- In cases involving TEFRA consolidated audit procedures, the Tax Court determined whether an item was a partnership item and the correct statute of limitation period.
- The courts decided numerous cases related to issues arising out of partnerships’ involvement in son-of-boss and other similar tax shelter transactions.
- The IRS issued several letter rulings concerning whether certain income and gains of publicly traded partnerships from development, production, transportation, or marketing of mineral resources were qualified income for purposes of gross income requirements of Sec. 7704(c).
- Final regulations clarify the tax treatment of noncompensatory options and convertible instruments issued by a partnership.
- The IRS also issued final regulations removing the de minimis partner rule in the determination of whether partnership allocations have substantial economic effect.
This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, income allocations, and basis adjustments. During the period of this update (Nov. 1, 2012–Oct. 31, 2013), Treasury and the IRS worked to provide guidance for taxpayers on numerous changes that had been made to subchapter K over the past few years. The courts and the IRS issued various rulings that addressed partnership operations and allocations.
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)1 was enacted in part to improve the auditing and adjustment of income items attributable to partnerships. It requires determining the treatment of all partnership items at the partnership level. Two questions that continue to come up during audit are whether an item is a partnership item and the correct statute of limitation period. In 2013 and late 2012, several cases addressed these issues.
In Estate of Albert Simon,2 the Tax Court had to decide whether it had jurisdiction to hear a case involving a deficiency the IRS had assessed against a taxpayer’s estate and his widow pertaining to a partner-level affected-items proceeding under TEFRA. The court held that it had jurisdiction to hear and resolve the IRS’s decision assessing a deficiency against the taxpayers because the IRS gave them proper notice of a final partnership administrative adjustment (FPAA) as required by Sec. 6223(a). However, the court lacked jurisdiction to redetermine any accuracy-related penalties under Sec. 6662 because the deficiency procedures did not apply to the assessment of penalties determined at the partnership level, regardless of whether partner-level determinations had to be made to assess the penalty.
In Rovakat, LLC,3 a partnership challenged the disallowances of losses it attributed to Swiss francs transactions as well as the 40% accuracy-related penalties levied in an FPAA. The Third Circuit, affirming the Tax Court, found that the redemption of stock from a company for U.S. dollars and Swiss francs was a sale of common stock, as opposed to a transfer of partnership interests, as asserted by the partnership. Both the other entities in the transactions were corporations. Because one corporation could not transfer a partnership interest in exchange for dollars and Swiss francs, it could not carry over its basis in the other corporation’s class A stock to the Swiss francs that ultimately were transferred to the partnership. The partnership asserted a basis in the Swiss francs that exceeded 400% of the correct amount, triggering a 40% penalty for a gross valuation misstatement. The appellate court found that the Tax Court did not err in finding that the partnership lacked reasonable cause and did not act in good faith, and thus, the partnership could not avoid the gross misstatement penalties.
In the past couple of years, courts have addressed whether basis was a partnership item. They have consistently disallowed losses from “son-of-boss” transactions.
In 2012, Rawls Trading4 involved two lower-tier source partnerships and an interim family partnership, with partners engaged in a short-sale variant of the son-of-boss tax shelter. They used several newly formed entities arranged in a tiered structure, each of which sought to be characterized as a partnership for tax purposes. The entities engaged in sheltering transactions that generated large losses. The interim family partnership claimed a loss on the sale of its partnership interest. The IRS claimed these losses resulted from transactions overstating the bases of partnership interests in the source partnerships. These overstated bases supposedly flowed through to the family partnership, which used them to generate the losses. The IRS issued an FPAA to the interim family partnership that included only the impact of the adjustments shown on the two source partnership FPAAs. However, the IRS issued the FPAA to the family partnership before the completion of the two source partnership proceedings. The Tax Court determined that the interim family partnership’s FPAA was invalid because the IRS issued it before the partnership-level proceedings in the source partnership cases were completed.
Subsequently, in the same case,5 the court had to determine whether the IRS’s determinations in the FPAA notices were correct and whether the taxpayers were liable for penalties related to the understatement of income from these transactions. The taxpayers failed to meet their burden of proving the IRS’s determinations were incorrect, but they established a reasonable-cause and good-faith defense under Sec. 6664(c) against the accuracy-related penalties. They had relied upon the advice of the attorneys that sold the taxpayer the transaction and an accountant recommended to the taxpayer by the attorneys in concluding the transactions were valid for federal income tax purposes. The IRS argued that the taxpayers could not rely on the experts because the attorneys and the accountant had promoted the tax shelter. The court found that the attorneys were promoters but that the accountant was not a promoter. Thus, it held that the taxpayers relied in good faith on a competent adviser who had accurate and necessary information. This result should be good news to tax advisers, since it was a win for taxpayers that relied on professional guidance for a tax position.
In another case,6 a partnership moved to dismiss the case against it for lack of subject matter jurisdiction to determine applicability of an accuracy-related penalty under Sec. 6662. The partnership sheltered income from tax by offsetting currency options in a son-of-boss shelter. The court determined that although it lacked jurisdiction to consider an accuracy-related penalty related to the outside basis of the partners in their partnership interests, it had jurisdiction to determine the applicability of any penalty to the partnership’s losses or deductions.
In 2012, in Superior Trading, LLC,7 the taxpayers sought reconsideration and/or orders vacating earlier judgments that had upheld the IRS’s adjustments to partnership items in an FPAA. In the FPAA, the IRS denied tax benefits in connection with distressed asset/debt (DAD) tax shelters that involved a Brazilian retailer and an offshore entity that serviced distressed consumer receivables. The IRS had argued that the DAD shelters were devices to transfer high-basis/low-value assets to tax-sensitive parties. The Tax Court had previously held8 that the two entities had not formed a bona fide partnership for federal tax purposes, that no valid contribution of receivables had occurred, that carryover basis treatment per Sec. 723 was improper, and that the claimed contribution and subsequent redemption were properly collapsed into a single transaction and treated as a sale of the receivables. The taxpayers sought post-judgment relief, which the court denied. The court characterized the motions as a “curious admixture of a regurgitation of unfounded assertions and half-baked theories” that the court had already rejected, combined with a criticism of the court’s holdings and baseless claims of newly discovered evidence. Undeterred, the taxpayers appealed to the Seventh Circuit.
In 2013, that court9 affirmed the Tax Court’s holdings and held that as a sham partnership motivated by no joint business goal, the taxpayer was entitled to none of the Internal Revenue Code’s benefits of partnerships. One party aimed to extract value from its otherwise worthless receivables, and the other party sought to make the losses a tax bonanza, the court held. The court, in an opinion by Judge Richard Posner, further reasoned that even if the taxpayer had been an actual, rather than fake, partnership, the cash transfer from the partnership to a company within two years of that company’s contribution of assets to the taxpayer would have created a presumption that the company had sold the assets to the partnership and received the cash distribution as delayed payment. Because the partnership was a sham without a business purpose, the penalty was affirmed because the valuation misstatement had been gross and the taxpayer had not proved it had reasonable cause to deduct the built-in losses.
Statutes of Limitation
Two cases in 2013 and late 2012 concerned the appropriate statute of limitation. In BASR Partnership,10 the taxpayer filed a petition for a readjustment of taxes and a refund of federal taxes paid because, it asserted, an FPAA was time-barred by the three-year limitation period of Sec. 6501(a) and that the fraud exception of Sec. 6229(c)(1) did not apply because none of the partner taxpayers had the requisite intent to trigger the extended statute of limitation period in Sec. 6501(c)(1).
The Court of Federal Claims held that Secs. 6501 and 6229(a) should be read together. The three-year baseline statute of limitation is in Sec. 6501, but Sec. 6229(a) provides a “minimum period for assessments of partnership items” that may be extended. Thus, “when an assessment of tax involves a partnership item or an affected item, section 6229 can extend the time period that the IRS otherwise has available under section 6501 to make that assessment.”11
There was no question that BASR’s partnership return included false or fraudulent items, but the IRS did not contend that the partners possessed an intent to evade tax within the meaning of Sec. 6501(c)(1). The court found that the legislative history of Sec. 6501(c)(1) supports the view that it is the taxpayer who must have the intent to evade tax. Therefore, the court determined that the meaning of “intent to evade tax” is limited to instances in which the taxpayer has the requisite intent to commit fraud. Because the IRS conceded that the taxpayers in this case did not have that intent, Sec. 6501(a) governed the period in which the IRS could assess tax by an FPAA.
In WHO515 Investment Partners,12 the taxpayers executed a consent to extend the period within which the IRS could assess tax against them. However, the taxpayers contended that the consent did not extend to partnership and related items, which were in turn attributable to the partnership. The court held that the IRS’s assessment was timely, regardless of the taxpayers’ subjective belief that the consent did not extend to partnership-related items. The consent expressly extended the period for assessing taxes attributable to any partnership items, affected items, computational adjustments, and partnership items converted into nonpartnership items, including any such items and adjustments that were in turn attributable to the partnership, the court noted.
Definition of Partnership and Partner
In the period covered by this update, the IRS addressed several questions regarding whether entities should be treated as a partnership. In a Chief Counsel advice memorandum,13 the IRS determined when a collaboration between two taxpayers was a partnership for federal purposes and whether that partnership could elect out of subchapter K, Sec. 761(a), and Regs. Sec. 1.761-2. Two corporations, A and B, entered into a written collaboration agreement relating to the development and commercialization of a product. In the agreement, A granted to B rights to co-promote the product in the United States and Canada and to develop and market it in the rest of the world. The parties shared in the collaboration’s profits and losses. In addition, under the agreement, A and B maintained complete and accurate records that were relevant to costs, expenses, sales, and payments. A and B sold the product under trademarks they owned jointly. A and B did not file a Form 1065, U.S. Return of Partnership Income, for any tax year or file a written election under Sec. 761(a) meeting the requirements in the regulations to elect out of subchapter K.
The IRS, considering the facts and circumstances, determined that the collaboration was a partnership for federal tax purposes and that it was ineligible to elect to be excluded from the application of subchapter K under Sec. 761(a) and Regs. Sec. 1.761-2. According to the IRS, the facts demonstrated that A and B acted with a business purpose and intended to and did join together in the conduct of a business enterprise. A and B clearly showed this intent through sharing in the net profits and losses from the manufacture, development, and marketing of the product. In addition, the IRS determined that the collaboration was not the type of unincorporated organization described in Regs. Sec. 1.761-2(a)(1) because it failed to meet the requirements of Regs. Secs. 1.761-2(a)(2) and (3).
In a private letter ruling,14 a federally recognized Indian tribe obtained a corporate charter for X under Section 17 of the Indian Reorganization Act of 1934.15 X intended to issue interests in itself to a limited liability company (LLC) in exchange for assets. X then intended to issue additional interests to U.S. persons that were accredited investors in exchange for cash in a private offering exempt from registration under the Securities Act of 1933. X would then use the cash to fund an addition to its investment portfolio and enter into an investment management agreement with one or more investment managers to manage the portfolio.
The IRS ruled that under Regs. Sec. 301.7701-1(a)(3), X was not recognized as a separate entity from the tribe for tax purposes but would continue to share the same tax status as the tribe. The proposed transactions would be considered to be between the tribe and the investors, resulting in the formation of a partnership between the tribe and the investors. Under Sec. 702, the investors would be required to take into account separately their distributive shares of the partnership income, whether or not distributed.
Publicly Traded Partnerships
Sec. 7704(a) provides that, except as provided in Sec. 7704(c), a publicly traded partnership is treated as a corporation. Sec. 7704(b) provides that the term “publicly traded partnership” means any partnership whose interests are (1) traded on an established securities market or (2) readily tradable on a secondary market (or its substantial equivalent). Sec. 7704(c)(1) provides that Sec. 7704(a) does not apply to a publicly traded partnership that meets the gross income requirements of Sec. 7704(c)(2) (at least 90% of its gross income is “qualifying income”) for a tax year and each preceding tax year beginning after Dec. 31, 1987, in which the partnership or any predecessor existed.
Sec. 7704(d)(1)(E) provides that qualifying income includes income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber). The conference report16 accompanying the Omnibus Budget Reconciliation Act of 198717 states:
Income and gains from certain activities with respect to minerals or natural resources are treated as passive-type income. Specifically, natural resources include fertilizer, geothermal energy, and timber, as well as oil, gas or products thereof. For this purpose, fertilizer includes plant nutrients such as sulphur, phosphate, potash and nitrogen that are used for the production of crops and phosphate-based livestock feed.18
The IRS issued a number of private letter rulings that requested a determination of whether the income generated by a partnership would qualify under Sec. 7704(d)(1)(E). For example, in each of two letter rulings,19 a publicly traded partnership proposed selling its nitrogen fertilizer products, including ammonia, urea, and urea ammonium nitrate (UAN) fertilizer, to customers operating in nonagricultural industries. The partnership in one of the letters also intended to sell nitric acid, produced as an intermediary step in the production of its direct-application fertilizer products, to customers operating in nonagricultural industries and to expand its facility to produce and market urea in solution. The IRS ruled that income derived from the production and marketing of ammonia, urea, UAN fertilizer, nitric acid, and urea in solution for nonretail sale to customers operating in nonagricultural industries would constitute qualifying income under Sec. 7704(d)(1)(E) to the extent that the products would otherwise be marketable as fertilizer for agricultural purposes.
In related rulings, the IRS held that the income earned by publicly traded partnerships from several other products would qualify under Sec. 7704(d)(1)(E): (1) a facility that would process natural gas into dimethyl ether and sell it as fuel for use in diesel engines;20 (2) a facility that would process natural gas into gasoline and liquefied petroleum gas (LPG) and sell the gasoline and LPG to third-party distributors, who further distributed the gasoline and LPG to end-user customers;21 (3) mining, processing, and marketing of sedimentary kaolin and bauxite for sale to oilfield service companies for use as a ceramic proppant in the production of crude oil and natural gas;22 and (4) the sale of fuel, lubricating oils, other refined petroleum products, including kerosene and naphtha, and other products including synthetic lubricating oils, methanol, and antifreeze, to customers engaged in oil and gas exploration and production.23
In another ruling,24 a publicly traded partnership under Sec. 7704(b) was engaged in terminaling, storing, and transporting products including crude oil, refined petroleum products, and LPG for customers including refineries, chemical companies, common carriers, and other pipeline transporters. The partnership’s assets included storage tanks, marine docks, and pipelines. These services were integral to transporting the company’s products, and its facilities served as hubs connecting multiple modes of transportation involved in transporting the products from producing regions to refineries and the resulting refined products to markets. The partnership wanted to expand its facilities to meet customers’ needs. The IRS held that such expansion was integral to transporting the partnership’s products and that amounts received from the partnership’s customers to help with the construction constituted qualifying income under Sec. 7704(d)(1)(E). The IRS also determined in a number of rulings25 in 2013 that income from storage and transportation of such products also qualified under Sec. 7704(d)(1)(E).
Likewise, in a number of situations,26 publicly traded partnerships under Sec. 7704(b) intended to carry on an oilfield service business that provided high-pressure hydraulic fracturing services to exploration and production companies to enhance their oil and natural gas recovery from unconventional basins. In Letter Ruling 201322024, the partnership used mobile units and associated equipment that was specifically designed to pump specialty fluids under high pressure. A typical contract required the partnership to provide a fleet of pumps and to perform a minimum number of specified stages over a certain period. Compensation for such services (and related materials) typically included mobilization fees based on mileage from the location of the partnership’s hydraulic fracturing fleet, charged at the initial stage of each job; operating stage/well/day rates; standby and downtime rates; force majeure payment rates and payments should a third party issue a mandate interfering with the partnerships’ operations; and reimbursable costs for materials, equipment, work, or services furnished by the partnerships plus handling charges. In Letter Rulings 201330023 and 201330024, the partnerships provided fluid handling services to customers engaged in the exploration for, and the development and production of, oil and natural gas by hydraulic fracturing. The IRS held in each case that gross income the partnership derived from such fracturing services was qualifying income within the meaning of Sec. 7704(d)(1)(E).
Treasury and the IRS issued concurrent final and proposed regulations in February 2013 relating to noncompensatory options. The final regulations27 relate to the tax treatment of noncompensatory options and convertible instruments issued by a partnership. They describe the income tax consequences of issuing, transferring, and exercising noncompensatory partnership options. The final regulations apply only if a call option, warrant, or conversion right grants the holder the right to acquire an interest in the issuer (or cash measured by the interest’s value). The final regulations generally provide that the exercise of a noncompensatory option does not cause the recognition of immediate gain or loss by either the issuing partnership or the option holder. The final regulations also modify the regulations under Sec. 704(b) regarding the maintenance of the partners’ capital accounts and the determination of the partners’ distributive shares of partnership items. In addition, the final regulations contain a characterization rule providing that the holder of a call option, warrant, convertible debt, or convertible equity issued by a partnership (or an eligible entity, as defined in Regs. Sec. 301.7701-3(a) that would become a partnership if the option holder were treated as a partner) is treated as a partner under certain circumstances.
The proposed regulations28 relate to the tax treatment of noncompensatory options and convertible instruments issued by a partnership. Specifically, they expand the characterization rule measurement events to include certain transfers of interests in the issuing partnership and other lookthrough entities. They also provide additional guidance in determining the character of the grantor’s gain or loss as a result of a closing transaction with respect to, or a lapse of, an option on a partnership interest. Treasury received comments previously expressing uncertainty as to whether Sec. 1234(b) applies to the grantor of an option on a partnership interest on the lapse or repurchase of the option. The comments indicated that it was unclear whether “securities,” as used in Sec. 1234(b)(2)(B), includes partnership interests. After considering all comments received, the IRS and Treasury proposed an amendment to the regulations under Sec. 1234(b) to expressly treat partnership interests as securities for purposes of Sec. 1234(b).
Partnership Operations and Income Allocation
Sec. 701 states that a partnership is not subject to tax but instead calculates its income or loss and allocates the amount to the partners. Sec. 702 specifies the items a partner must take into account separately; Sec. 703 provides that a partnership must make any election affecting its taxable income computation. Under Sec. 704(a), partnership items are allocated based on the partnership agreement; however, there are several exceptions to this general allocation rule.
In a case the Tax Court decided in June 2013,29 the IRS had issued husband-and-wife taxpayers a notice of deficiency for which the taxpayers sought a redetermination. One of the issues was the deferral of compensation for services under the installment method. The taxpayers reported the sale of the wife’s interest in a partnership under the installment method, including the portion related to the partnership’s unrealized receivables. The Tax Court agreed with the IRS and determined that nothing in Sec. 453 (governing installment sales) or its legislative history suggested that Congress intended to allow taxpayers to escape the basic principles of revenue recognition by deferring compensation for services under the installment method. The court also stated that the taxpayers’ chosen accounting method did not clearly reflect income with respect to the portion of the note attributable to partnership unrealized receivables.
Sec. 704(b) Allocations
Sec. 704(b)(2) requires partner allocations of partnership income, gains, losses, deductions, and credits to have substantial economic effect. Before the adoption of final regulations in December 201230 eliminated it for tax years beginning on or after Dec. 28, 2012, Regs. Sec. 1.704-1(b)(2)(iii)(e) provided a de minimis rule under which, for purposes of applying the substantiality rules, the tax attributes of de minimis partners need not be taken into account. A de minimis partner is one (including a lookthrough entity) that owns, directly or indirectly, less than 10% of the capital and profits of a partnership and is allocated less than 10% of each partnership item of income, gain, loss, deduction, and credit. The IRS and Treasury received a number of comments in response to proposed regulations removing the de minimis partner rule.31 Although commenters suggested that removal of the de minimis rule without providing other administrative relief would result in an undue burden, Treasury and the IRS determined that tax administration is best served by eliminating the de minimis partner rule. Treasury may address alternative approaches in future guidance and will consider the comments on alternative approaches. The final regulations are effective for all partnership tax years that begin on or after Dec. 28, 2012, regardless of when the allocation became part of the partnership agreement. Thus, the substantiality of all partnership allocations, regardless of when they became part of the partnership agreement, must be retested without the benefit of the de minimis partner rule. For allocations in existing partnership agreements, the retest has to be as of the first day of the first partnership tax year beginning on or after Dec. 28, 2012.
Sec. 707(a) Transactions
Sec. 707(a) holds that where a partner performs services for a partnership “other than in his capacity as a member of such partnership,” those services are treated as though they were rendered by a nonpartner. In Plotkin,32 the evidence showed the taxpayer was actively involved in carrying on the business of a nursing home operator. He treated funds paid into a limited partnership (LP) and a corporation owned by him as his own, using the funds and some of a nursing home’s sale proceeds for personal expenses and debts. The taxpayer never made himself a partner of the nursing home operator but instead assigned that partnership interest to the LP he organized. He then assigned partnership interests to his children, his ex-wife, and others.
The IRS determined that he owed additional taxes for five tax years, as he could not treat amounts paid to him from the partnership as distributions but rather as taxable income. The Eleventh Circuit and Tax Court noted that the taxpayer had to accept the tax consequences of his affirmative choice of organization, which assigned him no partnership interest in the nursing home operator or LP. Services performed for a partnership other than in his capacity as a member of the partnership were treated as rendered by a nonpartner under Sec. 707(a). Also, there was no showing that the payments were distributions made pursuant to a partnership agreement under Sec. 704(a) as distributive shares.
In a Chief Counsel advice memorandum,33 X, an S corporation, structured a transaction with another taxpayer, Y, as a leveraged partnership to try to prevent built-in gain recognition for 10 years (and one day), thereby avoiding the Sec. 1374 tax. X contributed the assets with the built-in gain, and Y contributed notes and cash. The assets could not be sold for 10 years, and the notes matured in year 4. The notes were intercompany notes between Y and its parent corporation. The partnership could not dispose of the notes. Later, the notes were refinanced to mature in years 7 and 8. At the same time as the formation, the partnership formed a lower-tier partnership that borrowed money from a bank that it used to make a special distribution to X. The partnership and Y guaranteed the partnership’s borrowing. The guarantees were guarantees of payment, which meant that the lender had the right to seek payment from the guarantors of any unpaid amounts without having to exhaust other remedies first. X indemnified Y on its guarantees. X reported the contribution of the assets as a nontaxable contribution of property under Sec. 721(a) and almost all of the special distribution as a nontaxable distribution of property under Sec. 731(a)(1).
The IRS determined that X did not bear any economic risk of loss from the indemnity agreement and that it had been included to cloak the actual transaction. Therefore, X’s indemnity agreement should be disregarded pursuant to the anti-abuse rules of Regs. Sec. 1.752-2(j), the IRS concluded. Thus X would not be allocated any of the liabilities. The IRS also determined that because the indemnity was disregarded, the purported contribution and distribution should not be treated as such but instead as a disguised sale under Sec. 707(a)(2)(B).
Sec. 707(c) provides that to the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital are considered as made to one who is not a member of the partnership. In Cahill,34 the taxpayer agreed to provide insurance consulting services to a partnership for a flat fee. The agreement called for a flat amount the taxpayer could draw each month that depended on the income the partnership allocated to him that month. The agreement stated that all draws would be treated as income earned by the taxpayer for tax purposes and that the partnership would report any draws on a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., or a Form 1099-MISC, Miscellaneous Income. The Tax Court held that the IRS correctly determined that the taxpayer had received taxable income in the form of guaranteed payments in a tax year in which he acted as a partner, even though he had not signed the partnership’s operating agreement.
In another case,35 the Tax Court’s sole issue for decision was whether husband-and-wife taxpayers were liable for self-employment tax under Sec. 1401 on payments made by an LLC to the wife, who was a 60% owner of the LLC. The LLC had deducted these payments as guaranteed payments on its tax return. In arguing that the payments were not guaranteed payments, the petitioners were trying to change the reporting position they took on their LLC’s returns, the IRS contended. Although the LLC reported the payments to the wife as guaranteed payments, the petitioners argued that the payments were partnership distributions rather than guaranteed payments, a position they took only after the IRS raised the self-employment tax issue while examining the LLC’s returns. The court held that the petitioners could not change the form of the transaction as reported on the LLC’s returns. The petitioners introduced no other evidence to prove that the payments to the wife were not in substance guaranteed payments under Sec. 707(c). The court also agreed with the IRS that the wife performed services for the LLC and was not merely a passive investor. This is a case of taxpayers’ being unable to argue substance over form; once they had chosen the form of the transaction, they were not allowed to change it.
Sec. 731(a)(1) provides that, in the case of a distribution by a partnership to a partner, gain is not recognized to the partner except to the extent that any money distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution. Regs. Sec. 1.731-1(c)(2) provides that the partner’s receipt of money or property from the partnership under an obligation to repay the amount of such money or to return such property does not constitute a distribution subject to Sec. 731 but is a loan governed by Sec. 707(a). To the extent that such an obligation is canceled, the obligor partner is considered to have received a distribution of money or property at the time of cancellation.
In a private letter ruling,36 the partners of an LLC were A and B. The LLC made several loans of money to A. The loans were evidenced by notes from A. The LLC intended to cancel certain notes from A. Concurrently with the cancellation, the LLC would make a pro rata distribution to B to prevent dilution. After the cancellations and distribution, the LLC would continue in existence, with A and B remaining partners. The IRS concluded that, under Regs. Sec. 1.731-1(c)(2), the LLC’s cancellation of the notes would be treated as a distribution of money from the LLC to A.
Sec. 108(i) was added to the Code by Section 1231 of the American Recovery and Reinvestment Act of 2009.37 It generally provides for an elective deferral of cancellation of debt (COD) income realized by a taxpayer from a reacquisition of an applicable debt instrument that occurred after Dec. 31, 2008, and before Jan. 1, 2011. COD income deferred under Sec. 108(i) is included in gross income ratably over a five-tax-year period beginning with the taxpayer’s fourth or fifth tax year following a reacquisition in 2010 or 2009, respectively (i.e., in 2014).
When a debt instrument is issued as part of the reacquisition, some or all of any original issue discount (OID) expense accruing from the debt instrument in a tax year prior to the first tax year of the inclusion period may also be required to be deferred. The OID that accrues before the first year of the inclusion period is limited to the amount of COD income from the debt instrument being reacquired. The aggregate amount of deferred OID deductions with respect to the applicable debt instrument for which the Sec. 108(i) election is made is taken into account ratably over the inclusion period.
In general, COD income deferred under Sec. 108(i) and related deferred OID deductions with respect to an applicable debt instrument that the taxpayer has not previously taken into account are accelerated and taken into account in the tax year in which an acceleration event occurs.
A Sec. 108(i) election is irrevocable and, if made, Secs. 108(a)(1)(A), (B), (C), and (D)38 do not apply to the COD income that is deferred. Sec. 108(i)(7) authorizes the IRS to prescribe regulations, rules, or other guidance as necessary or appropriate for purposes of applying Sec. 108(i).
In August 2009, the IRS and Treasury issued Rev. Proc. 2009-37,39 which provides election procedures and reporting requirements for taxpayers (including partnerships and S corporations) and other guidance under Sec. 108(i). The IRS issued temporary regulations40 and a notice of proposed rulemaking41 in 2010.
In July 2013, the IRS and Treasury issued final regulations relating to the application of Sec. 108(i)42 to partnerships and S corporations and providing rules regarding the deferral of COD income and OID deductions by a partnership or an S corporation with respect to reacquisitions of applicable debt instruments between Dec. 31, 2008, and Jan. 1, 2011. The final regulations make it clear that the Sec. 108(i) election must be made at the partnership level and cannot be made at the partner level. They also clarify two issues: First, to clarify the last sentence of Sec. 108(i)(6),43 the final regulations add an example to illustrate that the deferred Sec. 752 amount is treated as a deemed distribution under Sec. 752(b) in a tax year of the inclusion period, to the extent that the deferred Sec. 752 amount (less any deferred Sec. 752 amount that has already been treated as a deemed distribution under Sec. 752(b) in a prior tax year of the inclusion period) is equal to or less than the partner’s deferred COD income that is recognized in such tax year. Second, the final regulations clarify that the exceptions to acceleration for distributions of entire separate interests under Regs. Sec. 1.108(i)-2(b)(6)(iii)(E) and for Sec. 381 transactions under Regs. Sec. 1.108(i)-2(b)(6)(iii)(F) do not apply if the electing partnership terminates under Sec. 708(b)(1)(A).
Sec. 708(b)(1)(A) provides that a partnership terminates if no part of any business of the partnership continues to be carried on by any of its partners in a partnership, while Sec. 708(b)(1)(B) provides that a partnership terminates if, within a 12-month period, there is a sale or exchange of 50% or more of the total interest in partnership capital and profits.
In a Chief Counsel advice memorandum,44 the IRS Office of Chief Counsel was asked for assistance to determine whether there was a continuation of a partnership for the purposes of appointing a tax matters partner. The original partnership merged with an existing disregarded entity held by the new partnership, while the partners contributed their interests in the original partnership in exchange for interests in the new partnership. This resulted in the partners’ holding the same interests in the new partnership as in the original partnership and the original partnership’s becoming a disregarded entity held by the new partnership. Regs. Sec. 1.708-1(b)(2) provides that the contribution of property to a partnership does not constitute a sale or exchange. As a result, the transfer of the partnership interests in the original partnership to the new partnership was not treated as a sale or exchange. Thus, there was no termination under Sec. 708(b)(1)(B). The new partnership should be considered a continuation of the original partnership, even though the new partnership bore a different employer identification number, the memo stated.
A basic principle of tax law is that taxpayers are entitled to structure their business transactions in a manner that produces the least amount of tax. However, business transactions must have economic substance. A transaction has economic substance if it has a reasonable possibility of a profit and a tax-independent business purpose. The IRS has recently been diligent in examining transactions that it considers to lack economic substance or to be a sham. The IRS generally has prevailed in most cases on the issue, and in 2010 the IRS got even more help when Congress codified the economic substance doctrine in the Health Care and Education Reconciliation Act of 2010.45
In 2013, in 6611, Ltd.,46 the taxpayers engaged in a series of transactions through their partnerships and other entities to invest in foreign currencies, generally at a loss, to reduce or eliminate their tax liabilities. Under audit, the IRS adjusted the partnership items to zero, which in turn resulted in adjusted bases for the taxpayers’ partnerships of zero and substantial understatements of tax.
The Tax Court held that the adjustments to zero of the taxpayers’ bases in partnership items were proper, since the partnerships were not true partnerships engaged in the investment activity for profit. The court determined further that the putative partnerships did not engage in any business activity and made investments in foreign currency that were virtually certain to generate losses, indicating that the partnerships had no profit motive and no purpose other than improper tax avoidance. Thus the taxpayers were subject to the tax and penalties assessed.
Likewise, in Powers,47 husband-and-wife taxpayers and others formed a partnership to operate a telephone company, and the taxpayers formed S corporations to receive compensation due them from the partnership. The taxpayers contended that they were entitled to deduct losses incurred by the corporations, that amounts identified as unreported income were nontaxable repayments of loans, and that the taxpayers were entitled to deduct net operating loss (NOL) carryovers. The Tax Court held that the taxpayers failed to substantiate their claims. Even assuming that the losses actually were based on the taxpayers’ interests in the partnership, the taxpayers failed to provide partnership details or show that debts owed them by the partnership were recourse loans, to permit a determination of the allocation of the losses to the taxpayers and their basis in the partnership. Further, the taxpayers failed to establish the existence of debts that allegedly were repaid as nontaxable deposits in the taxpayers’ accounts. They also failed to substantiate sufficient capital or note bases in a corporation to absorb the NOL that the IRS disallowed in a prior tax year.
In Chemtech Royalty Associates, LP,48 Dow Chemical Co. set up sham partnerships in which it attempted to enter into transactions with foreign banks that would create losses for the partnerships. The District Court for the Middle District of Louisiana held that the Chemtech partnerships and all the transactions would be disregarded for federal income tax purposes. It determined that cash invested by the foreign banks as “Class A Limited Partners” in their respective Chemtech interests should not be treated as partnership interests but should be treated as loans to Dow. Thus, distributions of priority return to the banks should not be treated as distributions under Sec. 731 but as interest paid by Dow in the tax year in which the distributions were made, and all other amounts received by the banks in excess of the amounts paid for their Class A interests should be treated as interest paid by Dow in the tax year in which the amounts were received by the banks. In addition, the payments related to the creation, operation, or winding up of the partnership should not be the basis for any deductible expense by any party. The court also held that because the partnership was a sham, the negligence penalty under Sec. 6662 applied.
Sec. 754 Election
When a partnership distributes property or a partner transfers his or her interest, the partnership can elect under Sec. 754 to adjust the basis of partnership property. A Sec. 754 election allows a step-up or step-down in basis under either Sec. 734(b) or Sec. 743(b) to reflect the fair market value at the time of the exchange. This election has the advantage of not taxing the new partner on gains or losses already reflected in the purchase price of his or her partnership interest. The partnership must file the election by the due date of the return for the year the election is effective, normally with the return. If a partnership inadvertently fails to file the election, it can ask for relief under Regs. Secs. 301.9100-1 and -3.
In several rulings in 2013,49 the IRS granted an extension of time to make a Sec. 754 election. In each case, the partnership was eligible to make the election but inadvertently omitted the election when filing its return. The IRS reasoned that the partnership in each case acted reasonably and in good faith, and it granted an extension to file the election under Regs. Secs. 301.9100-1 and -3. In these rulings, each partnership had 120 days after the ruling to file the election. The IRS granted the partnerships the extension for making the Sec. 754 election even though they had relied on one or more professional tax advisers.
In another letter ruling,50 a partnership was technically terminated under Sec. 708(b)(1)(B). The partnership inadvertently failed to timely file a short-year return. Thus, it did not file a Sec. 754 election. The partnership claimed that had it filed the tax return, it would have also filed a Sec. 754 election. The IRS granted relief and allowed an additional 120-day period to make the omitted election.
1 Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248.
2Estate of Albert Simon, T.C. Memo. 2013-174.
3Rovakat, LLC, No. 12-1779 (3d Cir. 6/17/13).
4Rawls Trading, LP, 138 T.C. 271 (2012).
5Rawls Trading, LP, T.C. Memo. 2012-340.
6Arbitrage Trading, LLC, 108 Fed. Cl. 588 (2013).
7Superior Trading, LLC, T.C. Memo. 2012-110.
8Superior Trading, LLC, 137 T.C. 70 (2011).
9Superior Trading, LLC, 728 F.3d 676 (7th Cir. 2013).
10BASR Partnership, No. 10-244 (Fed. Cl. 10/29/13).
11Id., slip op. at 14, quoting Prati, 603 F.3d 1301 (Fed. Cir. 2010).
12WHO515 Investment Partners, T.C. Memo. 2012-316.
13Chief Counsel Advice (CCA) 201323015 (6/7/13).
14IRS Letter Ruling 201329003 (7/19/13).
15Indian Reorganization Act of 1934, 25 U.S.C. §477.
16H.R. Rep’t No. 100-495, 100th Cong., 1st Sess. (1987).
17Omnibus Budget Reconciliation Act of 1987, P.L. 100-203.
18H.R. Rep’t No. 100-495 at 946–947.
19IRS Letter Rulings 201308004 (2/22/13) and 201331002 (8/2/13).
20IRS Letter Ruling 201314038 (4/5/13).
21IRS Letter Rulings 201315015 (4/12/13) and 201324002 (6/14/13).
22IRS Letter Ruling 201330027 (7/26/13).
23IRS Letter Ruling 201338001 (9/20/13).
24IRS Letter Ruling 201314029 (4/5/13).
25IRS Letter Rulings 201328005 (7/12/13), 201336006 (9/6/13), and 201337014 (9/13/13).
26IRS Letter Rulings 201322024 (5/31/13), 201330023 (7/26/13), and 201330024 (7/26/13).
29Mingo, T.C. Memo. 2013-149.
32Plotkin, No. 12-10620 (11th Cir. 11/27/12).
33CCA 201324013 (6/14/13).
34Cahill, T.C. Memo. 2013-220.
35Howell, T.C. Memo. 2012-303.
36IRS Letter Ruling 201314004 (4/5/13).
37American Recovery and Reinvestment Act of 2009, P.L. 111-5.
38Providing exclusion from gross income for COD income arising from, respectively, bankruptcy, insolvency, farm indebtedness, and qualified real property business indebtedness.
39Rev. Proc. 2009-37, 2009-36 I.R.B. 309.
43“Any decrease in partnership liabilities deferred [and not taken into account by a partner under Sec. 752] shall be taken into account by such partner at the same time, and to the extent remaining in the same amount, as income deferred under this subsection is recognized.”
44CCA 201315026 (4/12/13).
45Section 1409 of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152 (codified at Sec. 7701(o)), provides that for transactions entered into after March 30, 2010, a transaction has economic substance only if it changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.
466611, Ltd., T.C. Memo. 2013-49.
47Powers, T.C. Memo. 2013-134.
48Chemtech Royalty Assocs., LP, No. 05-944-BAJ-DLD (M.D. La. 2/26/13).
49IRS Letter Rulings 201311016 (3/15/13) and 201337010 (9/13/13).
50IRS Letter Ruling 201314013 (4/5/13).
Hughlene Burton is chair of the Department of Accounting at the University of North Carolina–Charlotte in Charlotte, N.C., and is a past chair of the AICPA Partnership Taxation Technical Resource Panel. She currently serves on the AICPA Tax Executive Committee. For more information about this article, contact Dr. Burton at email@example.com.