Partners contributing capital to a partnership often require a preferred return on their investment.1 Those returns are analogous to dividends paid to holders of a corporation's preferred stock.2 Just as there are many ways to structure a preferred dividend (conditional versus unconditional, cumulative versus noncumulative, etc.), there are many ways to structure a preferred return. In any case, the structure adopted dictates the tax consequences. Preferred stock with debtlike features, for instance, may be classified as debt under section 385 or common law principles, with the result that payments from the issuer to the holder would be interest that is deductible by the former but ordinary income to the latter.

The code seemingly provides clear rules regarding the tax treatment of preferred returns. A preferred return that depends on partnership income is included in the partner's distributive share of that income under section 704(b) and is treated as a distribution under section 731.3 The recipient of such a return will therefore have capital gains to the extent the partnership's income is derived from the sale of capital assets or the receipt of qualified dividend income.

If a preferred return is determined without regard to partnership income, however, it is a guaranteed payment for the use of capital (GPUC) under section 707(c). Despite an apparently clear statutory rule, the line between preferred returns that are GPUCs and those that are not is notoriously blurry.4 There are few clear-cut cases. A preferred return that is computed as a percentage of capital invested and is required to be paid annually, for instance, is most likely a GPUC to the extent it is actually paid.5 Practitioners, however, emphasize "the significant uncertainty that currently exists in identifying payments that constitute" GPUCs.6

Whether a preferred return is a GPUC matters because guaranteed payments are treated as payments made by the partnership to a nonpartner, "but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses)."7 As a result, GPUCs are generally understood to be ordinary income to the payee under section 61 and deductible by the payer under section 162, subject to the capitalization requirement of section 263.8 The regulations under section 707(c) also provide that "for the purposes of other provisions of the internal revenue laws, guaranteed payments are regarded as a partner's distributive share of ordinary income."9 However, regulations recently proposed by Treasury and the IRS under section 163(j) (REG-106089-18) call this understanding into question.10

Section 163 generally allows taxpayers to deduct interest paid or accrued on indebtedness.11 The deduction is limited for business interest.12 That limit was amended by the Tax Cuts and Jobs Act. New section 163(j) generally limits the amount of business interest expense deductible by a taxpayer to the sum of its business interest income and 30 percent of its adjusted taxable income.13

Prop. reg. section 1.163(j)-1(b)(20)(iii)(I) provides that for purposes of section 163(j), "any guaranteed payments for the use of capital under section 707(c) are treated as interest." This regulation conflicts with the traditional understanding of GPUCs. First, it suggests that partnerships may no longer be able to deduct GPUCs in full under section 162.14 Second, it treats GPUCs as non-partner payments for the purposes of a code section other than section 61(a) or 162(a).15 Third, it suggests that partnership interests that entitle their holders to GPUCs are partnership debt on which interest may accrue. It is no surprise, then, that many members of the tax bar were caught off guard by the decision to propose such a regulation, and they believe Treasury and the IRS are reaching beyond the limits of their power.16

This report lays out the argument underlying that widely shared impression. In a nutshell, the proposed regulation, assuming it is finalized without modification, does not pass muster under Chevron17 and is arbitrary and capricious under section 706(2)(A) of the Administrative Procedure Act (APA).18 There is, moreover, no easy way to modify this regulation to ensure its validity under either Chevron or the APA. It should therefore be withdrawn.19

It may well be that from the point of view of sound tax policy, some partnership interests entitling their holders to GPUCs should be treated as partnership debt on which interest may accrue. This report, however, focuses on the narrow legal question that most immediately faces Treasury and the IRS: the validity of the proposed regulation.

The Chevron Challenge

In Mayo Foundation, 20 the Supreme Court held that the principles underlying Chevron "apply with full force in the tax context." However, not all agency regulations are subject to judicial review under Chevron. Under Mead, 21 an agency action is entitled to Chevron deference "when it appears that Congress delegated authority to the agency generally to make rules carrying the force of law, and that the agency interpretation claiming deference was promulgated in the exercise of this authority."22

Applying Mead to a tax regulation in Mayo Foundation, the Supreme Court found the fact that the regulation had been issued through the notice and comment process and under Congress's general grant of regulatory authority in section 7805(a) to be "a very good indicator of delegation meriting Chevron treatment" and a "significant sign that a rule merits Chevron deference."23

Treasury and the IRS are using the notice and comment process to issue the section 163(j) regulations and are doing so under their section 7805(a) authority.24 Indeed, they have no choice but to invoke section 7805(a) given that section 163(j) — unlike section 163(l), for instance — contains no specific grant of regulatory authority. Interestingly enough, section 163(j) used to contain several explicit grants of regulatory authority. For example, before the TCJA, section 163(j)(9)(A) granted Treasury and the IRS the authority to "prescribe such regulations as may be appropriate to carry out the purposes of this subsection, including . . . such regulations as may be appropriate to prevent the avoidance of the purposes of this subsection."25

The fact that Treasury and the IRS are using the notice and comment process and are acting under their section 7805(a) authority implies that the section 163(j) regulations are subject to review under Chevron. Although the Supreme Court sidestepped this issue in Mayo Foundation, the use of the notice and comment process and the invocation of section 7805(a) also make the section 163(j) regulations legislative regulations subject to the APA.26

Judicial review under Chevron is a two-step process.27 The first step requires a court to determine "whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress."28

As the Supreme Court has recently stated, the fact that parties to a dispute hold reasonable but conflicting interpretations of a statute is insufficient to establish that Congress's intent was unclear.29 "Rather, the court must make a conscientious effort to determine, based on indicia like text, structure, history, and purpose, whether the [statute] really has more than one reasonable meaning."30 And "if a court, employing traditional tools of statutory construction, ascertains that Congress had an intention on the precise question at issue, that intention is the law and must be given effect."31


1. See, e.g., Sheldon I. Banoff, "Guaranteed Payments for the Use of Capital: Schizophrenia in Subchapter K," 70 Taxes 820, 822 (1992); Eric B. Sloan and Matthew Sullivan, "Deceptive Simplicity: Continuing and Current Issues With Guaranteed Payments," 916 PLI/Tax 124-1 (2010); Lewis R. Steinberg, "Fun and Games With Guaranteed Payments," 57 Tax Law. 533, 562 (2004); and Andrew Kreisberg, "Guaranteed Payments for Capital: Interest or Distributive Share?" Tax Notes, July 4, 2011, p. 55.

2. See, e.g., Steinberg, supra note 1 ("In order to mimic the payoffs of corporate preferred stock, such partnership equity is typically entitled to a preferential return each year."). See also Banoff, supra note 1.

3. Kreisberg, supra note 1.

4. See, e.g., William S. McKee, William F. Nelson, and Robert L. Whitmire, Federal Taxation of Partnerships & Partners, para. 14.03[1][b] ("If a partner's right to receive amounts from his partnership is fixed and certain, or 'guaranteed' in some sense, it may be difficult to determine whether the amounts are section 707(c) guaranteed payments or section 731 distributions."); and Sloan and Sullivan, supra note 1.

5. 5 New York State Bar Association Tax Section, "Report on Guaranteed Payments and Preferred Returns," at 27 (Nov. 14, 2016).

6. NYSBA Tax Section, "Report on Proposed Section 199A Regulations," at 40-41 (Oct. 19, 2018).

7. Section 707(c).

8. See, e.g., Rev. Rul. 91-26, 1991-2 C.B. 184. As noted by the Supreme Court, revenue rulings "reflect the agency's longstanding interpretation of its own regulations." United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 220 (2001). See also Laura Cunningham and Noël Cunningham, The Logic of Subchapter K 172 (2017).

9. Reg. section 1.707-1(c). There is no consensus, however, about what it means for GPUCs to be "regarded" as a partner's distributive share of ordinary income.

10. Although the IRS is a Treasury bureau and the initial drafting of regulations has been delegated to the IRS by the Treasury assistant secretary for tax policy, I refer throughout to Treasury as the agency issuing regulations and to the IRS as the government entity responsible for administering every other aspect of the code. See Michael Saltzman and Leslie Book, IRS Practice and Procedure, para. 3.02[3].

11. Section 163(a).

12. Section 163(j).

13. Section 163(j)(1)(A) and (B). This limit is increased by the taxpayer's floor plan financing interest expense, i.e., interest on debt incurred by the taxpayer (typically, a car dealership) to finance the acquisition of motor vehicles held for sale or lease and to secure that debt. Section 163(j)(1)(C) and (9).

14. Interestingly, because the proposed regulation treats GPUCs as interest for purposes of section 163(j) — not for purposes of section 163 in general — it is unclear whether in Treasury's view GPUCs remain deductible under section 162. It would be odd (and arguably incoherent) for Treasury to conclude that GPUCs are deductible under section 162 but that the deduction is limited by section 163(j).

15. Prop. reg. section 1.163(j)-1(b)(20)(iii)(I) in effect treats GPUCs as payments from a partnership to one of its creditors, not one of its partners, for purposes of section 163(j).

16. See, e.g., American Bar Association Section of Taxation, "Comments on Proposed Regulations Under Section 163(j) Regarding Passthrough Entities and Their Owners," at 13 (Mar. 7, 2019).

17. Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc., 467 U.S. 837 (1984).

18. 5 U.S.C. section 706(2)(A).

19. Throughout the rest of this report, I assume that prop. reg. section 1.163(j)-1(b)(20)(iii)(I) will be issued in final form without modification. I thus generally refer to it as a regulation rather than a proposed regulation.

20. Mayo Foundation for Medical Education and Research v. United States, 562 U.S. 44, 55 (2011).

21. United States v. Mead Corp., 533 U.S. 218, 226-227 (2001).

22. This is the so-called step zero of a Chevron analysis. Thomas Merrill and Kristin Hickman, "Chevron's Domain," 89 Geo. L.J. 833, 873 (2001).

23. Mayo Foundation, 562 U.S. at 57 (quoting Mead, 533 U.S. at 229-231). Section 7805(a) generally authorizes Treasury and the IRS to "prescribe all needful rules and regulations for the enforcement" of the code.

24. Preamble to REG-106089-18, 83 F.R. 67490, 67533 (Dec. 28, 2018) (invoking section 7805 as the authority under which the proposed section 163(j) regulations are issued).

25. Section 163(j)(9) as of December 31, 2016. Current section 163(j)(9) defines floor plan financing interest. See supra note 13.

26. Altera Corp. v. Commissioner, 145 T.C. 91, 116-117 (2015). In finding a regulation issued under section 7805(a) legislative, the Tax Court rejected the view long held by the government (and many members of the tax bar) that such regulations, unlike regulations issued under a specific grant of regulatory authority, are always interpretive and therefore not subject to review under the APA. That view is incorrect. See, e.g., Hickman, "Coloring Outside the Lines: Examining Treasury's (Lack of) Compliance With Administrative Procedure Act Rulemaking Requirement," 82 Notre Dame L. Rev. 1727, 1759-1795 (2007).

27. I here apply what Hickman calls the "decision tree" model of Chevron. Hickman, "The Three Phases of Mead," 83 Fordham L. Rev. 527, 537 (2014). As Hickman also points out, "legitimate questions abound regarding Chevron's proper scope and operation." Hickman, "Chevron's Inevitability," 85 Geo. Wash. L. Rev. 1392, 1461 (2017). Some readers may therefore disagree with the way in which Chevron is applied in this report.

28. Chevron, 467 U.S. at 842-843.

29. Kisor v. Wilkie, 139 S. Ct. 2400, 2423 (2019).

30. Id. at 2423-2424.

31. Chevron, 467 U.S. at 843 n.9

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Originally Published by Tax Notes Federal

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