163(j) limit and tiered partnerships

FACTS AS I NOW KNOW THEM (changes possible; colleague asked the question, and he may still be getting facts)

P1 is a MMLLC with default tax treatment. P1 owns a SMLLC (also default treatment) that operates the business. In anticipation of a partial sale in 2018, the SMLLC becomes P2 by creating/issuing profits interests for the benefit of the partners of P1. Those interests are limited in their share of profits to future income and events. After 6 days, an investor group bought 60% of the partnership interests of P2 for cash in 2018. The investor funds went to P2 as closing agent. P2 in turn paid closing costs and made distributions to P1, which in turn distributed cash to its partners.

In applying the varying-interest rule to allocate income/loss in P2, they expect the allocated loss to P1 to have significant interest expense allocated – in large part due to both write-off of previously deferred finance costs and prepayment penalties on old financing. (The gain on the sale of the partnership interest is likely to be reported in a footnote on the K-1, i.e. not as part of “operating income.”)

SPECIFIC NARROW QUESTION BEING ASKED

Can the gain on the sale of the partnership interests in P2 to the investor group be included in “adjusted taxable income” of P1 or the individual partners in 2018? (163(j)(4) covers how multi-tiered partnerships work for this purpose). In other words, will that gain enter into taxable income for purposes of the 163(j) limitation in the year of sale? (The gain on the sale of the partnership interests is likely to be reported in a footnote on the K-1, i.e. not part of “operating income.”).

Or is it not included by reason of 163(j)

(8) Adjusted taxable income. For purposes of this subsection, the term “adjusted taxable income” means the taxable income of the taxpayer—
(A) computed without regard to—
(i) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business, ...

MORE BACKGROUND, AND SOME QUESTIONS I AM RAISING

Is the issuance of the profits interests in P2 (former SMLLC) in the context and with the terms described a taxable event? The P1 partners already owned 100% of P1, so it can be argued that it's not an accession to wealth, but there is no comparable section to 305 in Subchapter K, is there? Does Eisner v, Macomber apply?

Is the fact that the investor group came in only 6 days after the interests were issued cause for applying the step-transaction doctrine, and if so with what result? Maybe there is no difference. I am told that the transactions were requested by the investor group as a way to ensure that the 754 adjustment would be allocated to them. If the steps are "collapsed" what is the tax result?

Are the previously deferred finance costs and prepayment penalties on old financing both included in interest expense under 163(j)? I'm told the proposed regs. would broadly define what is interest, and that it would include the deferred finance costs, but does not specify the prepayment penalty.

Too easy, too hard, or too boring?

Why is this a partnership interest sale? Why not a sale of assets? Does it make a difference? The issue is the “allocable to” wording, right? Have you researched that in other Tax Code contexts?

Also explain to us how the calculation works and if it is good or bad to include the gain in the calc

Why is this a partnership interest sale? Why not a sale of assets?. There are 2 ways to interpret this question. Way 1 would be that you want to know why they sold partnership interests. Answer to that is no idea - it's just how they did it. Way 2 would be that you want to know why it would not be treated as a sale of assets. Answer to that is I don't know. But if that is your question (is it?) I will try to answer. I infer that the rule is that one treats a sale of a partnership interest as a sale of a proportionate part of the underlying assets. For some purposes, anyway. Section 751 says it's a sale of a capital asset except where section 751 applies.

The issue is the “allocable to” wording, right? Have you researched that in other Tax Code contexts? . Yessir, that's the issue. No, I vaguely recall that phrase may be relevant in other contexts but I will research where, and how it works, and, importantly, whether a similar rationale applies here.

Also explain to us how the calculation works and if it is good or bad to include the gain in the calc. Well, check me on this, but yes, it's good to include the gain in the calculation because it increases "adjusted taxable income", which is what we get to deduct 30% of. (Sorry, Spell). And I think the "we" ends up being the partners of P1. But I admit/confess to not getting deeply into 163(j)(4) because it takes time, and you know ...

Here's what I thought. The tiered approach in 163(j)(4) takes the interest deduction up the tiers and thru to the partners. But that may not go deep enough so I have lots more to do. I haven't even found the 400+ pages of proposed regs.

Unless "someone" already knows the aanswer and cares to share it.

"properly allocable to a trade or business is important in 1.163-8T, regarding interest tracing. I didn't delve deeply, but it seems that, there, we are figuring how the interest (a known business item) is to be allocated, not so much whether something is allocable to a trade or business. My issue is less mechanical and more qualitative. We could read this part of the definition of adjusted taxable income "(A) computed without regard to—
(i) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business..." to be more accurately worded as "(A) computed without regard to—
(i) any item of income, gain, deduction, or loss which is not properly part of a trade or business..."

What about 1.163(j)-6(e)(3)?

Well, check me on this, but yes, it's good to include the gain in the calculation because it increases "adjusted taxable income", which is what we get to deduct 30% of.

…wasn’t sure if they were trying to avoid the provision, since it only applies to those taxpayer with 3-year average annual gross receipts of over $25m.

There are 2 ways to interpret this question.

You made a comment about buyer desiring certainty as to a 754 adjustment…wanting to ensure that said benefit would accrue to them alone. Seems odd. The benefit of the 743 adjustment is always only beneficial to the buyer. And I was also questioning the fact that we have a partnership interest being sold…hard to say, but one might argue that there was no partnership, but a single member LLC. (In which case, assets were sold). It gets tricky when there are 2 partners and one of them holds only a profits interest.

The taxpayer is way larger than $25 million in sales.

I'd like to return to 754 and some other stuff I raised later, and stay with whether the gain on the sale of the partnership interests is properly allocable etc.

I was serious when I said I haven't even found the 400+ pages of proposed regs.. Is that where 1.163(j)-6(e)(3) is? Kindly link, and thank you.

Is the issue in Redlark useful in answering my question?

Rather, the Commissioner argues, the I.R.S. has determined, as a matter of general policy, that personal income tax always constitutes a personal obligation so that deficiencies in meeting that obligation are never “properly allocable” to the taxpayer's trade or business.

https://caselaw.findlaw.com/us-9th-circuit/1097027.html

While watching Steelers/Patriots as warmup to watching Eagles/Rams, I found the proposed regs. Don't ask!

And I found this in 1.163(j)-6(e)(3).

(3) Disposition of partnership interests. If a partner recognizes gain or loss upon the disposition of interests in a partnership, and the partnership in which the interest is being disposed owns only non-excepted trade or business assets, the gain or loss on the disposition of the partnership interest is included in the partner’s ATI.

Is my search over?

Is my search over?. I think it is, as to the "narrow" issue.

Now, what about these questions?

Is the issuance of the profits interests in P2 (former SMLLC) in the context and with the terms described a taxable event? The P1 partners already owned 100% of P1, so it can be argued that it's not an accession to wealth, but there is no comparable section to 305 in Subchapter K, is there? Does Eisner v. Macomber apply?

I saw nothing specific, but I think Eisner makes the receipt of partnership interests proportionately by each partner not income.

Is the fact that the investor group came in only 6 days after the interests were issued cause for applying the step-transaction doctrine, and if so with what result? Maybe there is no difference. I am told that the transactions were requested by the investor group as a way to ensure that the 754 adjustment would be allocated to them. If the steps are "collapsed" what is the tax result?

Maybe the step doctrine would mean that the sale of the profits interest was by the partnership. not the partners, followed by a distribution from the partnership to the original partners.

Jeff's earlier comment was You made a comment about buyer desiring certainty as to a 754 adjustment…wanting to ensure that said benefit would accrue to them alone. Seems odd. The benefit of the 743 adjustment is always only beneficial to the buyer. And I was also questioning the fact that we have a partnership interest being sold…hard to say, but one might argue that there was no partnership, but a single member LLC. (In which case, assets were sold). It gets tricky when there are 2 partners and one of them holds only a profits interest.

I'm not following that last part. There are multiple original partners and multiple new partners.

Are the previously deferred finance costs and prepayment penalties on old financing both included in interest expense under 163(j)? I'm told the proposed regs. would broadly define what is interest, and that it would include the deferred finance costs, but does not specify the prepayment penalty..
Prop. reg. 1.163(j-1(b)(20) does indeed cover the deferred financing costs.

(20) Interest. The term interest means any amount described in paragraph (b)(20)(i), (ii), (iii), or (iv) of this section.

(H) Debt issuance costs. Any debt issuance costs subject to §1.446-5 are treated as interest expense of the issuer.

This case makes clear that a prepayment penalty is a form of interest. https://www.leagle.com/decision/1956129025estc126511142. So do RRs 57-198 and 73-137.

I saw nothing specific, but I think Eisner makes the receipt of partnership interests proportionately by each partner not income.

If issuing stock to existing shareholders, proportionately, isn’t a taxable event, I don’t see how the issuance of a profits interests would be either. Normally, the grant of a vested profit interests isn’t taxable, even if disproportionate, which they ususally are, because they’re granted to the manager(s).

I'm not following that last part. There are multiple original partners and multiple new partners.

How’s that. You said:

P1 owns a SMLLC (also default treatment) that operates the business. In anticipation of a partial sale in 2018, the SMLLC becomes P2 by creating/issuing profitsinterests for the benefit of the partners of P1.

Sure sounded like the only thing making P2 a true partnership was the issuance of P2 profits interests.

This case makes clear that a prepayment penalty is a form of interest.

Right. That is regular old tax law. I wouldn’t think the (write-off of the) deferred financing costs would be, but it says what it says…

Sure sounded like the only thing making P2 a true partnership was the issuance of P2 profits interests.. OK, got it.