Treasury has reversed course on minimum “floor” allocations in proposed revisions to the partnership tax regulations. Often, partnerships (and LLCs taxed as partnerships) allocate a percentage of their income to a particular partner, but provide a minimum allocation amount. Current IRS regulations bless these allocations by explicitly providing that the entire allocation is treated as the partner’s “distributive share” of partnership income if the “floor” is surpassed by the percentage amount. The current rules state that “guaranteed payment” treatment results only to the extent that the minimum “floor” is triggered. However, the IRS is proposing contrary treatment in newly proposed regulations that addressing private equity management fee waivers (a different but related issue).

Distributive Shares versus Guaranteed Payments

Some partners aren’t affected by the distinction between “distributive share” and “guaranteed payment” characterization, particularly where the partnership produces ordinary income (e.g., service partnerships). However, partners in capital asset partnerships (e.g., real estate holding LLCs) may benefit by receiving a “distributive share” of partnership income, where such partnership income constitutes lower-taxed long-term capital gains.

What Change is the IRS Proposing?

In proposed regulations, the IRS would characterize a “floor” allocation as a “guaranteed payment” to the extent of the minimum floor amount, regardless of the overall allocation. Presumably, amounts in excess of the floor would retain their “distributive share” characterization.

When is the Change Effective?

It is not clear when this regulatory change will be effective, because the proposed regulations specifically address effectiveness with respect to the other revisions targeting management fee waivers. Therefore, partnerships (and LLCs taxed as partnerships) may want to consider revising any existing “floor” allocations in their agreements. Furthermore, many organizations may have longstanding “floor” allocations that were important in the organization’s early stages and that have consistently been exceeded as a result of increases in the organization’s income. Absent a revision, affected partners could experience a partial change in the characterization of their allocations, and therefore, a potential increase in taxes.

Partnerships that have implemented “floor” allocations should speak with their tax advisors about the possible effect of these proposed regulations.