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Monthly Tax Roundup (Volume 2, Issue 11)

Tax Alert

Introduction

From start to finish, November was a challenging month for taxpayers, with trial courts rendering adverse decisions in several closely watched cases. At the beginning of the month, a federal district court applied the economic substance doctrine to deny the section 245A dividends received deduction to Liberty Global, Inc., in a summary judgment decision articulating a broad view of the doctrine's scope. On November 15, the U.S. Tax Court ruled in favor of the government in YA Global, concluding that a foreign investment fund had engaged in a U.S. trade or business through an agency relationship with its U.S.-based fund manager. Finally, on November 28, the U.S. Tax Court rendered partial summary judgment for the government in Soroban Capital Partners, adopting a narrow interpretation of the limited partner exception from self-employment taxes. In this Monthly Tax Roundup, we consider the broader implications for similarly situated taxpayers, while highlighting additional judicial and regulatory developments, including long-awaited proposed regulations under section 987. 

Tax fact: According to the Internal Revenue Service (IRS) Fiscal Year (FY) 2023 Financial Report, the agency set a goal to initiate at least 1,121 exams of large corporations with assets of at least $250 million in FY 2023. The IRS says it exceeded that goal, starting 1,400 exams.

"In 1790, the nation which had fought a revolution against taxation without representation discovered that some of its citizens weren't much happier about taxation with representation." — Lyndon B. Johnson


Limited Partners Must Have a Limited Role to Avoid Net Earnings from Self-Employment

George Hani, Jim Gadwood, and Andrew Beaghley

Net earnings from self-employment do not include "the distributive share of any item of income or loss of a limited partner, as such[.]" Section 1402(a)(13). In a much-anticipated opinion, the Tax Court recently evaluated this limited-partner exception in the context of a limited partnership and held that the exception does not apply to a limited partner who is limited in name only. See Soroban Capital Partners LP v. Commissioner, 161 T.C. No. 12. Accordingly, applying the exception requires an inquiry into a limited partner's functions and roles with respect to the limited partnership. The court has considered the scope of this limited-partner exception in the context of other passthrough entities with owners that have some form of limited liability, finding that such persons must be passive investors to qualify. While this is the first time the court has opined in the limited partnership context, the court reached the same result as in the prior cases.

When the limited-partner exception was enacted in 1977, limited partners were generally constrained to limited partnership entities and the exception was necessary to prevent passive investors from participating in the Social Security program without participating in the workforce as the program was intended. The subsequent advent of other state-law entities providing some form of limited liability for at least some owners made the scope of the limited-partner exception less clear. The U.S. Department of the Treasury (Treasury) sought to resolve this ambiguity through proposed regulations in 1997, but subsequent legislation imposed a temporary moratorium on Treasury finalizing these regulations. There has been no regulatory action since then, though the issue does now appear on Treasury's priority guidance plan.

Section 1402(a)(13) provides that net earnings from self-employment exclude "the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services" (emphasis added). In Soroban, the partnership treated guaranteed payments to the limited partners as net earnings from self-employment but excluded partnership allocations or ordinary business income from net earnings from self-employment. In interpreting the limited-partner exception in Section 1402(a)(13), the Tax Court focused on the statutory language, in particular the phrase "as such" emphasized above. The court reasoned that "the limited partner exception applies only to a limited partner who is functioning as a limited partner." Merely being a limited partner in name is insufficient. Accordingly, a factual inquiry is required to determine the role of the partners claiming the exemption. The court did not undertake this factual inquiry as part of its opinion, which ruled in response to pending cross motions for full and partial summary judgment. Further proceedings in this case are therefore anticipated.

The Tax Court also addressed whether it had jurisdiction under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) partnership audit rules to make a factual determination regarding a limited partner's role in a partnership. Under the TEFRA rules, partnership items must be determined in a partnership-level proceeding while adjustments to affected items that require a partner-level determination are made in a separate deficiency proceeding after the partnership-level proceeding concludes. The Tax Court concluded that a functional inquiry into limited partners' roles and activities in the partnership involves factual determinations that are necessary to determine the partnership's aggregate net earnings from self-employment, itself a partnership item. Accordingly, the court held that such a factual inquiry is a partnership item appropriately determined in a partnership-level proceeding.

Other cases presenting these same issues are currently pending before the Tax Court. We anticipate the court will reach the same legal conclusions as above in these cases. That said, factual differences could produce different results under the inquiry into a limited partner's roles and activities with respect to the partnership. And of course, multiple cases create the potential for a circuit split in the future. Limited partnerships and their partners should stay tuned for further developments in this area.


Sixth Circuit Declines to Rule on Remedy Under the APA

Kevin Kenworthy and Samuel Lapin

On November 20, 2023, the Federal Court of Appeals for the Sixth Circuit issued the latest installment in Mann Construction, Inc. v. United States, No. 23-1138 (Nov. 20, 2023), which addressed the validity of Notice 2007-83, one of a series of notices in which the IRS classified certain transactions as abusive and subjected participants to increased reporting requirements and penalties. This installment addresses the authority of a court to provide nationwide remedies for agency rulemaking that violates the Administrative Procedure Act (APA). The Sixth Circuit held that any dispute about the proper remedy became moot when the IRS paid the taxpayers a full refund. As a result, the Sixth Circuit vacated and remanded a district court decision that would have had nationwide effect. 

Notice 2007-83 classified certain employee benefit plans involving cash value life insurance policies as an abusive "listed transaction." The IRS determined that Mann Construction and its two co-owners had failed to report their participation in one of the transactions covered by Notice 2007-83 and assessed section 6707A penalties. After paying the penalties, the taxpayers filed suit requesting a refund, abatement of unpaid penalties, and injunctive and declaratory relief on the grounds that the IRS had failed to comply with the APA notice and comment procedures when issuing Notice 2007-83. The taxpayers later waived their requests for declaratory and injunctive relief. In a 2022 decision, the Sixth Circuit held that Notice 2007-83 was procedurally invalid for failure to comply with notice and comment requirements under the APA. Awaiting a ruling on remand from the district court on the appropriate manner of enforcing the Sixth Circuit's 2022 decision, the IRS paid a refund of all penalties at issue with interest, abated unpaid penalties, and committed not to apply Notice 2007-83 to the taxpayers or to any taxpayer in the Sixth Circuit's jurisdiction. Nevertheless, the district court held in January 2023 that the proper remedy under the APA is to vacate Notice 2007-83 nationwide. The government appealed.

On appeal, the Sixth Circuit held, as it did in a 2022 decision on a similar issue, that the refund eliminated any case or controversy, essential to a federal district court's jurisdiction, and the case became moot. The Sixth Circuit held that the IRS had already made the taxpayers whole because the relief available to taxpayers in refund suits is limited to the recovery of payments. In addition, the Sixth Circuit rejected the taxpayers' argument that their request for relief under the APA sustained the district court's jurisdiction to vacate Notice 2007-83 nationwide. The court found that the IRS voluntarily granted taxpayers declaratory and injunctive relief allowed under the APA by committing not to enforce Notice 2007-83 in the Sixth Circuit even though the taxpayers waived their request for such relief. Finally, the court also rejected the taxpayers' argument that the IRS's continued application of Notice 2007-83 to other taxpayers outside of the Sixth Circuit's jurisdiction could maintain their claim. The court held not only that the taxpayer lacked standing to litigate injuries to other taxpayers, but it also held that agencies had no obligation to follow an unfavorable court ruling outside of the ruling court's jurisdiction. As a result, the Sixth Circuit held that the district court lacked jurisdiction to issue its decision and remanded the case to the district court. 

Because it ruled on jurisdictional grounds, the Sixth Circuit did not directly address the merits of the district court's ruling on appropriate relief for violation of APA requirements. Nevertheless, this latest episode in the Mann Construction saga provides insight into how courts will remedy flawed rulemaking in the context of a refund suit. While it maintains its litigating position, the IRS appears to have, as a practical matter, acknowledged the vulnerability of these classification notices to validity challenges under the APA and has begun to formalize several as regulations (discussed here, here, and here) in accordance with notice and comment procedures. Nevertheless, the question of an appropriate remedy for APA violations in the federal tax context is not likely to go away anytime soon.


U.S. District Court Applies Economic Substance Doctrine to Deny Liberty Global, Inc., a Section 245A Deduction

Robert Kovacev and Omar Hussein

In Liberty Global, Inc. v. United States, the U.S. District Court for the District of Colorado applied the economic substance doctrine to deny Liberty Global, Inc. (LGI) a section 245A dividends received deduction (DRD) to offset a $2.4 billion gain, holding that LGI's multi-step "Project Soy" did not have a sufficient non-tax purpose to overcome the doctrine. See Liberty Global, Inc. v. United States, 2023 WL 8062792 (D. Colo. Oct. 31, 2023). This is the latest in a series of events in this case. In 2020, Liberty Global filed a refund suit in the District of Colorado challenging the validity of a retroactive temporary regulation that applied to sections 245A and 954. The court agreed with Liberty Global and held the regulation was invalid, as Treasury did not meet the requirements of the APA when promulgating the regulation. See our prior coverage here.

After that, the U.S. Department of Justice (DOJ) filed an affirmative suit against Liberty Global, alleging that the underlying transaction violated the economic substance doctrine and should be disregarded regardless of the fate of the temporary regulation. The court denied Liberty Global's motion to dismiss that action and the parties filed summary judgment motions. See our prior coverage here

In 2018, LGI engaged in a four-step transaction, codenamed "Project Soy," to "exploit" an alleged mismatch between the global intangible low-taxed income (GILTI), Subpart F, and controlled foreign corporation (CFC) rules under the Tax Cuts and Jobs Act of 2017 (TCJA). Steps 1-3 generated earnings and profits (E&P) through a Belgian affiliate holding company (CFC), and in Step 4, LGI sold the holding company to its U.K. parent for a $2.4 billion gain. Because Steps 1-3 generated sufficient E&P, LGI was able to treat the gains as dividends, and claimed a section 245A DRD for the total amount.

However, in June 2019, Treasury issued retroactive temporary regulations that sought to close the supposed "loophole" LGI attempted to utilize. Following an audit in 2019, the IRS determined that LGI was not entitled to the 2018 deductions due to the temporary regulations. In a partial summary judgement decision, the Colorado District Court determined that the temporary regulations violated APA and did not have retroactive effect. In response, the IRS claimed that even if the temporary regulations violated the APA, LGI was not entitled to the section 245A deduction because the transactions lacked economic substance. 

Section 7701(o), which codified the economic substance doctrine, states that "[i]n the case of any transaction to which the economic substance doctrine is relevant," a transaction will only have economic substance if it "changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction."  

Based on the statutory language, LGI first argued that courts must conduct a preliminary "relevance" analysis to determine if the transaction at issue is "relevant" to the economic substance doctrine, before determining whether the transaction actually had economic substance. The court rejected this argument, stating that "the doctrine's relevance is co-coextensive with the statute's test for economic substance," and that "there is no 'threshold' inquiry separate from the statutory factors." Next, the court also rejected LGI's argument that the proper "unit of analysis" for the doctrine was Step 3 of the transaction (entity conversion from a Belgian BVBA to an NV), holding that Project Soy should instead be analyzed in the aggregate. Finally, the court held that the "basic business transaction" exception to the doctrine did not apply. As a result, the entire transaction was assessed against the economic substance doctrine. 

Regarding the first statutory requirement under section 7701(o)(1)(A), the court highlighted LGI's admission through testimony that the first three steps of Project Soy "did not change, in a meaningful way, LGI's economic position." Further, the court determined that if no steps taken as part of a transaction meaningfully change a taxpayer's economic (i.e., non-tax) position, then the steps "in the aggregate" will not either. The court therefore held that LGI's plan failed to meet the first statutory requirement. 

Second, the court assessed whether the steps in Project Soy had substantial economic (non-tax) purpose under section 7701(o)(1)(B). Similar to the first requirement, LGI admitted through testimony that steps 1-3 "served no substantial non-tax purpose for LGI." However, LGI argued in its brief that the steps served several non-tax purposes, namely, compliance with Belgian corporate law and preferential distribution rights in the Belgian subsidiary. However, even in light of the non-tax outcomes of the underlying steps, the court determined that the "only substantial purpose of the transaction was tax evasion." As a result, the court the court disregarded steps 1-3, eliminating the E&P generated to support the section 245A DRD, subjecting LGI to a $2.4 billion in gain in Step 4.

This decision is appealable to the Tenth Circuit Court of Appeals.

This case foreshadows the increasingly aggressive use of economic substance arguments by the IRS. When combined with the recent decision to eliminate the requirement that Exam teams must receive managerial approval before basing a disallowance on economic substance, it is clear that taxpayers engaged in complex multi-step transactions need to prepare a defense to potential economic substance arguments.


In Closely Watched YA Global, Tax Court Concludes Foreign Investment Fund Engaged in U.S. Trade or Business 

Rocco Femia, Jeffrey Tebbs, and Marissa Lee

On November 15, 2023, the U.S. Tax Court rendered an opinion in favor of the government in YA Global Investments, LP v. Commissioner, concluding that a Cayman Islands investment fund had engaged in a U.S. trade or business through an agency relationship with its U.S.-based fund manager and that the fund was liable for withholding tax on income effectively connected with that U.S. trade or business that was allocable to its foreign partners. The decision blows wind into the sails of the ongoing IRS Large Business and International Division (LB&I) campaign, Financial Service Entities engaged in a U.S. Trade or Business. While it is unclear whether a future court would extend the adverse result beyond the distinctive facts in YA Global, foreign investment funds should review their transactions, policies, and documentation in light of this decision. Funds should also consider whether to modify their approach to filing protective U.S. withholding tax returns to ensure the commencement of the limitations period. 

YA Global Investments, LP (YA Global) was formed as a Delaware limited partnership in 2001 and registered under the laws of the Cayman Islands in 2007. The partnership provided funding to portfolio companies in exchange for stock, convertible debentures, promissory notes, and warrants. Yorkville Advisors acted as YA Global's sole general partner and as its investment manager engaged in activities in the U.S. As a threshold issue, the court concluded that Yorkville Advisors constituted an agent of YA Global and thereby attributed the activities of Yorkville Advisors in the U.S. to YA Global. Significantly, the investment management agreements appointed Yorkville Advisors as YA Global's "Agent" and allowed YA Global to issue interim instructions to Yorkville Advisors on managing the partnership's assets. 

Based on that agency relationship, the court then concluded that YA Global engaged in the conduct of a U.S. trade or business for the years at issue. In particular, the court concluded that YA Global's activities were not limited to the management of investments. Under longstanding caselaw, the management of investments in the U.S. does not constitute a U.S. trade or business. In reaching the conclusion that YA Global's activities were not limited to the management of investments, the court closely examined the structure of fees paid by the fund's portfolio companies to Yorkville Advisors and/or YA Global and determined that such fees were not "simply additional payments for the use of capital," because the fund was not "simply deciding whether to purchase a security on the terms offered," but instead "arrang[ing] and structur[ing] the transaction in which the security is issued." The court further concluded that the statutory securities trading safe harbor did not apply. Notably, the court declined to accept the assertion by the IRS that YA Global had specifically engaged in underwriting or lending, as it was only necessary that the fund had engaged in a U.S trade or business "of any sort." Accordingly, the court did not fully adopt the analysis of the IRS, which had been released as a legal memorandum in 2015.

The court accepted the IRS position that the partnership's taxable income needed to be adjusted to reflect the application of section 475's mark-to-market rules and upheld the IRS determination that all of the partnership's income was effectively connected with its U.S. trade or business, as U.S. source income from the sale of personal property attributable to a U.S. office or fixed place of business of the partnership. Under section 1446(a), the partnership was therefore required to have withheld and paid tax on the portion of income effectively connected with that U.S. trade or business that was allocated to any foreign partners. 

Finally, the court rejected YA Global's claim that the statute of limitations barred the assessment on several grounds. In particular, the court concluded that the limitation period never started because YA Global did not file withholding tax returns (Forms 8804) and because the partnership's timely filed information returns (Forms 1065) did not disclose any U.S. trade or business and were therefore insufficient to advise the IRS of the withholding tax liability. 


Tax Court Rules Against Liberty Global in Foreign Tax Credit Dispute

Jeffrey Tebbs and Andrew Beaghley 

On November 8, 2023, the U.S. Tax Court issued an opinion in Liberty Global, Inc. v. Commissioner, ruling in favor of the IRS in a $242 million dispute involving overall foreign loss (OFL) recapture. The decision resolves an issue of first impression affecting the foreign tax credit. This Tax Court case is separate from the Liberty Global litigation pending in the District of Colorado involving the section 245A dividends received deduction and the economic substance doctrine. 

In 2010, Liberty Global, Inc. (LGI) sold its majority interest in a CFC to an unrelated party, resulting in $3.25 billion in gain, of which $2.8 billion was reported as capital gain and $438 million was recharacterized as a dividend under section 1248. The taxpayer and the IRS disagreed on whether the OFL recapture rules affected the amount of gain and the extent to which the gain was recharacterized as foreign source. 

The OFL recapture rules require a taxpayer that incurs a foreign loss that offsets U.S. source income to recharacterize foreign source income reported in later years as U.S. source income. The recapture prevents a U.S. taxpayer from first reducing its U.S. tax liability on U.S. source income by virtue of a foreign source loss, and later claiming foreign tax credits with respect to subsequent foreign source income that merely offsets the prior foreign loss. The OFL recapture rules include special provisions addressing dispositions, intended to prevent taxpayers from permanently avoiding OFL recapture by disposing of assets that ordinarily produce foreign source income subject to recapture. Of relevance here, section 904(f)(3)(D) provides for OFL recapture when a majority shareholder disposes of CFC stock.

For the transaction at issue, LGI and the government agreed that the OFL recapture rules of section 904(f)(3) applied to the sale and resulted in the recapture of LGI's entire OFL account balance, by recharacterizing $474 million of gain as foreign-source income subject to recapture. However, LGI asserted that the OFL recapture rules operated to prevent the recognition of gain beyond the amount necessary to recapture the OFL account balance. The court disagreed, holding that the recapture rules do not prevent recognition of the remaining gain under other provisions of the Code. Invoking the principle that Congress does not "hide elephants in mouseholes" (Sackett v. EPA, 143 S. Ct. 1322, 1340 (2023)), the court emphasized that, under the taxpayer's position, an immaterial OFL account balance could prevent the recognition of substantial gain in an otherwise taxable disposition.

In the alternative, LGI conceded that the entire gain from the sale should be recognized but asserted that the full amount was then recharacterized as foreign source. The Tax Court disagreed, concluding that gain on the disposition is only recharacterized as foreign source to the extent necessary to eliminate the OFL account balance. As this alternative represented LGI's tax return filing position, the court disallowed $242 million in foreign tax credits claimed by LGI. In lieu of the foreign tax credit, LGI was permitted to deduct foreign income taxes for the year under section 164(a). 


IRS Extends "Transition" Period for R&E Credit Refund Claims

George Hani, Robert Kovacev, and Samuel Lapin

On October 30, 2023, the IRS updated its guidance on what constitutes a valid research and experimentation (R&E) credit refund claim. In 2021, the IRS announced its position that a valid R&E credit refund claim must, in addition to qualified research expenses, include information on all business components, research activities and the employees that performed then, and the information that each individual sought to discover. The IRS initially allowed taxpayers a one-year transition period (through January 10, 2023) during which the IRS will notify a taxpayer if it concludes that a claim is deficient and allow the taxpayer 45 days to perfect its claim before they are rejected. 

The IRS has now extended again the transition period during which the IRS will notify a taxpayer that its R&E refund claim is deficient and allow another year (through January 10, 2025) to perfect its claim. In addition, the IRS updated the FAQs providing guidance on its position. Specifically, the IRS added a "Best Practice Example Submission for Five Items of Information" to illustrate how taxpayers might format the additional information they must include in an R&E credit refund claim. 

These latest updates come as the IRS has proposed changes to the Form 6765, Credit for Increasing Research Activities, and the instructions to the Form 6765 that, among other things, would require taxpayers to provide the five items of information. Find more information about these additional requirements and the IRS's justifications for them here and here.


Proposed Section 987 Regulations Retain FEEP Method and Offer Two New Elections 

Layla Asali, Jeffrey Tebbs, and Caroline Reaves

On November 9, 2023, Treasury and the IRS released long-awaited proposed regulations under section 987 addressing foreign currency translation gains and losses from a qualified business unit (QBU) that operates in a currency other than that of its owner. While the proposed regulations retain the controversial Foreign Exchange Exposure Pool (FEEP) method, taxpayers are offered two elective methods to reduce complexity: (1) a "current rate election" that permits foreign currency translation of all QBU items at the current tax year's exchange rate, subject to a loss suspension rule, and (2) an "annual recognition election" to recognize all QBU foreign currency gain or loss each year. The proposed regulations also extend their application to entities previously excluded from scope. Comments are due February 12, 2024. 

Determinations of Section 987 Taxable Income, Gain, and Loss 

The proposed regulations retain as a default rule the FEEP method, which was first introduced in 2006 proposed regulations to address IRS concerns regarding selective recognition of section 987 losses but has yet to go into effect despite final regulations. The FEEP method generally requires an annual translation of each QBU's balance sheet to its owner's functional currency based on either the historic exchange rate or the current tax year's exchange rate, depending on the character of the asset or liability. QBU items other than "marked items" (generally financial assets or liabilities), are translated using historic rates, whereas marked items are translated at the spot rate for purposes of determining foreign currency gain or loss, and at the average yearly rate for purposes of determining taxable income or loss of the QBU. While the rules requiring the FEEP method were finalized in 2016, the effective date has been perennially postponed, most recently to tax years beginning after December 7, 2023. As discussed below, the effective date has been extended again, and the regulations are generally proposed to apply to tax years beginning after December 31, 2024. 

In response to taxpayer concerns regarding administrability and complexity of the FEEP method, the proposed regulations contain two elective methods, either or both of which may be selected. 

The current rate election permits taxpayers to treat all QBU items as marked items and translate all items of income, gain, deduction, and loss of a QBU at the yearly average exchange rate to compute the QBU's taxable income or loss. In addition, all items of a QBU would be translated at the year-end spot rate for purposes of computing foreign currency gain or loss. While designed to align with financial accounting treatment, under this method, taxpayers are subject to a suspended loss rule, which generally suspends the recognition of section 987 foreign currency loss until a foreign currency gain of the same source and character is recognized. Special rules apply to QBU successors, taxable liquidations, and foreign inbound liquidations. 

Under the annual recognition election method, taxpayers would recognize the full amount of net unrecognized foreign currency gain or loss with respect to marked items at the end of each year. If elected, taxpayers could then use the current yearly average exchange rate for all QBU items for purposes of determining section 987 taxable income or loss, as opposed to the FEEP method's requirement of historic rates for non-marked items. In contrast to the "annual deemed termination election" in the 2016 temporary and proposed regulations, this election would no longer result in a deemed termination of the QBU, deemed remittance from the QBU, and deemed re-contribution to the QBU. Special rules apply to any net accumulated unrecognized foreign currency loss in the year the election is first made. 

If a taxpayer has elected both methods, the loss suspension rules do not apply to the extent that the losses are recognized in a period when both methods were in effect. The election(s) apply to every QBU owned by the same owner and must be made or revoked consistently for all members of the same consolidated group, as well as CFCs and partnerships in which the consolidated group's ownership interest exceeds 50 percent. Once made, the election may not be revoked — or once revoked, made again — within 60 months without consent. 

Select Additional Changes

  • Broad application of the rules to previously excluded entities including banks, insurance and leasing companies, finance coordination centers, regulated investment companies (RICs), and real estate investment trusts (REITs). 
  • Rules intended to ensure that foreign currency gain or loss does not distort the GILTI high-tax exclusion calculation. 
  • A new hybrid entity approach to non-section 987 aggregate partnerships (i.e., partnerships not wholly owned by related parties) under which a partnership is generally treated as the QBU owner but must allocate its net unrecognized foreign currency gain or loss to its partners on an annual basis. S corporations, previously excluded, would be treated in the same manner as partnerships.
  • Transition rules to account for unrecognized foreign currency gain or loss accrued before the first day of the first taxable year in which the regulations apply.
  • Rules related to intercompany transactions within a consolidated group. 
  • Modifications to the adjustments for tax-exempt income and non-deductible expenses in the computation of unrecognized foreign currency gain or loss.

Applicability Dates

  • If finalized, these new regulations would apply to tax years beginning after December 31, 2024. In addition, the unmodified portions of final section 987 regulations from 2016 and 2019 for which the effective date was delayed (most recently in Notice 2022-34) will come into effect in tax years beginning after December 31, 2024.
  • Taxpayers will have the option to apply the potential final regulations, as well as the 2016 and 2019 final regulations, to earlier tax years, provided they are applied consistently and in their entirety to applicable tax years. However, if taxpayers first apply the 2016 and 2019 final regulations to years beginning after November 9, 2023, they are not permitted to use the "fresh start" transition rule contained in those final regulations. 
  • Taxpayers may also rely on the proposed regulations, and the unmodified portions of the 2016 and 2019 final regulations, for years ending after November 9, 2023, provided they are followed in their entirety and in a consistent manner. 

Treasury and IRS Clarify Loss Disallowance Rules for Partnerships

Layla Asali and Caroline Reaves

Treasury and the IRS issued new proposed regulations that address the application of the section 267 related party loss disallowance rules to transactions involving partnerships. Section 267(a) generally disallows losses on sales or exchanges of property between related persons. The current regulations, which date back to 1960, apply an aggregate theory of partnerships and provide that a transaction between a partnership and a person other than a partner "shall be considered as occurring between the other person and the members of the partnership separately." See Treas. Reg. 1.267(b)-1(b)(1). However, these regulations predate significant statutory amendments to section 267 and section 707, enacted in 1982, that specifically address transactions between partnerships and related persons. For example, section 267(b)(10) treats a corporation and a partnership as related persons if the same persons own more than 50 percent of the stock of the corporation and more than 50 percent of the capital or profits interest in the partnership. The enactment of these statutory amendments called into question the viability of the aggregate rule in the 1960 regulations. As such, the new proposed regulations would withdraw that aggregate rule on the basis that the statutory changes since 1982 "indicate that Congress intended for a partnership to be viewed as an entity, rather than as an aggregate of its partners, in applying the rules of section 267 and 707(b)." 

The proposed regulations, which are proposed to be applicable to tax years ending on or after the date the regulations are finalized, would favorably resolve an area of uncertainty that has persisted for decades, though it is curious that Treasury and IRS did not include language permitting reliance on these proposed regulations prior to their finalization.



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