The American Bar Association Section of Taxation (the “Section”) has released comments with respect to the proposed regulations issued by the Treasury and the Service pursuant to changes made by the American Jobs Creation Act of 2004 with respect to Subchapter K. The proposed regulations provide guidance with respect to contributions of built-in loss property to partnerships, substantial basis reduction events, modifying the basis allocation rules to prevent certain unintended consequences in the current rules with regard to substitute basis transactions, and allocations resulting from revaluations of partnership property. While the Section’s comments regarding the proposed regulation package were generally favorable, the Section made a number of comments regarding the government’s approach to specific provisions. Of note, concerns were raised with respect to how section 704(c)(1)(C) is intended to apply to partnership mergers and divisions, how the mandatory basis adjustment rules ought to operate in the context of tiered partnerships, and how section 704(c) reverse layers of gain and loss should be treated by partnerships.
Specifically, as discussed in the Section’s comments, the Section does not believe the proposed regulations do an adequate job of tracking section 704(c)(1)(C) built in loss layers in partnership mergers and divisions. The result of any failed tracking of section 704(c)(1)(C) loss layer could result in section 704(c)(1)(C) preventing a loss allocation unnecessarily. The Section believes that any final regulations should delineate how section 704(c)(1)(C) ought to apply to partnership mergers and divisions. Further, the Section believes that the final regulations should allow tracking of section 704(c)(1)(C) layers in partnership mergers and divisions, to the extent possible.
Regarding the mandatory basis reduction rules of sections 734 and 743, the proposed regulations provide that an event at an upper-tier partnership that triggers a mandatory basis reduction rule will force any lower-tier partnership to also revalue its assets (regardless of whether the lower-tier partnership is in a loss position). The Section commented that the mandatory basis adjustments should not be required to be pushed into lower-tier partnerships unless the lower-tier partnerships would have also been subject to the mandatory basis adjustment rules had the event happened at the lower-tier partnership level.
Additionally, the proposed regulations provide that a “layering” approach must be used with respect to reverse section 704(c) layers (i.e., an approach that treats each partner as having a separate layer for each asset upon each revaluation event). The Section believes that a “netting” approach (i.e., an approach that collapses layers with respect to a partner’s share of partnership assets), which is arguably blessed by current regulations, should also be allowed. One of the Section’s main concerns with requiring a layering approach is the increased taxpayer compliance costs associated with tracking each layer for every partner.