On September 10, 2021, Senate Finance Committee Chair Ron Wyden, D-Ore., released draft legislation that would make sweeping changes to the current partnership tax rules. If enacted in its current form, the proposal would:

• Tax all master limited partnerships and other publicly traded partnerships as corporations by eliminating the 90% passive income exception. Under that exception, publicly traded partnerships 90% of whose income consists of interest, dividends, capital gains, and certain other passive income generally can avoid being subject to corporate tax.
• Tax mutual funds and ETFs on redemptions in kind. Unlike regular corporations, mutual funds and ETFs currently do not recognize taxable income when they distribute assets to fulfill redemption requests. Accordingly, to minimize their taxable income (which effectively is passed through to their shareholders under the “regulated investment company” tax rules), these entities frequently use appreciated assets to fulfill redemption requests. Wyden's proposal would end this tax benefit.
• Require most partnerships to allocate tax items based on each “partner’s interest in the partnership” (PIP), which is based on a facts-and-circumstances analysis of the partners' relative economic interests. Under current law, partnerships may use either the PIP standard or apply a “substantial economic effect” (SEE) test. The section-by-section summary that accompanies the proposed legislation describes the SEE test as subject to tax-motivated manipulation, and expects the IRS to issue “simplified” regulations to address the adoption of an exclusive PIP standard.   
• Require partnerships that are at least 50% owned by related parties to allocate tax items pro rata based on relative capital contributions. The proposal generally would treat a disproportionately large distribution relative to contributed capital as a taxable receipt of a partnership interest from the other partners.
• Require “remedial” allocations of built-in gain and loss under section 704(c) of the tax code. To avoid taxable gain or loss shifting among partners, 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 remedial method generally would accelerate charge-backs. 
• Require “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. Wyden's proposal 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).
• Expand 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. Wyden's proposal would eliminate the seven-year testing period, so that the mixing bowl rules apply regardless of when the distribution occurs.
• Treat “guaranteed payments” as payments to non-partners. Under current law, certain guaranteed payments may be treated as distributive shares of partnership income and gain. The proposal would instead treat guaranteed payments as payments to non-partners (e.g., compensation if paid in exchange for services), which could be subject to limitations on deduction. 
• Require partnership debt be allocated 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 the partners generally are 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 allows partners to elect to pay any resulting tax liability over eight years.
• Require mandatory “inside basis” adjustments. Changes to a partnership's ownership percentages may create disparities between the partnership's basis in its assets and the partners' basis in their partnership interests. For example, assume that John initially contributed $50 to a partnership in exchange for a 50% interest, and the partnership holds a single asset that it bought for $100 and that is now worth $200. If John sells his partnership interest to Jane for $100 (which represents John's 50% share of the partnership's $200 net asset value), Jane will will have $100 basis in her purchased interest, but the partnership's basis in its asset (its inside basis) generally is not required to be stepped up unless the partnership makes an election to do so under section 754. If the partnership then sells the asset for $200, it must allocate $50 of the resulting $100 gain to Jane notwithstanding that Jane already effectively paid for that appreciation (and John paid tax on it). Wyden's proposal would mandate inside basis adjustments. 
• Revise the interest barrier rules. Section 163(j) generally allows a deduction for business interest expense only to the extent that it exceeds business interest income plus 30% of EBITDA (or EBIT, beginning after 2021). Currently, section 163(j) applies both at the partnership and partner levels under a “hybrid” model. Wyden's proposal would apply section 163(j) only at the partnership level and restrict partners from using their excess share of a partnership's business income to offset business interest expense from other sources. By contrast, the House Ways and Means Committee's proposed tax provisions for the Build Back Better Act would apply section 163(j) only at the partner level.

If enacted, Wyden's proposal would significantly impact partnerships, ETFs, mutual funds, and their managers and investors.