Final Regs. Remove De Minimis Partner Rule


The IRS issued final regulations that remove the de minimis partner rule from Regs. Sec. 1.704-1(b)(2)(iii)(e) (T.D. 9607). This means that when determining whether special allocations have substantial economic effect, partnerships will no longer be permitted to ignore the tax attributes of de minimis partners. The IRS received many suggestions for alternative approaches to the de minimis partner rule and is considering those suggestions, but the final regulations merely eliminate the rule and do not provide any replacement for it.

Sec. 704(b) allows a partnership to make special allocations to partners as long as the allocations have substantial economic effect. Regulations under Sec. 704(b) provide rules for testing whether an allocation’s economic effect is substantial within the meaning of Sec. 704(b). The regulations include a rule for testing an allocation’s substantiality when a partner is a lookthrough entity, which 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.

Up until now, Regs. Sec. 1.704-1(b)(2)(iii)(e) included a de minimis partner rule under which the tax attributes of “de minimis partners” did not have to be taken into account for purposes of applying the substantiality rules. Regs. Sec. 1.704-1(b)(2)(iii)(e) defined 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 de minimis partner rule was intended to allow partnerships to avoid the complexity of testing the substantiality of insignificant allocations to partners that own very small interests in the partnership. However, the rule 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, and “[i]n the interest of sound tax administration,” the regulations remove the de minimis partner rule, although it can be applied to partnership tax years beginning after May 19, 2008, and before the date the final regulations take effect.

The elimination of the de minimis partner rule is effective for all partnership tax years beginning on or after the date the final regulations are published in the Federal Register (scheduled for Dec. 28). This means that the substantiality of all partnership allocations, regardless of when they became part of the partnership agreement, must be retested without the benefit of the de minimis partner rule. For allocations in existing partnership agreements, the IRS says the retesting has to be done as of the first day of the first partnership tax year beginning on or after the date the final regulations become effective.

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