Editor: Kevin D. Anderson, CPA, J.D.
On Jan. 5, 2021, Treasury and the IRS issued a second set of final regulations on business interest expense (BIE) deductions (T.D. 9943, the 2021 final regulations) that provide additional rules to reflect changes to Sec. 163(j) made by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, and the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136. These final rules implement certain aspects of the proposed regulations that were published in September 2020 (REG-107911-18, the 2020 proposed regulations) concurrently with the first set of final regulations (T.D. 9905, the 2020 final regulations). The 2020 final regulations largely adopted the 2018 proposed regulations (REG-106089-18), with revisions to certain controversial rules. The 2021 final regulations similarly follow the 2020 proposed regulations, with a few significant changes, including a helpful transition rule for passive hedge fund investors.
Certain aspects of the 2021 final regulations merit special consideration by hedge fund managers. As discussed in more detail below, the 2021 final regulations effectively reverse the 2018 proposed regulations that had the potential to subject interest expense to limitation at both the fund and passive investor levels. The 2021 final regulations provide welcome relief to hedge funds and their passive investors, although as noted below, the 2021 final regulations may increase the administrative burden and reporting requirements on hedge fund managers.
Prior to enactment of the TCJA, BIE incurred by partnerships engaged in a trade or business activity of trading personal property for their own account as described in Temp. Regs. Sec. 1.469-1T(e)(6) (trading partnerships or trader funds) would generally be subject to the investment income limitation under Sec. 163(d) solely with respect to non-materially participating partners (most limited partners). Typical hedge funds fall into this category. The TCJA amended Sec. 163(j) in such a way that BIE incurred by trader funds could be subject to limitation at the fund level, and then non-materially participating partners could be subject to an additional limitation at the individual level. This change created an issue involving the definition of BIE under Sec. 163(j)(5), which provides that BIE does not include investment interest within the meaning of Sec. 163(d).
Notwithstanding the Sec. 163(j)(5) language, the preamble to the 2018 proposed regulations stated that the BIE of certain passthrough entities allocable to trade or business activities that are per se nonpassive under Sec. 469, and with respect to which the taxpayer does not materially participate, is subject to Sec. 163(j) at the entity level, even if the interest expense would subsequently be subject to limitation under Sec. 163(d) at the individual partner level. To the extent that interest expense from a trading activity was limited under Sec. 163(j) and became a carryover item of partners who did not materially participate in the trading activity, the interest expense would be treated as investment interest in the hands of those partners for purposes of Sec. 163(d) once the interest expense was no longer limited under Sec. 163(j). This approach would have effectively created a double-layered limitation for partners subject to the Sec. 163(d) limitation.
The 2021 final regulations
Commenters noted that creating a system subjecting partners' interest expense to both Sec. 163(j) and Sec. 163(d) was not consistent with rules under Sec. 163(j)(5). Treasury and the IRS ultimately determined that the approach applied in the 2018 proposed regulations was inconsistent with the statutory language and intent of Sec. 163(j)(5). Treasury and the IRS then considered several approaches to preventing the double-layered limitation.
The 2021 final regulations adopt the approach contained in the 2020 proposed regulations, under which trading partnerships are required to bifurcate interest expense from a trading activity between partners that materially participate in the trading activity (e.g., a general partner) and partners that are passive investors within the meaning of Sec. 469. The Sec. 163(j) limitation is then applied at the partnership level solely to the portion of the interest expense that is allocable to the materially participating partners. The portion of interest expense from a trading activity allocable to passive investors is subject to limitation under Sec. 163(d) at the partner level, as provided in Sec. 163(d)(5)(A)(ii).
In addition to the bifurcation of interest expense, the 2021 final regulations adopt Prop. Regs. Sec. 1.163(j)-6(d)(4), which requires a trader fund to separately allocate its other items of income, gain, loss, and deduction from trading activities between passive investors and all other partners. The portion properly allocable to the passive investors is not considered in applying Sec. 163(j) at the partnership level and is treated as among investment items subject solely to the investment interest limitation under Sec. 163(d).
The 2021 final regulations state that for the bifurcation method to be effective, the trading partnership will generally have to determine whether its individual partners materially participate in its trading activity. In adopting the bifurcation method, the IRS is assuming the trading partnership knows whether its partners materially participate in the partnership's trading activity. Grouping rules under Sec. 469, where an individual taxpayer may meet the material participation threshold by grouping activities if certain requirements are met, add another layer of complexities to the application of the bifurcation method. Consequently, the 2021 final regulations adopt a revision of the 2020 proposed regulations' approach to the Sec. 469 grouping rules by prohibiting individual partners to group any activity described in Sec. 163(d)(5)(A)(ii) with any other activities, including other activities of the same category.
The 2021 final regulations provide further relief to partners of trading partnerships who do not materially participate in the trading activity and who relied on the 2018 proposed regulations, having their share of excess business interest expense (EBIE) subjected to the Sec. 163(j) limitation at the partnership level as well as the Sec. 163(d) limitation at the partner level. A transition rule is provided in the 2021 final regulations to permit passive investors of trading partnerships to deduct EBIE allocated to them from the partnership in any tax year ending prior to the effective date of the 2021 final regulations, without regard to the amount of excess taxable income (ETI) or excess business interest income (EBII) that may be allocated by the partnership to the partner in the first tax year ending on or after the effective date of these final regulations.
For purposes of this transition rule, any EBIE that is no longer subject to disallowance under Sec. 163(j) solely because of the transition rule is not subject to limitation or disallowance under Sec. 163(d). In that case, the partnership treats the interest expense as BIE for purposes of calculating its limitation under Sec. 163(j). This transition rule does not affect the treatment of interest expense by the partnership as BIE in prior years. Thus, the Sec. 163(j)(5) rule that interest expense cannot be treated as both BIE and investment interest expense still applies, and the partnership's BIE cannot be treated as a partner's investment interest expense in future years.
The preamble to the 2021 final regulations states that the material participation rules should not be affected by tiered partnership structures. The bifurcation approach applies where interest income or interest expense is allocable to non-materially participating partners within the meaning of Sec. 469 and as described in Sec. 163(d)(5)(A)(ii). Since Sec. 469 does not apply to partners that are partnerships, individual passive investors may not be able to benefit from the bifurcation rules if they are part of a tiered partnership structure.
For example, in trader funds structured as master-feeders, interest income and interest expense are incurred at the lower-tier entity (master fund), while limited individual partners are generally invested through an upper-tier partnership (domestic feeder). According to language in the preamble of the 2021 final regulations, it appears that interest expense incurred at the lower tier is subject only to the rules of Sec. 163(j)(4), determined at that level. In other words, in the typical tiered, master-feeder structure, BIE may be subject to the Sec. 163(j) limitation at the lower-tier master fund level, but the interest expense would not then be subject to retesting under either Sec. 163(j) or 163(d) at the upper-tier feeder fund or ultimate partner level.
The 2021 final regulations apply to tax years beginning on or after March 22, 2021. However, taxpayers may early adopt these rules to a tax year beginning after Dec. 31, 2017, and before March 22, 2021, provided they consistently apply the 2020 final regulations published in the Federal Register on Sept. 14, 2020, as revised by the 2021 final regulations, to that tax year and each subsequent tax year.
New administrative burdens
Under the 2021 final regulations, interest expense incurred by trader funds may be subject to Sec. 163(j) or 163(d), but not both, with respect to a specific partner. While creating what appears to be an equitable result and one that is consistent with Sec. 163(j)(5), the 2021 final regulations may create a significant administrative burden on trading partnerships. To comply with these rules, trading partnerships will be required to determine whether each partner's status is passive or nonpassive and then specially allocate relevant items to each group of partners. Passive partners will have an additional requirement to comply with the Sec. 469 grouping rules.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or email@example.com.
Contributors are members of or associated with BDO USA LLP.