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Current Developments This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, foreign-source income, debt and income allocations, partnership continuation and basis adjustments.
Hughlene A. Burton, Ph.D., CPA For more information about this article, contact Dr. Burton at Haburton@email.uncc.edu. Editor’s note: Dr. Burton is a member of
the
Treasury and
the IRS have worked to provide guidance on numerous changes made to subchapter
K in the past few years. During the period of this update (Nov. 1, 2005–Oct.
31, 2006), proposed and final partnership regulations were issued on the Sec.
199 deduction, foreign-source income and the substantiality of allocations. The
courts and the Service also issued various rulings addressing partnership operations
and allocations.
Partnership Issues
Classification
When deciding if a partnership exists,
it must be determined whether the partners intended to join together
for the purpose of carrying on a trade or business and to share the
profits and losses of that venture. However, a written partnership
agreement is not required. Because a partnership can exist without a written partnership
agreement, the question “Is the venture a partnership or not?” must be
answered repeatedly.
In two letter rulings,1 two unrelated entities were
tenants-in-common as to certain real estate. The owners had entered into a
management agreement with an affiliate of one of them. The tenants-in-common
agreement provided that each party would receive 50% of all income and was
obligated to pay 50% of all expenses. Each owner could sell its share of the
property pursuant to a buy-sell agreement. The owners requested a ruling that
the property’s ownership did not create a partnership, so that they could
determine whether the property qualified as replacement property under Sec.
1031(a). The IRS concluded that the taxpayers’ co-ownership arrangement
satisfied all the conditions in Rev. Proc. 2002-22,2
including those regarding voting, hiring of a manager and managing
operations. Thus, the co-ownership of the property did not constitute a partnership.
TEFRA Issues
The
Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) 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 entity level. A question that continues
to arise is whether an item is a partnership item. This year, several
cases addressed TEFRA
issues. In PK Ventures, Inc.,3 the parties agreed that the
characterization of transfers from a partner to a TEFRA partnership as debt or
equity was a partnership item that could be adjusted only on the issuance of a
Federal partnership administrative adjustment (FPAA). If the Service does not
issue a valid FPAA for a specific year, neither it nor the court can adjust
partnership items for those years. In this case, transfers were made by a
partner to the partnership for 1986–1990, but an FPAA was issued only for 1991.
The IRS determined that the earlier transfers were capital contributions, not
debt; thus, it disallowed the interest deduction taken by the partnership for
1991. The court agreed.
Another issue was whether the taxpayers had sufficient basis in their
partnership interests to deduct losses from the partnership from 1990–1995. Because an FPAA was issued only for 1991, the court determined that any
transfers made in that year should be reclassified as equity in the calculation
of the taxpayers’ basis; however, the transfers before and after 1991 could not
be changed and, for basis purposes, had to be treated consistently with the
reporting on the partnership’s tax returns.
Two cases4 addressed whether an FPAA was timely filed, and
analyzed the interaction between the statute of limitations (SOL) that applies
to partnership proceedings under Sec. 6229 and the general three-year SOL on
assessments under Sec. 6501. In both cases, the FPAA was issued after the
general SOL expired. The taxpayers argued that Sec. 6229 establishes a
limitations period separate and apart from that described in Sec. 6501. Thus,
if an FPAA is issued after the general statute has run, changes cannot be made
to a partner’s tax return. The IRS argued that the two provisions act in tandem
and that Sec. 6229 can extend the Sec. 6501 period for assessment, but can
never shorten it.
In both cases, the Court of Federal Claims agreed with the Service and
found that the FPAA was issued timely; the IRS could adjust the partnership
return as needed and then proceed against the partners for the tax consequences
of that adjustment. In each case, the court relied on the language in the
statute and committee reports to arrive at this conclusion.
In another situation,5 the Service considered
whether a payment made by an affiliated group member to a partnership in which
it was not a partner was a partnership item. In the ruling, a subsidiary was a
partner in a partnership. The subsidiary’s parent made a payment to the
partnership in the ordinary course of business, not in its capacity as an agent
for the consolidated group or on the subsidiary’s behalf. The partnership
treated the payment as income and the parent took a deduction. The IRS
disallowed the deduction and recharacterized it as a loan to the partnership.
Because the group filed a consolidated return, the parent was severally liable
for the tax liability attributable to partnership items allocated to the
subsidiary as a partner. Under Sec. 6231(a)(2)(B), the parent would be treated
as a partner for TEFRA partnership procedures purposes. However, the TEFRA
procedures only apply to the specific items that the partnership is required to
determine under Code subtitle A. Thus, if the TEFRA procedures do not apply to
the adjustment of an item, the item is not a partnership item.
It was determined that the parent’s payment was not a partnership item
and that its status as a partner for Sec. 6231(a)(2)(B) purposes did not make
it a partner for subchapter K purposes. Accordingly, the parent’s deduction for
its payment to the partnership was not subject to the TEFRA procedures.
Foreign Partnerships
A
growing area is the use of partnerships, instead of corporations, in inter-national operations. As the number of foreign partnerships that operate in the
U.S. increases, so will the number of rulings. This past year, Treasury
issued three sets of
regulations on different aspects of foreign partnerships.
First, final and temporary regulations6 were used on how subpart F
relates to partnerships. They provide that a controlled foreign corporation’s
(CFC’s) distributive share of partnership income is excluded from foreign
personal holding company income under Sec. 954(i). These regulations affect
CFCs that are qualified insurance companies, qualified insurance companies with
an interest in a partnership and U.S. shareholders of such CFCs.
Treasury also issued final regulations on tax withholding under Secs.
1441 and 1442.7
These rules apply to withholding on certain
U.S.-source income paid to foreign persons and related requirements on
collection and deposit of withheld amounts. The final regulations adopt the
proposed regulations issued in 2005, with two modifications. The first deals
with the requirement for certain foreign grantor trusts to provide a taxpayer
identification number (TIN). If a withholding certificate is executed after 2000
and provided to a qualified intermediary or other withholding agent by a
foreign grantor trust with five or fewer grantors, the trust does not need to
provide a TIN for the certificate to be valid. The second change relates to the
reporting of treaty-based return positions. Under the final regulations,
reporting under Sec. 6114 is not required in certain circumstances when the
payment is properly reported on Form 1042-S, Foreign Person’s U.S. Source of
Income Subject to Withholding.
The third set of regulations helps determine the party deemed to pay a
foreign tax for purposes of Secs. 901 and 903.8 These proposed rules
clarify the treatment of hybrid entities (i.e., a partnership for U.S. tax
purposes, but taxable under foreign law as an entity). For tax imposed on an
entity disregarded as separate from its owner for U.S. tax purposes, foreign
law is deemed to impose legal liability for the tax on the owner. The proposed
regulations clarify that tax imposed on a disregarded entity is considered paid
by its owner and should be allocated under Secs. 702, 704 and 901(b)(5).
Partnership Formation
Sec. 721(a)
provides that no gain or loss is recognized on the exchange of property for a
partnership interest. Services are not property for this purpose. If Sec. 721
does not apply to the transaction, a partner will have to report income.
In one ruling,9 two owners of a limited liability company (LLC) contributed
cash to a second LLC. The first and second LLCs then contributed cash to third
and fourth LLCs. The first LLC acquired the stock of four corporations. Later,
three of the corporations merged into the third LLC; the fourth corporation
merged into the fourth LLC. The mergers were treated as if the corporations
transferred all their assets to the LLC in exchange for an LLC interest and the
LLC’s assumption of the corporation’s liabilities, followed by a distribution
of the interest in the third and fourth LLCs to the first LLC in complete
liquidation of the latter’s interest in the corporations, under Sec. 331.
The IRS determined that the contribution of the assets and liabilities
to the third and fourth LLCs did not trigger gain or loss under Sec. 721. Each
of the corporations would have to recognize gain on their distribution of their
interests in the third or fourth LLC under Sec. 336. Likewise, the distribution
of the interests in those LLCs to the first LLC was a transfer that would cause
a technical termination under Sec. 708. However, neither the corporations nor
the third or fourth LLCs have to recognize gain on the termination under Regs.
Sec. 1.708-1(b)(1)(iv), because the sale or exchange of the same partnership interest more
than once in a 12-month period is counted only once.
Liabilities
Under
Sec. 752(a), an increase in a partner’s share of a partnership’s liabilities is
deemed a contribution of money that increases the partner’s outside basis. Sec.
752(b) provides that a decrease in a partner’s share of liabilities is treated
as a cash distribution. The Service issued final regulations under Sec. 752 for
taking into account certain obligations of a business entity disregarded as
separate from its owner.10 These rules
provide that a disregarded entity’s obligations under Regs. Sec. 1.752-2(b)(1)
are taken into account only to the extent of the disregarded entity’s net
value. The net value is determined by subtracting all obligations that do not
constitute a Regs. Sec. 1.752-2(b)(1) payment obligation from the fair market
value (FMV) of
the entity’s assets. The regulations also clarify that the net value of a
disregarded entity must be determined initially as of the earlier of the first
date occurring on or after the date on which the requirement to determine the
net value arises, or the end of the partnership’s tax year in which the
requirement to determine the net value arises.
Sec.
701 states that a partnership is not subject to tax. Rather, the partnership
calculates its income or loss and allocates it to the partners. Sec. 702
specifies the items a partner must take into account separately; Sec. 703
provides that any election affecting the computation of taxable income from a
partnership must be made by the partnership. Under Sec. 704(a), the allocation
of partnership items is made based on the partnership agreement; however, there
are several exceptions to this general rule.
Who Is a Partner?
Once a partnership calculates its income
or loss under Secs. 702 and 703, it is allocated to the partners, but first,
the issue of who is actually a partner must be determined. In
TIFD III-E, Inc.,11 the taxpayer was a partner
in a partnership, along with two foreign banks that did not pay taxes in the
U.S. The partnership’s operating agreement allocated 98% of the income to the
banks. Under this agreement, the income allocated to the banks far exceeded the
cash they would actually receive. Their actual allocation was based on a clause
in the partnership agreement that called for the partnership to reimburse their
initial investment at an annual rate of 9.03587%. The IRS determined that these
allocations were made to shelter most of the partnership’s income from taxation
and to redirect such income tax free to the U.S. partner. It also found that
the foreign banks were not bona fide equity partners.
The district court disagreed; the Service appealed. The Second Circuit
reversed, finding that the banks had no meaningful stake in the partnership’s
success or failure; thus, the IRS correctly determined that the foreign banks
were not bona fide equity partners. Thus, the taxpayer would be allocated all
of the partnership’s income; the payments to the banks would be treated as a
return on a loan.
When Is Income Reported?
Sec. 702 requires partners to report their
shares of the partnership’s taxable income or loss. Regs. Sec. 1.702-1(a)
provides that each partner is required to take into account its share of income
or loss, whether or not distributed. This issue recently came into question in
two cases. First, in Timothy J. Burke,12
the taxpayer argued that he should not have to report all of the
income allocated to him from a partnership, because part of his
income was being held in escrow due to a dispute between him and his partner. He contended that his distributive share of income
was indefinite and that the partnership receipts in escrow were frozen and
unavailable to him.
The Service and the Tax Court disagreed. The latter determined that
there was nothing conditional or contingent about his receipt of the
partnership’s income. Thus, the taxpayer was taxable on his share of the
partnership’s profits, even though he did not receive it. The dispute between
the partners did not change the outcome of such findings.
In a similar case,13 the taxpayer first argued that he was a creditor,
not a partner. However, he had entered into a limited partnership (LP)
agreement; the court ruled that he could not alter the form of the transaction
after the fact. The taxpayer then argued that he should not have to report his
share of the income, because the general partner allegedly committed various
wrongful acts. Using the decision in Burke,
the court ruled that, even if the taxpayer’s allegations were true, he would
still be required to report his share of income when earned.
Sec. 704(b) allows a partnership to make special allocations, as long
as they have substantial economic effect. The current regulations explain how a
partnership meets the rules for economic effect and substantiality. In 2005,
the Service issued proposed regulations for testing the substantiality of an
allocation when the partners are lookthrough entities or consolidated group
members.14
They provide additional guidance on the effect of other provisions (such as
Sec. 482) on a partner’s tax treatment of its share of partnership income or
loss under Sec. 704(b), and revise the existing rules for determining the
partners’ partnership interests.
Treasury also issued final regulations on the allocation of creditable
foreign tax expenditures (CFTE) by partnerships.15 The temporary and proposed
regulations provided a separate safe harbor in which the allocation of CFTEs
were deemed to be in accordance with the partners’ interest. The final
regulations retain this provision and provide that the allocation of CFTEs must
be in proportion to the distributive share of income to which they relate to
meet the safe harbor. In addition, the final regulations’ safe harbor uses a
three-step process to determine the distributive share of income to which a
CFTE relates. First, the partnership determines its CFTE categories. Second, it
determines the U.S. net income in each category. Third, it allocates and
apportions the CFTEs to the categories based on the net income recognized for
foreign tax purposes in each category.
Sec. 704(c) Rulings
Last year, in Rev. Rul. 2004-43,16
the IRS addressed whether Sec. 704(c)(1)(B) would apply to Sec. 704(c) gain or
loss created in an assets-over partnership merger. The result was that Sec.
704(c)(1)(B) applied to newly created Sec. 704(c) gain or loss on property
contributed by the transferor partner. However, it did not apply to any reverse
Sec. 704(c) gain or loss created from a revaluation of property in the
continuing partnership. Likewise, for Sec. 737(b) purposes, net precontribution
gain will include the newly created Sec. 704(c) gain or loss from
the property contributed by the transferor partnership, but not the
reverse Sec. 704(c) gain or loss created by the revaluation of
assets in the continuing partnership. After numerous comments, the Service revoked17 Rev. Rul. 2004-43, and issued
proposed regulations18 that will apply the principles of
Rev. Rul. 2004-43 to property distributions following assets-over partnership mergers.
This past year, in a ruling,19 an individual and an S corporation formed two LPs that each held stock of a family
corporation. The first LP wanted to liquidate, by distributing all its assets
to its partners and merging into the second LP. The IRS determined that the
merger fell within the “identical ownership” exception in Notice 2005-15, so
that Sec. 704(c)(1)(B) did not apply; further, the net-precontribution-gain
provision under Sec. 737 did not include the newly created Sec. 704(c) gain
created by the merger. In addition, because the liquidation occurred more than
seven years after the LP’s original formation, neither Sec. 704(c)(1)(B) nor
737 applied to the liquidating property distribution. Finally, because the
distribution of the assets was proportional, Sec. 751(b) did not apply. This ruling was the best possible outcome the taxpayers
could expect.
In another ruling,20
a trust wanted to transfer its marketable securities to an LLC, then
terminate. After the trust’s termination, the LLC membership
interests would be distributed to the remainder beneficiaries and
the LLC would be converted to a partnership. The Service ruled that the distribution of the LLC
assets would be a nontaxable pro-rata distribution based on Rev. Rul. 99-521 and, under Sec. 721(a), no
gain or loss would be recognized on the conversion of the LLC to a partnership.
In addition, if the LLC elected the partial-netting approach for making reverse
Sec. 704(c) allocations, this would be reasonable under Regs. Sec.
1.704-3(e)(3) and (a)(1). Likewise, because the beneficiaries were eligible
partners of the LLC, the distribution to them would not create gain under Sec.
731(a). Again, this is a very favorable outcome for taxpayers.
Tax Year
In
2002, Treasury issued final regulations22 on adoptions,
changes and retentions of annual accounting periods. Rev. Proc. 2002-3823 was issued along with the regulations to provide
procedures for partnerships to obtain automatic approval to adopt, change or
retain their annual accounting period. A partnership that complies with the
procedure will be deemed to have established a business purposes under Sec. 706(b) and obtained IRS approval
to adopt, change or retain its annual accounting period.
The Service issued Rev. Proc. 2006-46,24 which
provides exclusive procedures for a partnership to obtain automatic
approval to adopt, change or retain its annual accounting period
under Sec. 442. This procedure clarifies, modifies, amplifies and
supersedes Rev. Proc. 2002-38. A partnership that complies with the procedure will
be deemed to have established a business purpose and obtained approval to
adopt, change or retain its annual accounting period.
Sec. 199
The
American Jobs Creation Act of 2004 created Sec. 199, which allows a deduction
for qualified domestic production activities. The deduction is limited to the
lesser of the allowable percentage times qualified production activities income
or taxable income, but cannot be more than 50% of Form W-2 wages. The Service issued
a notice and proposed, final and temporary regulations,25 to help taxpayers apply Sec. 199. The proposed and final regulations
provide that, in the case of a partnership, Sec. 199 applies at the partner
level; each partner takes into account its share of each item described in Sec.
199. Each partner is treated as having Form W-2 wages equal to its share of the
partnership’s W-2 wages. In addition, the proposed and final regulations make
clear that, because the calculation of the Sec. 199 deduction occurs at the
partner level, any allowable deduction will have no effect on a partner’s basis
in its partnership interest.
The Tax Increase Prevention and Reconciliation Act of 2005 made
amendments to Sec. 199 related to Form W-2 wages. That law states that the
50%-of-wage limit applies only to wages generated in the qualified production
activity. This means that wages for employees not involved in such activity
would not count for limit purposes. In response, the IRS issued temporary
regulations and Rev. Proc. 2006-47,26 to help taxpayers
understand the methods used for calculating Form W-2 wages for Sec. 199
purposes. Under the original rules, qualified Form W-2 wages were determined
under a two-pronged test. The temporary regulations remove the second prong
from the test.
Nonqualified Deferred Compensation (Sec. 409A)
In Notice
2005-1,27 the IRS set forth its initial guidance on the application
of Sec. 409A. It subsequently issued proposed regulations28 that generally incorporate the guidance in the notice.
Sec. 409A may apply to arrangements between a partner and a partnership that
provide for the deferral of compensation. However, the proposed regulations do
not address this issue. Until regulations are published, the relevant guidance
for partnerships and LLCs is Q&A-7 in Notice 2005-1, which provides that
taxpayers may treat the issuance of a partnership interest (including a profits
interest, or an option to purchase a partnership interest) under the same
principles governing equity issues. Additionally, the Service has indicated that, until further guidance is issued,
Sec. 409A will apply to
guaranteed payments described in Sec. 707(c), as well as the right to receive
such payments in the future, only when the guaranteed payment is for services
and the partner providing the services does not include it in current income.
Losses
Three items
determine whether a partner can deduct its share of partnership losses
currently: (1) partnership interest basis under Sec. 704(d); (2) Sec. 465
amount at-risk; and (3) Sec. 469 passive activity income.
In Ramsburg, Jr.,29 the taxpayer’s interest in
a partnership had been treated as a passive activity; thus, he could not deduct
allocated losses. During the year in question, the partnership sold its assets
to the partner, then liquidated. However, no cash passed between the taxpayer
and the partnership. The taxpayer maintained that he should be able to deduct
all of the suspended passive losses, because he had disposed of his entire
partnership interest. Under Sec. 469, a taxpayer cannot deduct suspended losses
unless the entire partnership interest is disposed of in a fully taxable
transaction to an unrelated party.
The court found that the taxpayer failed to meet any of the Sec. 469
criteria. Instead, he actually maintained and
increased his interest in the passive activity, by purchasing the
partnership’s assets. In addition, the taxpayer could not establish
that the liquidating distribution required gain recognition under
Sec. 731(a). Finally, the liquidating distribution was between related parties; thus, the suspended losses under Sec. 469 could not be
deducted until the taxpayer had passive activity income.
Distributions
Under
Sec. 731(a), partners will recognize gain to the extent they receive cash in
excess of their basis in their partnership interests. Sec. 751 was enacted to
prevent the conversion of ordinary income into capital gain and the shifting of
ordinary income among partners. The current regulations under Sec. 751(b) were published
in 1956 and have not been amended to reflect changes made to subchapter K.
These regulations have been widely criticized as being complex and burdensome
and not meeting the Code’s objectives. Treasury and the IRS are studying the
current Sec. 751(b) regulations and considering alternative approaches to
achieve the statute’s purpose in a simpler way. Notice 2006-1430 was issued to request taxpayer comments on this
matter.
Sec. 754 Elections
When a partnership distributes property or a partner transfers its 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 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 the
partnership interest. The election must be filed by the due date of the return
for the year the election is effective and normally is filed with the return.
If a partnership inadvertently fails to file the election, it can ask for
relief under Regs. Sec. 301.9100-1 and -3.
In several rulings,31 the Service granted an extension to make a Sec. 754
election. In each case, the partnership was eligible to make such an election,
but inadvertently omitted it when filing its return. The IRS reasoned that the
partnership in each case acted reasonably and in good faith, and granted an
extension to file the election under Regs. Sec. 301.9100-1 and -3. Each
partnership had 60 days after the ruling to file the election. The extension
was granted even when the partnership relied on a tax professional to file its
return.32
In another situation,33 an interest in a general partnership was transferred to the surviving corporation of a merger. The general partnership terminated as a result of the transfer. It failed to file an election under Sec. 754 for the new partnership. The Service granted a 60-day extension to file the election on the new partnership’s behalf.
In a number of cases,34 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 the failure was
inadvertent and granted the partnership a 60-day extension to file the
election.
In most rulings in this area, the Service has allowed a late election under Sec. 754. Not so in one ruling,35 in which a father transferred an interest in real estate to his children, but retained the right to the property’s income. The family then transferred the property to an LLC, but the father retained his right to the income from the property. The father died; his estate distributed his LLC interest to his children. The LLC failed to file a Sec. 754 election when the next tax return was filed. Under audit, it was determined that the property transferred to the LLC was fully includible in the father’s estate under Sec. 2036. The IRS denied the LLC’s request for an extension to file the Sec. 754 election. Instead, it determined that, under Sec. 1014, the LLC could adjust its bases in the property it held that was included in the father’s estate, to reflect the value of the property included in his gross estate. |
