionate allocations resulting from common commercial staged closings should not violate the fractions rule if they are not inconsistent with the purpose of the fractions rule under § 1.514(c)–2(k)(4) and certain conditions are satisfied. The conditions include the following: (A) the new partner acquires the partnership interest no later than 18 months following the formation of the partnership (applicable period); (B) the partnership agreement and other relevant documents anticipate the new partners acquiring the partnership interests during the applicable period, set forth the time frame in which the new partners will acquire the partnership interests, and provide for the amount of capital the partnership intends to raise; (C) the partnership agreement and any other relevant documents specifically set forth the method of determining any applicable interest factor and for allocating income, loss, or deduction to the partners to adjust partners’ capital accounts after the new partner acquires the partnership interest; and (D) the interest rate for any applicable interest factor is not greater than 150 percent of the highest applicable Federal rate, at the appropriate compounding period or periods, at the time the partnership was formed.

Under the proposed regulations, if those conditions are satisfied, the IRS will not closely scrutinize changes in allocations resulting from staged closings under § 1.514(c)–2(k)(1) and will disregard in computing overall partnership income or loss for purposes of the fractions rule disproportionate allocations of income, loss, or deduction made to adjust the capital accounts when a new partner acquires its partnership interest after the partnership’s formation.

The Treasury Department and the IRS received comments requesting guidance with respect to calculations of overall partnership income and loss when allocations change as a result of capital commitment defaults or reductions. The commenter indicated that, in the typical real estate partnership, a limited partner generally will not contribute its entire investment upon being admitted as a partner. Rather, that limited partner will commit to contribute a certain dollar amount over a fixed period of time, and the general partner will then “call” on that committed, but uncontributed, capital as needed. These calls will be made in proportion to the partners’ commitments to the partnership.

The commenter identified certain remedies that partnership agreements provide if a partner fails to contribute a portion (or all) of its committed capital. These remedies commonly include: (i) allowing the non-defaulting partner(s) to contribute additional capital in return for a preferred return on that additional capital; (ii) causing the defaulting partner to forfeit all or a portion of its interest in the partnership; (iii) forcing the defaulting partner to sell its interest in the partnership, or (iv) excluding the defaulting partner from making future capital contributions. Alternatively, the agreement may allow partners to reduce their commitment amounts, reducing allocations of income and loss as well. The commenter noted that, depending on the facts, any of these partnership agreement provisions could raise fractions rule concerns.

There is little guidance in the existing regulations regarding changes to allocations of a partner’s share of income and losses from defaulted capital calls and reductions in capital commitments. Section 1.514(c)–2(k)(1) applies to changes in allocations resulting from a default if there is a “transfer or shift” of partnership interests. The Treasury Department and the IRS have determined that changes in allocations resulting from unanticipated defaults or reductions do not run afoul of the purpose of the fractions rule if such changes are provided for in the partnership agreement. Therefore, the proposed regulations provide that, if the partnership agreement provides for changes to allocations due to an unanticipated partner default on a capital contribution commitment or an unanticipated reduction in a partner’s capital contribution commitment, and those changes in allocations are not inconsistent with the purpose of the fractions rule under § 1.514(c)–2(k)(4), then: (A) changes to partnership allocations provided in the agreement will not be closely scrutinized under § 1.514(c)–2(k)(1) and (B) partnership allocations of income, loss, or deduction (including allocations to adjust partners’ capital accounts to be consistent with the partners’ adjusted capital commitments) to partners to adjust the partners’ capital accounts as a result of unanticipated capital contribution defaults or reductions will be disregarded in computing overall partnership income or loss for purposes of the fractions rule.

Section 1.514(c)–2(m)(1) of the existing regulations provides that if a QO holds an indirect interest in real property through one or more tiers of partnerships (a chain), the fractions rule is satisfied if: (i) the avoidance of tax is not a principal purpose for using the tiered-ownership structure; and (ii) the relevant partnerships can demonstrate under “any reasonable method” that the relevant chains satisfy the requirements of § 1.514(c)–2(b)(2) through (k). Section 1.514(c)–2(m)(2) of the existing regulations provides examples that illustrate three different “reasonable methods:” the collapsing approach, the entity-by-entity approach, and the independent chain approach.

The Treasury Department and the IRS have received comments requesting guidance with respect to tiered partnerships and the application of the independent chain approach. Under the independent chain approach in § 1.514(c)–2(m)(2) Example 3 of the existing regulations, different lower-tiered partnership chains (one or more tiers of partnerships) are examined independently of each other, even if these lower-tiered partnerships are owned by a common upper-tier partnership. The example provides, however, that chains are examined independently only if the upper-tier partnership allocates the items of each lower-tier partnership separately from the items of another lower-tier partnership.

The comment noted that in practice, a real estate partnership generally invests in a significant number of properties, often through joint ventures with other partners. A typical real estate partnership will not make separate allocations to its partners of lower-tier partnership items. Accordingly, the proposed regulations amend § 1.514(c)–2(m)(2) Example 3 to remove the requirement that a partnership allocate items from lower-tier partnerships separately from one another. Partnership provisions require that partnership items such as items that would give rise to UBTI be separately stated. See § 1.702–1(a)(8)(ii). That requirement suffices to separate the tiers of partnerships, and, thus, the proposed regulations do not require the upper-tier partnership to separately allocate partnership items from separate lower-tier partnerships. The proposed regulations also revise § 1.514(c)–2(m)(1)(ii) to remove the discussion of minimum gain chargebacks that refers to language that has been deleted from the example.

Section 1.514(c)–2(k)(2) of the existing regulations provides that the partnership limitation in section 514(c)(9)(B)(vi) does not apply to a partnership if all QOs hold a de minimis interest in the partnership, defined as no more than five percent in the capital or profits of the partnership, and taxable partners own substantial interests in the partnership through which they participate in the partnership on substantially the same terms as the QO partners. If the partnership limitation in section 514(c)(9)(B)(vi) does not apply to the partnership, the fractions rule does not apply to the partnership. Because the fractions rule does not apply to a partnership if all QOs are de minimis interest holders in the partnership, the Treasury Department and the IRS considered whether the inverse fact pattern, in which all non-QO partners are de minimis partners, implicates the purpose of the fractions rule. See § 1.514(c)–2(k)(4) (providing that the purpose of the fractions rule is to “prevent tax avoidance by limiting the permanent or temporary transfer of tax benefits from tax-exempt partners to taxable partners, whether by directing income or gain to tax-exempt partners, by directing losses, deductions or credits to taxable partners, or by some similar manner.”).

The Treasury Department and the IRS have determined that the purpose of the fractions rule is similarly not violated if all non-QO partners hold a de minimis interest. Therefore, the proposed regulations provide that the fractions rule does not apply to a partnership in which non-QO partners do not hold (directly or indirectly through a partnership), in the aggregate, interests of greater than five percent in the capital or profits of the partnership, so long as the partnership’s allocations have substantial economic effect. For purposes of the proposed rule, the determination of whether an allocation has substantial economic effect is made without application of the special rules in § 1.704–1(b)(2)(iii)(c)(2) (regarding the presumption that there is a reasonable possibility that allocations will affect substantially the dollar amounts to be received by the partners from the partnership if there is a strong likelihood that offsetting allocations will not be made in five years, and the presumption that the adjusted tax basis (or book value) of partnership property is equal to the fair market value of such property).

The existing regulations also provide for a de minimis exception for allocations away from QO partners. Section 1.514(c)–2(k)(3) of the existing regulations provides that a QO’s fractions rule percentage of the partnership’s items of loss and deduction, other than nonrecourse and partner nonrecourse deductions, that are allocated away from the QO and to other partners in any taxable year, are treated as having been allocated to the QO for purposes of the fractions rule if: (i) the allocation was neither planned nor motivated by tax avoidance; and (ii) the total amount of those items of partnership loss or deduction is less than both one percent of the partnership’s aggregate items of gross loss and deduction for the taxable year and $50,000. The preamble to the existing final regulations under section 514(c)(9)(E) explained that the de minimis allocation exception was “to provide relief for what would otherwise be minor inadvertent violations of the fractions rule.” TD 8539, 59 FR 24924. The exception was “not intended ... [to] be used routinely by partnerships to allocate some of the partnership’s losses and deductions.” Id. To that end, the final regulations limited the exception to $50,000. As an example of a de minimis allocation intended to meet this exception, the preamble described a scenario in which a plumber’s bill is paid by the partnership but overlooked until after the partner’s allocations have been computed and then is allocated entirely to the taxable partner. Id.

In current business practices, a $50,000 threshold does not provide sufficient relief for de minimis allocations away from the QO partner. The proposed regulations still require that allocations not exceed one percent of the partnership’s aggregate items of gross loss and deduction for the taxable year, but raise the threshold from $50,000 to $1,000,000.