Tax Matters

Partnership Items
The courts recently faced a series of cases involving the classification of partnership items. IRC section 6255(a) (2) defines a partnership item as something a partnership must take into account during the tax year that is more appropriately decided at the partnership rather than the partner level. For example, determining each partner’s share of the entity’s aggregate income, gain, loss, deduction or credit is a partnership item; the amount a partner has at risk or his or her basis in the partnership is not. When something is a partnership item, any legal proceedings about that item involve the partnership and individual partners have only limited rights. For nonpartnership items, the individual taxpayer has all normal rights and any court cases involve the partner, not the entity. The Tax Court recently clarified the issue of what is and is not a partnership item in a case about who were an entity’s “real” partners.

TWA is a partnership that provides accounting services. In 1994 it negotiated with the taxpayer, Victor Grigoraci, to admit him as a partner. TWA’s other partners were all S corporations owned by accountants who worked at the firm. To avoid being the only partner with personal liability, Grigoraci followed legal advice and also formed an S corporation to become a TWA partner.

Following the admission of Grigoraci’s S corporation as a partner, TWA reported his distributive share of earnings as going to his S corporation. That entity paid Grigoraci a salary, which he reported as self-employment income. He reported the remainder of his share of TWA’s income as non-self-employment income. The IRS held that Grigoraci should have reported all of the TWA income his S corporation received as self-employment income on the grounds he was the true partner. Grigoraci filed suit asking the Tax Court to treat the S corporation as the partner. Thus the income above his salary would not be additional self-employment income.

Result. For the taxpayer. The actual issue before the court was whether determining the identity of the real partner was a partnership item. The code defines a partnership item as one “required to be taken into account for the partnership’s taxable year…to the extent regulations…provide that… such item is more appropriately determined at the partnership level than at the partner level.” The regulations, according to the IRS, mandate that items the partnership takes into account under subtitle A are, by definition, partnership items. The court disagreed. It concluded the regulations provide only a list of such items. The regulations do not say all items taken into account under subtitle A are thus more appropriately determined at the partnership level and are, therefore, partnership items.

In prior cases the courts determined a partnership item to be one that affects the distributive shares of income or loss other partners report. In Katz v. Commissioner, 116 TC 5 (2001), the court ruled that how a partner and his bankruptcy estate had allocated partnership income between them was not a partnership item because the result did not affect the amount of income the other partners reported. Therefore, the identity of who was the true partner of TWA was not a partnership item because it did not affect the other partners.

This decision does not mean determining the existence of a partner is never a partnership item. For example, in Blonien v. Commissioner, 118 TC 541 (2002), determining an individual was a partner was ruled a partnership item since it would change the number of partners, thereby affecting how much income the other partners reported.
This case should help CPAs identify the appropriate test to use to determine the existence of a partnership item. As a general rule, unless the result will affect the income the other parties report, it should not be considered a partnership item.

Victor Grigoraci v. Commissioner, TC Memo 2002-202.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

Asbestos Removal Costs Deductible
Businesses may deduct environmental remediation costs currently as repairs if the expenditures keep property in an ordinarily efficient operating condition but don’t materially increase its value or useful life. If the expenditures stop deterioration and appreciably extend the property’s useful life, the costs must be capitalized. Previously, the courts had held asbestos removal costs to be capital expenditures. (See Dominion Resources Inc. v. United States, 2000-2 USTC 50,633; Norwest Corp. and Subsidiaries v. Commissioner, 108 TC 265.) In a more recent case, the court held the cost of cleaning contaminated soil also was a capital expenditure. (See United Dairy Farmers, Inc. v. United States, 2001-2 USTC 50,680.) But sometimes the courts take a different approach.

Cinergy, a public utility, built an addition to its office building in 1972. In doing so it sprayed fireproofing material containing asbestos onto the steel structure. In the late 1980s the material began to flake and crumble if touched or disturbed. In 1990 the company paid a contractor approximately $224,000 to remedy the potential health hazard—even though the amount of asbestos in the air was below the levels set by the Occupational Safety and Health Administration. The contractor removed the asbestos in some parts of the building, while in others it encapsulated the substance. The company deducted the project’s costs as an ordinary repair. The IRS disallowed the deduction claiming it represented a capital expenditure. Cinergy paid the additional tax; however, in 1999 it filed suit for a refund in the Federal Court of Claims.

Result. For the taxpayer. The Court of Claims held the company could deduct the expenditures currently since they (1) had not appreciably increased the value of the building, (2) were only a small percentage of the building’s value, (3) had not substantially increased the building’s useful life and (4) had not allowed the company to use the building in a different way. The court distinguished this case from Dominion Resources, where the asbestos removal permitted the owner to put the building to a different use, thus requiring it to capitalize the expenditures.

The court also contrasted this case with Norwest, where the asbestos removal costs were held to be capital expenditures since the company had incurred them as part of a general plan to rehabilitate and renovate the property. Cinergy incurred removal costs as part of a discrete project whose sole purpose had been to solve the asbestos problem. The remediation only restored value to the property that had existed before the deterioration began.

The court also held that the government’s reliance on United Dairy Farmers was misplaced. In that case a company purchased stores that contained underground gasoline storage tanks. Prior to the purchase, these tanks had leaked and contaminated the soil. United had to capitalize the cost of cleaning the soil since the problem existed at the date of its purchase. In contrast, Cinergy did not have an asbestos problem when it completed the building construction. Instead the company constructed property with the potential to require future remediation as opposed to having constructed property containing a defect. The court further said Cinergy could not have anticipated the asbestos problem when it built the building; therefore it could deduct the costs currently.

The Court of Claims drew an analogy between this case and Chicago, Burlington, & Quincy Railroad v. United States, 7401 USTC 9253, to support its conclusion. In Chicago, the court held the costs of water diversion projects to stop the erosion of rail embankments were deductible expenses since the owner had incurred them to stop a problem which, if allowed to continue, would have shortened the property’s useful life. The deduction was allowed even though the erosion abatement work was relatively permanent, had a life of more than a year, had restored the rail embankments to their original condition and had added value. Likewise, in this case, the court held that Cinergy could deduct its costs since the asbestos removal and encapsulation fixed a problem that could have shortened the building’s useful life. Further, the Court of Claims cited a list of courts that allowed current deductions for fixing an unforeseeable problem assuming that work did not increase the value or useful life of the property compared to what it was before the problem existed.

Note: It is important for CPAs to understand how the court determined whether the useful life or value had increased. It compared the value and useful life of the property before the deterioration and after the remediation as opposed to comparing the property’s value and useful life after the deterioration and remediation.

Cinergy Corp. v. United States, 2003-1 USTC 50,602.

Prepared by Charles J. Reichert, CPA, CIA, professor of accounting at the University of Wisconsin, Superior.