The IRS has issued comprehensive proposed regulations that would limit duplicated losses and inappropriate transfers of built-in losses between partners. The regulations seek to implement and fine-tune tax code provisions enacted in the American Jobs Act of 2004. They will have a significant impact as partnerships grow as the entity of choice for many business enterprises. Although labelled “proposed,” taxpayers should consider the IRS’s interpretation of the rules set forth in these regulations as current audit policy unless otherwise indicated.
Built-in loss property
Property has a built-in loss if its basis exceeds its fair market value. Congress determined that where a partner had contributed built-in loss property to a partnership, and then transferred a partnership interest to another partner, both partners could claim the same loss. The problem also occurs when a partnership distributes the built-in loss property to another partner, and when a partnership makes liquidating distributions to the partner who contributed the built-in loss property.
The proposed regulations would restrict the loss deduction to the partner who contributed the built-in loss property to the partnership. If the partner who contributed the built-in loss property disposes of its partnership interest, the transferee does not succeed to the transferor partner’s basis adjustment (built-in loss). The regulations impose certain reporting requirements for the appropriate basis adjustments.
Scope of rules
For the regulations to apply, the built-in loss must exceed $250,000 immediately after a distribution of partnership property or a transfer of a partnership interest. The regulations would not apply if the partnership interest is transferred in certain nonrecognition transactions, such as tax-free reorganizations. Gifts do not qualify for this exception.
Where there are tiered partnerships, the proposed regulations would also require mandatory basis adjustments. The adjustments must be pushed down to the lower tier where the built-in loss property is. Practitioners have indicated that it may be difficult to implement the basis adjustments where the upper-tier partnership does not control the lower-tier partnership. The IRS acknowledged that these requirements may not be particularly administrable.
The regulations also address abusive transactions that allow a partnership to increase the basis of depreciable assets while decreasing tax-free the basis of preferred stock of a corporate partner held by the partnership. These types of transactions were developed by Enron Corporation and enabled a partnership to take duplicated tax deductions at no economic cost.