On January 25, 2022, the Department of the Treasury and the Internal Revenue Service (collectively “Treasury”) published in the Federal Register final regulations (T.D. 9960) which generally treat a domestic partnership2 as an aggregate of its partners for purposes of determining whether, and to what extent, its partners have Subpart F inclusions (the “Final Subpart F Regs”).3 Application of the Final Subpart F Regs can impact a domestic partnership’s Schedules K-1, K-2 and K-3 reporting.
Historical Treatment of Partnerships
For tax purposes, two distinct approaches can apply to partnerships and their partners. Under the “aggregate approach,” the partners of a partnership, and not the partnership are treated as owning the partnership’s assets and conducting the partnership’s operations. Under the “entity approach,” a partnership is respected as separate and distinct from its partners, and therefore the partnership, and not the partners, is treated as owning the partnership’s assets and conducting the partnership’s operations. Whether an aggregate approach or entity approach should be applied to a particular Code section depends on which approach is more appropriate to such section.4
The international tax provisions of the Code also apply the aggregate approach with respect to certain Code provisions5 and the entity approach with respect to other Code provisions. Prior to the changes made as part of the Tax Cuts and Jobs Act, Pub. L. 115-97 (the “TCJA”), the Subpart F provisions generally applied the entity approach to domestic partnerships. A domestic partnership is generally treated as an entity for purposes of determining whether U.S. shareholders (as defined in IRC §951(b)) own more than 50% of the stock (by voting power or value) of a foreign corporation and therefore, whether a foreign corporation is a controlled foreign corporation (“CFC,” as defined in IRC §957). In addition, a domestic partnership was historically treated as an entity for purposes of treating a domestic partnership as the U.S. shareholder that has the Subpart F inclusion with respect to a CFC.6 If a domestic partnership was treated as the U.S. shareholder with respect to the Subpart F inclusion from a CFC, then each partner of the partnership would be allocated their distributive share of the partnership’s Subpart F inclusion, even if certain U.S. partners were not U.S. shareholders in such CFC.
As part of the TCJA, IRC §951A was enacted which requires a U.S. shareholder of a CFC to include in gross income such shareholder’s global intangible low-taxed income (“GILTI”) for such tax year. While similar to Subpart F income, one key difference is that a U.S. shareholder’s pro rata share of tested items of a CFC are not amounts directly included in the U.S. shareholder’s gross income, but rather are amounts taken into account by the U.S. shareholder in determining the U.S. shareholder’s GILTI inclusion. Thus, unlike Subpart F income, a U.S. shareholder computes a single GILTI inclusion by reference to all of its CFCs rather than computing a separate GILTI inclusion with respect to each CFC. Taking into account the mechanics of how U.S. shareholders calculate their GILTI inclusions under IRC §951A, Treasury issued final Section 951A regulations (T.D. 9866) that generally apply an aggregate approach to domestic partnerships and their partners for purposes of determining a U.S. shareholder’s GILTI inclusion.
Overview of the Final Subpart F Regs T
o be consistent with the approach taken for GILTI purposes, Treasury issued the Final Subpart F Regs which also apply the aggregate approach for purposes of determining a U.S. shareholder’s Subpart F inclusion. This aggregate treatment does not apply however, for purposes of determining whether a U.S. person is a U.S. shareholder, whether a U.S. shareholder is a controlling domestic shareholder (as defined in §1.964-1(c)(5)),7 and whether a foreign corporation is a CFC. This aggregate treatment also does not apply for any other purpose of the Code, including for purposes of applying IRC §1248.
Under the Final Subpart F Regs, a domestic partnership and its partners that are not U.S. shareholders in the domestic partnership’s CFC (“small U.S. partners”) do not have a Subpart F inclusion. Rather the U.S. shareholder-partners (i.e., the partners that directly, indirectly and constructively own 10% or more of the voting power or value of the domestic partnership’s CFC stock) include their pro rata share of Subpart F income as if the domestic partnership were a foreign partnership. The Final Subpart F Regs generally apply to tax years of foreign corporations beginning on or after January 25, 2022, and to tax years of U.S. persons in which or with which such tax years of foreign corporations end.8
PFIC Proposed Regulations
Also on January 25, 2022, Treasury published in the Federal Register proposed regulations [REG-118250-20] regarding the treatment of domestic partnerships that own stock of passive foreign investment companies (“PFICs”) and their domestic partners (the “Proposed PFIC Regs”). Among the many proposed changes included, the Proposed PFIC Regs include rules that essentially apply the aggregate approach for certain purposes of the Qualified Electing Fund (“QEF”)9 and Mark-to-Market10rules.
The “CFC overlap rule” in IRC §1297(d) generally provides that the PFIC regime does not apply to a U.S. person that is subject to the Subpart F rules with respect to such foreign corporation (a “CFC/PFIC”).
Treasury notes in the preamble to the Proposed PFIC Regs that a small U.S. partner of a foreign corporation that would otherwise be a PFIC with respect to that person if held directly should not be permitted to rely on the CFC overlap rule to avoid the PFIC regime simply because the U.S. person owns its interest in the foreign corporation indirectly through a domestic partnership.11 While many tax commentators have argued that small U.S. tax partners should get the benefit of the CFC overlap rule,12 under Treasury’s interpretation of existing regulations, a domestic partnership is not a shareholder to which the CFC overlap rule applies. The Proposed PFIC Regs state, consistent with Treasury’s interpretation of existing regulations, that for purposes of §1297(d), the term “qualified portion” does not include any portion of a domestic partner’s holding period during which the partner was not a U.S. shareholder with respect to the CFC/PFIC.13
The Proposed PFIC Regs are generally proposed to apply to tax years beginning on or after the date of publication of the Treasury decision adopting them as final regulations in the Federal Register.
The Proposed PFIC Regs also include a transition rule for a small U.S. partner that will permit it to apply the CFC overlap rule during periods when the small U.S. partner included its distributive share of the partnership’s Subpart F or14 GILTI inclusions. This transition rule generally applies to a shareholder’s tax years beginning before the finalization of the Proposed PFIC Regs.15
Tax Compliance Issues
If small U.S. partners cannot benefit from the CFC overlap rule, various compliance issues can arise with respect to a domestic partnership that (1) applies the Final Subpart F Regs, (2) owns stock in a CFC/PFIC and (3) has both U.S. shareholder-partners and small U.S. partners. As the Proposed PFIC Regs are largely not yet applicable, existing PFIC regulations that generally apply the entity approach to certain PFIC rules could still apply to a domestic partnership even though the partnership applies the aggregate approach for Subpart F/GILTI inclusion purposes.
For example, the domestic partnership rather than the small U.S. partners, is the U.S. person that makes a QEF election under existing rules.16 If a domestic partnership with U.S. shareholder partners and small U.S. partners applies the Final Subpart F Regs for its investment in a CFC/PFIC, should the domestic partnership make the QEF election on behalf of its small U.S. partners, or can a small U.S. partner individually make a valid QEF election?17 Unlike the Proposed PFIC Regs, which are largely not applicable yet, the current PFIC rules do not provide rules for a partner in a domestic partnership to make a QEF election in such situation. Perhaps the IRS would be willing to accept the QEF election by a domestic partnership in order to ward off substantial compliance burden where such domestic partnership owns an interest in a CFC/ PFIC. 18
The instructions to the Form 8621 (Rev. January 2022) provide that a QEF election made by a domestic partnership is made in the pass-through entity's capacity as a shareholder of a PFIC. The entity will include the QEF earnings as income for the year in which the PFIC's tax year ends. The interest holder in the pass-through entity takes the income into account under the rules applicable to inclusions of income from the pass-through entity. In the context of a domestic partnership that applies the Final Subpart F Regs to a CFC/PFIC and makes the QEF election per the existing rules, it is unclear to the authors how the partnership would appropriately report QEF earnings on the Forms K-1, K-2 and K-3 and how the partnership and/or U.S. shareholder-partners would make adjustments to apply the CFC overlap rule with respect to the U.S. shareholder-partners’ distributive share of partnership QEF earnings, if any.
Hopefully, the IRS will provide clear guidance with respect to partnership reporting in situations where a domestic partnership owns an interest in a CFC/PFIC. Without such guidance, it is unclear how taxpayers should report such information on the relevant forms besides putting forth a good faith effort in trying to comply with these complicated rules.
1 The views in this article are those of the authors’ and not necessarily those of Citrin Cooperman Advisors LLC. This article is not intended to serve, and should not be construed as, tax advice. This article was completed on March 15, 2023.
2 For purposes of subparts A and F of part III, and part V, of subchapter N, an S corporation is treated as a partnership and the shareholders of such corporation are treated as partners of such partnership. IRC §1373(a).
3 The Final Subpart F Regs also modified the Final §951A Regulations by amending Reg. §1.951A-1(e) to remove paragraphs (e)(1) through (3) and include a general cross-reference to Reg. §1.958-1(d) in Reg. §1.951A-1(e) for the treatment of domestic partnerships for purposes of §951A. The Final Subpart F Regs also removed paragraph (h) of Reg §1.951-1(h).
4 See Casel v. Comm’r, 79 T.C. 424, 433 (1982) citing H. Rept. No. 2543, 83d Cong., 2d Sess. 59 (1954).
5 See, for example, Reg. §1.871-14(g)(3)(i) which provides that whether interest paid to a partnership and included in the distributive share of a partner that is a nonresident alien individual or foreign corporation is received by a 10 percent shareholder is determined by applying the rules of Reg. §1.871-14(g) only at the partner level and Reg. §1.367(a)-1T(c)(3)(i)(A) which provides that if a partnership (whether foreign or domestic) transfers property to a foreign corporation in an exchange described in IRC §367(a)(1), then a U.S. person that is a partner in the partnership is treated as having transferred a proportionate share of the property in an exchange described in IRC §367(a)(1).
6 However, see Notice 2009-7 which designated as a transaction of interest a “Subpart F income partnership blocker structure” and Reg. §1.951-1(h) before removal by the Final Subpart F Regs which applied the aggregate approach to domestic partnerships in Subpart F income partnership blocker structures.
7 However, see proposed §1.958-1(d)(1) which provides that domestic partnerships are not considered to own stock of a foreign corporation under §958(a) for purposes of §1.964-1(c) as well as any provision that specifically applies by reference to §1.964-1(c). As a result, domestic partnerships and S corporations (by virtue of §1373(a)) would be treated as aggregates of their partners and shareholders, respectively, for purposes of determining the controlling domestic shareholders of foreign corporations under the proposed regulations. Proposed §1.958-1(d)(1) is proposed to apply to tax years beginning on or after the date of publication of the Treasury decision adopting the rules as final regulations in the Federal Register.
8 For tax years of foreign corporations beginning after December 31, 2017, and before the Final Subpart F Regs are applicable, a domestic partnership may apply the Final Subpart F Regs, subject to certain consistency requirements.
9 See IRC §§ 1293 and 1295 and the regulations thereunder.
10 See IRC §1296 and the regulations thereunder.
11 Treasury also addressed certain favorable PLRs that held small U.S. partners of a domestic partnership owning CFC stock received the benefit of the CFC overlap rule stating that the favorable PLRs were issued before specific regulations were issued that provide that domestic partnerships are not PFIC shareholders for certain purposes.
12 See for example, Blanchard, “Whether Treating a Domestic Partnership as an Aggregate Causes Small U.S. Partners to Become Subject to the PFIC Regime,” 48 Tax Mgmt. Int’l J. 622 (Dec. 2019).
13 Proposed §1.1291-1(c)(5)(i).
14 While the proposed regulation uses the term “and,” Treasury uses the term “or” in the preamble to the Proposed PFIC Regs which seems to be consistent with underlying purpose of the transition rule.
15 Proposed §1.1291-1(c)(5)(ii).
16 See Reg. §1.1295-1(d).
17 This assumes that the small U.S. partner would not be able to rely on the CFC overlap rule consistent with Treasury’s interpretation of the existing regulations as confirmed in the Proposed PFIC Regs.
18 In PLR 200327026, the IRS held that a domestic partner in a foreign partnership substantially complied with the requirements of IRC §§ 1293 and 1295 even though the wrong entity (i.e., the foreign partnership) filed the QEF elections and Forms 8621 with the foreign partnership’s U.S. partnership income tax return with respect to PFICs owned by the foreign partnership.
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