Prior to 1997, taxpayers had to navigate a complex set of rules to determine whether their association was one that would be taxed as a corporation or one that would be taxed as a partnership. In many situations the entity of choice was the limited partnership. High-priced counsel would issue opinion letters stating that the entity would be taxed as a partnership. A key element of counsel’s opinion was that the general partner was in substance a partner. Advanced ruling requests from the IRS required a showing that the general partner had at least a 1% interest in profits and losses.
Starting in 1997, the Service simplified the process by permitting unincorporated businesses to elect to be taxed under either subchapter K or subchapter C. Since the adoption of the check-the-box regulations, taxpayers have enjoyed certainty with respect to entity classification for federal income tax. However, these regulations do not provide the same level of certainty in the determination of who is a partner for income tax purposes. Recent activity by the IRS indicates that this is still a real issue and will require taxpayers to analyze whether each member of a partnership or LLC will be treated as a partner for tax purposes.
Determining Who Is a PartnerChief Counsel Advice (CCA) 200704030 was issued in October 2006 and offers some insight into the approach that the IRS will take to determine who is a partner. The basic transaction described in the CCA was relatively straightforward. The promoters purchased transferable state income tax credits and sold them to investors for a profit. Had the transaction been structured as a straight sale of the credits, the promoters would have recognized ordinary income on the transaction, and the investors would have incurred an itemized deduction that would give them little or no benefit due to the alternative minimum tax.
Rather than an outright sale of the credits, the transaction was structured as a partnership, which improved the transaction’s tax result for both parties. The investors in the partnership received a 1% capital account. The investors were allocated all of the credits, but no profits and no cashflow. The promoters received a 99% capital account, all profits and losses and any cashflow generated by the partnership. Because credits allocated to partners have no effect on capital accounts, the capital accounts of the parties remained unchanged after the allocation of the credits to the investors.
The promoters had the option to purchase the investors’ interests after one year, and this option was generally exercised. After the allocation of credits to the individual investors there was little or no value to the investors’ partnership interests, so the sale price to the promoters was presumably a nominal amount. The result of the transactions was that the investors got the benefit of the credits and realized a capital loss that could offset capital gains while the promoters realized a capital gain upon the eventual liquidation of the partnership.
The Service analyzed the transaction under several theories, including the partnership anti-abuse rules of Regs. Sec. 1.701-2, which were issued in 1994. The general anti-abuse rule could potentially apply to all partnership transactions. Because of its potential broad scope, IRS agents are required to seek National Office approval before applying the rule (Announcement 94-87). These regulations give the IRS broad powers in the case of partnerships and/or partnership transactions that fail any of the following three tests that the regulations hold are critical to the application of subchapter K:
- The partnership must be bona fide and each partnership transaction or series of related transactions (individually or collectively) must be entered into for a substantial business purpose;
- The form of each partnership transaction must be respected under substance over form principles; and
- The tax consequences under subchapter K to each partner of partnership operations and of transactions between the partner and the partnership must accurately reflect the partners’ economic agreement and clearly reflect the partner’s income.
Should the purported partnership arrangement fail any of these three tests, the IRS has a broad array of remedies available to achieve a result that is consistent with the intent of subchapter K. The remedies available include: (1) the ability to disregard the partnership; (2) the ability to treat a purported partner as a nonpartner; (3) the ability to adjust the partnership’s or a partner’s method of accounting; (4) the ability to modify the partnership allocations; and/or (5) the ability to otherwise adjust or modify the claimed tax treatment. These options provide the IRS with a trump card to overturn arrangements it finds abusive, as evidenced in the CCA.
In the CCA, the IRS examined the allocation of the credits and, using the substance-over-form doctrine, concluded that the use of the partnership to effectively sell the credits was an abuse of subchapter K. The IRS asserted that the investors were not partners in the partnership and therefore were not entitled to a capital loss on the transaction. The promoters of the partnership also did not fare well. Using its powers under the anti-abuse regulations, the Service went on to recharacterize the transfer of the credits under the disguised sale rules of Sec. 707, resulting in ordinary income to the promoters. This same conclusion was reached in a similar tax credit partnership transaction in CCA 200704028.
IRS IntentionsIn recent years, the IRS has decided to flex its muscles and use this powerful weapon to attack tax shelters and other transactions that it perceives to be abusive. Recent IRS comments indicate that it has given field offices blanket authority to assert the anti-abuse regulations in a number of situations. The partnership credit transaction described above is one of those transactions for which the IRS has granted blanket approval for the use of the anti-abuse regulations. Whether the use of the anti-abuse regulations will have long-term success will ultimately be determined by the courts.
The lesson learned is that business purpose matters. Partners must come together to share both profits and losses, and each one needs to have a meaningful economic stake in the venture. The CCA provides fair warning that the IRS will use the anti-abuse rule to attack not only listed transactions but also those transactions that on their face appear to be in compliance with the other rules of subchapter K.
The anti-abuse regulations offer a framework for analyzing transactions that technically comply with the law but whose tax results appear to be too good to be true. Practitioners should refer to them when structuring their transactions. The advent of the check-the-box regulations clouded the issue of just who should be considered a partner because members do not always fit neatly into the state law definition of a partner. The CCA made it clear that one important element was the participation in profits. Therefore, to survive an attack under the anti-abuse regulations as to whether someone is a partner or an allocation should be respected, taxpayers would be wise to review the requirements for partnership classification before making an election under the check-the-box regulations.
Frank J. O’Connell Jr. is a partner in Crowe Chizek in Oak Brook, IL.
Unless otherwise noted, contributors are members of or associated with Crowe Chizek.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.