- The courts determined in several cases whether specific items were partnership items and the correct application of the statute of limitation under the TEFRA rules.
- There were numerous court decisions about transactions involving partnerships or LLCs that the IRS claimed lacked economic substance and/or were shams. In addition, Congress passed legislation to codify the economic substance doctrine.
- The IRS issued proposed regulations on how Sec. 108(i), which allows for the deferral of income from the discharge of business debt through the reacquisition of a debt instrument, relates to partnerships. The IRS also issued final regulations addressing the consequences under Secs. 704(c) and 737 of certain partnership mergers.
This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, debt and income allocations, distributions, passive activity losses, and basis adjustments. During the period of this update (November 1, 2009–October 31, 2010), 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. Treasury issued proposed partnership regulations regarding the deferral of cancellation of debt (COD) income with respect to the reacquisition of applicable debt. The courts and the IRS issued various rulings that addressed partnership operations and allocations. In addition, as part of health care legislation, Congress codified economic substance.
In 1982, the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)1 was enacted 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 arise under audit are whether an item is a partnership item and what is the correct statute of limitation period. This year several cases addressed both of these issues.
In Alpha I L.P.,2 the taxpayer transferred its interests in a limited partnership (LP) to four charitable remainder trusts (CRTs). One of the assets owned by the LP was marketable securities. After the transfer of the interest, the LP sold the stock for a loss that it allocated to all the members. The IRS issued a final partnership administrative adjustment (FPAA) in which it reduced the LP’s basis in the stock. The adjustment’s effect was to convert the loss on the sale to a gain. In addition, the IRS determined that the transfer of the LP interests to the CRTs should be disregarded as an economic sham and that the original owners, not the CRTs, should be treated as the members of the LP.
The members contended that the court lacked jurisdiction to consider whether the transfers to the trusts were shams because the transfer was not a partnership item. The IRS argued that the identity of partners in a partnership was a partnership item or at the very least an affected item. The court found that the identity of partners was neither a partnership item nor an affected item and thus was improperly determined in the FPAA because the transfer of an interest has no effect on either the partnership’s aggregate or each partner’s separate share of partnership income or loss. Last year the government filed a motion for reconsideration of the issue.3 However, the Court of Federal Claims denied this motion.
This year the taxpayers conceded that they owed taxes as a result of the sham transaction but contested whether they owed penalties.4 In this case the partnerships argued that they had substantial authority for the position in their initial tax returns and that they had relied in good faith on the advice of tax professionals. The court concluded that the partnerships had not established that there was substantial authority for the position they took and that they did not act in good faith. The partnerships based their good-faith defense on their reliance on an opinion letter from a tax lawyer. However, the court held that reliance on the opinion letter did not protect the partnerships because the firm that designed the tax shelters referred them to the tax lawyer and the lawyer was not told that the firm was being paid a percentage of the tax savings. Thus, the court held that the partnerships were engaged in a tax shelter and that the substantial understatement penalty of Sec. 6662(b)(1) and the negligence penalty of Sec. 6662(b)(2) applied.
In Krause,5 the IRS issued an FPAA that disallowed a deduction for a loss at the partnership level. The taxpayers agreed to the loss disallowance but sued, seeking a refund of the penalties imposed regarding the underpayment of taxes related to the disallowed loss. The IRS argued that Sec. 7422(h) barred the taxpayers from challenging the applicability of the penalty because this case was an individual action for a refund attributable to partnership items. The taxpayers argued that they should be allowed to recover the penalties based on Heasley6 and other cases, which deal with penalties for valuation overstatements.
The court rejected the taxpayer’s argument, stating, “These cases did not deal with partnership penalties and the accompanying body of TEFRA law and thus do not apply.” Moreover, the taxpayers had not disputed the IRS adjustments or penalties in the FPAA before the IRS finalized it. Thus, the court did not address the merits of the taxpayers’ argument because they had not raised it at the partnership level. In addition, the taxpayers did not assert a reasonable cause defense or claim that there was a computational error in passing the partnership adjustment on to them. Rather, they were alleging that the penalty was illegal because of its effect on them. The court found that this was a partnership-level argument that the taxpayers should have raised before the IRS finalized the FPAA.
The issue in the original Bush case7 (and approximately 30 other cases) concerned the interpretation of two sentences in partnership closing agreements. The pertinent sentences allowed losses suspended under Sec. 465 to offset any income earned by the partnership. The suspended losses in question were from passive activities. The taxpayers interpreted the closing agreements to mean that Sec. 469 would not apply if the partnership created income, so they could offset the suspended passive activity losses against any type of income. The IRS disagreed. The court determined that the sentences in the closing agreement did not explicitly prohibit the application of Sec. 469 and that it was unreasonable to read the closing agreement as allowing the passive partners to use the suspended passive activity losses to offset any type of income.
During the proceedings to determine the tax liability of the partnerships,8 the taxpayers entered into closing agreements with the IRS, and the IRS assessed deficiencies based on the agreements. However, it did not send a written deficiency notice to the partnerships. The IRS contended that deficiency notices were not required because the assessments were computational adjustments. The taxpayers argued that notices were required because the amount of the taxpayers’ at-risk capital required a further partner-level determination. The appellate court agreed with the taxpayer that, regardless of whether partner-level determinations were necessary, the IRS was required to issue notices of deficiency since the assessments were not computational adjustments. However, the court noted that the omission of the deficiency notices was harmless because the taxpayers had voluntarily paid the taxes prior to collection proceedings, and there was no showing that challenging the deficiencies in the Tax Court would have made a difference. Thus, the taxpayers were liable for the taxes due on the additional income.
In Petaluma FX Partners,9 a taxpayer contributed offsetting long and short foreign currency options to a partnership. He increased his basis to reflect the contribution of the long options but did not decrease the basis by the liability related to the short options. The partner withdrew from the partnership two months later by receiving cash and marketable securities. The taxpayer reported a loss on the sale of the marketable securities because he did not adjust his basis for the contribution of the short options. The IRS later issued an FPAA that treated the partnership as a sham and reduced the basis of all assets in the partnership to zero, eliminating the loss on the stock sale. The taxpayer claimed that the Tax Court lacked jurisdiction to consider what he characterized as nonpartnership items, including the partner’s outside basis. The court ruled that whether the partnership was a sham was a partnership item, so the court had the jurisdiction to determine that the partner’s outside basis was zero.
The taxpayer appealed the Tax Court’s decision this year.10 The appellate court determined that the Tax Court did have jurisdiction to determine that the partnership was a sham that should be disregarded for tax purposes. However, the appellate court reversed the Tax Court’s ruling that it had jurisdiction to determine that the partners had no outside basis in the partnership. In addition, the Tax Court’s holding that it had jurisdiction to determine whether accuracy-related penalties applied and that the valuation misstatement penalties did not apply was set aside until it could be determined if the taxpayers owed any additional tax.
In another case,11 the partnership filed a tax return reporting that the partnership was not subject to TEFRA. When the IRS audited the return, it did not initiate the standard TEFRA procedures but rather applied its normal deficiency procedures for entities not subject to TEFRA. Based on this audit, the IRS issued an FPAA notifying the partnership that no adjustment would be made. Later the IRS agent realized that the partnership was subject to TEFRA and issued a second FPAA, which included an adjustment to income. The taxpayer sued, claiming that the second FPAA was invalid and that the first FPAA should be the only closing agreement used in the process. The IRS countered that the second FPAA should be considered because the partnership misrepresented that it was not subject to TEFRA and, under the rules of Sec. 6223(f), the IRS is allowed to send a second FPAA if there is a showing of either “fraud or malfeasance or misrepresentation of a material fact.” The court determined that the partnership’s misrepresentation was a material fact, so the second FPAA was valid and the taxpayer owed the additional tax for the adjustments in that FPAA.
Practice tip: Tax preparers should take heed of this case when preparing a client’s tax return. Seemingly minor omissions by the preparer may end up costing the taxpayer a great deal.
In Chief Counsel Advice 201014060,12 the IRS noted that proceeds from the sale of a partnership interest are not a partnership item unless the partner sold his or her interest to the partnership itself or the partnership made a Sec. 754 election with respect to the new partner based on the purchase price. The date that the partner’s interest transferred to a new partner will also be determined by the partnership return absent a TEFRA proceeding to change this determination.
Statutes of Limitation
There were also cases that concerned the appropriate statute of limitation. In a son-of-boss case,13 following the advice of a law firm, the partner and his wife increased the basis in stock they owned in an LLC and then claimed a loss on the sale of that stock on their 2001 tax return. They later signed the first of a series of forms to extend the time to assess tax for their 2001 tax liability. The IRS had sent an FPAA for the LLC for the 1999 tax year after finding that the entity the taxpayers had entered into was a sham, concluding that any claimed basis increases or losses resulting from the transactions were disallowed. The Tax Court determined that the IRS was not barred from issuing the FPAA by any period of limitation and that the limitation period for assessing taxes attributable to partnership items for the partner and his wife for 2001 remained open because they signed timely forms agreeing to extend the assessment period until 2007. The IRS issued the FPAA for the LLC’s 1999 tax year before that date, which suspended the period to assess the 2001 income tax. This was true even though the period for assessing the 1999 income tax for the partner and his wife had already expired.
In Blak Investments,14 two partners borrowed Treasury securities and sold them in the open market at a loss in a short sale. They contributed the short sale proceeds and the obligation to cover the short sale to their partnership in exchange for interests in the partnership. The two partners claimed that their bases in the partnership were increased by the short sale proceeds but were not reduced by the obligation to cover the short sale. The partnership then redeemed the two partners’ interests in the partnership. On their federal income tax returns, the two partners claimed significant losses for the redemption and subsequent sale of assets received in the redemption. Neither the partnership nor the two partners disclosed their participation in the short sale transaction on their tax returns.
The IRS later determined that the partners must reduce their basis for the obligations used to cover the short sale, so they could not claim the loss. The taxpayers claimed that the IRS did not have the authority to make the adjustment because the statute of limitation had run out (based on the interaction of the effective date provisions of Sec. 6501(c), which governs the limitation period for undisclosed listed transactions, and Sec. 6707A(c), which provides the definition of listed transaction). The IRS countered that Sec. 6707A(c) had no bearing on the statute of limitation for undisclosed listed transactions under Sec. 6501(c)(10). Consequently, the limitation period had not closed because the taxpayers had not disclosed their participation in the short sale transaction on their tax returns as required under Sec. 6501(c)(10). The Tax Court agreed with the IRS and held that the period of limitation for assessment of tax resulting from the adjustment of partnership items for the transaction at issue was still open, and the taxpayers were liable for the additional tax due.
Partnership Operations and Income Allocation
Sec. 701 states that a partnership is not subject to tax. Instead, the partnership 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 the computation of the partnership’s taxable income.
Under Sec. 706, a partnership’s required tax year is the majority interest tax year, unless the partnership elects under Sec. 444 to use a tax year other than its required tax year. A partnership should make a Sec. 444 election on Form 8716, Election to Have a Tax Year Other Than a Required Tax Year. The Form 8716 should be filed by the earlier of the 15th day of the fifth month following the month that includes the first day of the tax year for which the election will be effective or the due date of the tax return.
In 2010,15 individuals formed a partnership that used the cash receipts and disbursements method of accounting. They formed the partnership solely to hold a membership interest in another entity. All the individuals who became partners had calendar-year ends. The partnership wanted to elect to have a tax year other than the required tax year under Sec. 444, but, relying upon the advice of a qualified tax professional, the partnership did not file Form 8716 in a timely manner. The IRS concluded that the taxpayer acted reasonably and in good faith and that the late filing was not due to any lack of due diligence or prompt action on the part of the taxpayer. Thus, it granted the partnership permission to file a new Form 8716 within 45 days of the ruling.
Under Sec. 704(a), the allocation of partnership items is made based on the partnership agreement; however, there are several exceptions to this general allocation rule. In Holdner,16 two partners (a father and son) each reported half of the business’s gross income. However, they did not split the expenses equally or file federal partnership returns. Instead, the father, who had significantly more other income, deducted most of the expenses on his returns. At trial, the father asserted that the allocation of expenses was related to his and his son’s respective investments in the business and to their agreements regarding specific expenses. The IRS concluded that the business was a partnership and that the taxpayers were equal partners who must allocate partnership income and expenses accordingly because the taxpayers did not establish that they had discussed or agreed to any specific division or allocation of the expenses but rather appeared to have arbitrarily and unilaterally allocated expenses primarily to shelter the father’s other income. The Tax Court agreed with the IRS and ruled that the taxpayers had to share the expenses equally.
Sec. 704(c) Allocations
One of the exceptions to Sec. 704(a) is Sec. 704(c), which requires that a partnership must allocate items of income, gain, loss, and deduction attributable to contributed property to take into account any variation between the property’s adjusted tax basis and its fair market value (FMV) at the time of contribution. Regs. Sec. 1.704-3(a) permits the use of any reasonable allocation method that is consistent with the purposes of Sec. 704(c).
Treasury issued proposed regulations in 2007 addressing the consequences under Secs. 704(c) and 737 of certain partnership mergers.17 In Notice 2009-70,18 the IRS explained that it had received a number of comments in response to these proposed regulations expressing concern about the proposed treatment of Sec. 704(c) layers in connection with a partnership merger. In addition, it had become aware that practitioners were taking positions based upon different interpretations of the current tiered partnership rules under Regs. Sec. 1.704-3(a)(9). Because of these issues, the IRS announced that it had decided more study was needed before the proposed regulations were finalized.
This year Treasury issued final regulations19 under Sec. 704(c) that adopt the proposed regulations20 without substantive change. Thus, the final regulations provide that the Sec. 704(c) anti-abuse rule takes into account the tax liabilities of both the partners in a partnership and certain direct and indirect owners of such partners. These final regulations further provide that a partnership cannot use a Sec. 704(c) allocation method to achieve tax results inconsistent with the intent of subchapter K of the Code.
Generally the Sec. 704(c) amount must be computed on a property-by-property basis. However, in certain circumstances securities partnerships can make reverse Sec. 704(c) allocations on an aggregate basis. In a ruling in 2010,21 a partnership was owned by a trust that held pension assets, three voluntary employee benefit associations, and a regulated investment company. The partnership used the full netting approach allowed in the regulations to aggregate built-in gains and losses from qualified financial assets for purposes of making reverse Sec. 704(c) allocations. The question that arose was whether this method was reasonable and whether the partnership could aggregate built-in gains and built-in losses from qualified financial assets contributed by the owners that had built-in gains and losses from revaluations of the trust’s qualified financial assets for purposes of making Sec. 704(c) and reverse Sec. 704(c) allocations. The IRS concluded that the method for making the Sec. 704(c) allocations was reasonable and was a permitted method. However, it expressly conditioned the ruling on contributions or revaluations of property and corresponding tax allocations not being made with a view to shifting the tax consequences of built-in gain or loss in a manner that substantially reduced the present value of the owners’ aggregate tax liability. A similar ruling is found in Letter Ruling 201028017.22
Allocations to Foreign Partners
In several letter rulings,23 a foreign individual residing in Russia was a partner in a U.S. partnership. The taxpayer was not a U.S. resident and was spending fewer than 183 days in any calendar year in the United States. However, a portion of the taxpayer’s distributive share of partnership income was from U.S. sources, and both the taxpayer and the income were considered to be effectively connected with the partnership’s U.S. trade or business. Given those facts, the taxpayer requested a ruling that his distributive share of partnership income was not taxable in the United States under the rules of the U.S.-Russian Federation income tax treaty. The IRS agreed. However, this conclusion applies only if the taxpayer is present in the United States fewer than 183 days of a calendar year.
The American Recovery and Reinvestment Tax Act of 200924 added Sec. 108(i) to generally provide for an elective deferral of COD income realized by a taxpayer from a reacquisition of an applicable debt instrument between December 31, 2008, and January 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 the tax year of the reacquisition. This year the IRS issued temporary and proposed regulations under Sec. 108(i).25 The regulations relate to the application of Sec. 108(i) to partnerships and S corporations and provide rules regarding the deferral of COD income and original issue discount deductions by a partnership or an S corporation with respect to reacquisition of applicable debt instruments during the period December 31, 2008–January 1, 2011. The temporary and proposed regulations provide that a partner’s basis in his or her partnership interest will be adjusted when the deferred income is recognized, not when the reacquisition occurs. In contrast, a partner’s Sec. 704(b) capital account will be adjusted when the income is deferred. The partner must take the deferred income into account when certain acceleration events occur. The regulations include a number of events, including contribution of assets to another partnership under Sec. 721 or a nonliquidating distribution of cash or other property, which will not be considered an acceleration event.
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. For a transaction to have economic substance, it must have a reasonable possibility of a profit, and there should be a tax-independent business purpose behind the transaction.
The IRS has recently been very diligent in examining transactions that it considers to lack economic substance. This year there were a number of cases that examined this issue. The IRS has prevailed in most cases on the issue, and this year the IRS got even more help with the matter when economic substance was codified by the Health Care and Education Reconciliation Act of 2010.26
In early 2009 in Maguire Partners,27 a district court determined in an economic substance case that the IRS could apply a regulation (in this case, Regs. Sec. 1.752-6) retroactively. In December 2009, the court reexamined the facts of the case and issued an amended findings of facts and conclusions of law with the same holding as its earlier decision.28 In Maguire, two individuals, through various entities, sold short options to a company and purchased long options and promissory notes from the same company. The partnerships received the long options and notes and assumed the short options. The IRS argued that the transactions did not have economic substance because the individuals received no economic benefit, other than an increase in basis, from the transactions. The court agreed with the IRS. The court also held that the individuals were motivated by the increased basis and not by any purported hedging benefit as they claimed and that the individuals’ actual cost basis was the original amount of their investment, not the increased basis reported by the partnerships, because they had no downside exposure and only an extremely remote possibility of receiving a return. Finally, the court ruled that the partnerships made a gross valuation misstatement when one of the individual’s partnerships reported an increase in its capital account equal to 67 times the actual economic outlay that the individual paid for the transaction.
In Jade Trading LLC,29 three taxpayers simultaneously purchased and sold a euro option by paying the difference between the purchase and the sales prices. Each taxpayer contributed the option spread to an LLC, claiming a basis in the LLC interest equal to the option’s purchase price. This treatment ignored the premium for the sold call option. The artificially high basis generated a loss almost 30 times higher than the net investment.
At issue in the case was whether the spread transaction contributed to the LLC lacked economic substance and therefore should be disregarded. In 2007, the court held that the transaction’s fictional loss, the lack of investment character with the options, the meaningless inclusion in a partnership, and the disproportionate tax advantage compared with the amount invested all pointed to the fact that the transaction lacked economic substance. Thus, the taxpayer had to take into consideration the premium for the sold call option when computing basis and could not deduct the loss falsely created by the transaction. In 2010, the Federal Circuit upheld the IRS adjustment.30 However, the court found that outside basis is an affected item that cannot be determined in partnership-level proceedings, so the Court of Federal Claims lacked jurisdiction to determine that the partners had no outside basis and thus could not review the IRS’s application of penalties based on outside bases. The court vacated and remanded that part of the case back to the lower court to determine if a portion of the penalties could have been computed without relying on the partners’ outside bases.
In Schell,31 one of the taxpayers held interests in two limited partnerships and reported his share of partnership farming losses on his tax returns. The IRS disallowed farming expense deductions for the partnerships, finding that the partnerships’ activities constituted sham transactions and lacked economic substance. The partnerships entered into settlement agreements with the IRS that made reductions in its losses. However, the settlement agreement did not mention the sham transaction determination. The partner then filed claims for refunds based on the assertion that the partnerships’ transactions were not shams. The IRS denied the refund claim. The court found that even though the settlement agreement did not refer to the transaction as a sham transaction, it did not change the IRS’s findings that the partnerships’ activities were sham transactions and did not convert the sham transaction issue into a nonpartnership item.
In another case,32 the taxpayer challenged the way the IRS applied Regs. Sec. 1.701-2 to his tax returns. Central to the dispute was the ultimate purpose for which the individual’s companies decided to purchase interests in LLCs. In this case the taxpayer used tiered partnerships, straddle investing, and transitory partners, among other things, to generate deductions—strategies that the IRS had previously warned taxpayers against using. The taxpayer argued that the purchases were simply part of an overall long-term investment strategy, whereas the IRS countered that the companies entered into the purchase of the LLCs solely for the purpose of tax avoidance. The court found that the taxpayer engaged in a series of transactions lacking economic substance and comprising an abusive tax shelter designed to permit him to purchase losses embedded in a tiered partnership structure and to reduce substantially, if not entirely, his federal tax liability. The taxpayer also was not entitled to assert the reasonable cause and good faith defenses because he was a sophisticated business person and investor and was well aware of the IRS’s position with respect to the transactions he undertook. Thus, the understated income tax liability was subject to the 20% understatement penalty.
Likewise, in Country Pine Finance, LLC,33 the members of the partnership sold an unrelated insurance business, generating gain and leaving them facing a contingent tax liability. The members entered into a custom adjustable rate debt structure (CARDS) transaction in order to reduce their tax liabilities. The CARDS transaction generated a loss on the partnership’s tax return. The IRS issued an FPAA that disallowed the claimed loss. The issue for decision was whether the partnership was entitled to this loss. The court found that the partnership members entered into the CARDS transaction in order to generate losses that they could use to offset the gain on the sale of the insurance business. The CARDS transaction lacked economic substance from both objective and subjective perspectives and stood no chance of earning a profit. The members did not have a nontax business purpose for entering into the CARDS transaction. For these reasons, the partnership was not entitled to the claimed loss.
In Palm Canyon X Investments,34 the IRS issued an FPAA in which it determined that a particular entity was a sham and that contracts entered into by the partnership and related parties lacked economic substance and thus should be disregarded. The investment strategy at issue involved offsetting currency positions that produced a capital or ordinary tax loss by exploiting the provisions governing the tax treatment of partners and partnerships. The court determined that the transaction satisfied neither the subjective prong nor the objective prong of the economic substance doctrine. The partnership did not show that it had a legitimate nontax business purpose for entering into the transaction, and the transaction did not have a reasonable prospect of achieving a pretax profit. Accordingly, the court sustained the adjustments to the partnership’s return. The court also sustained the determination of the accuracy-related penalty because the partnership had failed to establish that there was no gross valuation misstatement, that the partnership was not negligent, or that the partnership had reasonable cause through reliance on the advice of a professional tax adviser.
In Stobie Creek Investments,35 on the advice of tax professionals, the taxpayers purchased foreign currency options through single-member LLCs and transferred the options and certain stock to a newly formed partnership. They then transferred the partnership interests to single-member S corporations. The ultimate goal of the transaction was to step up the basis of the assets, thereby reducing the capital gain on the sale of the assets.
The IRS disregarded the partnership as a sham, disallowed the stated basis of the stock because it was attributable to a tax-avoidance transaction, and increased the partnership’s capital gain income from the stock sale. The court agreed. On appeal, the Federal Circuit36 upheld the lower court’s ruling that the transactions lacked economic substance. The court also agreed that the taxpayer was subject to the accuracy-related penalties and was not entitled to a reasonable cause defense because the tax advisers the taxpayer relied on had an inherent conflict of interest that the taxpayer should have been aware of.
In yet another case,37 the taxpayers entered into long and short swaps that generated losses for the taxpayers. The IRS disallowed the losses from the swaps because they were tax shelters that lacked economic substance. The taxpayers argued that they entered into the swaps to facilitate a proposed tender offer for an Australian company. The tender offer was considered; however, the primary objective of the way the swaps were structured was to allow the taxpayers to claim the considerable losses created. The court ruled that the shelters lacked economic substance and that there were no negligence or reasonable cause defenses available for the taxpayers. However, the taxpayers did not lose everything. The case dealt with several entities over a number of years. The court found that the IRS did not act in a timely manner on one of the tax shelters, so the statute of limitation had expired. Thus, for the first year for one of the partnerships in question, the taxpayers were allowed to deduct the losses created by the swaps.
Finally, in Sala38 the IRS argued that the transactions in a foreign currency investment program that gave rise to the taxpayer’s claimed tax loss had no economic substance. In a rare IRS loss, the district court ruled in favor of the taxpayer. The IRS appealed the case to the Tenth Circuit, which agreed with the IRS and concluded that the taxpayer’s participation in the program lacked economic substance. According to the court, the promoter of the transaction designed it primarily to create a reportable tax loss that would almost entirely offset the taxpayer’s income with little actual economic risk. Though a taxpayer is permitted to structure a transaction in a way that minimizes his or her tax liability, the transaction has to have economic substance. The predetermined nature of the liquidation indicated a lack of economic substance, and the existence of some potential profit was insufficient to impute substance to an otherwise sham transaction where a common-sense examination of the evidence as a whole indicated that the transaction lacked economic substance. Thus, the Tenth Circuit reversed the district court’s decision and remanded the case back to the district court with instructions to vacate its judgment and enter judgment for the government.
A disguised sale may occur when a partner contributes property to a partnership and soon thereafter receives a distribution of money or other consideration from the partnership under Sec. 707. A transaction may be deemed a sale if, based on all the facts and circumstances, the partnership’s distribution of money or other consideration to the partner would not have been made except for the partner’s transfer of the property. If the contribution and distribution transactions occur within two years of one another, they are presumed to be a disguised sale unless the facts and circumstances clearly establish otherwise.
In Canal Corporation,39 the company transferred its assets and most of its liabilities to an LLC. The LLC then borrowed money from a third party and distributed the loan proceeds to the corporation. The corporation guaranteed the loan, but the guarantee was limited to its assets, which were minimal. The IRS determined and the court agreed that the corporation had to report a gain when it received the distribution, concluding that the transaction was not a contribution and distribution but instead was a disguised sale under Sec. 707. The taxpayer had entered into this transaction on the basis of an opinion from a financial adviser and an international accounting firm. However, the court found that the taxpayer had unreasonably relied on the opinion because it was rife with improper assumptions and written by a tax adviser with a conflict of interest.
Practice tip: The reader should note that this case (as well as the Maguire Partners, Nevada Partner Funds, and Palm Canyon X Investments cases) may have serious implications for opinions taxpayers receive from their tax advisers. The courts in these cases all rejected the taxpayer’s reliance on opinions from respected law or accounting firms as a basis for a reasonable cause defense where the opinions espoused clearly flawed tax positions and the taxpayers were sophisticated enough to realize that the results of the positions taken were too good to be true or the firm providing the opinion had an obvious inherent conflict of interest.
In another case,40 the IRS issued FPAAs that found the partnerships had failed to report income from the sale of state tax credits. The partnerships had pooled capital to support historic rehabilitation projects. They also pooled the resulting tax credits and allocated the investors a share of the credits. The IRS determined that the investors were not partners and that their transactions with the partnerships were sales of tax credits. The court disagreed and found that the investors were partners. It ruled that the investors had a valid business purpose for supporting the historic rehabilitation developers and earning state tax credits. Thus, the transactions were not disguised sales under Sec. 707.
Sec. 705 requires partners to maintain their outside basis by increasing the original basis by the sum of the partner’s distributive share for the tax year and prior tax years of partnership income and decreasing it by the sum of the partner’s distributive share for the tax year and prior tax years of losses. Sec. 704(d) limits the deductibility of distributed partnership losses to the extent of the adjusted basis of the partner’s interest in the partnership at the end of the partnership year in which the loss occurred. Under that provision, the nondeductible portion of a loss may be carried forward and deducted in a subsequent year in which additional basis is generated.
This year in Leblanc,41 the taxpayers were partners in a partnership that generated large losses that the IRS disallowed because they lacked economic substance. After approximately 12 years in the partnership, the taxpayers abandoned their partnership interest and deducted a loss under Sec. 165 that was roughly equal to the amount of previously disallowed losses. The IRS disallowed the loss on the abandonment because the taxpayers had no basis in their partnership interest. The taxpayers argued that the IRS used the wrong method to compute their basis and that based on their basis calculation, which did not take the disallowed losses into account, they did have basis to take the loss. The court agreed with the IRS that under Sec. 705(a) the taxpayer’s basis should take into account the taxpayer’s entire period of ownership of the partnership interest (and thus take into account the disallowed losses) and found that the taxpayers were not entitled to the loss because they had a negative basis in their partnership interest. In so ruling, the court noted that the taxpayers were attempting to achieve what Congress had previously prohibited in the Code—the conversion of a disallowed partnership deduction into an allowable loss deduction on the abandonment of their partnership interest.
Under Sec. 731(a), partners will recognize a gain to the extent they receive cash in excess of their basis in their partnership interests. In Wallis,42 the taxpayer did not include in income, either as capital gain or ordinary income, any of the amount received from a partnership interest. The partnership units on which the payments were based were awarded in fixed amounts and ultimately paid to a withdrawing partner without regard to the partnership’s income or a partner’s particular equity share. The partnership considered the payments to be additional taxable compensation and deducted the amount of the payments from its own income. The units were referred to as a benefit or entitlement that could be forfeited; thus, the partnership did not consider the units as partners’ income when awarded and did not set aside funds for future payments. The payments were essentially a retirement benefit since they were tied to age and could be funded through a qualified plan with the same limits as those on retirement benefits.
Last year the Tax Court found, citing its earlier decision in Sloan,43 that the payments were guaranteed payments under Sec. 736(a)(2) and upheld the IRS’s assessment of tax and penalty. With respect to the penalty, the Tax Court found that because the taxpayer had 35 years of experience as a tax lawyer, the IRS Form 1099 he received from the partnership would have alerted him to how the partnership treated the payments, and he had no reasonable cause for not disclosing the inconsistency. Thus, the penalty was proper. In 2010,44 the taxpayer appealed the decision to the Eleventh Circuit, which affirmed the Tax Court’s decision.
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 FMV 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 this year,45 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 60 days after the ruling to file the election. In another ruling with similar facts,46 the IRS granted the partnership for making the Sec. 754 election, but the extension was 120 days instead of the normal 60 days.
In other instances this year,47 a partner died and the partnership failed to file a timely Sec. 754 election for an optional basis adjustment. As with the other rulings, the IRS concluded that it was an inadvertent failure and granted the partnership a 60-day extension to file the election.
1 Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248.
2 Alpha I L.P., 84 Fed. Cl. 209 (2008).
3 Alpha I L.P., 86 Fed. Cl. 568 (2009).
4 Alpha I L.P., No. 06-407 T (Fed. Cl. 5/24/10).
5 Krause, No. A-08-CA-865-SS (W.D. Tex. 1/22/10).
6 Heasley, 902 F.2d 380 (5th Cir. 1990).
7 Bush, 84 Fed. Cl. 90 (2008).
8 Bush, No. 2009-5008 (Fed. Cir. 3/31/10).
9 Petaluma FX Partners LLC, 131 T.C. 84 (2008).
10 Petaluma FX Partners LLC, No. 08-1356 (D.C. Cir. 1/12/10).
11 NPR Investments, LLC, No. CV 5:05-CV-219-TJW (E.D. Tex. 8/10/10).
12 CCA 201014060 (4/9/10).
13 LVI Investors, LLC, T.C. Memo. 2009-254.
14 Blak Investments, 133 T.C. No. 19 (2009).
15 IRS Letter Ruling 201027002 (7/9/10).
16 Holdner, T.C. Memo. 2010-175.
18 Notice 2009-70, 2010-34 I.R.B. 255.
19 T.D. 9485.
21 IRS Letter Ruling 201032003 (8/13/10).
22 IRS Letter Ruling 201028017 (7/16/10).
23 IRS Letter Rulings 201027041 (7/9/10), 201028026 (7/16/10), and 201028027 (7/16/10).
24 American Recovery and Reinvestment Act of 2009, P.L. 111-5.
25 T.D. 9498 and REG-144762-09.
26 Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
27 Maguire Partners, No. CV 06-07371-JFW(RZx) (C.D. Cal. 2/4/09).
28 Maguire Partners, No. CV 06-07371-JFW(RZx) (C.D. Cal. 12/11/09).
29 Jade Trading, LLC, 80 Fed. Cl. 11 (2007).
30 Jade Trading, LLC, No. 2008-5045 (Fed. Cir. 3/23/10).
31 Schell, 589 F.3d 1378 (Fed. Cir. 2009).
32 Nevada Partners Fund, LLC, No. 3:06cv379-HTW-MTP (S.D. Miss. 4/30/10).
33 Country Pine Finance, LLC, T.C. Memo. 2009-251.
34 Palm Canyon X Investments, LLC, T.C. Memo. 2009-288.
35 Stobie Creek Investments LLC, 82 Fed. Cl. 636 (2008).
36 Stobie Creek Investments LLC, No. 2008-5190 (Fed. Cir. 6/11/10).
37 Bemont Investments LLC, No. 4:07cv9 (E.D. Tex. 8/2/10).
38 Sala, No. 08-1333 (10th Cir. 7/23/10).
39 Canal Corp., 135 T.C. No. 9 (2010).
40 Virginia Historic Tax Credit Fund 2001 LP, T.C. Memo. 2009-295.
41 Leblanc, 90 Fed. Cl. 186 (2009).
42 Wallis, T.C. Memo. 2009-243.
43 Sloan, T.C. Memo. 1981-641.
44 Wallis, No. 10-10447 (11th Cir. 8/11/10).
45 IRS Letter Rulings 201031005 (8/6/10), 201012031 (3/26/10), and 201013025 (4/2/10).
46 IRS Letter Ruling 201032001(8/13/10).
47 IRS Letter Rulings 201017034 (4/30/10) and 201011004 (3/19/10).
Hughlene Burton is an associate professor in the Department of Accounting at the University of North Carolina–Charlotte in Charlotte, NC, and is chair of the AICPA Tax Division’s Partnership Taxation Technical Resource Panel. For more information about this article, contact Dr. Burton at email@example.com.