The House Ways and Means Committee and the Senate Finance Committee, the two primary architects of tax legislation in Congress, have each released competing plans for tax legislation that would impact partnerships. While both proposals are significant, the proposals from the Senate would radically overhaul some foundational principles of partnership taxation. Whether either of these proposals formally end up as part of President Biden’s “Build Back Better” initiatives remains to be seen. That being said, the proposals from the House presently are closer to legislative fruition than are the Senate’s proposals. Following are some of the key changes that would impact partnerships.

Further Restriction on Favorable Tax Rates for Holders of Carried Interests

Although the Senate’s proposal would not change the current tax treatment for holders of carried interests, the House’s proposal would make it more difficult for such holders to benefit from favorable capital gains rates. Presently, partners in certain types of partnerships who hold a profits interest that they received in exchange for the performance of services (i.e., a carried interest) must satisfy a greater than three-year holding period in order to benefit from the more favorable long-term capital gains rates with respect to the carried interest. The House proposal would lengthen the holding period to a greater than five-year requirement, except for individuals with adjusted gross income of less than $400,000 or for partnerships that engage in a real property trade or business. Among other things, the House proposal would also subject all partnership items that are eligible for favorable capital gains rates to the carried interest rules, whereas certain items (such as Section 1231 gains and qualified dividend income) currently are exempt from the carried interest rules.

Change in Location to Calculate Business Interest Expense Limitation

Partnerships generally deduct business interest expense under present law only to the extent that it does not exceed 30% of the partnership’s tax-basis earnings before interest, depreciation, and amortization (EBITDA). For tax years beginning after 2021, the calculation changes under current law to 30% of tax-basis earnings before interest (essentially EBIT). In any case, the partnership determines its deductible business interest expense under current law at the entity level.

The House proposal would shift the location of the calculation from the entity level to the partner level, beginning with tax years that commence after 2021. Partnerships conceivably would need to report additional information to allow partners to perform the calculation, and would need to separately identify the amount of business interest expense that the partnership incurred.

Conversely, the Senate proposal would keep the location of the calculation at the entity level. However, the Senate proposal would no longer allow partners to deduct business interest expense from other sources by using the partnership’s excess deduction capacity (i.e., excess taxable income and excess business interest income). The Senate proposal would apply to tax years that commence after 2021.

Characterization of Losses on Worthless Partnership Interests as Capital Losses

Here is another House proposal that is not included in the Senate’s proposal. Presently, it is possible in certain circumstances for a partner to characterize a loss for a worthless partnership interest as an ordinary loss. The House proposal would remove this possibility from a worthlessness scenario, such that all losses would be characterized as capital losses at the time of the identifiable event.

Generally Require Partnerships to Apply the Partner’s Interest in the Partnership (PIP) Standard for Making Partner Allocations

This proposal from the Senate, which is not contained in the House proposal, would mark a monumental change to the manner in which partnerships allocate tax items to partners. Subject to a limited exception that will be discussed, this provision would require partnerships to use solely the PIP allocation rules to determine the validity of an allocation for tax purposes, and would eliminate an alternative safe harbor “substantial economic effect” (SEE) test.

The PIP rules and the SEE rules both rely on the same overriding principle that tax allocations must conform to the underlying economic agreement between the partners. The SEE rules work to validate tax allocations by adjusting them into a partner’s capital account, and then by confirming that the partner’s capital account relative to the other partners’ capital accounts conforms to the partner’s relative economic claims against partnership assets. The PIP rules instead focus on each tax allocation (rather than the adjusted capital balance), and validate an allocation when the facts and circumstances pertaining to the allocation conform to the underlying economic arrangement (such as risk of loss or rights to profit).

The SEE rules arguably are more complicated than the PIP rules, but are more objective. Because a vast number of partnerships today rely on the safe harbor SEE rules, a shift to the more vague PIP rules may require re-negotiation for countless business arrangements, and may lead to ongoing uncertainty about the validity of tax allocations. The proposed elimination of the SEE rules would be effective for tax years beginning after 2023.

As mentioned previously, in certain situations the Senate proposal would require partnerships to instead use a new “consistent percentage method” (CPM). The CPM rules would apply when the partners are members of a controlled group and together own more than 50% of the partnership’s capital or profits (or when otherwise deemed necessary by the IRS). The CPM method would require partnership allocations to be based on each partner’s relative share of net contributed capital. If a distribution is made out of proportion with the partner’s relative capital, then the partner would have an income recognition event and the other partners would be barred from recognizing a loss.

The proposed CPM is based on a premise that related parties do not have significantly adverse interests to justify allocations that are not based on relative capital. This is a very broad assertion that arguably does not have merit in many common scenarios involving legitimate business concerns.

Remedial Allocation Method Would Be Required for Section 704(c) Allocations

The built-in gain or loss “responsibility” belonging to a contributor of property having a value that differs from tax basis would be required to be allocated to the contributor using only the remedial allocation method. This proposal from the Senate, which also does not appear in the House’s proposal, would eliminate the other choices such as the traditional method, the traditional method with curative allocations, and the ability to use any other reasonable method.

The remedial allocation method generally would accelerate recognition by the contributor of any built-in gain or loss responsibility ahead of a true economic transaction, leading to incremental phantom taxation events each year. In addition, the remedial allocation method would create immense complexity for many partnerships on an annual basis that does not exist presently.

Mandatory Revaluations of Section 704(b) Capital Accounts

The Senate proposal, but not the House proposal, would also require a revaluation of partner capital accounts upon the occurrence of specified events (such as new partner admissions in exchange for capital, or liquidations of a partner’s interest). Because these mandatory revaluations are treated as a deemed contribution of zero basis property, they will also trigger remedial allocations outlined in the previous paragraph. Furthermore, the scope of the specified revaluation events under present law would be expanded to also include changes in partnership allocations.

Partnership Debt Allocation Method to Be Required in Accordance with the Partner’s Profits Interest

This provision in the Senate proposal, which does not exist in the House proposal, would essentially gut the existing Section 752 rules by rendering moot the economic risk of loss rules to allocate partnership debt among partners. Except in circumstances when partners themselves make loans to the partnership, all partnership debts (including “recourse” debt) would be required to be allocated in accordance with the partner’s profits interest, for tax years beginning after 2021. Recourse debt allocations under current rules would often be reallocated under the proposal, causing significant gain events for partners with negative capital account balances. This gain recognition potential is so large that the proposal provides an 8-year transition period to pay the tax liability created by the loss of debt allocations.

Other Significant Changes

The Senate proposal, but not the House proposal, would make a few other significant changes. Section 754 elections would no longer be elective, meaning that partnership and partner basis adjustments under Sections 743 and 734 would become mandatory. These basis adjustments typically accompany the sale, exchange, or liquidation of a partnership interest.

Also, the rules under Section 707(c) for guaranteed payments, which are partner-capacity payments determined without regard to partnership income, would be repealed. It is unclear whether such payments would then become reportable as independent contractor fees or as employee wages.


The gamut of proposed partnership changes would significantly impact partnership operations and potentially the original business arrangements between partners. Although some measures would simplify current rules, most of the proposals would add daunting complexity. The House proposals presently are the most likely to be included in final legislation, but Congressional negotiations remain fluid. If you have any questions about how these proposals may impact you or your business, please contact us.

Published on October 12, 2021