Tax Matters

Invalid Partnership
Since the Treasury Department adopted what are known as the check-the-box regulations, CPAs have been confident that unincorporated entities with two or more owners would be treated as partnerships unless they elected corporate treatment. The Circuit Court for the District of Columbia recently reversed a district court decision that an entity which met these conditions was a valid partnership. The case points out additional rules taxpayers must follow to create a valid partnership.

In 1990 American Home Products (AHP) sold a subsidiary, Boyle-Midway, and recognized a substantial capital gain. Merrill Lynch approached AHP with a tax plan to generate a capital loss to offset the gain from the sale. Under the plan AHP became a 10% partner in a foreign partnership, which engaged in a contingent installment sale. The gain from the sale was allocated 90% to the foreign partners and 10% to AHP.

Because the foreign partners were not subject to U.S. taxation, the bulk of the gain escaped tax. The following year AHP acquired additional interests in the partnership, Boca Investerings, raising its share to 85%. The partnership closed the installment sale, recognizing a large capital loss with 85% allocated to AHP. While the total gain and loss over the two years offset each other, the changing allocations and international involvement created a large deductible tax loss for AHP.

The IRS had denied AHP’s deductions based on the theory the partnership was a sham and should be disregarded. The district court ruled the partnership was valid, and the government appealed.

Result. For the IRS. Although a district court finding of fact can be overturned only if the appeals court finds a “clear error,” the D.C. Circuit concluded it must reverse the district court decision. The lower court’s error was in failing to apply the rule the D.C. Circuit created in ASA Investerings (see “A Weapon From the Past,” JofA, Jul.02, page 65), a case involving another Merrill Lynch partnership that had engaged in a contingent installment sale.

In the seminal Culbertson case, the U.S. Supreme Court said a partnership would be honored only if “considering all the facts…the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.” In ASA Investerings the D.C. Circuit concluded the initial requirement from Culbertson was that a nontax business purpose must exist for creating a partnership or none can exist. If a valid nontax purpose exists, the courts can evaluate the other requirements to determine the existence of a partnership.

With AHP the taxpayers failed to demonstrate any nontax purpose. As further evidence of a tax motive for creating the partnership, the court pointed to the fact the taxpayer could have engaged in the transactions more easily and cheaply without the partnership. Finally the court pointed out that other partners in the transaction were created at the same time as this partnership—with no purpose other than to generate tax benefits—as proof of a tax-only motive for the entire deal. Since it had no nontax business motive, the partnership was a sham.

This decision reestablished the rule that a valid partnership must have at minimum a nontax business purpose. The rule will affect future tax planning where taxpayers seek to use partnerships to delay recognizing gain on asset sales as well as try to create artificial losses. CPAs must establish the nontax business purpose before evaluating the potential tax advantages a proposed entity would generate.

Boca Investerings Partnership v. United States, U.S. Court of Appeals for the District of Columbia Circuit, January 2003.

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

MACRS Reclassification Not Change in Accounting Method
IRC section 446(e) requires that a taxpayer secure IRS consent to change its method of accounting. Treasury regulations section 1.446-1(e)(2)(i) specifies that a taxpayer do this before computing its income under the new method. The rule also requires a taxpayer to file form 3115 with the IRS commissioner during the taxable year in which it wants to make the change. However, regulations section 1.446-1(e)(2)(ii)(b) says an adjustment in the useful life of a depreciable asset is not a change in accounting method.

Brookshire Brothers Holding Inc. operated grocery stores in Texas. The holding company and its subsidiaries filed a consolidated tax return. Brookshire used the modified accelerated cost recovery system (MACRS) for purposes of recovering the cost of the tangible assets used in its businesses. In 1991 Brookshire began constructing gas stations at its grocery store locations. It identified the stations as nonresidential real property, reporting depreciation on a straight-line basis over 311/2 years and then 39 years after the recovery period changed.

In response to the Industry Specialization Program Coordinated Issue Paper for Petroleum and Retail Industries (ISP), which the IRS issued effective March 1, 1995, Brookshire filed amended returns for 1993, 1994 and 1995. On these returns Brookshire reclassified the gas stations as 15-year property and recalculated the depreciation deduction using the 150%-declining-balance MACRS method, as specified in the ISP. The company continued this treatment on its 1996 and 1997 tax returns.

The IRS audited the 1996 and 1997 returns and issued a deficiency notice, asserting Brookshire had to reduce its MACRS deductions for those years because it had changed its accounting method without obtaining prior consent. Brookshire filed a petition in the Tax Court. The IRS argued the useful life exception was not applicable under MACRS. After the Tax Court ruled in Brookshire’s favor, the IRS appealed the decision to the Fifth Circuit Court of Appeals.

Result. For the taxpayer. The Fifth Circuit agreed with the Tax Court and determined that the kind of change Brookshire had made was the functional equivalent of a change in useful life—nothing more or less. Thus, the useful life exception in regulations section 1.446-1(e)(2)(ii)(b) exempted Brookshire from having to get permission to change an accounting method. Even if this exception had not applied, the court determined the accounting change had occurred in a closed year—1993—and the statute of limitations had run by the time the IRS questioned it.

Taxpayers have used the useful life exception in regulations section 1.446-1(e)(2)(ii)(b) for many years to avoid having to ask for a change of accounting method. It is reassuring the Fifth Circuit agrees that a reclassification of property under MACRS is nothing more than a change in useful life, which does not require a change in accounting method.

Commissioner v. Brookshire Brothers Holding Inc., 91 AFTR2d 2003-629.

Prepared by Sharon Burnett, CPA, PhD, assistant professor of accounting and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.