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The 163(j) Package – Implications for passthrough entities

163(j) Package – Implications for passthrough entities

This report provides initial impressions and observations about the 163(j) Package’s application to passthrough entities.

For a discussion of the general background and applicability dates for the Final Regulations and the 2020 Proposed Regulations, as well as links to other 163(j) Package Focus Reports, read TaxNewsFlash

Implications of section 163(j) for partnerships and S corporations

Section 163(j) is applied to partnership business indebtedness at the partnership level. To the extent a partnership’s business interest deduction is limited, the deferred business interest (“excess business interest expense”) must be allocated to the partners, which reduces the partners’ bases in their partnership interests. Section 163(j)(4) provides that excess business interest expense (“BIE”) is then treated as paid or accrued by the partner to the extent the partner is allocated “excess taxable income,” which is adjusted taxable income (“ATI”) of the partnership in excess of the amount the partnership requires to deduct its own interest under section 163(j). To the extent excess BIE is treated as paid or accrued by a partner, such BIE is then subject to a section 163(j) limitation at the partner level. 

Like partnerships, section 163(j) is generally applied to S corporation business indebtedness at the S corporation level. However, unlike partnerships, any limitation of an S corporation’s BIE is carried forward at the S corporation and potentially deducted by the S corporation in future tax years.

The 2018 Proposed Regulations addressed many of the issues created as a result of the application of section 163(j) at the partnership level, but also reserved on many issues. The Final Regulations generally follow the provisions that were contained in the 2018 Proposed Regulations, with some modifications, and the 2020 Proposed Regulations address most of the issues that were reserved in the 2018 Proposed Regulations. Significant changes and other provisions applicable to partnerships and S corporations in the Final Regulations and the 2020 Proposed Regulations are noted below.  

Excess business interest income

As noted above, section 163(j)(4)(B)(ii)(I) provides that excess BIE allocated to a partner from a partnership is treated as paid or accrued by the partner only to the extent the partner is allocated excess taxable income from such partnership. The 2018 Proposed Regulations would have provided that excess BIE is also treated as paid or accrued by a partner to the extent the applicable partnership allocates excess business interest income (“BII”) (business interest income of the partnership in excess of the amount the partnership requires to deduct its own interest under section 163(j)) to the partner. The Final Regulations retain this rule.

Guaranteed payments for the use of capital

The 2018 Proposed Regulations would have included guaranteed payments for the use of capital under section 707(c) as an amount treated as interest for purposes of section 163(j). The Final Regulations remove guaranteed payments for the use of capital from the list of items automatically treated as interest, but add a principal purpose test to the interest anti-avoidance rule, and include an example of a guaranteed payment for the use of capital that is treated as interest under the anti-avoidance rule.

The anti-avoidance rule applies if an expense is economically equivalent to interest and a principal purpose of structuring the transaction as a guaranteed payment for the use of capital is to reduce an amount incurred by the taxpayer that otherwise would be treated as interest. The fact that the taxpayer has a business purpose for obtaining the use of funds or that the funds were obtained at a lower pre-tax cost does not affect the determination of whether the transaction had a principal purpose of avoidance. If the anti-avoidance rule applies, the partner’s income from accrual or receipt of the guaranteed payment for the use of capital is generally treated as interest income.

KPMG observation

While the removal of guaranteed payments for the use of capital from the definition of interest is helpful, the example of a guaranteed payment for the use of capital that is subject to recast under the anti-avoidance rule raises concerns that guaranteed payments for the use of capital may still often be treated as interest. In the example, a partnership that has significant debt and interest expense is considering obtaining a loan from a third party to expand business operations. The example states that, “for the purpose of reducing the amount of additional interest expense [the partnership] would have otherwise incurred by borrowing,” one of the partners agrees to make a contribution to the partnership in exchange for a guaranteed payment for the use of capital. The example concludes that the guaranteed payment for the use of capital is subject to recast under the anti-avoidance rule. The facts of the example seem to mandate the conclusion by stating the purpose of the contribution is to reduce additional interest expense, but provides little guidance on when a guaranteed payment would not be subject to the anti-avoidance rule in situations where a partnership may consider borrowing or obtaining additional capital from a partner to fund its operations.

 

KPMG observation

The potential recast of a guaranteed payment for the use of capital as BIE to the partnership and BII to the contributing partner also raises questions about the application of the new self-charged interest rule in the 2020 Proposed Regulations (discussed below) to these payments. Similar to the self-charge interest rule in the 2020 Proposed Regulations, Reg. § 1.469-7 uses the term “lending transaction” to describe self-charged transactions and clarifies that guaranteed payments for the use of capital under section 707(c) are included within the meaning of a lending transaction. This may provide an argument that guaranteed payments for the use of capital that are treated as interest expense and income under the anti-avoidance rule could benefit from the self-charged lending rules of the 2020 Proposed Regulations.

Self-charged interest

The 2020 Proposed Regulations would provide that in the case of a lending transaction between a partner and a partnership in which the partner holds a direct interest, if the lending partner is allocated excess BIE from the borrowing partnership, the lending partner is deemed to receive an allocation of excess BII equal to the lesser of (1) its excess BIE from the borrowing partnership for the tax year, or (2) the interest income on the loan for the tax year. Double counting rules would apply to prevent interest income from being used more than once in calculating the partner’s section 163(j) limitation. The proposed self-charged interest rule would not apply to S corporations because BIE of an S corporation is carried over by the S corporation as a corporate level attribute.

Allocation of deductible BIE and excess items – 11 steps

The Final Regulations retain the complex 11-step method for allocating deductible BIE and excess items (excess business interest expense, excess BII, and excess taxable income) and decline to provide alternative allocation methods, such as allowing taxpayers to adopt a reasonable method.

However, in the case of partnerships that allocate all items of income and expense on a pro rata basis, the Final Regulations provide an exception to the 11-step calculation requirement. In such case, partners may simply allocate the partnership’s section 163(j) items pro rata.

KPMG observation

The pro rata exception does not appear to provide taxpayers with a calculation method that they were not otherwise entitled to under the 2018 Proposed Regulations. This is so because in the case of a partnership where all items are allocated pro rata, allocations of deductible business interest expense and excess items pro rata should not vary from the allocations that would have resulted under the 11-step calculation method.

Debt financed distributions

In order to characterize interest expense associated with debt incurred to make distributions to partners or S corporation shareholders, the 2020 Proposed Regulations would adopt rules similar to the rules set forth in Notice 89-35, 1989-1 C.B. 675, with certain modifications.

Specifically, the 2020 Proposed Regulations would require that debt incurred to make a distribution to partners or S corporation shareholders would first be allocated to the entity’s available expenditures (those expenditures made in the same tax year, but only to the extent debt proceeds are not otherwise allocated to them). Any additional distributed debt proceeds would then be allocated to distributions to the partners or shareholders.

The tax treatment of each partner’s or shareholder’s share of interest expense allocated to distributions is generally determined based on each partner’s or shareholder’s use of the funds. However, to the extent the owner’s share of interest expense allocated to distributions exceeds the entity’s interest on the portion of debt distributed to that particular owner (“excess interest expense”), the tax treatment is determined by allocating the excess interest expense among all of the entity’s assets, pro rata, based on the adjusted basis of the assets, reduced by any allocable debt. The tax treatment of the interest allocated to available expenditures is determined based on how the distributed proceeds were allocated among the available expenditures.

Interest allocated to the entity’s available expenditures and excess interest expense would be characterized (e.g., as business, investment, or passive non-trade or business) at the entity level. To the extent the interest is characterized as BIE, section 163(j) would be applied to such interest at the entity level. Interest allocated to distributions to partners or shareholders, other than excess interest expense, would be characterized and subject to section 163(j), if applicable, at the owner level.

Additionally, the 2020 Proposed Regulations address the impact of transfers of partnership interests or S corporation stock on the characterization of interest, including an anti-avoidance rule, the repayment of debt used to finance a distribution, and the characterization of debt allocated to a contribution to the capital or purchase of a partnership interest or S corporation stock.

KPMG observation

The proposed treatment of debt financed distribution interest is similar to the long-standing ruled provided in Notice 89-35, but would be less flexible and may have negative implications depending on a partner’s or S corporation shareholder’s use of the funds and the passthrough entity’s asset composition. In addition, the 2018 Proposed Regulations do not appear to contain a transition rule for interest expense incurred by a partnership or S corporation prior to finalization. As a result, partnerships, S corporations and their owners should plan for a potential change to the treatment of interest on existing indebtedness.

 

KPMG observation

Query how the debt financed distribution interest allocation rules under the 2020 Proposed Regulations interact with the debt financed distribution exception to the partnership disguised sale rules, which requires that the proceeds of the debt incurred to make the distribution are allocable under Reg. § 1.163-8T to a transfer of money or other consideration to the distributee partner made within 90 days of incurring the liability.

Trader partnerships

The 2018 Proposed Regulations would have provided that interest expense of a partnership engaged in per se non-passive activities under section 469, such as trading activities, is fully subject to section 163(j) at the partnership level, even if the interest expense may also be subject to limitation under section 163(d) as investment interest expense at the partner level for certain non-materially participating partners. The 2020 Proposed Regulations would reverse this rule and would require the partnership to bifurcate its items between partners that materially participate and those that are passive investors.

Any interest expense allocated to the active partners would be subject to section 163(j) at the partnership level (taking into account all other items allocated to the active partners), and all items allocable to passive investors would be separately stated and allocated to such partners and would be subject to section 163(d) at the partner level.

Because a partnership may not have knowledge about whether a partner could be considered to materially participate in the partnership’s trading activity under the section 469 grouping rules, the 2020 Proposed Regulation would amend the section 469 regulations to prevent the grouping of the trader partnership’s activities with other activities. 

KPMG observation

The proposed limitation to grouping per se passive activities such as trading is intended to simplify the determination of whether a limited partner can properly be treated as not materially participating in the partnership’s activities and prevent two interest limitations from applying to the same interest expense. However, this proposed change may be detrimental to certain limited partners who otherwise could be treated as materially participating in a trading partnership for purposes of section 469, and also may complicate the analysis for general partners as to whether they materially participate in a particular trading partnership.

Basis addback upon disposition

Section 163(j)(4)(B)(iii)(II) provides that if a partner disposes of a partnership interest, the adjusted basis of the partnership interest is increased immediately before the disposition by the entire amount of the partner’s remaining excess BIE (“Basis Addback Rule”). Under the 2018 Proposed Regulations, the Basis Addback Rule would have only applied if a partner disposes of all or substantially all of the partner’s partnership interest. Thus, if a partner disposes of less than substantially all of the partner’s interest in a partnership, the partner would not have been able to increase its basis by any portion of the remaining excess BIE.

The Final Regulations modify this rule to provide that a partial disposition of a partnership interest triggers a proportionate basis addback with respect to the disposed partnership interest, and a corresponding decrease to such partner’s excess BIE. The proportionate basis addback is calculated in a manner similar to that set forth in Revenue Ruling 84-53, 1984-1 C.B. 159 (i.e., based on the ratio of the fair market value of the disposed interest to the total fair market value of the partnership interest immediately prior to the disposition.)

Treasury requests comments on whether a current distribution of money or other property by the partnership to a continuing partner as consideration for an interest in the partnership should also trigger a basis addback and, if so, how to determine the appropriate amount of the addback.

Basis addback to partnership’s basis in assets

The 2020 Proposed Regulations would extend the Basis Addback Rule to the partnership’s basis in its assets. Specifically, if the Basis Addback Rule is triggered with respect to a partner, the partnership would increase the adjusted basis of partnership property by an amount equal to the partner’s basis addback. The basis increase would be allocated among partnership capital gain properties in the same manner as a positive section 734(b) basis adjustment. However, the positive section 734(b) basis adjustment would be non-depreciable or non-amortizable regardless of whether the property to which the adjustment is allocated is depreciable or amortizable property.

KPMG observation

The extension of the Basis Addback Rule to the partnership’s basis in its assets can be helpful to the remaining partners, as it prevents the shifting of built-in gain to the remaining partners by providing for an increased 734(b) adjustment. The section 734(b) basis adjustment would also reduce a positive section 743(b) basis adjustment that would result on transfer of a partnership interest. The section 734(b) basis adjustment is detrimental to the extent partners anticipated the creation of depreciable or amortizable basis with respect to the partnership’s assets.

Special disposition rule with respect to 2019 excess BIE

Pursuant to the CARES Act, in the case of excess BIE of a partnership for any tax year beginning in 2019 that is allocated to a partner, 50% of such excess BIE is treated as BIE that is paid or accrued by the partner in the partner’s first tax year beginning in 2020 and is not subject to the section 163(j) limitation at partner level (the “50% of 2019 EBIE Rule”).

The 2020 Proposed Regulations provide that if a partner disposes of its partnership interest in the partnership’s 2019 or 2020 tax year, the 50% of 2019 EBIE Rule still applies, and thus, the disposition will not result in a basis increase with respect to such EBIE.

KPMG observation

It was not clear from the CARES Act changes to section 163(j) whether a partner that disposed of a partnership interest in 2019 or 2020 would be eligible to deduct 2019 excess business interest expense with respect to such partnership interest pursuant to the 50% of 2019 EBIE Rule. The interpretation of this rule in the 2020 Proposed Regulations is a taxpayer favorable outcome.

Excess BIE in tiered partnerships

In the Preamble to the 2018 Proposed Regulations, Treasury reserved on the application of section 163(j) to tiered partnership structures and requested comments on whether excess BIE should be allocated by an upper-tier partnership (“UTP”) to its partners, and how and when the basis of a UTP should be adjusted when a lower-tier partnership (“LTP”) has BIE that is limited under section 163(j). The 2020 Proposed Regulations would apply an entity approach to the treatment of excess BIE in tiered partnerships that would involve a series of complex rules:

  • When excess BIE is allocated to a UTP (“UTP EBIE”), the UTP’s basis in LTP is reduced in accordance with section 163(j)(4)(B)(iii), but the UTP partners’ bases in UTP would not be reduced until the UTP EBIE is treated as paid or accrued by UTP.
  • In order to properly track the reduction in LTP’s asset value associated with BIE to one or more tiers of UTP partners, any direct or indirect UTP would treat any BIE paid accrued by LTP as a section 705(a)(2)(B) expenditure solely for purposes of section 704(b). Any capital account reduction resulting from such section 705(a)(2)(B) expenditure would occur regardless of whether LTP’s BIE is deductible or subject to limitation under section 163(j). If a UTP subsequently treats UTP EBIE as paid or accrued, no further section 704(b) capital account reduction would occur.
  • UTP EBIE would be treated as a nondepreciable capital asset with a fair market value of zero and basis equal to the amount by which UTP reduced its basis in LTP on account of the allocation of UTP EBIE. As a result, UTP EBIE would be a built-in loss asset on UTP’s balance sheet.
  • UTP EBIE would therefore have two components, a carryforward component and a basis component. Both the carryforward component and basis component of UTP EBIE would be reduced upon an allocation of excess taxable income or excess BII from LTP, or in the event UTP disposes of its interest in LTP. However, the basis component may also be reduced by a negative section 743(b) or section 734(b) adjustment.
  • To the extent UTP is allocated excess taxable income or excess BII from LTP, UTP would determine a particular tranche of UTP EBIE that is treated as paid or accrued by UTP using any reasonable method (for example, on a first in, first out (“FIFO”), or last it, last out (“LIFO”), basis). The specific tranche of UTP EBIE that is treated as paid or accrued would be allocated to the “specified partner” whose section 704(b) capital account was reduced as a result of the section 705(a)(2)(B) expenditure with respect to the applicable tranche of UTP EBIE. In addition, any negative section 743(b) or section 734(b) basis adjustments associated with the tranche of UTP EBIE would be taken into account.
  • If a UTP partner transfers all or a portion of a UTP partnership interest, the transferee would become the “specified partner” with respect to all or a portion of the transferor’s interest in the UTP EBIE. Special rules would apply in the case of certain nonrecognition transactions.
  • If UTP disposes of an interest in LTP, UTP would determine the UTP EBIE that is reduced using any reasonable method (for example, on a FIFO or LIFO basis) and increase UTP’s basis in LTP accordingly, taking into account any negative section 743(b) or section 734(b) basis adjustments.
  • The 2020 Proposed Regulations would also include an “anti-loss trafficking” rule to prevent a transferee of a specified partner’s interest from benefitting from any UTP EBIE for which the transferee did not have a corresponding section 704(b) capital account reduction. This rule would apply to the extent a negative section 743(b) or section 734(b) basis adjustment does not achieve the intended result.

KPMG observation

The proposed rules to track UTP EBIE would add significant complexity to the already complex section 163(j) regime applicable to partnerships. The UTP EBIE rules have some similarities to tracking section 704(c) property and layers. It appears that UTP would need to track UTP EBIE from a particular LTP as separate “property” and each year’s allocation of UTP EBIE from a particular LTP as a new “layer.” The proposed rules would also dictate that a negative section 743(b) or section 734(b) adjustment can attach to UTP EBIE, which would prevent a transferee of a UTP interest from benefitting from a potential future deduction related to the UTP BIE. The Proposed Regulations do not provide a transition rule related to the treatment of excess business interest expense allocated prior to the finalization of these rules, which may raise additional complexity to the extent UTP EBIE has not been tracked in accordance with the 2020 Proposed Regulations.

Allocable ATI and allocable BII of UTP partners

The 2020 Proposed Regulations would provide a new set of formulaic rules to determine each UTP partner’s allocable share of ATI and BII. These rules also would be used by any partnership that elects to compute its 2020 tax year section 163(j) limitation using its 2019 ATI, as provided under the CARES Act.

Publicly traded partnerships

In order to be freely marketable, publicly traded partnership (“PTP”) units must be fungible. PTPs generally use the section 704(c) remedial allocation method coupled with a section 754 election and resulting section 743(b) basis adjustment to ensure fungibility of units. However, because the allocation of the components of ATI, taking into account section 704(c), generally is not pro rata, a PTP’s allocation of deductible BIE and section 163(j) “excess items” (excess taxable income, excess BII and excess BIE) may not be pro rata and would negatively impact unit fungibility. In addition, certain partners’ remedial and basis items may cause fungibility concerns for tax years 2018 through 2021 because depreciation, depletion, and amortization are added back to tentative taxable income in determining ATI.

To address these concerns, the 2020 Proposed Regulations would provide the following additional rules:

  • A PTP would determine a partner’s share of section 163(j) excess items in accordance with the partner’s share of corresponding section 704(b) items that comprise ATI (the “Pro Rata Inside Basis Rule”).
  • Solely for the purposes of section 163(j), a PTP would allocate gain relating to section 704(c) property based on partners’ section 704(b) sharing ratios and would determine each partner’s remedial items as if the partner were entitled to a share of inside basis equal to its share of section 704(b) items (the “Partner Basis Items Rule”).
  • A PTP would treat a section 743(b) basis adjustment amount related to a remedial item as an offset to the related section 704(c) remedial item (the “Section 704(c) Remedial Income Rule”).

KPMG observation

While noted as a fungibility concern in the Preamble to the 2020 Proposed Regulations, the Partner Basis Items Rule appears to not apply to the allocation of losses relating to section 704(c) property, which could cause fungibility issues. This may have been inadvertent. In addition, there are fungibility concerns for a PTP unit where a section 743(b) adjustment does not correlate to an inherited remedial section 704(c) amount (e.g., where a buyer purchases its interest at a time when the PTP has a revaluation loss). The Section 704(c) Remedial Income Offset Rule does not appear to apply to this situation.

 

KPMG observation

It was unclear under the 2018 Proposed Regulations whether an item of remedial income related to a remedial allocation of depreciation, depletion or amortization (“DDA”) items would result in an increase to ATI at the partner level prior to 2022. A partner generally decreases the partner’s ATI for the partner’s distributive share of DDA remedial items, subject to the addback of these amounts for tax years 2018-2021. If an item of remedial income related to DDA were to be treated as a “negative” item of DDA, a reduction to ATI could result. The 2020 Proposed Regulations’ treatment of remedial income as an increase to a partner’s ATI appears to confirm that remedial items of income are not considered “negative” DDA items.

Qualified expenditures

A partnership’s ATI is reduced by deductions for expenditures under sections 173 (circulation expenditures), 174(a) (research and expenditure expenditures), 263(c) (intangible drilling and development expenditures), 616(a) (mine development expenditures), and 617(a) (mine exploration expenditures) (“qualified expenditures”). These expenditures, however, may not reduce the taxable income of a partner to the extent that the expenditures are capitalized at the partner level under section 59(e)(4)(C) or section 291(b). The 2020 Proposed Regulation would provide that a partner’s distributive share of a partnership’s qualified expenditures that are capitalized by a partner under section 59(e) increase the ATI of the partner. A similar rule would apply to S corporations.

KPMG observation

A similar issue exists for partnerships with oil and gas property. In the case of a partnership, oil and gas depletion and the gain or loss on the disposition of oil and gas property are computed separately by the partners and not by the partnership. If a partnership holding oil and gas property is subject to section 163(j), it is unclear whether the gain, loss, or depletion with respect to oil and gas property would affect the partnership’s determination of ATI. In addition, the 2020 Proposed Regulations do not address the situation where a partner is required to capitalize certain qualified expenditures of a partnership under section 291(b). Treasury is aware of both issues and requests comments.

Exempt partnerships or S corporations

Under the 2018 Proposed Regulations, a partnership or S corporation that qualifies as an exempt entity would not be subject to section 163(j), however the exempt partnership’s or S corporation’s BIE would have been subject to section 163(j) at the partner level. The Final Regulations change course and provide that an exempt partnership’s or S corporation’s BIE does not retain its character as BIE and is therefore not subject to section 163(j) at the partner level or shareholder level.

The Final Regulations also clarify that Reg. §§ 1.163(j)-6(m)(3) and (4), which provide special rules for partnerships or S corporations with prior year business interest limitations that thereafter become “not subject to section 163(j),” only apply to the extent the entity becomes eligible for the small business exemption and do not apply to the extent the entity becomes not subject to a section 163(j) limitation because it made an election to have an excepted trade or business.

Short S corporation tax years

The Final Regulations modify Reg. §§ 1.1362-3(c), 1.1368-1(g)(2), and 1.1377-1(b)(3) to provided that a separate section 163(j) limitation will apply when an S corporation has either an actual short tax year, or in the limited circumstances where the S corporation elects to treat its tax year as two separate tax years.

Contact us

For more information, contact a tax professional with KPMG's Washington National Tax:

Debbie Fields | +1 (202) 533 4580 | dafields@kpmg.com

Jon Finkelstein | +1 (202) 533 3724 | jfinkelstein@kpmg.com

Ossie Borosh | +1 (202) 533 5648 | oborosh@kpmg.com

Charles Kaufman | +1 (212) 954 3936 | ckaufman@kpmg.com

Beverly Katz | +1 (202) 533 3820 | beverlykatz@kpmg.com

Tim Chan | +1 (949) 885 5730 | timothyychan@kpmg.com

Anna Holtsman | +1 (202) 533 4334 | aholtsman@kpmg.com