Current Developments in Partners and Partnerships

By Hughlene A. Burton, Ph.D., CPA

EXECUTIVE
SUMMARY

  • The courts determined in several cases whether specific items were partnership items that gave the court jurisdiction under the Tax Equity and Fiscal Responsibility Act rules.
  • There were numerous court decisions about transactions involving partnerships or limited liability companies that the IRS claimed lacked economic substance and/or were shams.
  • Congress passed legislation to codify the economic substance doctrine.
  • Court cases also addressed disguised sales of partnership interests under Sec. 707, loss limitation rules under Sec. 704(b), partners’ gain on distributions from a partnership, and the Sec. 754 election to adjust the basis of partnership property.

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, 2010–October 31, 2011), 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. The courts and the IRS issued various rulings that addressed partnership operations and allocations. In addition, as part of health care legislation, Congress codified the economic substance doctrine. 1

TEFRA Issues

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) 2 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 the correct statute of limitation period. Last year, the IRS noted in a chief counsel advice that a payment from a partnership to a partner other than in the partner’s capacity as a partner under Sec. 707 would be a partnership item for TEFRA purposes. 3 Several court cases also addressed this and related issues.

In Petaluma FX Partners, 4 a partner 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 a final partnership administrative adjustment (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 jurisdiction to determine that the partner’s outside basis was zero. The Tax Court also held that it had jurisdiction to determine whether accuracy-related penalties applied and that the valuation misstatement penalties did not apply.

In 2010 the taxpayer appealed the decision. 5 The D.C. Circuit 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 court set aside the Tax Court’s holdings regarding the penalties until it could be determined whether the taxpayers owed any additional tax.

On remand, the Tax Court 6 had to determine whether it had jurisdiction over the accuracy-related penalties. In this case, none of the adjustments were items that flowed directly to the partner-level deficiency computation as computational adjustments. Therefore, any deficiencies had to be determined against the partners as affected items and must be resolved in separate partner-level deficiency procedures, the Tax Court held. Based on the D.C. Circuit’s decision, the Tax Court would have jurisdiction over a penalty at the partnership level only if it related to an adjustment of a partnership item. The adjustment also had to be capable of being computed without partner-level proceedings, leading at least potentially to only a computational adjustment to the partners’ returns. Thus, the Tax Court determined that, since none of the FPAA adjustments were partnership-level adjustments, it did not have jurisdiction to levy any penalties on the partner.

In a case of who may appeal an FPAA, 7 the Third Circuit Court of Appeals affirmed a Tax Court decision that a partner who was not a tax matters partner (TMP) could file a petition for readjustment with respect to an FPAA only if the TMP did not file a readjustment petition within the 90-day period allowed under Sec. 6226(a). In this case, the Tax Court had determined that the TMP for the partnership was another partner, and because that partner had filed a readjustment petition, the court lacked jurisdiction to hear the other partner’s petition.

Statutes of Limitation

Several cases concerned the appropriate statute of limitation, especially where taxpayers had, arguably, understated gross income by overstating basis. In Carpenter, 8 the IRS argued that the six-year limitation period in Sec. 6229(c)(2) and Sec. 6501(e)(1)(A) applied, while the taxpayer asserted that the general three-year limitation period in Sec. 6501(a) governed the timeliness of the FPAA. At issue was a transaction that the IRS determined to be a variant of the son-of-boss tax shelter. Thus, it disallowed a step-up in basis for an asset that was sold. Consequently, the IRS determined that the taxpayer had underreported gain on the sale of the asset.

The IRS contended that the appropriate statute of limitation should be six years because the omission of income exceeded 25% of gross income. The taxpayers argued that the overstatement of basis did not constitute an omission from gross income, so the extended limitation period should not apply. The Tax Court determined that it could not speculate on how the Congress that enacted Sec. 6501(e)(1)(A) in 1954 would have meant it to apply in the present-day context. The court said it could not even ask what the statute meant; instead, it merely asked what the Ninth Circuit and the U.S. Supreme Court told it the statute meant. The Ninth Circuit had concluded 9 that Colony, Inc., 10 controlled the meaning of the phrase “omits from gross income,” as it had appeared in a predecessor to Sec. 6501(e)(1)(A) (where it also appears). The Supreme Court in Colony determined that the phrase did not include an overstatement of basis. Thus, the Tax Court in this case held that only a three-year limitation period under Sec. 6501(a) applied. Consequently, the FPAA issued after the expiration of the three-year period was untimely, and the taxpayer’s and the partners’ consents to extend the period were invalid.

The same issue arose in Home Concrete & Supply LLC. 11 The taxpayers filed a 1999 tax return that reported a sale of partnership assets, the basis of which had been stepped up under Sec. 734, resulting in a loss on the sale. The information about the step-up was included in the tax return. The IRS did not audit the return until 2003 and did not issue an FPAA until 2006. In the FPAA, the IRS disallowed all losses from the sale of the assets because it classified the formation and activity of the partnership as a tax sham that had no economic substance.

A district court ruled in favor of the government, holding that the taxpayer’s overstatement was an omission from gross income and that it could not invoke the disclosure safe-harbor provision under Sec. 6501(e)(1)(A)(ii). 12 Thus, the FPAA was timely filed under the six-year limitation period of Sec. 6501(e)(1)(A), the district court held.

On appeal last year, the Fourth Circuit reversed the decision based on Colony, concluding that the overstatement of basis in property was not an omission from gross income that extended the limitation period under Sec. 6501(e)(1)(A), and the taxpayers’ overstated basis did not trigger the six-year statute of limitation. Instead, the general three-year statute of limitation applied; therefore, the FPAA was untimely, the court held.

The IRS had argued that Regs. Sec. 301.6501(e)-1, which the IRS issued after litigation in Home Concrete began, required the application of the six-year statute. The IRS further argued that the court must apply the regulation because, under the Chevron 13 standard, which the Supreme Court held in Mayo 14 applied to all tax regulations, the court was required to give deference to IRS regulations that interpret ambiguous statutes, as long as the IRS’s interpretations are not arbitrary or capricious. According to the Fourth Circuit, however, the Chevron standard should not be applied in this case because Sec. 6501(e)(1)(A) called for a three-year limitation period, and the Supreme Court had held in Colony that the predecessor statute to Sec. 6501(e)(1)(A) was not ambiguous.

Another case involving the same issue in the Tenth Circuit came to a different conclusion. Originally, in Salman Ranch Ltd. , 15 the Tax Court relied on Colony and held that an overstatement of basis was not an omission of income and therefore the extended limitation period (six years) did not apply. In response to the losses in this and other prior cases regarding whether the overstatement of basis constituted an omission of income, Treasury issued the final regulations, which provide that, except in the context of income from the sale of goods and services by a trade or business, “an understated amount of gross income resulting from an overstatement of unrecovered cost or other basis constitutes an omission from gross income.” 16

Last year, when the Tenth Circuit 17 heard the Salman Ranch appeal, it held that a partnership’s gross income included gain that required calculating the excess of the amount realized over adjusted basis; thus, an omission from gross income included an overstatement of the basis figure used to derive the gain. Therefore, the partnership’s full report of the amount received from the sale was not by itself sufficient to preclude an omission from gross income.

In coming to this conclusion, the court reasoned that Sec. 6501(e)(1)(A) was ambiguous as to Congress’s intent for the treatment of overstatements of basis outside the context of a trade or business. Therefore, the court was required by Mayo to apply the Chevron standard to the regulations. Applying the standard, the court determined that the IRS’s interpretation of the statute was reasonable and not arbitrary or capricious because (1) the IRS’s interpretation of gross income in Sec. 6501(e)(1)(A) was consistent with the definition of gross income elsewhere in the Code; and (2) the IRS’s interpretation was consistent with legislative history suggesting Congress enacted the gross receipts provision as an exception to the general definition of gross income. Therefore, the Tenth Circuit, relying on the new regulations, reversed the Tax Court’s decision and remanded the case for the Tax Court to determine other remaining issues.

Other circuit courts have also upheld the IRS’s position. The Federal Circuit in Grapevine Imports 18 reversed and remanded a Court of Federal Claims decision, deferring to the regulations. The Seventh Circuit, in Beard, 19 also reversed a Tax Court decision where the Tax Court had granted the taxpayers summary judgment because the three-year limitation period had expired, but, unlike other courts, the Seventh Circuit concluded that the meaning of the statute was clear that an inflation of basis should be considered an omission from gross income.

However, the Tax Court has continued to rule against the IRS. In Intermountain Insurance Service, 20 the Tax Court once again held that an overstatement of basis did not constitute an omission from gross income and also found that the Supreme Court’s decision in Colony conflicted with the regulations and, as a result, that the regulations were not entitled to deference. The appellate court disagreed and remanded the case.

Because of the split in the circuits, the Supreme Court granted certiorari in Home Concrete in September, with arguments scheduled for January 2012; 21 its decision should resolve this issue—one way or the other.

Practice tip: Practitioners should be aware of the new regulations and the courts’ interpretations of them, and should note that even though the regulations were not issued until 2010, the Tenth Circuit applied them to 2001 and 2002 FPAAs.

Partnership Operations and Income Allocation

Under Sec. 721 the contribution of property to a partnership in exchange for a partnership interest is a nontaxable event. One exception to this rule applies if liabilities contributed to the partnership exceed the basis of the property contributed. In an IRS advice memorandum, 22 an insolvent subsidiary made a check-the-box election to be taxed as a partnership. The IRS determined that the election by the insolvent subsidiary did not affect the liabilities of the corporation. Therefore, if the basis of the assets contributed to the partnership was greater than or equal to the debt contributed, the partner would not have to recognize a gain.

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 most elections affecting the computation of the partnership’s taxable income. As long as a partnership does not have a corporate partner, it can elect to use either the accrual basis of accounting or the cash receipts and disbursements method. Under the cash method of accounting, deductions are allowed when the entity pays the amount.

In a case decided last year, 23 a partnership that used the cash receipts and disbursements method of accounting developed a strategy to create trust basis through a contingent liability transaction and create built-in losses in 60 trusts that it created. It planned to sell the trusts to clients that could derive tax benefits from the built-in losses. As part of the plan, 11 dormant corporations were transferred to 11 of the trusts. The taxpayer loaned funds to each corporation that were repayable on December 28, 2000. On that day, the taxpayer’s chief financial officer issued 11 “payoff” checks to the corporations’ accounts. On its tax return, the partnership claimed the payments were deductible as research and experimental expenses in its activity of researching and developing tax strategies. However, the CFO did not cause the checks to be deposited until early in 2001, when the bank would not honor them, and they were subsequently canceled.

Because the checks were not presented and honored in due course, they were not deductible expenditures for the cash-basis taxpayer in the year issued; instead, the expenses should be treated as items in 2001, when the payments were made via a different funding mechanism, the Tax Court held. However, the court found the payments were not deductible in 2001 either. The expenses were not deductible under Sec. 174(a), as they were not expenditures for research in the experimental or laboratory sense. Neither were they deductible under Sec. 162(a) as ordinary and necessary business expenses, the court held. The court did reject the IRS’s argument that the payoff amounts should be recharacterized as constructive dividends to one partner, since the court found the taxpayer was a valid partnership.

Sec. 709 allows a partnership to deduct costs incurred in organizing the partnership. Last year, the IRS finalized regulations that it had issued originally in 2008 regarding the election to deduct start-up and organization expenses under Secs. 195 and 709. 24 The final regulations provide that any taxpayer that wishes to make an election to capitalize start-up and organization costs must “affirmatively elect to capitalize” the costs on a timely filed tax return.

Allocation of Items and Self-Employment Income

Under Sec. 704(a), the allocation of partnership items is based on the partnership agreement; however, there are several exceptions. Regs. Sec. 1.704-1(b) allows a partnership to make special allocations of partnership items if the allocations have substantial economic effect. Regs. Sec. 1.704-1(b)(2) spells out the rules for determining if an allocation meets the definition of substantial economic effect. Under a de minimis rule partners who own less than 10% of the profits and capital of a partnership do not have to be taken into account when applying the substantiality rules. 25 The rule was intended to allow partnerships to avoid the complexity of testing insignificant allocations, not to allow partnerships to avoid the substantiality rules if all the partners each own less than 10% of the partnership and are allocated less than 10% of the partnership items. Thus, Treasury issued proposed regulations 26 that would remove the de minimis partner rule because it may have unintended tax consequences. Treasury is still looking for ways to reduce the burden of complying with the substantial economic effect rules without diminishing the safeguards the rule provides.

Sec. 1401(a) imposes a tax on the self-employment income of every individual for a tax year (the self-employment tax). Self-employment income is defined as the net earnings from self-employment derived by an individual during any tax year, excluding (1) the portion in excess of the Social Security wage base limitation for the year, as well as (2) all earnings from self-employment if the total amount of the individual’s net earnings from self-employment for the tax year are less than $400. 27

In Renkemeyer 28 the partnership had four partners—three who were individual taxpayers and one that was an S corporation owned by a tax-exempt employee stock ownership plan and trust (ESOP) whose beneficiaries were the three individual partners. The partnership operated as a law firm. In 2004, almost all of the law firm’s net business income for its tax year was derived from legal services rendered by the three attorney partners, but the law firm allocated 87.557% of its net business income to the S corporation. The partners alleged there was a partnership agreement for 2004 that supported the special allocation of income under Sec. 704(b), but the partners were unable to produce a copy of the agreement. The partnership amended its partnership agreement in 2005, eliminating the S corporation as a partner and making each partner a 1% general partner and a 32% limited partner. The partnership income was allocated according to a formula based on the fees it collected that were attributable to each partner. The partners did not pay self-employment taxes on the income allocated to them in 2005 because they claimed that their interests in the partnership were limited partnership interests.

The Tax Court first determined that the allocation for 2004 did not reflect economic reality and reallocated the law firm’s net business income for that year to its partners on the basis of each partner’s profits and loss interest. In addition, for both years, because the partners’ income came from legal services the partners performed on behalf of the law firm, the Tax Court held the taxpayers’ distributive shares of the law firm’s net business income were net earnings from self-employment subject to tax under Secs. 1401 and 1402.

In a second case, 29 a taxpayer who previously operated as a sole proprietor set up two corporations and a limited liability company (LLC) and thereafter paid only self-employment tax on distributions to his 10% general partner interest, rather than on the entire net income from his psychiatric practice. Before the formation of the LLC, the taxpayer had been required to pay self-employment tax on the entire net income from his psychiatric practice under Secs. 1401 and 1402. The taxpayer argued that the corporations and the LLC were formed to manage and track overhead and indirect expenses and to qualify for group health insurance. The IRS and the Tax Court found that the corporations were not formed for a purpose that was the equivalent of a business activity. Thus, the corporations were without substance and were disregarded for federal tax purposes. As a result, the LLC became a single-member LLC, which, because it had not elected association status, also was disregarded for federal tax purposes. Thus all of the income was treated as from a sole proprietorship and subject to self-employment taxes.

Foreign Partnerships

In a series of letter rulings, 30 the IRS ruled on whether a corporate partner would be treated as a passive foreign investment company (PFIC). In each ruling, an LLC had U.S. members (individuals and a domestic corporation), each of which owned less than 10% of the LLC. The LLC owned 100% of a foreign corporation that earned passive income under Sec. 1297(a) and which qualified as a controlled foreign corporation (CFC) and a PFIC. In each situation, Notice 2010-41 31 did not apply to the LLC. Based on this information, the IRS determined the foreign corporation should not be treated as a PFIC with respect to the LLC or its U.S. members.

U.S. taxpayers are structuring more and more transactions with foreign entities, often to obtain favorable tax treatment. In an exceedingly complex case 32 that involved such a transaction, the court found that the transaction was a loan and not a partnership investment; thus there was no partnership. In the transaction, American companies sent money to French banks that combined the money with money of their own. The total amount was used to earn income from low-risk financial instruments. French income taxes were paid on the income from the investment. The American companies received some cash from the income on the securities but, more importantly, were given the purported ability to claim foreign tax credits on the taxes paid on the entire investment amount.

Through this arrangement, the American companies received a high return on an almost risk-free investment. The IRS determined that the transaction was structured to accrue foreign tax credits for its partners but earn little to no cash return from its French investments. Therefore, in an FPAA, the IRS determined that the U.S. taxpayers were not entitled to claim their claimed share of French foreign taxes paid or accrued. Thus, the foreign tax credits the American companies claimed were disallowed. A district court agreed, holding that the partnership used the swaps to improperly create and devise a manner to transfer otherwise unallowable FTCs to the partnership. The court noted that “the substance of a transaction may prevail, however, only when a taxpayer’s reporting and actions show an honest and consistent respect for the substance of a transaction.” This transaction was designed in a complicated and multilevel manner to mask what was in substance a loan from the U.S. taxpayers to the French banks, since the facts demonstrated that the U.S. partnership’s primary focus and interest in the transaction was to generate FTCs, the court said.

Economic Substance

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 should have a tax-independent business purpose.

The IRS has recently been diligent in examining transactions that it considers to lack economic substance. Last year a number of cases examined this issue. The IRS generally has prevailed in most of them, and its position was strengthened when Congress codified the economic substance doctrine in the Health Care and Education Reconciliation Act of 2010. 33

In New Phoenix Sunrise Corp. , 34 the taxpayer set up a partnership to enter into swap contracts. The transaction was structured so that the taxpayer could claim a loss of over $10 million from a pair of swap contracts that caused it an economic loss of slightly more than $100,000. The Tax Court found that the transaction lacked economic substance and that the taxpayer’s reliance on the advice of a law firm that had promoted the tax shelter did not prevent the application of penalties. The Sixth Circuit agreed with the Tax Court and found that the transaction lacked economic substance because expert testimony showed that the probability of the partnership’s making a profit was tiny on paper and nonexistent in practice. Without the opportunity to make a profit, the only consequence of the transaction to the taxpayer was a tax benefit. Thus, the court held that made the transaction was an economic sham and that the Tax Court had properly upheld the IRS’s assessment of a deficiency. The Sixth Circuit also affirmed the Tax Court’s holding that the taxpayer’s reliance on the advice of the law firm that had promoted the tax shelter did not prevent the application of the penalties.

In Rovakat 35 the IRS disallowed a partnership’s claim for ordinary losses of approximately $3.5 million over three tax years. These losses stemmed from the partnership’s receipt of $34,185 in Swiss francs that, the TMP claimed, carried a $5,805,000 tax basis. The IRS determined that the claimed losses were not allowable because the partner failed to establish the partnership’s basis in the francs. Alternatively, it found that the claimed losses should not be allowed because the transaction underlying the receipt of the francs lacked economic substance. The Tax Court agreed with the IRS on both points. The series of transactions lacked arm’s-length dealing at almost every stage and lacked a profit motive, the court said. In addition, because the partnership’s basis in the francs as reported on its returns exceeded 400% of the basis that the partnership actually had, the Tax Court found that an accuracy-related penalty under Sec. 6662(a) on account of a gross valuation misstatement also applied.

In another case 36 an LLC (Fidelity) was set up with a U.S. minority member (Egan) and a foreign majority member to enter into a set of transactions where it purchased and sold options related to foreign currency exchange rates and configured in them pairs. The terms set for each pair assured that a loss on one option in a pair would be offset by a corresponding gain on the other. In substance, the transaction would provide virtually no opportunity for a net gain but also no risk of a net loss. Later, Fidelity terminated four of the options that had gained value, which generated a gain in excess of $150 million that was allocated primarily to the foreign member. Egan then bought most of the foreign member’s stake in Fidelity. Subsequently, Fidelity terminated other options that generated a loss in excess of $150 million that was allocated to the now majority member Egan. To create outside basis in Fidelity so that Egan could deduct those losses, he had earlier created another LLC, Fidelity World, that entered into two pairs of offsetting options, which Fidelity World contributed to Fidelity. By taking into account the cost of the options in the offsetting pairs it purchased, but not the corresponding options in the offsetting pairs it sold, in calculating outside basis, Egan claimed an outside basis in Fidelity of $150 million, based on the options contributed by Fidelity World.

The IRS determined that the options transactions lacked economic substance and that Egan’s contribution to Fidelity lacked economic substance. It also found that Fidelity was a sham and lacked economic substance. The IRS disallowed the contributions Egan made to Fidelity and reduced Egan’s outside basis in the LLC. As a result, it also disallowed the losses claimed from the Fidelity’s options transactions. A district court agreed with the IRS and found that, for Fidelity, the transactions had no function but to create artificial paper gains on some transactions and losses on others. The First Circuit affirmed the district court’s decision.

In yet another case 37 an LLC was formed in connection with the acquisition of a portfolio of nonperforming loans (NPLs) held by a Chinese financial institution. Southgate Master Fund LLC’s disposition of its portfolio of NPLs generated more than $1 billion in paper losses, about $200 million of which was claimed as a deduction by one of its partners. The IRS determined that Southgate was a sham partnership that need not be respected for tax purposes and that Southgate’s allocation of the $200 million loss to the partner should be disallowed. The district court upheld these determinations.

The Fifth Circuit found that the LLC’s acquisition of the portfolio had economic substance, as it entered into the investment with a reasonable possibility of making a profit. However, the LLC was a sham partnership that had to be disregarded for tax purposes, the court held. The court found that the financial institution’s inclusion as a partner did not result from any intent to conduct business as a partnership. It also found that the partner’s basis-build transaction with the LLC lacked objective economic reality and that the creation of the LLC was a redundancy that lacked business purpose. Thus, the court held that the LLC’s acquisition of the portfolio of NPLs should be recharacterized as a direct sale by the financial institution to the deducting partner. However, the Fifth Circuit further held that the LLC’s reliance on tax opinions that concluded that its tax positions would more than likely be upheld provided a reasonable-cause defense under Sec. 6664(c)(1) to accuracy-related penalties.

In a case 38 the IRS did not win, an LLC was organized to rehabilitate an historic property. The IRS argued that it wasn’t a valid partnership. Instead, it asserted, one purported partner, a New Jersey state sports and exhibition authority that owned the property, sold rehabilitation tax credits to the other, a corporation. The Tax Court did not agree. Rather, it found that the corporation did not invest in the transaction solely to earn rehabilitation tax credits. The two partners joined in a transaction with economic substance to allow them to invest in the rehabilitation. The investment provided a net economic benefit to the corporation through a 3% preferred return and the tax credits.

The court held that taking into account the stated purpose behind the LLC’s formation, the parties’ investigation of the transaction, the documents, and the parties’ roles, there was a valid partnership. The court found that the state authority partner transferred the benefits and burdens of ownership of the property to the LLC. According to the court, the use of a partnership was necessary to allow the for-profit corporation to invest in the rehabilitation of a state-government-owned building. Although the corporate partner reduced its tax liability as a result, the rehabilitation tax credit was intended to draw private investments into public rehabilitations. Thus, the court found that the IRS’s recharacterization of the transaction was inappropriate.

In Jade Trading, LLC, 39 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 claimed loss of almost $14.9 million on an initial investment of $225,000 for each taxpayer.

At issue in the case was whether the spread transaction contributed to the LLCs by the taxpayers lacked economic substance such that it should be disregarded. In 2007, the Court of Federal Claims held that the transaction’s fictional loss, the lack of investment character of 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. In 2010, 40 on appeal, the Federal Circuit upheld the IRS adjustment. 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 had 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 to the lower court to determine if a portion of the penalties could have been computed without relying on the partners’ outside bases.

Last year, 41 the Claims Court, rehearing the case, concluded that none of the penalties could be applied without relying on the individual partners’ outside bases, which was not a partnership item. Therefore, the court determined that it lacked jurisdiction to determine the applicability of accuracy-related penalties.

Last year in Candyce Martin Trust, 42 a group of family trusts, through a tiered partnership structure, entered into a series of option contracts that included purchasing long options and selling short options. The parties disputed whether the obligation on the short options should be treated as a partnership liability under Sec. 752 for purposes of calculating partnership basis. The government contended that the obligation on the short options sold by the family trusts should be treated as a liability for purposes of Sec. 752. The taxpayer agreed that the basis was increased by the costs of its long option position contributed to the partnership but contended that no adjustment to the basis for the short options position was required under Sec. 752, because the short option positions were contingent or speculative obligations and therefore not “liabilities.”

The district court found that the transaction was designed as a putative “short term” hedging strategy consisting of both the long and short options because the long and short options were entered into on the same day, and both sets of options were contributed to the partnership and simultaneously closed out. The court, quoting the Federal Circuit in Jade Trading , said the transactions “cannot be separated because they were totally dependent on one another from an economic and pragmatic standpoint.” By characterizing the short options position as a purely contingent obligation and therefore not a liability to offset basis, the taxpayer created an artificially high basis by claiming a basis in the long options but disregarding the obligation on the short option. This led to a purported $315.7 million tax loss. According to the district court, the arrangement was a son-of-boss tax shelter. The district court held that the transaction did not have objective economic substance, based on a combination of factors: the absence of a nontax business purpose; lack of a reasonable expectation of profit; increased exposure to financial risk by investing cash in the S&P 500 and buying/selling options; the expected loss based on the taxpayer’s downward market view; and the above-market fees charged for the options transaction.

Disguised Sales

A disguised sale under Sec. 707 may occur when a partner contributes property to a partnership and soon thereafter receives a distribution of money or other consideration from the partnership. 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 Virginia Historic Tax Credit Fund, 43 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 them among the partner investors. The IRS determined that the investors were not partners and that their transactions were sales of tax credits. The Tax 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, it held that the transactions were not disguised sales under Sec. 707.

The IRS appealed the decision last year. 44 The Fourth Circuit found that the funds’ exchange of tax credits for investor contributions included the transfer of “property” from the funds to investors for purposes of Sec. 707(a)(2)(B). It then considered whether these transfers should have been properly recharacterized as “sales” under that provision and the factors in Regs. Sec. 1.707-3. Particularly in light of the presumption that a sale occurs unless it is clearly demonstrated otherwise, the relevant factors strongly indicated a finding that the transactions were sales, the court held. The court disagreed with the Tax Court’s conclusion that the funds “clearly established” that their investors faced entrepreneurial risks sufficient to overcome the regulatory presumption that the transactions were sales. The court agreed with the IRS that the funds should have included the money received from investors as income on their tax returns and upheld the adjustments in the FPAA.

Loss Limitations

Sec. 705 requires partners to maintain their outside basis by increasing the original basis by the sum of the partner’s distributive share of partnership income for the tax year and prior tax years and decreasing it by the sum of the partner’s distributive share of losses for the tax year and prior tax years. 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.

In Superior Trading 45 a number of partnerships engaged in a coordinated series of complex distressed asset debt transactions involving a foreign retailer in bankruptcy reorganization. The taxpayers wrote off almost the entire basis of consumer debt receivables they acquired as bad debt deductions or as a capital loss. The IRS denied the losses claimed on behalf of the partnerships. The IRS argued the taxpayers had a zero basis in the receivables instead of their claimed carryover basis equal to the full face amount of the receivables. The Tax Court agreed with the IRS. The Tax Court was not convinced that the foreign company ever made a bona fide contribution of the receivables, and the receivables’ basis in a partner’s hands was their fair market value on the date of transfer, not their historical basis in the foreign company’s hands. The Tax Court also determined the taxpayers failed to adequately establish that their partnership contribution agreement would be enforceable against the debtors and, therefore, that the distressed consumer receivables had any tax basis.

In CCA 201140025, 46 the IRS deter-mined that an FPAA does not need to reflect any settlement amount. The value and basis of a note in a partnership’s hands and any partnership bad-debt claim related to the note are a partnership item. A partner’s share of losses related to the deduction is limited to the partner’s outside basis, and the limitation has to be determined through an affected item notice of deficiency rather than through the FPAA. Absent a settlement, the partner will be bound by the partnership item components of outside basis determined in the partnership proceeding when computing the outside basis limitation.

An IRS advice memorandum 47 addressed how a Sec. 179D deduction for energy-efficient commercial buildings affects basis. Some taxpayers had taken the position that the Sec. 179D deduction is available to partners without regard to the basis limitation rules under Sec. 704(d), either on the theory that the deduction is a partner-level deduction or because the basis limitation of Sec. 704(d) and the basis adjustment rules of Sec. 705(a) do not apply to Sec. 179D. The IRS concluded that the deduction under Sec. 179D does reduce a partner’s basis under Sec. 705(a) and is limited to basis under Sec. 704(d).

Distributions

Under Sec. 731(a), partners recognize a gain to the extent they receive cash in excess of their basis in the partnership interests. In Klebanoff, 48 the taxpayer received payments from a partnership that she did not report on her income tax return. She agreed that she received the payments but contended that they were draws against future profits and not taxable. The IRS contended that the payments were a guaranteed payment subject to self-employment tax.

The taxpayer lent her expertise to a business venture with two real estate entrepreneurs. The business venture was undertaken using an LLC, and the taxpayer and another person formed a separate LLC to be a 50% partner in the first LLC. The taxpayer was to receive advances against future distributions of profits from the development and sale of five hospice care units. The venture did not succeed, and the LLCs were abandoned. The Tax Court determined that the payments received by the taxpayer resulted in payment in liquidation of her partnership interest, not a guaranteed payment. Because she had no basis in her partnership interest, the amount was taxable as a capital gain under Sec. 731(a). However, since the payments were determined to be a distribution and not a guaranteed payment, they were not subject to self-employment tax under Sec. 1402, the court held.

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 fair market value 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 last year, 49 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 120 days after the ruling to file the election. It should be noted that the normal extension time has been increased from 60 days to 120 days. In two other rulings, taxpayers who relied on tax advisers did not make the proper election. 50 The IRS granted the partnerships relief for making the Sec. 754 election, but the extension was only 60 days. The IRS did not indicate why the extension of time was shorter.

In other instances last year, 51 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 120-day extension to file the election.

 

Footnotes

1 Health Care and Education Reconciliation Act of 2010, P.L. 111-152, §1409.

2 Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248.

3 CCA 201112020 (3/25/11).

4 Petaluma FX Partners, LLC, 131 T.C. 84 (2008).

5 Petaluma FX Partners, LLC, 591 F.3d 649 (D.C. Cir. 2010).

6 Petaluma FX Partners, LLC, 135 T.C. 581 (2010).

7 Devonian Program, No. 10-4062 (3d Cir. 8/5/11).

8 Carpenter Family Investments, LLC, 136 T.C. 373 (2011).

9 Bakersfield Energy Partners, LP, 568 F.3d 767 (9th Cir. 2009).

10 Colony, Inc., 357 U.S. 28 (1958).

11 Home Concrete & Supply, LLC, 634 F.3d 249 (4th Cir. 2011).

12 Home Concrete & Supply, LLC, 599 F. Supp. 2d 678 (E.D.N.C. 2008).

13 Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984).

14 Mayo Found. for Med. Educ. & Research, 131 S. Ct. 704 (U.S. 2011).

15 Salman Ranch, Ltd., No. 13677-08 (Tax Ct. 8/7/09) (order and decision granting summary judgment).

16 Regs. Sec. 301.6501(e)-1(a)(1)(iii).

17 Salman Ranch, Ltd., No. 09-9015 (10th Cir. 5/31/11).

18 Grapevine Imports, Ltd., 636 F.3d 1368 (Fed. Cir. 2011).

19 Beard, 633 F.3d 616 (7th Cir. 2011).

20 Intermountain Ins. Serv. of Vail, LLC, 134 T.C. 211 (2010), rev’d and remanded, No. 10-1204 (D.C. Cir. 8/18/11).

21 Home Concrete & Supply, LLC, Sup. Ct. Dkt. No. 11-139 (U.S. 9/27/11) (petition for cert. granted).

22 AM 2011-003 (8/26/11).

23 The Heritage Organization LLC, T.C. Memo. 2011-246.

24 T.D. 9542.

25 Regs. Sec. 1.704-1(b)(2)(iii)(e).

26 REG-109564-10.

27 Sec. 1402(b).

28 Renkemeyer, 136 T.C. 137 (2011).

29 Robucci, T.C. Memo. 2011-19.

30 IRS Letter Rulings 201106003 (2/11/11), 201107004 through 201107009 (1/18/11), and 201108020 through 201108022 (2/25/11).

31 Notice 2010-41, 2010-22 I.R.B. 715.

32 Pritired 1 LLC, No. 4:08-cv-00082 (S.D. Iowa 9/30/11).

33 Health Care and Education Reconciliation Act of 2010, §1409, enacting Sec. 7701(o).

34 New Phoenix Sunrise Corp., No. 09-2354 (6th Cir. 11/18/10).

35 Rovakat, LLC, T.C. Memo. 2011-225.

36 Fidelity Int’l Currency Advisor A Fund, LLC, No. 10-2421 (1st Cir. 10/21/11).

37 Southgate Master Fund LLC, No. 09-11166 (5th Cir. 9/30/11).

38 Historic Boardwalk Hall, LLC, 136 T.C. No. 1 (2011).

39 Jade Trading, LLC, 80 Fed. Cl. 11 (2007).

40 Jade Trading, LLC, 598 F.3d 1372 (Fed. Cir. 2010).

41 Jade Trading, LLC, No. 03-2164T (Fed. Cl. 4/29/11).

42 Candyce Martin 1999 Irrevocable Trust , No. C 08-5150 (N.D. Cal. 10/6/11).

43 Virginia Historic Tax Credit Fund 2001, LP, T.C. Memo. 2009-295.

44 Virginia Historic Tax Credit Fund 2001, LP, Nos. 10-1333, 10-1334, and 10-1336 (4th Cir. 3/29/11).

45 Superior Trading, LLC, 137 T.C. No. 6 (2011).

46 CCA 201140025 (10/7/11).

47 AM 2010-007 (12/13/10).

48 Klebanoff, T.C. Summ. 2011-46.

49 IRS Letter Rulings 201135021 (9/2/11), 201115002 (4/15/11), and 201116010 (4/22/11).

50 IRS Letter Rulings 201129024 (7/22/11) and 201129030 (7/22/11).

51 IRS Letter Rulings 201141001 (10/14/11), 201122011 (6/3/11), and 201114011 (4/8/11).

EditorNotes

Hughlene Burton is chair of the Department of Accounting at the University of North Carolina–Charlotte in Charlotte, NC, and is a past chair of the AICPA Tax Division’s Partnership Taxation Technical Resource Panel. For more information about this article, contact Dr. Burton at haburton@uncc.edu.

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