The IRS issued proposed regulations on October 24 that, if finalized, would remove the de minimis partner rule in Regs. Sec. 1.704-1(b)(2)(iii)(e) (REG-109564-10).
Sec. 704(b) allows a partnership to make special allocations as long as they have substantial economic effect. In 2008, the IRS issued final regulations under Sec. 704(b) that provide rules for testing whether an allocation’s economic effect is substantial within the meaning of Sec. 704(b) where partners are lookthrough entities or members of a consolidated group (T.D. 9398).
The 2008 regulations generally provide a lookthrough rule for testing an allocation’s substantiality. In determining the after-tax economic benefit or detriment of a partnership allocation to any partner that is a lookthrough entity, the lookthrough rule takes into account the tax consequences resulting from the interaction of the allocation with the tax attributes of any owner of the lookthrough entity. A similar rule applies to partners that are members of a consolidated group.
The de minimis partner rule provides that, for purposes of applying the substantiality rules, the tax attributes of de minimis partners need not be taken into account. Regs. Sec. 1.704-1(b)(2)(iii)(e) defines a de minimis partner as “any partner, including a look-through entity that owns, directly or indirectly, less than 10 percent of the capital and profits of a partnership, and who is allocated less than 10 percent of each partnership item of income, gain, loss, deduction, and credit.”
The intent of the de minimis partner rule was to allow partnerships to avoid the complexity of testing the substantiality of insignificant allocations to partners owning very small interests in the partnership.
However, the rule has had the unintended consequence of allowing partnerships to entirely avoid the application of the substantiality rules if the partnership is owned by partners each of whom owns less than 10% of the capital or profits and who are allocated less than 10% of each partnership item. To avoid this result, the proposed regulations would remove Regs. Sec. 1.704-1(b)(2)(iii)(e), containing the de minimis partner rule.
The IRS is requesting comments on how to reduce the burden of complying with the substantial economic effect rules, with respect to lookthrough partners, without diminishing the safeguards the rules provide. Comments are requested within 90 days after the proposed regulations appear in the Federal Register. They can be sent to the Federal eRulemaking Portal at www.regulations.gov (IRS REG-109564-10).
The proposed regulations would be effective the date final regulations are published in the Federal Register.