Tiered Partnerships and the Passive Loss Rules

Many investors do not own a business or a building directly. They own an interest in a fund or holding partnership, which in turn owns interests in several operating partnerships, which may own still other entities. Each Schedule K-1 in that chain reports income, losses, and footnotes, and the investor's return has to fit all of it together. The passive activity rules are where these structures most often go wrong, because the key determinations are made at different levels of the chain.

This briefing walks through the questions to ask when a client holds interests through tiered partnerships: how activities are grouped, who must materially participate, how interest paid between related entities is treated, and two reporting areas that often surprise people, PFICs and Section 704(c).

Grouping Starts at the Entity Level

Section 469 applies activity by activity, so the first question is always what counts as an "activity." Treas. Reg. §1.469-4 lets taxpayers group trade or business and rental operations that form an appropriate economic unit, based on facts such as common control, common ownership, geographic location, and interdependence.

In a tiered structure, the order matters. Under Treas. Reg. §1.469-4(d)(5)(i), each partnership (and each S corporation) groups its own activities first. The partner may then group those activities with each other, with activities the partner conducts directly, and with activities conducted through other entities. What the partner may not do is split apart activities that an entity has already grouped together.

Several practical points follow:

• Read the K-1 footnotes for each tier. They should identify each activity separately. If an upper-tier K-1 lumps lower-tier activities together, ask whether that reflects an actual grouping decision or just convenience.
• Rental and business activities have extra limits. Under Treas. Reg. §1.469-4(d)(1), a rental activity may be grouped with a trade or business only if one is insubstantial relative to the other or each owner of the business has the same proportionate interest in the rental.
• Groupings are sticky and must be disclosed. Once made, a grouping generally must be kept in later years unless it was clearly inappropriate or a material change makes it so (Treas. Reg. §1.469-4(e)). Rev. Proc. 2010-13 requires a written statement with the return for new groupings, additions, and regroupings.
• Grouping affects dispositions. Suspended losses are released under Section 469(g) when you dispose of your entire interest in an activity. A broad grouping can mean that selling one lower-tier interest does not free its losses.

Material Participation Is Tested Partner by Partner

The partnership does not decide whether you materially participate. That determination is made for each individual partner, for each activity, for each year, under the seven tests in Temp. Treas. Reg. §1.469-5T(a), such as 500 hours of participation, or more than 100 hours and not less than anyone else. Under Temp. Treas. Reg. §1.469-2T(e)(1), the character of income and loss passed through to you depends on your participation in the activity during the entity's taxable year.

For tiered structures, that has some consequences:

• Work counts wherever the activity sits. Hours you spend working in an activity conducted by a lower-tier partnership count toward that activity, even though you own it through another entity. Keep contemporaneous records by activity, not by entity.
• Grouping can help or hurt. Grouping several activities lets your hours count toward the combined activity, which can make the 500-hour test easier to meet. It can also tie a profitable activity to a loss activity in ways that are hard to undo.
• Spouses count together. Under Section 469(h)(5), a spouse's participation is counted in determining material participation, whether or not you file jointly.
• Limited partners face fewer tests. Under Section 469(h)(2) and Temp. Treas. Reg. §1.469-5T(e), a limited partner generally can qualify only under the 500-hour test, the five-of-ten-years test, or the three-year test for professional service activities such as health, law, and accounting. Whether an LLC member is treated as a limited partner for this purpose depends on the facts, and courts have often declined to treat LLC members that way automatically.
• Rentals are generally passive. Rental activities are passive regardless of participation under Section 469(c)(2) and (4), unless you qualify as a real estate professional under Section 469(c)(7) or an exception in Temp. Treas. Reg. §1.469-1T(e)(3) applies.

Self-Charged Interest Between Tiers

Tiered structures often move money between related entities and their owners. Picture an upper-tier partnership that lends cash to a lower-tier partnership running a passive rental. The lower-tier partnership's interest expense flows to the investors as a passive deduction, while the matching interest income flows up as portfolio income. Without a special rule, the same investors would have passive losses they cannot use and portfolio income they must pay tax on, all from paying interest to themselves.

Treas. Reg. §1.469-7, issued under the authority in Section 469(l), addresses this. For lending between a taxpayer and a passthrough entity in which the taxpayer owns a direct or indirect interest, and for loans between identically owned passthrough entities, a portion of the interest income is recharacterized as passive activity gross income to match the passive interest deduction. The regulation's examples include a loan from an upper-tier partnership to a lower-tier partnership, so the rule reaches indirect ownership through tiers. It applies only to interest income and expense recognized in the same taxable year, and a passthrough entity can elect out under Treas. Reg. §1.469-7(g) by attaching a statement to its return.

On the investor's return, this usually shows up as a K-1 footnote identifying self-charged interest. If the footnote is missing and you know related-party loans exist, ask for the information before filing.

PFICs Held Through Partnerships

Investment and fund partnerships sometimes hold shares of foreign mutual funds or other passive foreign investment companies (PFICs). Under Section 1298(a)(3), PFIC stock owned by a partnership is treated as owned proportionately by its partners, so a U.S. partner can be an indirect PFIC shareholder several tiers removed.

The Form 8621 filing rules in Treas. Reg. §1.1298-1 depend on who sits in the chain:

• Through a domestic partnership. The domestic partnership, as the first U.S. person in the chain, generally files Form 8621. A U.S. partner must also file if the partner is treated as receiving an excess distribution, recognizes gain on a disposition treated as an excess distribution, or has a QEF or mark-to-market inclusion. There is an exception for QEF and mark-to-market inclusions when the partnership itself timely files.
• Through a foreign partnership. The U.S. partner is the first U.S. person in the chain and generally must file Form 8621, subject to the regulation's exceptions, such as the $25,000 aggregate value threshold when no excess distribution or QEF election is involved.
• The QEF election is made at the right level. Under Treas. Reg. §1.1295-1(d)(2), a domestic partnership makes the qualified electing fund election for PFIC stock it holds. When the partnership is foreign, each U.S. partner makes its own election.

The stakes are real. Under Section 6501(c)(8), failing to file a required Form 8621 can keep the statute of limitations open for the return.

Section 704(c) Through the Tiers

When property with a built-in gain or loss is contributed to a partnership, Section 704(c) requires that the built-in amount be allocated back to the contributing partner. Tiered structures complicate this. Treas. Reg. §1.704-3(a)(9) provides that if a partnership contributes Section 704(c) property to a lower-tier partnership, or a partner contributes an interest in a partnership holding such property to an upper-tier partnership, the upper-tier partnership must allocate its share of the lower-tier items from that property in a way that takes into account the contributing partner's remaining built-in gain or loss.

Revaluations add another layer. When a partnership revalues its assets, for example when a new investor is admitted, the resulting "reverse" Section 704(c) amounts must be tracked as well. For investors, the practical effect is that allocations of depreciation and gain can differ from ownership percentages for reasons that trace back several tiers. When a K-1 shows allocations that do not match the economic deal, Section 704(c) is often the explanation.

A Note on Basis Adjustments in Tiered Structures

When an interest in an upper-tier partnership is sold, a Section 743(b) basis adjustment reaches the lower-tier partnership's assets only if the lower-tier partnership also has a Section 754 election in effect, as described in Rev. Rul. 87-115. Buyers of interests in tiered structures should confirm the election status at every level.

Key Takeaways

• Each partnership groups its activities first under Treas. Reg. §1.469-4(d)(5); a partner can combine those groupings further but cannot split them.
• Material participation is tested for each individual, for each activity, for each year, wherever in the chain the activity is conducted.
• Treas. Reg. §1.469-7 can recharacterize interest on loans between related entities and their owners, including through tiers, so passive interest expense is matched by passive interest income.
• Form 8621 obligations for PFICs held through partnerships depend on whether the partnership is domestic or foreign and on what inclusions the partner has.
• Section 704(c) and reverse Section 704(c) allocations must be followed through every tier under Treas. Reg. §1.704-3(a)(9).

If you hold investments through layered partnerships and want confidence that your passive activity and reporting positions hold together, schedule a consultation with SMB CPA Group. You can also contact us, learn about our custom scope of work for partnership and investment structures, or review our pricing.

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