Revenue Reconciliation Act
page7
 
Partnerships and partners subject to large partnership
rules
Definition
of electing large partnership
An "electing large partnership" is any
partnership that elects under the provision, if the
number of partners in the preceding taxable year is
100 or more. The number of partners is determined by
counting only persons directly holding partnership
interests in the taxable year, including persons
holding through nominees; persons holding indirectly
(e.g., through another partnership) are not counted.
Regulations may provide, however, that if the number
of partners in any taxable year falls below 100, the
partnership may not be treated as an electing large
partnership. The election applies to the year for
which made and all subsequent years and cannot be
revoked without the Secretary's consent.
Special
rules for certain service partnerships
An election under this provision is not effective
for any partnership if substantially all the
partners are: (1) individuals performing substantial
services in connection with the partnership's
activities, or personal service corporations the
owner-employees of which perform such services; (2)
retired partners who had performed such services; or
(3) spouses of partners who had performed such
services. In addition, the term "partner"
does not include any individual performing
substantial services in connection with the
partnership's activities and holding a partnership
interest, or an individual who formerly performed
such services and who held a partnership interest at
the time the individual performed such services.
Exclusion
for commodity partnerships
An election under this provision is not effective
for any partnership the principal activity of which
is the buying and selling of commodities (not
described in sec. 1221(1)), or options, futures or
forwards with respect to commodities.
Special
rules for partnerships holding oil and gas
properties
Simplified
reporting treatment of electing large partnerships
with oil and gas activities
The bill provides special rules for electing large
partnerships with oil and gas activities that
operate under the simplified reporting regime. These
partnerships are collectively referred to herein as
"oil and gas large partnerships."
Generally, the bill provides that an oil and gas
large partnership reports information to its
partners under the general simplified large
partnership reporting regime described above. To
prevent the extension of percentage depletion
deductions to persons excluded therefrom under
present law, however, certain partners are treated
as disqualified persons under the bill.
The treatment of a disqualified person's
distributive share of any item of income, gain,
loss, deduction, or credit attributable to any
partnership oil or gas property is determined under
the bill without regard to the special rules
applicable to large partnerships. Thus, an oil and
gas large partnership reports information related to
oil and gas activities to a partner who is a
disqualified person in the same manner and to the
same extent that it reports such information to that
partner under present law. The simplified reporting
rules of the bill, however, apply with respect to
reporting such a partner's share of items not
related to oil and gas activities.
The bill defines two categories of taxpayers as
disqualified persons. The first category encompasses
taxpayers who do not qualify for the deduction for
percentage depletion under section 613A (i.e.,
integrated producers of oil and gas). The second
category includes any person whose average daily
production of oil and gas (for purposes of
determining the depletable oil and natural gas
quantity under section 613A(c)(2)) is at least 500
barrels for its taxable year in which (or with
which) the partnership's taxable year ends. In
making this computation, all production of domestic
crude oil and natural gas attributable to the
partner is taken into account, including such
partner's proportionate share of any production of
the large partnership.
A taxpayer that falls within a category of
disqualified person has the responsibility of
notifying any large partnership in which it holds a
direct or indirect interest (e.g., through a
pass-through entity) of its status as such. Thus,
for example, if an integrated producer owns an
interest in a partnership which in turn owns an
interest in an oil and gas large partnership, it is
responsible for providing the management of the
electing large partnership information regarding its
status as a disqualified person and details
regarding its indirect interest in the electing
large partnership.
Under the bill, an oil and gas large partnership
computes its deduction for oil and gas depletion
under the general statutory rules (subject to
certain exceptions described below) under the
assumptions that the partnership is the taxpayer and
that it qualifies for the percentage depletion
deduction. The amount of the depletion deduction, as
well as other oil and gas related items, generally
are reported to each partner (other than to partners
who are disqualified persons) as components of that
partner's distributive share of taxable income or
loss from passive loss limitation activities. The
bill provides that in computing the partnership's
oil and gas percentage depletion deduction, the
1,000-barrel-per-day limitation does not apply. In
addition, an oil and gas large partnership is
allowed to compute percentage depletion under the
bill without applying the
65-percent-of-taxable-income limitation under
section 613A(d)(1).
As under present law, an election to deduct IDCs
under section 263(c) is made at the partnership
level. Since the bill treats those taxpayers
required by the Code (sec. 291) to capitalize 30
percent of IDCs as disqualified persons, an oil and
gas large partnership may pass through a full
deduction of IDCs to its partners who are not
disqualified persons. In contrast to present law, an
oil and gas large partnership also has the
responsibility with respect to its partners who are
not disqualified persons for making an election
under section 59(e) to capitalize and amortize
certain specified IDCs. Partners who are
disqualified persons are permitted to make their own
separate section 59(e) elections under the bill.
Consistent with the general reporting regime for
electing large partnerships, the bill provides that
a single AMT adjustment (under either corporate or
non-corporate principles, as the case may be) is
made and reported to the partners (other than
disqualified persons) of an oil and gas large
partnership as a separate item. This
separately-reported item is affected by the
limitation on the repeal of the tax preference for
excess IDCs. For purposes of computing this
limitation, the bill treats an oil and gas large
partnership as the taxpayer. Thus, the limitation on
repeal of the IDC preference is applied at the
partnership level and is based on the cumulative
reduction in the partnership's alternative minimum
taxable income resulting from repeal of that
preference.
The bill provides that in making partnership-level
computations, any item of income, gain, loss,
deduction, or credit attributable to a partner who
is a disqualified person is disregarded. For
example, in computing the partnership's net income
from oil and gas for purposes of determining the IDC
preference (if any) to be reported to partners who
are not disqualified persons as part of the AMT
adjustment, disqualified persons' distributive
shares of the partnership's net income from oil and
gas are not to be taken into account.
Regulatory
authority
The Secretary of the Treasury is granted authority
to prescribe such regulations as may be appropriate
to carry out the purposes of the provisions.
Effective
Date
The provision s generally applies to partnership
taxable years beginning after December 31, 1997.
b.
Simplified audit procedures for electing large
partnerships (sec. 1022 of the bill and secs. 6240,
6241, 6242, 6245, 6246, 6247, 6249, 6251, 6255, and
6256 of the Code)
Present
Law
In
general
Prior to 1982, regardless of the size of a
partnership, adjustments to a partnership's items of
income, gain, loss, deduction, or credit had to be
made in separate proceedings with respect to each
partner individually. Because a large partnership
sometimes had many partners located in different
audit districts, adjustments to items of income,
gains, losses, deductions, or credits of the
partnership had to be made in numerous actions in
several jurisdictions, sometimes with conflicting
outcomes.
The Tax Equity and Fiscal Responsibility Act of 1982
("TEFRA") established unified audit rules
applicable to all but certain small (10 or fewer
partners) partnerships. These rules require the tax
treatment of all "partnership items" to be
determined at the partnership, rather than the
partner, level. Partnership items are those items
that are more appropriately determined at the
partnership level than at the partner level, as
provided by regulations.
Under the TEFRA rules, a partner must report all
partnership items consistently with the partnership
return or must notify the IRS of any inconsistency.
If a partner fails to report any partnership item
consistently with the partnership return, the IRS
may make a computational adjustment and immediately
assess any additional tax that results.
Administrative
proceedings
Under the TEFRA rules, a partner must report all
partnership items consistently with the partnership
return or must notify the IRS of any inconsistency.
If a partner fails to report any partnership item
consistently with the partnership return, the IRS
may make a computational adjustment and immediately
assess any additional tax that results.
The IRS may challenge the reporting position of a
partnership by conducting a single administrative
proceeding to resolve the issue with respect to all
partners. But the IRS must still assess any
resulting deficiency against each of the taxpayers
who were partners in the year in which the
understatement of tax liability arose.
Any partner of a partnership can request an
administrative adjustment or a refund for his own
separate tax liability. Any partner also has the
right to participate in partnership-level
administrative proceedings. A settlement agreement
with respect to partnership items binds all parties
to the settlement.
Tax
Matters Partner
The TEFRA rules establish the "Tax Matters
Partner" as the primary representative of a
partnership in dealings with the IRS. The Tax
Matters Partner is a general partner designated by
the partnership or, in the absence of designation,
the general partner with the largest profits
interest at the close of the taxable year. If no Tax
Matters Partner is designated, and it is impractical
to apply the largest profits interest rule, the IRS
may select any partner as the Tax Matters Partner.
Notice
requirements
The IRS generally is required to give notice of the
beginning of partnership-level administrative
proceedings and any resulting administrative
adjustment to all partners whose names and addresses
are furnished to the IRS. For partnerships with more
than 100 partners, however, the IRS generally is not
required to give notice to any partner whose profits
interest is less than one percent.
Adjudication
of disputes concerning partnership items
After the IRS makes an administrative adjustment,
the Tax Matters Partner (and, in limited
circumstances, certain other partners) may file a
petition for readjustment of partnership items in
the Tax Court, the district court in which the
partnership's principal place of business is
located, or the Claims Court.
Statute
of limitations
The IRS generally cannot adjust a partnership item
for a partnership taxable year if more than 3 years
have elapsed since the later of the filing of the
partnership return or the last day for the filing of
the partnership return.
Reasons
for Change
Present audit procedures for large partnerships are
inefficient and more complex than those for other
large entities. The IRS must assess any deficiency
arising from a partnership audit against a large
number of partners, many of whom cannot easily be
located and some of whom are no longer partners. In
addition, audit procedures are cumbersome and can be
complicated further by the intervention of partners
acting individually.
Explanation
of Provision
The bill creates a new audit system for electing
large partnerships. The provision defines
"electing large partnership" the same way
for audit and reporting purposes (generally, any
partnership that elects under the reporting
provisions, if the number of partners in the
preceding taxable year is 100 or more).
As under present law, electing large partnerships
and their partners are subject to unified audit
rules. Thus, the tax treatment of "partnership
items" are determined at the partnership,
rather than the partner, level. The term
"partnership items" is defined as under
present law.
Unlike present law, however, partnership adjustments
generally will flow through to the partners for the
year in which the adjustment takes effect. Thus, the
current-year partners' share of current-year
partnership items of income, gains, losses,
deductions, or credits will be adjusted to reflect
partnership adjustments that take effect in that
year. The adjustments generally will not affect
prior-year returns of any partners (except in the
case of changes to any partner's distributive
shares).
In lieu of flowing an adjustment through to its
partners, the partnership may elect to pay an
imputed underpayment. The imputed underpayment
generally is calculated by netting the adjustments
to the income and loss items of the partnership and
multiplying that amount by the highest tax rate
(whether individual or corporate). A partner may not
file a claim for credit or refund of his allocable
share of the payment. A partnership may make this
election only if it meets requirements set forth in
Treasury regulations designed to ensure payment (for
example, in the case of a foreign partnership).
Regardless of whether a partnership adjustment flows
through to the partners, an adjustment must be
offset if it requires another adjustment in a year
after the adjusted year and before the year the
offsetted adjustment takes effect. For example, if a
partnership expensed a $1,000 item in year 1, and it
was determined in year 4 that the item should have
been capitalized and amortized ratably over 10
years, the adjustment in year 4 would be $700, apart
from any interest or penalty. (The $900 adjustment
for the improper deduction would be offset by $200
of adjustments for amortization deductions.) The
year 4 partners would be required to include an
additional $700 in income for that year. The
partnership may ratably amortize the remaining $700
of expenses in years 4-10.
In addition, the partnership, rather than the
partners individually, generally is liable for any
interest and penalties that result from a
partnership adjustment. Interest is computed for the
period beginning on the return due date for the
adjusted year and ending on the earlier of the
return due date for the partnership taxable year in
which the adjustment takes effect or the date the
partnership pays the imputed underpayment. Thus, in
the above example, the partnership would be liable
for 4 years' worth of interest (on a declining
principal amount).
Penalties (such as the accuracy and fraud penalties)
are determined on a year-by-year basis (without
offsets) based on an imputed underpayment. All
accuracy penalty criteria and waiver criteria (such
as reasonable cause, substantial authority, etc.)
are determined as if the partnership were a taxable
individual. Accuracy and fraud penalties are
assessed and accrue interest in the same manner as
if asserted against a taxable individual.
Any payment (for Federal income taxes, interest, or
penalties) that an electing large partnership is
required to make is non-deductible.
If a partnership ceases to exist before a
partnership adjustment takes effect, the former
partners are required to take the adjustment into
account, as provided by regulations. Regulations are
also authorized to prevent abuse and to enforce
efficiently the audit rules in circumstances that
present special enforcement considerations (such as
partnership bankruptcy).
Administrative
proceedings
Under the electing large partnership audit rules, a
partner is not permitted to report any partnership
items inconsistently with the partnership return,
even if the partner notifies the IRS of the
inconsistency. The IRS may treat a partnership item
that was reported inconsistently by a partner as a
mathematical or clerical error and immediately
assess any additional tax against that partner.
As under present law, the IRS may challenge the
reporting position of a partnership by conducting a
single administrative proceeding to resolve the
issue with respect to all partners. Unlike under
present law, however, partners will have no right
individually to participate in settlement
conferences or to request a refund.
Partnership
representative
The bill requires each electing large partnership to
designate a partner or other person to act on its
behalf. If an electing large partnership fails to
designate such a person, the IRS is permitted to
designate any one of the partners as the person
authorized to act on the partnership's behalf. After
the IRS's designation, an electing large partnership
could still designate a replacement for the
IRS-designated partner.
Notice
requirements
Unlike under present law, the IRS is not required to
give notice to individual partners of the
commencement of an administrative proceeding or of a
final adjustment. Instead, the IRS is authorized to
send notice of a partnership adjustment to the
partnership itself by certified or registered mail.
The IRS could give proper notice by mailing the
notice to the last known address of the partnership,
even if the partnership had terminated its
existence.
Adjudication
of disputes concerning partnership items
As under present law, an administrative adjustment
could be challenged in the Tax Court, the district
court in which the partnership's principal place of
business is located, or the
Claims Court
. However, only the partnership, and not partners
individually, can petition for a readjustment of
partnership items.
If a petition for readjustment of partnership items
is filed by the partnership, the court with which
the petition is filed will have jurisdiction to
determine the tax treatment of all partnership items
of the partnership for the partnership taxable year
to which the notice of partnership adjustment
relates, and the proper allocation of such items
among the partners. Thus, the court's jurisdiction
is not limited to the items adjusted in the notice.
Statute
of limitations
Absent an agreement to extend the statute of
limitations, the IRS generally could not adjust a
partnership item of an electing large partnership
more than 3 years after the later of the filing of
the partnership return or the last day for the
filing of the partnership return. Special rules
apply to false or fraudulent returns, a substantial
omission of income, or the failure to file a return.
The IRS would assess and collect any deficiency of a
partner that arises from any adjustment to a
partnership item subject to the limitations period
on assessments and collection applicable to the year
the adjustment takes effect (secs. 6248, 6501 and
6502).
Regulatory
authority
The Secretary of the Treasury is granted authority
to prescribe regulations as may be necessary to
carry out the simplified audit procedure provisions,
including regulations to prevent abuse of the
provisions through manipulation. The regulations may
include rules that address transfers of partnership
interests, in anticipation of a partnership
adjustment, to persons who are tax-favored (e.g.,
corporations with net operating losses, tax-exempt
organizations, and foreign partners) or persons who
are expected to be unable to pay tax (e.g., shell
corporations). For example, if prior to the time a
partnership adjustment takes effect, a taxable
partner transfers a partnership interest to a
nonresident alien to avoid the tax effect of the
partnership adjustment, the rules may provide, among
other things, that income related to the partnership
adjustment is treated as effectively connected
taxable income, that the partnership adjustment is
treated as taking effect before the partnership
interest was transferred, or that the former partner
is treated as a current partner to whom the
partnership adjustment is allocated.
Effective
Date
The provision applies to partnership taxable years
beginning after December 31, 1997.
c.
Due date for furnishing information to partners of
electing large partnerships (sec. 1023 of the bill
and sec. 6031(b) of the Code)
Present
Law
A partnership required to file an income tax return
with the Internal Revenue Service must also furnish
an information return to each of its partners on or
before the day on which the income tax return for
the year is required to be filed, including
extensions. Under regulations, a partnership must
file its income tax return on or before the
fifteenth day of the fourth month following the end
of the partnership's taxable year (on or before
April 15, for calendar year partnerships). This is
the same deadline by which most individual partners
must file their tax returns.
Reasons
for Change
Information returns that are received on or shortly
before April 15 (or later) are difficult for
individuals to use in preparing their tax returns
(or in computing their payments) that are due on
that date.
Explanation
of Provision
The bill provides that an electing large partnership
must furnish information returns to partners by the
first March 15 following the close of the
partnership's taxable year. Electing large
partnerships are those partnerships subject to the
simplified reporting and audit rules (generally, any
partnership that elects under the reporting
provision, if the number of partners in the
preceding taxable year is 100 or more).
The provision also provides that, if the partnership
is required to provide copies of the information
returns to the Internal Revenue Service on magnetic
media, each schedule (such as each Schedule K-1)
with respect to each partner is treated as a
separate information return with respect to the
corrective periods and penalties that are generally
applicable to all information returns.
Effective
Date
The provision is effective for partnership taxable
years beginning after December 31, 1997.
d.
Partnership returns required on magnetic media (sec.
1024 of the bill and sec. 6011 of the Code)
Present
Law
Partnerships are permitted, but not required, to
provide the tax return of the partnership (Form
1065), as well as copies of the schedules sent to
each partner (Form K-1), to the Internal Revenue
Service on magnetic media.
Reasons
for Change
Most entities that file large numbers of documents
with the Internal Revenue Service must do so on
magnetic media. Conforming the reporting provisions
for partnerships to the generally applicable
information reporting rules will facilitate
integration of partnership information into already
existing data systems.
Explanation
of Provision
The bill provides generally that any partnership is
required to provide the tax return of the
partnership (Form 1065), as well as copies of the
schedule sent to each partner (Form K-1), to the
Internal Revenue Service on magnetic media. An
exception is provided for partnerships with 100 or
fewer partners.
Effective
Date
The provision is effective for partnership taxable
years beginning after December 31, 1997.
e.
Treatment of partnership items of individual
retirement arrangements (sec. 1025 of the bill and
sec. 6012 of the Code)
Present
Law
Return
filing requirements
An individual retirement account ("IRA")
is a trust which generally is exempt from taxation
except for the taxes imposed on income from an
unrelated trade or business. A fiduciary of a trust
that is exempt from taxation (but subject to the
taxes imposed on income from an unrelated trade or
business) generally is required to file a return on
behalf of the trust for a taxable year if the trust
has gross income of $1,000 or more included in
computing unrelated business taxable income for that
year (Treas. Reg. sec. 1.6012-3(a)(5)).
Unrelated business taxable income is the gross
income (including gross income from a partnership)
derived by an exempt organization from an unrelated
trade or business, less certain deductions which are
directly connected with the carrying on of such
trade or business (sec. 512(a)(1). In calculating
unrelated business taxable income, exempt
organizations (including IRAs) generally also are
permitted a specific deduction of $1,000 (sec.
512(b)(12)).
Unified
audits of partnerships
All but certain small partnerships are subject to
unified audit rules established by the Tax Equity
and Fiscal Responsibility Act of 1982. These rules
require the tax treatment of all "partnership
items" to be determined at the partnership,
rather than the partner, level. Partnership items
are those items that are more appropriately
determined at the partnership level than at the
partner level, including such items as gross income
and deductions of the partnership.
Reasons
for Change
Under present law, tax returns often must be filed
for IRAs that have no taxable income and,
consequently, no tax liability. The filing of these
returns by taxpayers, and the processing of these
returns by the IRS, impose significant costs.
Imposing this burden is unnecessary to the extent
that the income of the IRA has been derived from an
interest in a partnership that is subject to
partnership-level audit rules. In these
circumstances, the appropriateness of any deductions
may be determined at the partnership level, and an
additional filing is unnecessary to facilitate this
determination.
Explanation
of Provision
The bill modifies the filing threshold for an IRA
with an interest in a partnership that is subject to
the partnership-level audit rules. A fiduciary of
such an IRA could treat the trust's share of
partnership taxable income as gross income, for
purposes of determining whether the trust meets the
$1,000 gross income filing threshold. A fiduciary of
an IRA that receives taxable income from a
partnership that is subject to partnership-level
audit rules of less than $1,000 (before the $1,000
specific deduction) is not required to file an
income tax return if the IRA does not have any other
income from an unrelated trade or business.
Effective
Date
The provision applies to taxable years beginning
after December 31, 1997.
2.
Other partnership audit rules
a.
Treatment of partnership items in deficiency
proceedings (sec. 1031 of the bill and sec. 6234 of
the Code)
Present
Law
Partnership proceedings under rules enacted in TEFRA139
must be kept separate from deficiency proceedings
involving the partners in their individual
capacities. Prior to the Tax Court's opinion in
Munro v. Commissioner, 92 T.C. 71 (1989), the IRS
computed deficiencies by assuming that all items
that were subject to the TEFRA partnership
procedures were correctly reported on the taxpayer's
return. However, where the losses claimed from TEFRA
partnerships were so large that they offset any
proposed adjustments to nonpartnership items, no
deficiency could arise from a non-TEFRA proceeding,
and if the partnership losses were subsequently
disallowed in a partnership proceeding, the non-TEFRA
adjustments might be uncollectible because of the
expiration of the statute of limitations with
respect to nonpartnership items.
Faced with this situation in Munro, the IRS
issued a notice of deficiency to the taxpayer that
presumptively disallowed the taxpayer's TEFRA
partnership losses for computational purposes only.
Although the Tax Court ruled that a deficiency
existed and that the court had jurisdiction to hear
the case, the court disapproved of the methodology
used by the IRS to compute the deficiency.
Specifically, the court held that partnership items
(whether income, loss, deduction, or credit)
included on a taxpayer's return must be completely
ignored in determining whether a deficiency exists
that is attributable to nonpartnership items.
Reasons
for Change
The opinion in Munro creates problems for
both taxpayers and the IRS. For example, a taxpayer
would be harmed in the case where he has invested in
a TEFRA partnership and is also subject to the
deficiency procedures with respect to nonpartnership
item adjustments, since computing the tax liability
without regard to partnership items will have the
same effect as if the partnership items were
disallowed. If the partnership items were losses,
the effect will be a greatly increased deficiency
for the nonpartnership items. If, when the
partnership proceedings are completed, the taxpayer
is ultimately allowed any part of the losses, the
taxpayer will receive part of the increased
deficiency back in the form of an overpayment.
However, in the interim, the taxpayer will have been
subject to assessment and collection of a deficiency
inflated by items still in dispute in the
partnership proceeding. In essence, a taxpayer in
such a case would be deprived of a prepayment forum
with respect to the partnership item adjustments.
The IRS would be harmed if a taxpayer's income is
primarily from a TEFRA partnership, since the IRS
may be unable to adjust nonpartnership items such as
medical expense deductions, home mortgage interest
deductions on charitable contribution deductions
because there would be no deficiency since, under Munro,
the income must be ignored.
Explanation
of Provision
The bill overrules Munro and allow the IRS to
return to its prior practice of computing
deficiencies by assuming that all TEFRA items whose
treatment has not been finally determined had been
correctly reported on the taxpayer's return. This
eliminates the need to do special computations that
involve the removal of TEFRA items from a taxpayer's
return, and will restore to taxpayers a prepayment
forum with respect to the TEFRA items. In addition,
the provision provides a special rule to address the
factual situation presented in Munro.
Specifically, the bill provides a declaratory
judgment procedure in the Tax Court for adjustments
to an oversheltered return. An oversheltered return
is a return that shows no taxable income and a net
loss from TEFRA partnerships. In such a case, the
IRS is authorized to issue a notice of adjustment
with respect to non-TEFRA items, notwithstanding
that no deficiency would result from the adjustment.
However, the IRS could only issue such a notice if a
deficiency would have arisen in the absence of the
net loss from TEFRA partnerships.
The Tax Court is granted jurisdiction to determine
the correctness of such an adjustment as well as to
make a declaration with respect to any other item
for the taxable year to which the notice of
adjustment relates, except for partnership items and
affected items which require partner-level
determinations. No tax is due upon such a
determination, but a decision of the Tax Court is
treated as a final decision, permitting an appeal of
the decision by either the taxpayer or the IRS. An
adjustment determined to be correct would thus have
the effect of increasing the taxable income that is
deemed to have been reported on the taxpayer's
return. If the taxpayer's partnership items were
then adjusted in a subsequent proceeding, the IRS
has preserved its ability to collect tax on any
increased deficiency attributable to the
nonpartnership items.
Alternatively, if the taxpayer chooses not to
contest the notice of adjustment within the 90-day
period, the bill provides that when the taxpayer's
partnership items are finally determined, the
taxpayer has the right to file a refund claim for
tax attributable to the items adjusted by the
earlier notice of adjustment for the taxable year.
Although a refund claim is not generally permitted
with respect to a deficiency arising from a TEFRA
proceeding, such a rule is appropriate with respect
to a defaulted notice of adjustment because
taxpayers may not challenge such a notice when
issued since it does not require the payment of
additional tax.
In addition, the bill incorporates a number of
provisions intended to clarify the coordination
between TEFRA audit proceedings and individual
deficiency proceedings. Under these provisions, any
adjustment with respect to a non-partnership item
that caused an increase in tax liability with
respect to a partnership item would be treated as a
computational adjustment and assessed after the
conclusion of the TEFRA proceeding. Accordingly,
deficiency procedures do not apply with respect to
this increase in tax liability, and the statute of
limitations applicable to TEFRA proceedings are
controlling.
Effective
Date
The provision is effective for partnership taxable
years ending after the date of enactment.
b.
Partnership return to be determinative of audit
procedures to be followed (sec. 1032 of the bill and
sec. 6231 of the Code)
Present
Law
TEFRA established unified audit rules applicable to
all partnerships, except for partnerships with 10 or
fewer partners, each of whom is a natural person
(other than a nonresident alien) or an estate, and
for which each partner's share of each partnership
item is the same as that partner's share of every
other partnership item. Partners in the exempted
partnerships are subject to regular deficiency
procedures.
Reasons
for Change
The IRS often finds it difficult to determine
whether to follow the TEFRA partnership procedures
or the regular deficiency procedures. If the IRS
determines that there were fewer than 10 partners in
the partnership but was unaware that one of the
partners was a nonresident alien or that there was a
special allocation made during the year, the IRS
might inadvertently apply the wrong procedures and
possibly jeopardize any assessment. Permitting the
IRS to rely on a partnership's return would simplify
the IRS' task.
Explanation
of Provision
The bill permits the IRS to apply the TEFRA audit
procedures if, based on the partnership's return for
the year, the IRS reasonably determines that those
procedures should apply. Similarly, the provision
permits the IRS to apply the normal deficiency
procedures if, based on the partnership's return for
the year, the IRS reasonably determines that those
procedures should apply.
Effective
Date
The provision is effective for partnership taxable
years ending after the date of enactment.
c.
Provisions relating to statute of limitations
i.
Suspend statute when an untimely petition is filed
(sec. 1033(a) of the bill and sec. 6229 of the Code)
Present
Law
In a deficiency case, section 6503(a) provides that
if a proceeding in respect of the deficiency is
placed on the docket of the Tax Court, the period of
limitations on assessment and collection is
suspended until the decision of the Tax Court
becomes final, and for 60 days thereafter. The
counterpart to this provision with respect to TEFRA
cases is contained in section 6229(d). That section
provides that the period of limitations is suspended
for the period during which an action may be brought
under section 6226 and, if an action is brought
during such period, until the decision of the court
becomes final, and for 1 year thereafter. As a
result of this difference in language, the running
of the statute of limitations in a TEFRA case will
only be tolled by the filing of a timely petition
whereas in a deficiency case, the statute of
limitations is tolled by the filing of any petition,
regardless of whether the petition is timely.
Reasons
for Change
Under present law, if an untimely petition is filed
in a TEFRA case, the statute of limitations can
expire while the case is still pending before the
court. To prevent this from occurring, the IRS must
make assessments against all of the investors during
the pendency of the action and if the action is in
the Tax Court, presumably abate such assessments if
the court ultimately determines that the petition
was timely. These steps are burdensome to the IRS
and to taxpayers.
Explanation
of Provision
The bill conforms the suspension rule for the filing
of petitions in TEFRA cases with the rule under
section 6503(a) pertaining to deficiency cases.
Under the provision, the statute of limitations in
TEFRA cases is suspended by the filing of any
petition under section 6226, regardless of whether
the petition is timely or valid, and the suspension
will remain in effect until the decision of the
court becomes final, and for one year thereafter.
Hence, if the statute of limitations is open at the
time that an untimely petition is filed, the
limitations period would no longer continue to run
and possibly expire while the action is pending
before the court.
Effective
Date
The provision is effective with respect to all cases
in which the period of limitations has not expired
under present law as of the date of enactment.
ii.
Suspend statute of limitations during bankruptcy
proceedings (sec. 1033(b) of the bill and sec. 6229
of the Code)
Present
Law
The period for assessing tax with respect to
partnership items generally is the longer of the
periods provided by section 6229 or section 6501.
For partnership items that convert to nonpartnership
items, section 6229(f) provides that the period for
assessing tax shall not expire before the date which
is 1 year after the date that the items become
nonpartnership items. Section 6503(h) provides for
the suspension of the limitations period during the
pendency of a bankruptcy proceeding. However, this
provision only applies to the limitations periods
provided in sections 6501 and 6502.
Under present law, because the suspension provision
in section 6503(h) applies only to the limitations
periods provided in section 6501 and 6502, some
uncertainty exists as to whether section 6503(h)
applies to suspend the limitations period pertaining
to converted items provided in section 6229(f) when
a petition naming a partner as a debtor in a
bankruptcy proceeding is filed. As a result, the
limitations period provided in section 6229(f) may
continue to run during the pendency of the
bankruptcy proceeding, notwithstanding that the IRS
is prohibited from making an assessment against the
debtor because of the automatic stay provisions of
the Bankruptcy Code.
Reasons
for Change
The ambiguity in present law makes it difficult for
the IRS to adjust partnership items that convert to
nonpartnership items by reason of a partner going
into bankruptcy. In addition, any uncertainty may
result in increased requests for the bankruptcy
court to lift the automatic stay to permit the IRS
to make an assessment with respect to the converted
items.
Explanation
of Provision
The bill clarifies that the statute of limitations
is suspended for a partner who is named in a
bankruptcy petition. The suspension period is for
the entire period during which the IRS is prohibited
by reason of the bankruptcy proceeding from making
an assessment, and for 60 days thereafter. The
provision does not purport to create any inference
as to the proper interpretation of present law.
Effective
Date
The provision is effective with respect to all cases
in which the period of limitations has not expired
under present law as of the date of enactment.
iii.
Extend statute of limitations for bankrupt TMPs
(sec. 1033(c) of the bill and sec. 6229 of the Code)
Present
Law
Section 6229(b)(1)(B) provides that the statute of
limitations is extended with respect to all partners
in the partnership by an agreement entered into
between the tax matters partner (TMP) and the IRS.
However, Temp. Treas. Reg. secs.
301.6231(a)(7)-1T(1)(4) and 301.6231(c)-7T(a)
provide that upon the filing of a petition naming a
partner as a debtor in a bankruptcy proceeding, that
partner's partnership items convert to
nonpartnership items, and if the debtor was the tax
matters partner, such status terminates. These rules
are necessary because of the automatic stay
provision contained in 11 U.S.C. sec. 362(a)(8). As
a result, if a consent to extend the statute of
limitations is signed by a person who would be the
TMP but for the fact that at the time that the
agreement is executed the person was a debtor in a
bankruptcy proceeding, the consent would not be
binding on the other partners because the person
signing the agreement was no longer the TMP at the
time that the agreement was executed.
Reasons
for Change
The IRS is not automatically notified of bankruptcy
filings and cannot easily determine whether a
taxpayer is in bankruptcy, especially if the audit
of the partnership is being conducted by one
district and the taxpayer resides in another
district, as is frequently the situation in TEFRA
cases. If the IRS does not discover that a person
signing a consent is in bankruptcy, the IRS may
mistakenly rely on that consent. As a result, the
IRS may be precluded from assessing any tax
attributable to partnership item adjustments with
respect to any of the partners in the partnership.
Explanation
of Provision
The bill provides that unless the IRS is notified of
a bankruptcy proceeding in accordance with
regulations, the IRS can rely on a statute extension
signed by a person who is the tax matters partner
but for the fact that said person was in bankruptcy
at the time that the person signed the agreement.
Statute extensions granted by a bankrupt TMP in
these cases are binding on all of the partners in
the partnership. The provision is not intended to
create any inference as to the proper interpretation
of present law.
Effective
Date
The provision is effective for extension agreements
entered into after the date of enactment.
d.
Expansion of small partnership exception (sec. 1034
of the bill and sec. 6231 of the Code)
Present
Law
TEFRA established unified audit rules applicable to
all partnerships, except for partnerships with 10 or
fewer partners, each of whom is a natural person
(other than a nonresident alien) or an estate, and
for which each partner's share of each partnership
item is the same as that partner's share of every
other partnership item. Partners in the exempted
partnerships are subject to regular deficiency
procedures.
Reasons
for Change
The more existence of a C corporation as a partner
or of a special allocation does not warrant
subjecting the partnership and its partners of an
otherwise small partnership to the TEFRA procedures.
Explanation
of Provision
The bill permits a small partnership to have a C
corporation as a partner or to specially allocate
items without jeopardizing its exception from the
TEFRA rules. However, the provision retains the
prohibition of present law against having a
flow-through entity (other than an estate of a
deceased partner) as a partner for purposes of
qualifying for the small partnership exception.
Effective
Date
The provision is effective for partnership taxable
years ending after the date of enactment.
e.
Exclusion of partial settlements from 1-year
limitation on assessment (sec. 1035 of the bill and
sec. 6229(f) of the Code)
Present
Law
The period for assessing tax with respect to
partnership items generally is the longer of the
periods provided by section 6229 or section 6501.
For partnership items that convert to nonpartnership
items, section 6229(f) provides that the period for
assessing tax shall not expire before the date which
is 1 year after the date that the items become
nonpartnership items. Section 6231(b)(1)(C) provides
that the partnership items of a partner for a
partnership taxable year become nonpartnership items
as of the date the partner enters into a settlement
agreement with the IRS with respect to such items.
Reasons
for Change
When a partial settlement agreement is entered into,
the assessment period for the items covered by the
agreement may be different than the assessment
period for the remaining items. This fractured
statute of limitations poses a significant tracking
problem for the IRS and necessitates multiple
computations of tax with respect to each partner's
investment in the partnership for the taxable year.
Explanation
of Provision
The bill provides that if a partner and the IRS
enter into a settlement agreement with respect to
some but not all of the partnership items in dispute
for a partnership taxable year and other partnership
items remain in dispute, the period for assessing
any tax attributable to the settled items is
determined as if such agreement had not been entered
into. Consequently, the limitations period that is
applicable to the last item to be resolved for the
partnership taxable year is controlling with respect
to all disputed partnership items for the
partnership taxable year. The provision does not
purport to create any inference as to the proper
interpretation of present law.
Effective
Date
The provision is effective for settlements entered
into after the date of enactment.
f.
Extension of time for filing a request for
administrative adjustment (sec. 1036 of the bill and
sec. 6227 of the Code)
Present
Law
If an agreement extending the statute is entered
into with respect to a non-TEFRA statute of
limitations, that agreement also extends the statute
of limitations for filing refund claims (sec.
6511(c)). There is no comparable provision for
extending the time for filing refund claims with
respect to partnership items subject to the TEFRA
partnership rules.
Reasons
for Change
The absence of an extension for filing refund claims
in TEFRA proceedings hinders taxpayers that may want
to agree to extend the TEFRA statute of limitations
but want to preserve their option to file a refund
claim later.
Explanation
of Provision
The bill provides that if a TEFRA statute extension
agreement is entered into, that agreement also
extends the statute of limitations for filing refund
claims attributable to partnership items or affected
items until 6 months after the expiration of the
limitations period for assessments.
Effective
Date
The provision is effective as if included in the
amendments made by section 402 of the Tax Equity and
Fiscal Responsibility Act of 1982.
g.
Availability of innocent spouse relief in context of
partnership proceedings (sec. 1037 of the bill and
sec. 6230 of the Code)
Present
Law
In general, an innocent spouse may be relieved of
liability for tax, penalties and interest if certain
conditions are met (sec. 6013(e)). However, existing
law does not provide the spouse of a partner in a
TEFRA partnership with a judicial forum to raise the
innocent spouse defense with respect to any tax or
interest that relates to an investment in a TEFRA
partnership.
Reasons
for Change
Providing a forum in which to raise the innocent
spouse defense with respect to liabilities
attributable to adjustments to partnership items
(including penalties, additions to tax and
additional amounts) would make the innocent spouse
rules more uniform.
Explanation
of Provision
The bill provides both a prepayment forum and a
refund forum for raising the innocent spouse defense
in TEFRA cases.
With respect to a prepayment forum, the provision
provides that within 60 days of the date that a
notice of computational adjustment relating to
partnership items is mailed to the spouse of a
partner, the spouse could request that the
assessment be abated. Upon receipt of such a
request, the assessment is abated and any
reassessment will be subject to the deficiency
procedures. If an abatement is requested, the
statute of limitations does not expire before the
date which is 60 days after the date of the
abatement. If the spouse files a petition with the
Tax Court, the Tax Court only has jurisdiction to
determine whether the requirements of section
6013(e) have been satisfied. In making this
determination, the treatment of the partnership
items that gave rise to the liability in question is
conclusive.
Alternatively, the bill provides that the spouse of
a partner could file a claim for refund to raise the
innocent spouse defense. The claim has to be filed
within 6 months from the date that the notice of
computational adjustment is mailed to the spouse. If
the claim is not allowed, the spouse could file a
refund action. For purposes of any claim or suit
under this provision, the treatment of the
partnership items that gave rise to the liability in
question is conclusive.
Effective
Date
The provision is effective as if included in the
amendments made by section 402 of the Tax Equity and
Fiscal Responsibility Act of 1982.
h.
Determination of penalties at partnership level
(sec. 1038 of the bill and sec. 6221 of the Code)
Present
Law
Partnership items include only items that are
required to be taken into account under the income
tax subtitle. Penalties are not partnership items
since they are contained in the procedure and
administration subtitle. As a result, penalties may
only be asserted against a partner through the
application of the deficiency procedures following
the completion of the partnership-level proceeding.
Reasons
for Change
Many penalties are based upon the conduct of the
taxpayer. With respect to partnerships, the relevant
conduct often occurs at the partnership level. In
addition, applying penalties at the partner level
through the deficiency procedures following the
conclusion of the unified proceeding at the
partnership level increases the administrative
burden on the IRS and can significantly increase the
Tax Court's inventory.
Explanation
of Provision
The bill provides that the partnership-level
proceeding is to include a determination of the
applicability of penalties at the partnership level.
However, the provision allows partners to raise any
partner-level defenses in a refund forum.
Effective
Date
The provision is effective for partnership taxable
years ending after the date of enactment.
i.
Provisions relating to Tax Court jurisdiction (sec.
1039 of the bill and secs. 6225 and 6226 of the
Code)
Present
Law
Improper assessment and collection activities by the
IRS during the 150-day period for filing a petition
or during the pendency of any Tax Court proceeding,
"may be enjoined in the proper court."
Present law may be unclear as to whether this
includes the Tax Court.
For a partner other than the Tax Matters Partner to
be eligible to file a petition for redetermination
of partnership items in any court or to participate
in an existing case, the period for assessing any
tax attributable to the partnership items of that
partner must not have expired. Since such a partner
would only be treated as a party to the action if
the statute of limitations with respect to them was
still open, the law is unclear whether the partner
would have standing to assert that the statute of
limitations had expired with respect to them.
Reasons
for Change
Clarifying the Tax Court's jurisdiction simplifies
the resolution of tax cases.
Explanation
of Provision
The bill clarifies that an action to enjoin
premature assessments of deficiencies attributable
to partnership items may be brought in the Tax
Court. The provision also permits a partner to
participate in an action or file a petition for the
sole purpose of asserting that the period of
limitations for assessing any tax attributable to
partnership items has expired for that person.
Additionally, the provision clarifies that the Tax
Court has overpayment jurisdiction with respect to
affected items.
Effective
Date
The provision is effective for partnership taxable
years ending after the date of enactment.
j.
Treatment of premature petitions filed by notice
partners or 5-percent groups (sec. 1040 of the bill
and sec. 6226 of the Code)
Present
Law
The Tax Matters Partner is given the exclusive right
to file a petition for a readjustment of partnership
items within the 90-day period after the issuance of
the notice of a final partnership administrative
adjustment (FPAA). If the Tax Matters Partner does
not file a petition within the 90-day period,
certain other partners are permitted to file a
petition within the 60-day period after the close of
the 90-day period. There are ordering rules for
determining which action goes forward and for
dismissing other actions.
Reasons
for Change
A petition that is filed within the 90-day period by
a person who is not the Tax Matters Partner is
dismissed. Thus, if the Tax Matters Partner does not
file a petition within the 90-day period and no
timely and valid petition is filed during the
succeeding 60-day period, judicial review of the
adjustments set forth in the notice of FPAA is
foreclosed and the adjustments are deemed to be
correct.
Explanation
of Provision
The bill treats premature petitions filed by certain
partners within the 90-day period as being filed on
the last day of the following 60-day period under
specified circumstances, thus affording the
partnership with an opportunity for judicial review
that is not available under present law.
Effective
Date
The provision is effective with respect to petitions
filed after the date of enactment.
k.
Bonds in case of appeals from certain proceedings
(sec. 1041 of the bill and sec. 7485 of the Code)
Present
Law
A bond must be filed to stay the collection of
deficiencies pending the appeal of the Tax Court's
decision in a TEFRA proceeding. The amount of the
bond must be based on the court's estimate of the
aggregate deficiencies of the partners.
Reasons
for Change
The Tax Court cannot easily determine the aggregate
changes in tax liability of all of the partners in a
partnership who will be affected by the Court's
decision in the proceeding. Clarifying the
calculation of the bond amount would simplify the
Tax Court's task.
Explanation
of Provision
The bill clarifies that the amount of the bond
should be based on the Tax Court's estimate of the
aggregate liability of the parties to the action
(and not all of the partners in the partnership).
For purposes of this provision, the amount of the
bond could be estimated by applying the highest
individual rate to the total adjustments determined
by the Tax Court and doubling that amount to take
into account interest and penalties.
Effective
Date
The provision is effective as if included in the
amendments made by section 402 of the Tax Equity and
Fiscal Responsibility Act of 1982.
l.
Suspension of interest where delay in computational
adjustment resulting from certain settlements (sec.
1042 of the bill and sec. 6601 of the Code)
Present
Law
Interest on a deficiency generally is suspended when
a taxpayer executes a settlement agreement with the
IRS and waives the restrictions on assessments and
collections, and the IRS does not issue a notice and
demand for payment of such deficiency within 30
days. Interest on a deficiency that results from an
adjustment of partnership items in TEFRA
proceedings, however, is not suspended.
Reasons
for Change
Processing settlement agreements and assessing the
tax due takes a substantial amount of time in TEFRA
cases. A taxpayer is not afforded any relief from
interest during this period.
Explanation
of Provision
The bill suspends interest where there is a delay in
making a computational adjustment relating to a
TEFRA settlement.
Effective
Date
The provision is effective with respect to
adjustments relating to taxable years beginning
after the date of enactment.
m.
Special rules for administrative adjustment requests
with respect to bad debts or worthless securities
(sec. 1043 of the bill and sec. 6227 of the Code)
Present
Law
The non-TEFRA statute of limitations for filing a
claim for credit or refund generally is the later of
(1) three years from the date the return in question
was filed or (2) two years from the date the claimed
tax was paid, whichever is later (sec. 6511(b)).
However, an extended period of time, seven years
from the date the return was due, is provided for
filing a claim for refund of an overpayment
resulting from a deduction for a worthless security
or bad debt (sec. 6511(d)).
Under the TEFRA partnership rules, a request for
administrative adjustment ("RAA") must be
filed within three years after the later of (1) the
date the partnership return was filed or (2) the due
date of the partnership return (determined without
regard to extensions) (sec. 6227(a)(1)). In
addition, the request must be filed before a final
partnership administrative adjustment ("FPAA")
is mailed for the taxable year (sec. 6227(a)(2)).
There is no special provision for extending the time
for filing an RAA that relates to a deduction for a
worthless security or an entirely worthless bad
debt.
Reasons
for Change
Whether and when a stock or debt becomes worthless
is a question of fact that may not be determinable
until after the year in which it appears the loss
has occurred. An extended statute of limitations
allows partners in a TEFRA partnership the same
opportunity to file a delayed claim for refund in
these difficult factual situations as other
taxpayers are permitted.
Further, on past occasions, the IRS issued FPAAs
that did not adjust the partnership's tax return.
This action created wasteful paperwork, and may
have, in some cases truncated the appeals rights of
individual partners. A special rule is necessary to
permit partners who may have been adversely impacted
by this past practice of the IRS to avail themselves
of the extended period irrespective of whether an
FPAA has been issued.
Explanation
of Provision
The bill extends the time for the filing of an RAA
relating to the deduction by a partnership for a
worthless security or bad debt. In these
circumstances, in lieu of the three-year period
provided in sec. 6227(a)(1), the period for filing
an RAA is seven years from the date the partnership
return was due with respect to which the request is
made (determined without regard to extensions). The
RAA is still required to be filed before the FPAA is
mailed for the taxable year.
Effective
Date
The provision is effective as if included in the
amendments made by section 402 of the Tax Equity and
Fiscal Responsibility Act of 1982.
3.
Closing of partnership taxable year with respect to
deceased partner (sec. 1046 of the bill and sec.
706(c)(2)(A) of the Code)
Present
Law
The partnership taxable year closes with respect to
a partner whose entire interest is sold, exchanged,
or liquidated. Such year, however, generally does
not close upon the death of a partner. Thus, a
decedent's entire share of items of income, gain,
loss, deduction and credit for the partnership year
in which death occurs is taxed to the estate or
successor in interest rather than to the decedent on
his or her final income tax return. See Estate of
Hesse
v. Commissioner, 74 T.C. 1307, 1311
(1980).
Reasons
for Change
The rule leaving open the partnership taxable year
with respect to a deceased partner was adopted in
1954 to prevent the bunching of income that could
occur with respect to a partnership reporting on a
fiscal year other than the calendar year. Without
this rule, as many as 23 months of income might have
been reported on the partner's final return.
Legislative changes occurring since 1954 have
required most partnerships to adopt a calendar year,
reducing the possibility of bunching. Consequently,
income and deductions are better matched if the
partnership taxable year closes upon a partner's
death and partnership items are reported on the
decedent's last return.
Present law closes the partnership taxable year with
respect to a deceased partner only if the partner's
entire interest is sold or exchanged pursuant to an
agreement existing at the time of death. By closing
the taxable year automatically upon death, the
provision reduces the need for such agreements.
Explanation
of Provision
The provision provides that the taxable year of a
partnership closes with respect to a partner whose
entire interest in the partnership terminates,
whether by death, liquidation or otherwise. The
provision does not change present law with respect
to the effect upon the partnership taxable year of a
transfer of a partnership interest by a debtor to
the debtor's estate (under Chapters 7 or 11 of Title
11, relating to bankruptcy).
Effective
Date
The provision applies to partnership taxable years
beginning after December 31, 1997.
D.
Modifications of Rules for Real Estate Investment
Trusts (secs. 1051-1063 of the bill and secs. 856
and 857 of the Code)
Present
Law
Overview
In general, a real estate investment trust ("REIT")
is an entity that receives most of its income from
passive real estate related investments and that
receives conduit treatment for income that is
distributed to shareholders. If an entity meets the
qualifications for REIT status, the portion of its
income that is distributed to the investors each
year generally is taxed to the investors without
being subjected to a tax at the REIT level; the REIT
generally is subject to a corporate tax only on the
income that it retains and on certain income from
property that qualifies as foreclosure property.
Election
to be treated as a REIT
In order to qualify as a REIT, and thereby receive
conduit treatment, an entity must elect REIT status.
A newly-electing entity generally cannot have
earnings and profits accumulated from any year in
which the entity was in existence and not treated as
a REIT (sec. 857(a)(3)). To satisfy this
requirement, the entity must distribute, during its
first REIT taxable year, any earnings and profits
that were accumulated in non-REIT years. For this
purpose, distributions by the entity generally are
treated as being made from the most recently
accumulated earnings and profits.
Taxation
of REITs
Overview
In general, if an entity qualifies as a REIT by
satisfying the various requirements described below,
the entity is taxable as a corporation on its
"real estate investment trust taxable
income" ("REITTI"), and also is
taxable on certain other amounts (sec. 857). REITTI
is the taxable income of the REIT with certain
adjustments (sec. 857(b)(2)). The most significant
adjustment is a deduction for dividends paid. The
allowance of this deduction is the mechanism by
which the REIT becomes a conduit for income tax
purposes.
Capital
gains
A REIT that has a net capital gain for a taxable
year generally is subject to tax on such capital
gain under the capital gains tax regime generally
applicable to corporations (sec. 857(b)(3)).
However, a REIT may diminish or eliminate its tax
liability attributable to such capital gain by
paying a "capital gain dividend" to its
shareholders (sec. 857(b)(3)(C)). A capital gain
dividend is any dividend or part of a dividend that
is designated by the payor REIT as a capital gain
dividend in a written notice mailed to shareholders.
Shareholders who receive capital gain dividends
treat the amount of such dividends as long-term
capital gain regardless of their holding period of
the stock (sec. 857(b)(3)(C)).
A regulated investment company ("RIC"),
but not a REIT, may elect to retain and pay income
tax on net long-term capital gains it received
during the tax year. If a RIC makes this election,
the RIC shareholders must include in their income as
long-term capital gains their proportionate share of
these undistributed long-term capital gains as
designated by the RIC. The shareholder is deemed to
have paid the shareholder's share of the tax, which
can be credited or refunded to the shareholder.
Also, the basis of the shareholder's shares is
increased by the amount of the undistributed
long-term capital gains (less the amount of capital
gains tax paid by the RIC) included in the
shareholder's long-term capital gains.
Income
from foreclosure property
In addition to tax on its REITTI, a REIT is subject
to tax at the highest rate of tax paid by
corporations on its net income from foreclosure
property (sec. 857(b)(4)). Net income from
foreclosure property is the excess of the sum of
gains from foreclosure property that is held for
sale to customers in the ordinary course of a trade
or business and gross income from foreclosure
property (other than income that otherwise would
qualify under the 75-percent income test described
below) over all allowable deductions directly
connected with the production of such income.
Foreclosure property is any real property or
personal property incident to such real property
that is acquired by a REIT as a result of default or
imminent default on a lease of such property or
indebtedness secured by such property, provided that
(unless acquired as foreclosure property), such
property was not held by the REIT for sale to
customers (sec. 856(e)). A property generally may be
treated as foreclosure property for a period of two
years after the date the property is acquired by the
REIT. The IRS may grant extensions of the period for
treating the property as foreclosure property if the
REIT establishes that an extension of the grace
period is necessary for the orderly liquidation of
the REIT's interest in the property. The grace
period cannot be extended beyond six years from the
date the property is acquired by the REIT.
Property will cease to be treated as foreclosure
property if, after 90 days after the date of
acquisition, the REIT operates the foreclosure
property in a trade or business other than through
an independent contractor from whom the REIT does
not derive or receive any income (sec.
856(e)(4)(C)).
Income
or loss from prohibited transactions
In general, a REIT must derive its income from
passive sources and not engage in any active trade
or business. Accordingly, in addition to the tax on
its REITTI and on its net income from foreclosure
property, a 100 percent tax is imposed on the net
income of a REIT from "prohibited
transactions" (sec. 857(b)(6)). A prohibited
transaction is the sale or other disposition of
property described in section 1221(1) of the Code
(property held for sale in the ordinary course of a
trade or business) other than foreclosure property.
Thus, the 100 percent tax on prohibited transactions
helps to ensure that the REIT is a passive entity
and may not engage in ordinary retailing activities
such as sales to customers of condominium units or
subdivided lots in a development project. A safe
harbor is provided for certain sales that otherwise
might be considered prohibited transactions (sec.
857(b)(6)(C)). The safe harbor is limited to seven
or fewer sales a year or, alternatively, any number
of sales provided that the aggregate adjusted basis
of the property sold does not exceed 10 percent of
the aggregate basis of all the REIT's assets at the
beginning of the REIT's taxable year.
Requirements
for REIT status
A REIT must satisfy four tests on a year-by-year
basis: organizational structure, source of income,
nature of assets, and distribution of income. These
tests are intended to allow conduit treatment in
circumstances in which a corporate tax otherwise
would be imposed, only if there really is a pooling
of investment arrangement that is evidenced by its
organizational structure, if its investments are
basically in real estate assets, and if its income
is passive income from real estate investment, as
contrasted with income from the operation of
business involving real estate. In addition,
substantially all of the entity's income must be
passed through to its shareholders on a current
basis.
Organizational structure requirements
To qualify as a REIT, an entity must be for its
entire taxable year a corporation or an
unincorporated trust or association that would be
taxable as a domestic corporation but for the REIT
provisions, and must be managed by one or more
trustees (sec. 856(a)). The beneficial ownership of
the entity must be evidenced by transferable shares
or certificates of ownership. Except for the first
taxable year for which an entity elects to be a REIT,
the beneficial ownership of the entity must be held
by 100 or more persons, and the entity may not be so
closely held by individuals that it would be treated
as a personal holding company if all its adjusted
gross income constituted personal holding company
income. A REIT is disqualified for any year in which
it does not comply with regulations to ascertain the
actual ownership of the REIT's outstanding shares.
Income
requirements
Overview
In order for an entity to qualify as a REIT, at
least 95 percent of its gross income generally must
be derived from certain passive sources (the
"95-percent test"). In addition, at least
75 percent of its income generally must be from
certain real estate sources (the "75-percent
test"), including rents from real property.
In addition, less than 30 percent of the entity's
gross income may be derived from gain from the sale
or other disposition of stock or securities held for
less than one year, real property held less than
four years (other than foreclosure property, or
property subject to an involuntary conversion within
the meaning of sec. 1033), and property that is sold
or disposed of in a prohibited transaction (sec.
856(c)(4)).
Definition
of rents
For purposes of the income requirements, rents from
real property generally include rents from interests
in real property, charges for services customarily
rendered or furnished in connection with the rental
of real property, whether or not such charges are
separately stated, and rent attributable to personal
property that is leased under or in connection with
a lease of real property, but only if the rent
attributable to such personal property does not
exceed 15 percent of the total rent for the year
under the lease (sec. 856(d)(1)).
Services provided to tenants are regarded as
customary if, in the geographic market within which
the building is located, tenants in buildings that
are of a similar class (for example, luxury
apartment buildings) are customarily provided with
the service. The furnishing of water, heat, light,
and air conditioning, the cleaning of windows,
public entrances, exits, and lobbies, the
performance of general maintenance, and of
janitorial and cleaning services, the collection of
trash, the furnishing of elevator services,
telephone answering services, incidental storage
space, laundry equipment, watchman or guard service,
parking facilities and swimming pool facilities are
examples of services that are customarily furnished
to tenants of a particular class of buildings in
many geographical marketing areas (Treas. Reg. sec.
1.856-4(b)).
In addition, amounts are not treated as qualifying
rent if received from certain parties in which the
REIT has an ownership interest of 10 percent or more
(sec. 856(d)(2)(B)). For purposes of determining the
REIT's ownership interest in a tenant, the
attribution rules of section 318 apply, except that
10 percent is substituted for 50 percent where it
appears in subparagraph (C) of section 318(a)(2) and
318(a)(3) (sec. 856(d)(5)).
Finally, where a REIT furnishes or renders services
to the tenants of rented property, amounts received
or accrued with respect to such property generally
are not treated as qualifying rents unless the
services are furnished through an independent
contractor (sec. 856(d)(2)(C)). A REIT may furnish
or render a service directly, however, if the
service would not generate unrelated business
taxable income under section 512(b)(3) if provided
by an organization described in section 511(a)(2).
In general, an independent contractor is a person
who does not own more than a 35 percent interest in
the REIT, and in which no more than a 35 percent
interest is held by persons with a 35 percent or
greater interest in the REIT (sec. 856(d)(3)).
Hedging
instruments
Interest rate swaps or cap agreements that protect a
REIT from interest rate fluctuations on variable
rate debt incurred to acquire or carry real property
are treated as securities under the 30-percent test
and payments under these agreements are treated as
qualifying under the 95-percent test (sec.
856(c)(6)(G)).
Treatment
of shared appreciation mortgages
For purposes of the income requirements for
qualification as a REIT, and for purposes of the
prohibited transaction provisions, any income
derived from a "shared appreciation
provision" is treated as gain recognized on the
sale of the "secured property." For these
purposes, a shared appreciation provision is any
provision that is in connection with an obligation
that is held by the REIT and secured by an interest
in real property, which provision entitles the REIT
to receive a specified portion of any gain realized
on the sale or exchange of such real property (or of
any gain that would be realized if the property were
sold on a specified date). Secured property for
these purposes means the real property that secures
the obligation that has the shared appreciation
provision.
In addition, for purposes of the income requirements
for qualification as a REIT, and for purposes of the
prohibited transactions provisions, the REIT is
treated as holding the secured property for the
period during which it held the shared appreciation
provision (or, if shorter, the period during which
the secured property was held by the person holding
such property), and the secured property is treated
as property described in section 1221(1) if it is
such property in the hands of the obligor on the
obligation to which the shared appreciation
provision relates (or if it would be such property
if held by the REIT). For purposes of the prohibited
transaction safe harbor, the REIT is treated as
having sold the secured property at the time that it
recognizes income on account of the shared
appreciation provision, and any expenditures made by
the holder of the secured property are treated as
made by the REIT.
Asset
requirements
To satisfy the asset requirements to qualify for
treatment as a REIT, at the close of each quarter of
its taxable year, an entity must have at least 75
percent of the value of its assets invested in real
estate assets, cash and cash items, and government
securities (sec. 856(c)(5)(A)). Moreover, not more
than 25 percent of the value of the entity's assets
can be invested in securities of any one issuer
(other than government securities and other
securities described in the preceding sentence).
Further, these securities may not comprise more than
five percent of the entity's assets or more than 10
percent of the outstanding voting securities of such
issuer (sec. 856(c)(5)(B)). The term real estate
assets is defined to mean real property (including
interests in real property and mortgages on real
property) and interests in REITs (sec.
856(c)(6)(B)).
REIT
subsidiaries
Under present law, all the assets, liabilities, and
items of income, deduction, and credit of a
"qualified REIT subsidiary" are treated as
the assets, liabilities, and respective items of the
REIT that owns the stock of the qualified REIT
subsidiary. A subsidiary of a REIT is a qualified
REIT subsidiary if and only if 100 percent of the
subsidiary's stock is owned by the REIT at all times
that the subsidiary is in existence. If at any time
the REIT ceases to own 100 percent of the stock of
the subsidiary, or if the REIT ceases to qualify for
(or revokes an election of) REIT status, such
subsidiary is treated as a new corporation that
acquired all of its assets in exchange for its stock
(and assumption of liabilities) immediately before
the time that the REIT ceased to own 100 percent of
the subsidiary's stock, or ceased to be a REIT as
the case may be.
Distribution
requirements
To satisfy the distribution requirement, a REIT must
distribute as dividends to its shareholders during
the taxable year an amount equal to or exceeding (i)
the sum of 95 percent of its REITTI other than net
capital gain income and 95 percent of the excess of
its net income from foreclosure property over the
tax imposed on that income minus (ii) certain excess
noncash income (described below).
Excess noncash items include (a) the excess of the
amounts that the REIT is required to include in
income under section 467 with respect to certain
rental agreements involving deferred rents, over the
amounts that the REIT otherwise would recognize
under its regular method of accounting, (2) in the
case of a REIT using the cash method of accounting,
the excess of the amount of original issue discount
and coupon interest that the REIT is required to
take into account with respect to a loan to which
section 1274 applies, over the amount of money and
fair market value of other property received with
respect to the loan, and (3) income arising from the
disposition of a real estate asset in certain
transactions that failed to qualify as like-kind
exchanges under section 1031.
Reasons
for Change
The REIT serves as a means whereby numerous small
investors can have a practical opportunity to invest
in a diversified portfolio of real estate assets and
have the benefit of professional management. The
committee believes that the asset requirements of
present law ensure that a REIT acts as a
pass-through entity for taxpayers wishing to invest
in real estate. Therefore, the committee finds the
30-percent gross income test unnecessary and
administratively burdensome. The committee further
finds that financial markets have changed over the
past decade such that interest risk can be managed
by many strategies other than swaps and caps.
Recognizing these developments in the financial
markets, the committee believes it necessary to
modify the classification of income from certain
hedging instruments to provide flexibility to REITs
in managing risk for their shareholders. The
committee also believes that, as a pass-through
entity, REITs should be permitted to retain the
proceeds of realized capital gains in a manner
comparable to that accorded to RICs.
Explanation
of Provisions
Overview
The bill modifies many of the provisions relating to
the requirements for qualification as, and the
taxation of, a REIT. In particular, the
modifications relate to the general requirements for
qualification as a REIT, the taxation of a REIT, the
income requirements for qualification as a REIT, and
certain other provisions.
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