On June 17, 2025, Senator Ron Wyden introduced two extensive partnership tax reform bills in the Senate (collectively, the “Bills,” and available here and here). The Bills expanded upon and incorporated many of Wyden’s 2021 partnership tax proposals, which we previously discussed here. The Bills also omitted various provisions from Wyden’s 2021 proposals. Notably, unlike Wyden’s 2021 proposals, the Bills would not (i) require all partnerships to allocate tax items according to each “partner’s interest in the partnership,” (ii) revise the Section 163(j) business interest limitations for partnerships, or (iii) tax all master limited partnerships and publicly traded partnerships as corporations.
Separately, after Wyden introduced the Bills, the FY2025 budget bill enacted an identical provision to one of the Bills’ proposals, which clarified that certain rules applicable to disguised payments for services and disguised sales of property between a partner and a partnership under Section 707(a)(2) are self-executing in the absence of regulations, as discussed here and here.
The Bills would make the following key changes to the existing partnership tax rules:
- Requiring mandatory “inside basis” adjustments on transfers of partnership interests. Changes to a partnership's ownership may cause a partnership's basis in its assets (the “inside basis”) to differ from a partner’s basis in its partnership interest (the “outside basis”). For example, A and B each contribute $50 to a partnership in exchange for a 50% interest, and the partnership purchases $100 of non-depreciable property. When the property is worth $200, A sells its partnership interest to C for $100. C’s outside basis is $100, but C's share of the inside basis ($50) would not increase unless the partnership has a Section 754 election in place. If the partnership then sells the asset for $200, it would allocate $50 of gain to C, even though C effectively paid for that appreciation (and A recognized $50 of income on the sale to C). The Bills would mandate inside basis adjustments for all transfers of partnership interests, which are currently required only if either a Section 754 election is in place or the partnership would have a “substantial built-in loss” immediately after the transfer.
- Requiring mandatory “inside basis” adjustments for certain partnership distributions. Partnerships can generally distribute property (other than cash and marketable securities) to partners without the partners or the partnership recognizing gain. A partner’s basis in distributed property generally equals the partnership’s inside basis in the property. Under certain scenarios, the partner’s basis in the distributed property may differ from the partnership's inside basis in the property. For example, if a partnership distributes property with an inside basis and fair market value of $40 to a partner whose outside basis is $30, the partner would instead take a $30 basis in the property (i.e., the asset’s remaining $10 basis would effectively disappear). An opposite rule "steps up" a partner's basis in property for liquidating distributions if the partner’s outside basis is greater than the partnership’s inside basis in the distributed property. Under current law, however, if either a Section 754 election is in place or the distribution results in a “substantial basis reduction,” then the partnership must resolve the basis discrepancy created by the distribution by either increasing or decreasing the basis of its remaining property (the “Section 734(b) Adjustment”). The Bills would mandate the Section 734(b) Adjustment for all partnerships.
- Limiting basis step-ups for certain transfers of partnership interests. If a partnership has a Section 754 election in place, then a transferee partner can generally increase its proportionate share of the partnership’s inside basis by up to its day-1 outside basis. The Bills would limit basis step-ups for non-recognition transfers of partnership interests, provided that the partnership has more than one related partner.
- Requiring recognition for certain related-party basis shifting transactions. As discussed in Wyden’s section-by-section summary (the “Summary”) of the Bills, some partnerships may intentionally plan around the Section 734(b) Adjustment to obtain tax benefits therefrom (e.g., increasing potential depreciation deductions and reducing potential gain). For partnerships with more than one related partner (“applicable partnerships”), the Bills would effectively require the distributee partner or non-distributee partners to recognize income equal to Section 734(b) Adjustments. For example, if an applicable partnership distributes property with an inside basis and fair market value of $40 to a partner whose outside basis is $30, the partner would recognize $10 of gain at the time of the distribution and have a $40 basis in the property (i.e., its $30 outside basis plus its $10 gain). The partnership would also increase the basis of its remaining property by $10.
- Requiring “remedial” allocations of built-in gain and lossunder Section 704(c) of the Code. To avoid taxable gain or loss shifting among partners, the built-in gain or loss inherent in assets contributed to a partnership generally must be charged back to the contributing partner. Regulations currently allow the charge-back to occur over time using a “reasonable method,” and explicitly permit reasonable methods that could significantly defer or even avoid a full charge-back. The Bills would require using the remedial method, which would generally accelerate charge-backs.
- Requiring “book-ups” in connection with acquisitions of partnership interests. Regulations currently permit, but do not require, partnerships to revalue their assets when new partners join. The Bills would require a revaluation when new partners join to ensure that the partnership charges any built-in gain or loss inherent in the partnership's assets at that time back to the legacy partners (using the remedial method as described above). Certain small partnerships with less than $25 million in average gross receipts during the last three years would not be subject to mandatory book-ups.
- Requiring partnerships that are at least 50% owned by related parties to allocate tax items pro rata based on relative capital contributions. The Bills generally would treat a disproportionately large distribution relative to contributed capital as a taxable receipt of a partnership interest from the other partners.
- Requiring partnerships to allocate debt among the partners based on how profits are shared. The current rules are more flexible. Because a reduction in a partner's share of partnership liabilities is treated as a distribution to that partner, and partners are generally taxed on distributions in excess of their basis in the partnership, this proposal could require partners to recognize taxable gain upon its enactment. A transition rule would allow partners to elect to pay any resulting tax liability over six years.
- Expanding the mixing bowl rules. The mixing bowl rules currently require a partner who contributes built-in gain property to a partnership to recognize the gain if the partnership distributes that property to another partner or distributes different property to the contributing partner within seven years. The Bills would eliminate the seven-year testing period, so that the mixing bowl rules apply regardless of when the distribution occurs.
- Expanding the net investment income tax. Under current law, and as discussed further here, some limited partners have argued that their distributive shares of income were not subject to either self-employment tax or the net investment income tax (“NIIT”). The Bills would expand the net investment income tax base for certain high-earners to include active income that is not already subject to employment tax, thereby effectively eliminating a taxpayer’s ability to claim that its income is not subject to NIIT.
- Expanding income recognition for contributions of appreciated securities to swap funds. Generally, gain or loss is not recognized upon the contribution of appreciated property to a partnership. However, gain is recognized upon a partnership contribution if the partnership's assets consist of more than 80% "stocks or securities," and such contribution results in diversification. To prevent this rule from applying, swaps funds generally ensure that at least 20% of their assets are not "stocks and securities" (e.g., real estate limited partnership interests). The Bills would limit the ability of swap funds to structure their asset base to satisfy the 80% standard by expanding the definition of "stocks and securities" to include limited and preferred interests in entities. Moreover, the Bills would also require gain recognition upon the contribution of blocks of marketable securities with "significant appreciation" to a partnership, if the contributor can diversify its holdings as a result.
- Modifying the “hot asset” rules. The Bills would characterize as ordinary income all distributions of inventory items and not just "substantially appreciated" inventory items as per the current law.
- Clarifying when a partnership terminates. The Tax Cuts and Jobs Act generally eliminated the “technical termination rule,” which terminated a partnership for tax purposes if 50% or more of the partnership’s equity interests was transferred within 12 months. Under current law, a partnership terminates “only if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.” As noted in the Summary, it is uncertain whether the current termination rule incorporates a historic partner requirement. The Bills would incorporate a historic partner requirement and thereby clarify that a partnership does not terminate if a historic partner (or a related party) carries on any business of the partnership.
