Vernoia, Enterline + Brewer, CPA LLC

When partner interests change

Final partnership rules add flexibility when partner interests change during the year

partnersThe IRS has issued major new regulations to control how partnership items must be allocated among partners whose interests in the partnership change during the partnership’s tax year. Among its changes, the final rules set forth an expanded scope of the so-called varying interest rule, which requires that partners’ distributive shares of partnership tax items for a tax year take into account the varying interests of the partners in the partnership during the tax year.

These final regulations make significant modifications that allow partnerships greater flexibility when a partner’s interest changes during the tax year. Prior rules required partnerships to use either the interim closing method or the proration method throughout the year. Partnerships can now switch between the two when a partner’s interest changes.

Methods and Conventions

Partnerships that apply the varying interests rule may use one of two methods: the interim-closing-of-the-books method and the proration method. For each partnership tax year in which a partner’s interest varies, earlier proposed regulations provided that the partnership must use the same method to take into account all changes occurring within that year. In response to comments, however, the final regulations allow partnership to use both methods and alternate between the two.

The final regulations introduce the concept of “segments” and “proration periods” into which partnerships must divide their tax year if the varying interests rule applies to them. Under the interim-closing method, the partnership divides the partnership year into segments—based on the dates partners dispose of or acquire interests in the partnership ( “variations”), and allocates items realized during those segments among the partners based on their partnership interests during that segment. A partnership that uses the proration method divides the tax year into “proration periods” and pro rates tax items based on those periods.

Extraordinary Items

The final regulations also provide a list of “extraordinary items.” An extraordinary item of a partnership is one that must be allocated based on the partners’ interests in the partnership when the extraordinary item arises, without regard to which method or convention the partnership uses. The proposed regulations had nine. The final regulations add two more. First, a partnership may treat items as extraordinary items for a tax year if, for that tax year, there is an agreement of the partners to consistently treat such items as extraordinary items. Second, the IRS may designate additional items as extraordinary in published guidance.

Small item Exception

The final regulations also add a small item exception where the total of all items in a particular class of extraordinary items is less than five percent of a partnership’s gross income (as computed with certain modifications) or gross expenses and losses. For the exception to apply, the aggregate amount of the partnership’s qualifying small items must be less than or equal to $10 million.

Comment. New proposed regulations, issued in tandem with the final rules in determining a partner’s distributive share, would add two additional “extraordinary items,” as well as broadening what may constitute an allocable cash-basis item and requiring a look-through rule for tiered partnerships.

T.D. 9728


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