Many of the provisions in the Tax Cuts and Jobs Act (TCJA) will have significant impact on individual taxpayers as well as all types of tax entities, including partnerships and limited liability companies (LLCs). However, there are some provisions of the TCJA that will only impact partnerships and LLCs that are taxed as partnerships. This update is the next in a series that address those specific provisions in greater detail. See the previous updates about the new three-year holding period for certain carried interests and the repeal of the partnership technical termination rule and basis adjustments for charitable contributions and foreign taxes.
Taxation of Foreign Partner’s Disposal of Interest in Partnership
Before discussing the changes that the TCJA brought about in this area, it is first helpful to understand the applicable pre-TCJA rules. Under prior law, gain or loss from the sale of a partnership’s assets that was allocated to a non-U.S. partner would have been treated as effectively connected income (“ECI”) and subjected the non-U.S. partner to U.S. taxation and withholding to the extent those partnership assets had been used in the conduct of a U.S. trade or business. A non-U.S. partner, however, could generally avoid such U.S. taxation and withholding by selling its partnership interest. This was the case even if the underlying partnership’s assets were used in the conduct of a U.S. trade or business. There was a special exception to this general rule, which triggered taxation of the non-U.S. partner to the extent the partnership’s assets included U.S. real property interests.
In 1991, the IRS issued Revenue Ruling 91-32, which applied the special exception that applied to U.S. real property to all types of partnership assets that generated ECI. However, in 2017 the U.S. Tax Court rejected the IRS’s position, holding that such look-through gain for non-real estate assets was not ECI that would be subject to U.S. taxation.
The TCJA now codifies Revenue Ruling 91-32 and effectively reverses the Grecian Magnesite decision. Thus, a non-U.S. partner’s gain or loss on the disposition of a partnership interest is now treated as ECI that is subject to U.S. taxation to the extent the selling partner would have been allocated gain or loss classified as ECI had the partnership sold all its assets for their fair market value on the date of sale. This new provision is applicable to both the disposition of interests in publicly traded partnerships and the disposition of interests in privately held partnerships. This change is effective for dispositions of partnership interests on or after November 27, 2017.