Sec. 987 final regulations: A practical approach for partnerships

Editor: Jeffrey N. Bilsky, CPA

On Dec. 10, 2024, Treasury and the IRS issued final and proposed regulations under Sec. 987 (T.D. 10016 and REG–117213–24). The Sec. 987 regulations provide guidance for determining taxable income or loss with respect to a qualified business unit (QBU) that uses a functional currency different from its owner. While this item references the final regulations, it is aimed at providing a practical analysis of how to apply the proper reasonable methods allowed under the final regulations to partnerships and S corporations. (Regs. Sec. 1.987–7(f)treats S corporations as partnerships and their shareholders as partners.)

Regulatory background

In proposed regulations issued in September 1991 (56 Fed. Reg. 48457), Treasury and the IRS conceived of an earnings and capital method of accounting for Sec. 987 gain or loss. From the outset, the 1991 proposed regulations were problematic, largely due to the influence nonmonetary assets had on Sec. 987 gain or loss.

In the preamble to proposed regulations issued on Sept. 7, 2006, withdrawing the 1991 proposed regulations (REG–208270–86), Treasury noted that “the equity pool paradigm in the 1991 proposed regulations impute[d] currency gain or loss to all equity of a QBU whether or not the assets of the QBU [were] economically exposed to changes in the value of the functional currency of the QBU.”

With the goal of excluding nonmonetary assets from the calculation of foreign currency gain or loss, the 2006 proposed Sec. 987 regulations introduced the foreign exchange exposure pool (FEEP) method, which incorporated a net equity calculation, squeezing the balance sheet and eliminating the effects of nonmonetary assets by accounting for them at historic rates. Still, Treasury and the IRS did not finalize the 2006 proposed regulations until 2016 (T.D. 9754 and T.D. 9795). Even then, the IRS moved the applicability date of those proposed regulations in a series of notices, the last being Notice 2022–34, which moved the applicability date of the 2016 and 2019 final regulations to tax years beginning after Dec. 7, 2023. In the interim, on Nov. 14, 2023, Treasury published the 2023 proposed regulations (REG–132422–17), which adopted a modified FEEP method, known as the owner functional currency net value (OFCNV) calculation.

On Dec. 10, 2024, as noted above, Treasury adopted those 2023 proposed regulations, with some modifications, as final regulations under Sec. 987. The final regulations apply to tax years beginning after Dec. 31, 2024.

Application to partnerships

Treasury and the IRS stated in the preamble to the final regulations: “The Treasury Department and the IRS have determined that, without additional guidance, the section 987 regulations in their entirety could not be applied to partnerships in an administrable way.” Regs. Sec. 1.987–7(b) states further that the final regulations do not apply to partnerships and the eligible QBUs owned by a partnership. Despite the preamble and Regs. Sec. 1.987–7(b) stating that the final regulations do not apply to partnerships, taxpayers must apply Secs. 987 and 989(a) with respect to partnerships using a reasonable method applied consistently from year to year (Regs. Sec. 1.987–7(b)). Further, certain parts of the final regulations do apply to partnerships.

For example, the general rule under Regs. Sec. 1.987–7(d)(1)(ii) provides that any Sec. 987 loss realized by a partnership is suspended and can only be recognized to the extent of gain generated in the future. However, Regs. Sec. 1.987–7(d)(2) offers three exceptions, which allow loss to be recognized regardless of gain in any of the following circumstances: (1) if the Sec. 987 method applied to the partnership does not allow historic items to give rise to Sec. 987 gain or loss; (2) if an annual recognition election is in effect; or (3) if a de minimis exception applies because the suspended loss is less than $3 million or 2% of the total amount of gross income of the owner and all members of the owner’s controlled group for the tax year.

The final regulations also provide a Sec. 988 mark–to–market election, which can be made with respect to a partnership. Further, the rule for determining the source and character of the Sec. 987 gain or loss applies to partnerships. Under Regs. Sec. 1.987–6(b)(1), the character of Sec. 987 gain or loss must be determined under a modified asset method like the method used for interest expense under Regs. Sec. 1.861–9(g) and Temp. Regs. Sec. 1.861–9T(g).

Furthermore, the final regulations do not address a preference toward applying an entity or aggregate approach. Instead, Treasury has stated, “Pending future guidance, taxpayers must apply sections 987 and 989(a) with respect to partnerships using a reasonable method consistent with the statute.” This can mean, as noted in the preamble:

For example, if a domestic corporation owns an interest in a foreign partnership … and the partnership owns an eligible QBU … the domestic corporation may apply [Sec.] 987 to the eligible QBU under an aggregate approach. Alternatively, under an entity approach, the partnership could be treated as a [Sec.] 987 QBU of the domestic corporation, and the eligible QBU could be treated as a [Sec.] 987 QBU of the partnership.

Per the preamble, a hybrid methodology under the principles of the 2023 proposed regulations is allowed, which is either the entity approach or the aggregate with modifications. The taxpayer may decide based on how they treat the partnership (i.e., whether it is another QBU or the owner of a QBU).

Methods available to partnerships and eligible QBUs owned by partnerships

As stated above, the final regulations require taxpayers to apply Secs. 987 and 989(a) to partnerships and Sec. 987 QBUs owned by partnerships in a reasonable manner using a method that is applied consistently from year to year. So, the question is: What methodologies are available for determining Sec. 987 gain or loss with respect to partnerships and Sec. 987 QBUs held by partnerships? The answer may be ascertainable by looking at the rules for branch QBUs, which must qualify their current, pretransition Sec. 987 methodology between eligible and ineligible methods under the final regulations. Regs. Sec. 1.987–10 may be persuasive as to what Treasury considers an “eligible method” and therefore a method that may be consistently applied year over year to partnerships and their eligible QBUs.

Earnings and capital method: Regs. Sec. 1.987–10(e)(4)(i) provides that an eligible method includes an earnings and capital method, which is defined as a method that requires Sec. 987 gain or loss to be determined and recognized with respect to both the earnings of the Sec. 987 QBU and capital contributed to it. This method generally is consistent with the method provided in the 1991 proposed regulations and generally establishes an equity and basis pool consisting of the initial net equity of the QBU, which is then adjusted for earnings, losses, contributions, and distributions. This method does, therefore, allow historic assets to give rise to Sec. 987 gains and losses. As such, if a partnership were to apply this method, losses generated by the partnership would be suspended unless the annual recognition election was in effect.

Another eligible method: Regs. Sec. 1.987–10(e)(4)(ii) provides that another eligible method is a method that produces the same total amount of income over the life of the owner of the Sec. 987 QBU as the earnings and capital method. Similarly, this method, like the above method, would not eliminate historic assets from the computation of Sec. 987 gains or losses. As such, Sec. 987 losses generated by a partnership under this method would be suspended unless the annual recognition election was in effect.

Earnings–only method: Regs. Sec. 1.987–10(e)(4)(iii) provides that an earnings–only method may qualify as an eligible method. This method applies the equity and basis pool concept of the 1991 proposed regulations; however, the initial equity of the Sec. 987 QBU is not included in the equity and basis pools. Under the final regulations, this method may be an eligible method if it meets the following criteria:

• The earnings-only method was first applied by the owner on a return filed before Nov. 9, 2023;
• The earnings-only method was applied consistently to all the owner’s Sec. 987 QBUs since the first tax year in which the owner applied an eligible pretransition method; and
• The owner of the Sec. 987 QBU otherwise applied Sec. 987 in a reasonable manner.

This method starts the equity and basis pools at zero, thereby eliminating any foreign currency gain or loss caused by nonmonetary capital movement. Thus, historic assets are not included in the equity or basis pools and, therefore, do not generate Sec. 987 gain or loss. Only earnings are included in the equity and basis pools in this method. Therefore, losses generated under this method are not suspended, as this method complies with the exception under Regs. Sec. 1.987–7(d)(2)(i).

However, if future guidance regarding the application of Sec. 987 to partnerships is consistent with the final regulations, a partnership that has not complied with Sec. 987, or generally has not used an eligible method and adopts the earnings–only method now, will likely not be treated as applying an eligible method. The calculation would not necessarily be consistent, nor would it have occurred on a tax return filed before Nov. 9, 2023. This could result in the taxpayer having to compute a transition gain or loss using an alternative method upon adoption of future final regulations. In the meantime, however, such a taxpayer would be considered compliant with Sec. 987 without having to apply the suspended–loss rules, and there is no need to make the annual recognition election.

FEEP method: The FEEP method allows the calculation of net value without the effect of nonmonetary assets, like the OFCNV calculation. This is a net value calculation, which determines the change in equity for the year and requires opening and closing tax–adjusted balance sheets for the year. This calculation requires historic assets to be tracked at historic rates. It also eliminates the effect historic assets have on the current–year calculation of Sec. 987 gains or losses. Furthermore, this method complies with the exception under Regs. Sec. 1.987–7(d)(2)(i), so losses generated under this method would not be suspended. If future guidance is consistent with the final regulations, a partnership that applies the FEEP method may likely qualify as using an eligible method.

Other considerations and next steps

Historically, Sec. 987 regulations have incorporated concepts from Subchapter K to make the regulations administrable to partnerships. While a detailed discussion is beyond the scope of this item, it is important to note that under Regs. Sec. 1.987–7(e), a partner must adjust their outside basis for the recognition of Sec. 987 gain, the deferral of Sec. 987 gain or loss, or the suspension of Sec. 987 loss. The regulation notes further that “principles of sections 704(d) and 705 apply as though the item of income or loss was part of the partner’s distributive share of partnership items.” No similar Subchapter K cross–references are available in the final regulations. Depending on whether the aggregate or entity approach is used, there will be differences between the two bases, as it is either the partner directly recognizing the Sec. 987 gains or losses or the partnership recognizing them.

The methods noted above are recommended for partnerships and their eligible QBUs and therefore available for the computation of Sec. 987 gain or loss in the current year. While Regs. Sec. 1.987–10 does not apply to partnerships, it offers persuasive guidance as to what Treasury and the IRS may consider an eligible method for partnerships. However, in choosing a method, it is important to consider the exception under Regs. Sec. 1.987–7(d)(2)(i) and whether losses are likely to be suspended.

If a taxpayer has not applied Sec. 987 to their partnership that either owns QBUs or is itself a QBU, they should likely begin applying a method now. Any future Sec. 987 guidance with respect to partnerships may require a transition calculation. To prepare for future guidance, taxpayers may want to think ahead and adopt an eligible method as established by Treasury and the IRS.

Editor Notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA LLP.