Exempt Organizations Advisory - IRS Proposes Regulations Regarding Fractions Rule

November 22, 2016

The IRS has issued proposed regulations regarding the application of the “fractions rule” to partnerships that hold debt-financed real property and have one or more tax-exempt qualified organization partners as well as other partners.  In general, the fractions rule limits the ability of such partnerships to allocate a disproportionate amount of income to the tax-exempt qualified organizations.  The proposed regulations would make certain changes to the implementation of the fractions rule that generally would permit partnership allocations that are consistent with specified common business practices and otherwise make it easier for taxpayers to comply with the fractions rule.

Section 514 provides that unrelated business taxable income (UBTI) includes a specified fraction of income derived from debt-financed property.  However, income derived from debt-financed real property by certain “qualified organizations,” including certain educational organizations and pension plans, may be excluded from UBTI.  This exclusion does not apply to qualified organizations that hold an interest in a partnership that holds debt-financed real property, unless the partnership can meet certain tests.  Under one such test, each partnership allocation to a qualified organization must satisfy the fractions rule.  In general, a partnership allocation satisfies the fractions rule if the allocation of items to any qualified organization partner does not result in that partner having a share of overall partnership income for any taxable year greater than that partner’s “fractions rule percentage” (which is the partner’s share of overall partnership loss for the taxable year for which the partner’s loss share is the smallest).

Existing regulations provide detailed rules for applying the fractions rule.  Treasury and the IRS have received comments requesting targeted changes to the existing regulations to allow certain allocations resulting from common business practices to comply with the rules.  The proposed rules implement certain of these changes, which are intended to allow allocations consistent with common arrangements involving preferred returns, partner-specific expenditures, unlikely losses, and chargebacks of partner-specific expenditures and unlikely losses.  The proposed regulations also simplify one of the examples involving tiered partnerships and provide rules regarding changes to partnership allocations as a result of capital commitment defaults and later acquisitions of partnership interests.  Additionally, the proposed regulations provide an exception for certain partnerships in which all partners other than qualified organizations own five percent or less of the capital or profits interests in the partnership.  Finally, the proposed regulations increase the threshold for de minimis allocations away from qualified organization partners.