Current Developments in Partners and Partnerships

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


  • Treasury issued proposed regulations on how to allocate income to varying interests.

  • This year three cases were decided that ruled that LLP and LLC members may be material participants for Sec. 469 purposes.

  • Proposed regulations would allow the IRS to treat certain partnership items as nonpartnership items under TEFRA.

  • The IRS issued guidance on Sec. 108 cancellation of indebtedness income and its application to partnerships.

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, 2008–October 31, 2009), 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. Treasury issued proposed partnership regulations regarding the allocation of income when there are varying interests throughout the year, the treatment of cancellation of debt (COD) income, and classification of partnership items in a TEFRA audit. The courts and the IRS issued various rulings that addressed partnership operations and allocations.


The American Recovery and Reinvestment Act of 2009 (ARRA) 1 added a provision that allows eligible small businesses to elect a three-, four-, or five-year net operating loss (NOL) carryback for one tax year after 2007. Taxpayers who are partners in partnerships that would qualify as small businesses can also make this election. The IRS issued two revenue procedures 2 to help taxpayers determine the time and manner for making the election. Rev. Proc. 2009-19 provided guidance for making an election under Sec. 172(b)(1)(H), which included the election of a three-, four-, or five-year carryback period, an election to apply Sec. 172(b)(1)(H) to an NOL for a tax year that began in 2008 instead of ending in 2008, and the election if a taxpayer had previously filed an election under Sec. 172(b)(3) to forgo the NOL carryback period. This procedure also provided guidance on how a taxpayer that is a partner in an eligible small business partnership makes the election to carry back the NOL three, four, or five years.

The IRS received many claims from taxpayers seeking a three-, four-, or five-year carryback that did not made a valid election based on the rules in Rev. Proc. 2009-19. To help taxpayers accurately make the election, the IRS issued Rev. Proc. 2009-26. This revenue procedure modified Rev. Proc. 2009-19 and changed the way the election should be made. Under Rev. Proc. 2009-26, an electing small business (ESB) may elect a three-, four-, or five-year carryback period simply by filing Form 1045, Application for Tentative Refund, Form 1139, Corporation Application for Tentative Refund, or an amended return that carries back the NOL for three, four, or five years. It should be noted that this election must be made within six months after the due date (excluding extensions) of the return for the tax year of the NOL. Thus, a taxpayer that seeks to make a timely election using Form 1045, Form 1139, or an amended return must file the form in advance of its ordinary due date.

TEFRA Issues

In 1982, the Tax Equity and Fiscal Responsibility Act of 1982 3 (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 partnership level. Two questions that continue to arise under audit are whether an item is a partnership item and what is the correct statute of limitation period. This year there were several cases that addressed both of these issues.

Transfer of Interests as Partnership Item

In Alpha I L.P., 4 the taxpayer transferred its interests in a limited partnership (LP) to four charitable remainder trusts (CRTs). One of the assets owned by the LP was marketable securities. After the transfer of the interest, the LP sold the stock for a loss that it allocated to all the members. The IRS issued a final partnership administrative adjustment (FPAA) in which it reduced the LP’s basis in the stock. The adjustment’s effect was to convert the loss on the sale to a gain. In addition, the IRS determined that the transfer of the LP interests to the CRTs should be disregarded as an economic sham and that the original owners, not the CRTs, should be treated as the members of the LP.

The members contended that the court lacked jurisdiction to consider whether the transfers to the trusts were shams because the transfer was not a partnership item. The IRS argued that the identity of partners in a partnership was a partnership item or at the very least an affected item. The court found that the identity of partners was neither a partnership item nor an affected item and thus was improperly determined in the FPAA because the transfer of an interest has no effect on either the partnership’s aggregate or each partner’s separate share of partnership income or loss. This year the government filed a motion for reconsideration of the issue. However, the Court of Federal Claims denied this motion. 5

Tax Court Jurisdiction

In LKF X Investments, LLC, 6 the issues were (1) whether the Tax Court had jurisdiction in the partnership-level proceeding to decide if the partnership should be disregarded for federal income tax purposes, (2) whether the Tax Court had jurisdiction to decide if accuracy-related penalties applied, and (3) whether the partnership was also liable for the accuracy-related penalty. The court resolved all those questions in the affirmative. The individual taxpayer participated in market-linked deposit transactions. He reported a nonpassive loss from his Schedule K-1 in the partnership but did not treat its corresponding obligations under a short option as liabilities under Sec. 752 and so did not reduce the basis in his partnership interest by the short-option premium. Because the premiums canceled each other out, the taxpayer failed to establish that the adjusted basis in his partnership interest was greater than zero.

Partnership Adjustments

In another case, 7 the taxpayers argued that the partnership adjustments were no longer partnership items because the individuals had filed an amended return that qualified under Sec. 6227 as a partner administrative adjustment request (AAR). The court rejected the argument that Ninth Circuit law considered amended returns as AARs in all instances because the regulations required that certain information had to be provided in the correct manner for a request to qualify as a partner AAR. In this case the taxpayers’ amended return did not substantially comply with the requirements for a partner AAR. In addition, the amended return was not filed in the manner required for Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), and did not include all the information required on that form. Thus, the items subject to adjustment were partnership items.

Notice of Deficiency

The issue in Napoliello 8 and Meruelo 9 dealt with the issuance of a notice of deficiency. In Napoliello the parties agreed that the deficiency notice was valid and that the court had jurisdiction in this partner-level case only if the deficiency procedures applied. There were two issues for decision. The first was whether the IRS had issued the taxpayers a valid deficiency notice. The court held that the deficiency notice was valid and that it had jurisdiction because the deficiency was attributable to an affected item requiring partner-level factual determinations. The second issue was whether the deficiency notice was invalid because the FPAA violated due process by failing to give the taxpayer adequate notice of the deficiency in his federal income taxes. The court held that the deficiency notice was valid because the determinations in the FPAA adequately put the taxpayer on notice that the IRS had finally determined adjustments to the partnership return. Thus, the IRS was entitled to judgment as a matter of law.

In Meruelo the taxpayers contended that the court lacked jurisdiction because the notice of deficiency was issued prematurely and was thus invalid. In this case the IRS had not begun an audit of the partnership containing the partnership items that were being adjusted in the notice of deficiency. The court determined that the fact that the partnership had not been audited did not bar the IRS from issuing a notice of deficiency to the partner for items related to the partnership. Therefore, it was proper for the IRS to have issued the notice of deficiency to the taxpayers just before the statute of limitation was going to expire on the taxpayers’ (and the partnership’s) tax years. Moreover, the three items in the notice of deficiency were affected items that required determinations at the partner level.

Tax Shelter Legal Opinions

Tigers Eye Trading, LLC, 10 raised an important issue about what a taxpayer can rely on when investing in a tax shelter transaction. In this case a participating partner filed a motion to declare Temp. Regs. Secs. 301.6221-1T(c) and (d) invalid on the grounds that it would prevent him from raising partner-level reasonable cause defenses to accuracy-related penalties. The court had previously held that this regulation was valid and applicable to prevent a participating partner from interposing his partner-level defenses in the partnership-level proceeding.

In this situation, the taxpayers had relied on an expert’s evaluation on whether the partner could have reasonably relied on a legal opinion concerning the tax shelter. The report was designed to support the partner’s reasonable reliance defense to the accuracy-related penalties. Whether the partner could use the report as a defense at the partnership-level proceeding depended on whether the law firm that prepared the opinion was a promoter of the tax shelter. If it was, the issue could be decided at the partnership level. If not, it would have been a partner-level defense because the opinion would have been tailored to the partner’s individual situation. Unfortunately, the court did not resolve this issue; it determined that the opinion was not admissible because it consisted of legal conclusions. However, as the number of listed transactions and tax shelters increases, this question may arise again.

Statute of Limitation

There were also several cases that concerned the appropriate statute of limitation. In Salman Ranch Ltd., 11 the government contended that the partnership’s omission from gross income of an amount in excess of 25% of its reported gross income extended the limitation period for issuing the FPAA. The partnership argued that the extended limitation period did not apply because the alleged overstatement of basis was not an omission from income, and the transaction was adequately disclosed in the returns of the partnership and partners.

The court held that the extended limitation period (six years) applied so the IRS had timely issued the FPAA. The 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 of the ranch did not by itself suffice to preclude an omission from gross income. Further, the returns of the partnership and the partners did not adequately disclose the nature and amount of a short-sale transaction on which the partnership’s step-up basis figure was based. The taxpayer appealed the decision in 2009. 12 In an interesting turn of events, the Appeals Court reversed the Tax Court’s decision and remanded the case back to the Tax Court with the instruction to enter judgment for the partnership.

In Bakersfield Energy Partners, LP, 13 the taxpayers were a limited partnership and its partners that owned an interest in oil and gas property. The taxpayers sought to sell the property. In an FPAA issued after the general three-year statute of limitation, the IRS claimed that before the sale was consummated, four of the seven partners in the partnership took a series of steps that led the partnership to increase its basis in its oil and gas property and thereby decreased its gross (and potentially taxable) income from the sale. The taxpayers asserted that the general three-year limitation period applied and the FPAA was untimely. The appellate court found that a taxpayer’s overstatement of basis was not an omission of income. Therefore, the IRS had only three years to assess the tax deficiency and it had failed to do so.

Another case 14 concerned how the taxpayers had reported their net loss upon the expiration of their long and short options. The IRS issued a notice of FPAA that determined overstatements of the bases of the partnership interests because the partnership had failed to separately reflect the gain and loss from long and short options on the currency market. The partnership reported contributions without disclosing that the contributions included only the long-option premiums. The IRS argued, and the court agreed, that there was a substantial omission from gross income, and the six-year period of limitation under Sec. 6501(e) applied in this situation. The IRS also argued that the partners created the partnership and artificially inflated the bases in some stock it held for the purpose of offsetting significant capital gains from the partners’ sales of another stock. The court would not render an opinion on whether Sec. 6501(e) would be applicable to the IRS’s economic substance or sham argument regarding the formation of the partnership.

TEFRA Audits

Two other issues arose in 2009 related to TEFRA audits. The first was the issuance of proposed regulations under Sec. 6231. 15 The proposed regulations will allow the IRS to convert partnership items to nonpartnership items when the application of TEFRA partnership procedures for certain tax avoidance transactions interferes with the effective and efficient enforcement of the internal revenue laws. The regulations affect taxpayers who have engaged in a listed transaction through an entity subject to the TEFRA partnership procedures. The proposed regulations are limited to tax avoidance transactions that the IRS and Treasury publicly identify as listed transactions. The fact that the transaction becomes a listed transaction after the date on which the taxpayer engaged in the transaction does not preclude the conversion of items under the proposed regulations. In addition, the proposed regulations allow the IRS to make the determinations regarding whether to convert partnership items to nonpartnership items on a partnership-by-partnership and partner-by-partner basis.

Second, the IRS issued several chief counsel advice memorandums (CCAs) 16 that dealt with the requirement to report dividends from affiliated domestic corporations on line 6b of Schedule K-1. Tax preparers should note that if this amount is not listed on line 6b, the IRS assumes there are no such dividends. In CCA 200942047, the IRS stated that if the partnership did not report this amount, there might be a need to open a TEFRA proceeding in order to determine the allocation of line 6b between foreign and domestic corporation dividends and the division of domestic corporate dividends between affiliated and nonaffiliated corporations.

Definition of a Partnership

In Secs. 761 and 7701, the term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on and that is not, within the meaning of subtitle A, a corporation, a trust, or an estate. An entity can make an entity classification election if it is an eligible entity and chooses to be classified initially as other than its default classification of corporation or partnership or when an eligible entity chooses to change its classification. The election must be made on Form 8832, Entity Classification Election, and filed with the tax return for the year the election is to be effective.

Rev. Proc. 2009-41 17 provides guidance for an eligible entity that requests relief for a late classification election that is filed within three years and 75 days of the requested effective date of the eligible entity’s classification election. The revenue procedure also provides guidance for those eligible entities that do not qualify for relief under this revenue procedure and that are required to request a letter ruling in order to request relief for a late entity classification election.

In Letter Ruling 200921009, 18 two LPs were equal partners in a general partnership (GP). The GP had a portion of its land acquired under threat of condemnation. After failing to agree on what to acquire for replacement property, the partners decided that two pieces of property would be acquired by separate continuing partnerships formed by the GP and that the partners would each control one of the partnerships, with the other partner owning a small interest in that partnership. The IRS determined that the new LPs would qualify as partnerships under Sec. 7701 because they were business entities and were eligible entities because they were not classified as corporations. They would each be a continuation of the GP and would be subject to preexisting elections made by the GP. In addition, the GP and the new partnerships were entitled to nonrecognition of gain under Sec. 1033. Thus, all the taxpayers would be able to defer the gain on the land by making a timely reinvestment of the condemnation proceeds.

In dealings with the IRS, partnerships must designate a tax matters partner. In 2009 the question arose as to who had the ability to change the tax matters partner. 19 Responsibility for designating a successor tax matters partner lies with the partnership. If, however, the partnership fails to appoint a tax matters partner, the Tax Court can appoint a successor. In this case, because the partnerships had each designated a new tax matters partner, the Tax Court held that it lacked the authority to do so on their behalf. The Tax Court ruled that the partnerships had satisfied the requirements of Sec. 6231. The IRS’s argument—that a certain related entity should not be able to serve as a tax matters partner because the entity’s liability would not be determined during the proceeding—did not matter. The Tax Court noted that the tax matters partner’s importance derived from his role as a fiduciary serving on behalf of the other partners and that his personal interest, if any, was beside the point.

Specialized Partnerships

Investment Partnerships

Sec. 721(a) provides that neither the partner nor the partnership will report a gain or a loss on the transfer of property in exchange for a partnership interest. Sec. 721(b) goes on to provide that the nonrecognition treatment of Sec. 721(a) does not apply to investment partnerships. In Letter Ruling 200934013, 20 a corporation owned 100% of a single-member limited liability company (LLC), a disregarded entity. The LLC’s operations consisted solely of investing in a diversified portfolio of passive assets. One of the corporation’s owners contributed cash to the LLC in exchange for a newly issued, nonvoting preferred interest and was admitted as a new member.

The corporation proposed to distribute its membership interests in the LLC to its owners and to amend the LLC’s operating agreement to provide the corporation with a disproportionate share of profits. The IRS held that the admission of the individual owner triggered the LLC’s conversion to a partnership to which the corporation was deemed to have contributed assets in a transaction treated as a Sec. 721 contribution. However, the LLC was not required to be treated as an investment company. Thus, Sec. 721(b) did not apply to the shareholder’s contribution.

In Letter Ruling 200931042, 21 an LLC was formed to lower investment costs and create greater investment opportunity for its members that would otherwise not be available to them as separate investors. In this situation, new members would make capital contributions in exchange for membership interests, and certain original members would make additional capital contributions in exchange for additional membership interests. The IRS concluded that the transfer by the new and original members was not a transfer of property to a partnership that would be treated as an investment company under Sec. 351 provided that this was the only transfer to the LLC. Thus, no gain or loss would be recognized by the LLC or any of the members on the contribution of the assets to the LLC under Sec. 721(b).

Family Limited Partnerships

The IRS and taxpayers have contested the valuation of interests in family limited partnerships (FLPs) for many years. However, this year the IRS questioned the valuation of a partnership when a taxpayer transferred partnership interests to two trusts. In Pierre, 22 the taxpayer funded an LLC with cash and marketable securities. Twelve days after funding the LLC, she transferred her entire interest in the LLC to trusts established for the benefit of her son and granddaughter. She accomplished this by making a gift of a 9.5% interest in the LLC and selling a 40.5% interest in the LLC to each trust in exchange for a promissory note.

In valuing the transfers for gift tax purposes, the taxpayer applied substantial discounts for lack of marketability and control. The IRS claimed that the transfers should be treated as transfers of the LLC’s cash and underlying assets because a single-member LLC should be treated as a disregarded entity under the check-the-box regulations. However, under state law the taxpayer did not have a property interest in the underlying assets of the LLC, which was recognized as an entity separate and apart from its members. The court refused to apply the check-the-box regulations in determining how a donor must be taxed under the federal gift tax provisions on a transfer of an ownership interest in the LLC. Therefore, the transfers were valued as an interest in the LLC and not as an interest in the underlying assets, and the taxpayer was allowed to take a discount on the transfer.

Partnership Operations and Income Allocation

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 any election affecting the computation of the partnership’s taxable income. Under Sec. 704(a), the allocation of partnership items is made based on the partnership agreement; however, there are several exceptions to this general allocation rule. Sec. 706 provides that, in computing the taxable income of a partner for a tax year, the inclusions required by Secs. 702 and 707 with respect to a partnership are based on the income, gain, loss, deduction, or credit of the partnership for any tax year of the partnership ending within or with the tax year of the partner. Sec. 706(d) provides that if there is a change in a partner’s interest in the partnership during the partnership’s tax year, each partner’s distributive share of any partnership item of income, gain, loss, deduction, or credit for such tax year is determined by the use of any method prescribed by regulations that takes into account the varying interests of the partners in the partnership during the tax year (the varying interests rule).

Treasury has issued proposed regulations 23 regarding the determination of partners’ distributive shares of partnership items of income, gain, loss, deduction, and credit when a partner’s interest varies during a partnership tax year. The proposed regulation provides that if a partner’s interest changes during the partnership’s tax year, the partnership determines the partner’s distributive share using the interim closing method. However, the partnership may use the proration method if all the partners agree. Under this method, except for extraordinary items (as defined in the proposed regulation), the partnership allocates the distributive share of partnership items under Sec. 702 among the partners in accordance with their pro-rata shares of these same items for the entire tax year. In determining a partner’s pro-rata share of partnership items, the partnership takes into account that partner’s interest in such items during each segment of the tax year. In addition, for each partnership tax year in which a partner’s interest varies, the proposed regulations provide that the partnership must use the same method to take into account all changes occurring within that year. It is important to note, however, that for extraordinary items, the partnership must use the closing-of-the-books method.

What Is Ordinary Income?

Sec. 702 requires partners to report in their income their share of the partnership’s taxable income or loss. Regs. Sec. 1.702-1(a) provides that each partner is required to take into account his or her share of income or loss, whether or not distributed. In 2009 in Hicks, 24 the taxpayer owned a 10% interest in an LLC, which reported its operations as if it were a partnership. However, the taxpayer did not report any income during the year because he did not receive any payment from the partnership. The IRS assessed a tax on his share of income reported on the LLC’s tax return. The court held that a partner was required to include his distributive share of each item of partnership income in gross income even if the partnership did not actually distribute any income to him during the year.

This year another issue that arose was who must report the income. In Gronbeck, 25 the taxpayer’s deceased husband invested in an LP that the IRS determined was an improper tax shelter. The IRS assessed the tax on the investor’s widow. Mrs. Gronbeck argued that the income in question was attributable to her husband and not to her because he was the sole owner of the partnership interest during the years when essentially all the partnership losses were claimed. The court disagreed and found that the taxpayer’s husband transferred his interest in the partnership to the taxpayer so that he could qualify for medical benefits. The ownership interest was not forced upon the taxpayer; rather, it was done voluntarily by the taxpayer and her husband to take advantage of state and federal medical benefits while allowing the taxpayer to control the partnership interest and other property interests. The court concluded that the wife was liable for the unpaid tax because she was the legal owner of the partnership interest.

Sec. 704(c) Regs.

Sec. 704(c) requires that a partnership must allocate items of income, gain, loss, and deduction attributable to contributed property to take into account any variation between the property’s adjusted tax basis and its fair market value (FMV) at the time of contribution. Regs. Sec. 1.704-3(a) permits the use of any reasonable allocation method that is consistent with the purposes of Sec. 704(c).

Treasury issued proposed regulations in 2007 addressing the consequences under Secs. 704(c) and 737 of certain partnership mergers. It received a number of comments in response to these proposed regulations expressing concern about the proposed treatment of Sec. 704(c) layers in connection with a partnership merger. In addition, Treasury has become aware that practitioners are taking positions based on different interpretations of the current tiered partnership rules under Regs. Sec. 1.704-3(a)(9). Because of these issues, the IRS and Treasury decided that more study was needed before the proposed regulations were finalized. In response, the IRS issued Notice 2009-70, 26 which invited public comments on the proper application of the rules relating to the creation and maintenance of multiple layers of forward and reverse Sec. 704(c) gain and loss to partnerships and tiered partnerships, including in the context of partnership mergers and divisions.

Allocation of Liabilities

Sec. 752(a) provides that any increase in a partner’s share of a partnership’s liabilities, or any increase in a partner’s individual liabilities by reason of the assumption by such partner of partnership liabilities, is considered a contribution of money by such partner to the partnership and will thus increase the partner’s outside basis. Likewise, Sec. 752(b) provides that any decrease in a partner’s share of the partnership’s liabilities, or any decrease in a partner’s individual liabilities by reason of the partnership’s assumption of such individual liabilities, is considered a distribution of money to the partner by the partnership.

In Murfam Farms, LLC, 27 the IRS determined that certain contingent obligations contributed to the taxpayers’ partnerships constituted liabilities for purposes of Regs. Sec. 1.752-6, and the assumption of the obligations by the partnerships mandated a reduction in each partner’s outside basis in the partnership. The taxpayers argued that the regulation was invalid because:

  • Its retroactive date failed to comply with the statutory limitation on the issuance of retroactive regulations;
  • The regulation prescribed rules that failed to carry out congressional intent; and
  • The regulation was issued without good cause.

In an unusual decision, the court agreed with the taxpayer and found that the regulation was invalid because its retroactive date failed to comply with the statutory bar on retroactive regulations relating to U.S. internal revenue laws. Thus, the partners did not have to reduce their outside basis and were allowed to deduct the losses allocated to them.

COD Income

The American Jobs Creation Act 28 amended Sec. 108(e)(8) to include COD income. In 2009 proposed regulations 29 were issued relating to the application of Sec. 108(e)(8) to partnerships and their partners. These regulations provide guidance on the determination of COD income of a partnership that transfers a partnership interest to a creditor in satisfaction of the partnership’s indebtedness (debt for equity exchange). The proposed regulations also provide that Sec. 721 applies to a contribution of a partnership’s recourse or nonrecourse indebtedness by a creditor to the partnership in exchange for a capital or profits interest in the partnership.

In addition, the IRS issued Rev. Proc. 2009-37 30 to clarify the procedures, including the time and manner, taxpayers must follow to make an election to defer recognizing COD income under Sec. 108(i). The taxpayer should make the election by including a statement that clearly identifies the applicable debt instrument. This statement must include the amount of income to which Sec. 108(i) applies and other information the IRS may prescribe. This revenue procedure also gives taxpayers making this election guidance on the type of additional information they must provide on returns for tax years after the tax year for which the taxpayer makes the election. If a partnership needs an election under this section, the partnership must make the election, not the partners. Practitioners should note that the IRS and Treasury plan to issue more guidance on Sec. 108(i) that may include regulations addressing matters in this revenue procedure. If the IRS issues regulations, they may be retroactive.


Three items determine whether a partner can deduct his or her share of partnership losses:

  • Partnership interest basis under Sec. 704(d);
  • Sec. 465 amount at risk; and
  • Sec. 469 passive activity income.

In Furey, 31 the IRS disallowed a loss from the partnership because it did not have adequate basis. According to the IRS, the taxpayers’ evidence relating to two partnerships—including evidence about the existence of the partnerships, the partnerships’ business activity, income and expenses, the partnerships’ books and records, and who the actual partners were—was highly suspect and completely inadequate to determine if they had enough basis to deduct losses from the partnerships. The court determined that the taxpayers offered implausible explanations and evidence relating to the losses and expenses in question. For example, one taxpayer stated that he had certain documents in his possession at home, but he never produced those records either to the IRS agent or in court. Thus, the court agreed with the IRS and ruled that the taxpayers could not deduct the losses.

Sec. 469 limits the amount of losses taxpayers are allowed to deduct from a passive activity. A passive activity is determined to be any activity in which the taxpayer does not materially participate or that is a rental activity. The regulations under Sec. 469 provide seven tests to determine material participants, but most limited partners cannot meet any of the seven tests. This year the courts ruled in three separate cases for the taxpayer where members of LLCs and LLPs claimed loss deductions on the assumption that they materially participated in the activity.

In Garnett, 32 the taxpayers owned interests in LLPs, LLCs, and tenancies in common. The taxpayers deducted losses from each of these interests. The IRS ruled that the taxpayers failed to meet the material participation criteria in Sec. 469 so the losses were limited by the passive activity loss rule. The issue this case addressed was whether the loss rules in Sec. 469(h)(2) applied. Under Sec. 469(h)(2), an interest in a limited partnership held by a limited partner is presumptively passive. The taxpayers argued that Sec. 469(h)(2) did not apply because they were considered general partners rather than limited partners, as they were active participants in the management of the companies. The judge agreed with the taxpayers and ruled that they could be treated as general partners for Sec. 469 purposes.

In Thompson, 33 the IRS found that the taxpayer was not allowed to claim losses from an air charter service that he formed as an LLC. The IRS disallowed the losses because it determined that an interest in an LLC was the same as that of a limited partner in a limited partnership for purposes of Sec. 469. As in Garnett, the court ruled in favor of the taxpayer, finding that the taxpayer did not hold a limited interest in the LLC so Sec. 469 did not limit the amount of losses the taxpayer was allowed to claim. The court came to a similar conclusion in Hegarty. 34

The reader should note that not all members of LLPs and LLCs will be allowed to deduct losses from the entity’s activities. In these three cases the IRS disallowed the loss because it treated all owners of LLPs and LLCs as limited partners that were presumed not to materially participate in the activity in question under Sec. 469(h)(2). However, in each of the cases the taxpayers were material participants in the activity. Thus, if a member of an LLP or LLC does not materially participate, the general passive activity loss rules of Sec. 469 still disallow his or her losses even if the passive activity presumption in Sec. 469(h)(2) does not apply. In addition, the judge in Garnett noted that members could be limited partners for liability purposes but general partners for other purposes based on the facts of the case. In the future there may be more cases in which the IRS applies this ruling to tax partners as general partners instead of limited partners.

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 there should be a tax-independent business purpose behind the transaction. The IRS has recently been very diligent in examining transactions that it considers to lack economic substance.

In Maguire Partners, 35 two individuals, through various entities including partnerships, sold short options to a company and purchased long options and promissory notes from the same company. The partnerships received the long options and notes and assumed the short options. The IRS argued that the transactions did not have economic substance because the individuals received no economic benefit, other than an increase in basis, from the transactions. The court agreed with the IRS. The court also held that the individuals were motivated by the increased basis and not by any purported hedging benefit as they claimed and that the individuals’ actual cost basis was the original amount of their investment, not the increased basis reported by the partnerships, because they had no downside exposure and only an extremely remote possibility of receiving a return. Finally, the court ruled that the partnerships made a gross valuation misstatement when one of the individual’s partnerships reported an increase in its capital account equal to 67 times the actual economic outlay that the individual had paid for the transaction.

Clearmeadow Investments, LLC, 36 involved an investment in an alleged son-of-boss tax shelter. In this case a taxpayer learned about an investment strategy that was developed by a law firm, and he hired the law firm to create an LLC and a corporation to trade in foreign currency market-linked deposits. The corporation claimed that it suffered a loss when it traded in the foreign currency. The taxpayer claimed the loss as the sole owner of the LLC and the corporation, but the IRS issued an FPAA that disallowed the loss. The court upheld the IRS’s decision, stating that the partnership formed by the LLC and the corporation did not have economic substance or a business purpose; even assuming that there was no technical violation of the Code, the transactions in question failed because they lacked economic substance.


Under Sec. 731(a), partners will recognize a gain to the extent they receive cash in excess of their basis in their partnership interests. In Robertson, 37 the taxpayers received distributions from the LLC for two years, but they could not establish that they had sufficient basis in their LLC interests for the distributions to be tax free for either year. The taxpayers’ capital accounts reported having zero balances on the LLC’s tax return. For the same reason, the taxpayers could not deduct their distributive share of the LLC’s loss. The taxpayers argued that they could not provide evidence as to their basis because many of their business records were destroyed after the tax preparer’s death. The court agreed with the IRS and ruled that the distributions were taxable under Sec. 731.

In addition, the IRS assessed penalties for the tax deficiencies and for failure to file a timely return. The taxpayers argued that they had reasonable cause for the failure to file, citing disaster declarations for certain areas of Florida for that year. However, although their tax preparer was located in Florida, his office was not in the county covered by the disaster declaration. In addition, the taxpayers’ return was due under extension more than a month before the disaster declaration. As for the deficiency penalty, the taxpayers argued that they were unsophisticated and had limited experience with partnership tax concepts. They reasonably believed that their tax preparer was a qualified tax professional and were not aware that he was under federal investigation for filing fraudulent returns. The court found the taxpayer liable for the failure-to-file penalty but for only a portion of the deficiency penalty.

In CCA 200916023, 38 the IRS addressed the issue of whether a limited partner must recognize gain in the case of a distribution by a partnership. Several pending examinations had the same fact pattern. In these cases a domestic limited partnership has three partners. GP, its general partner, had a 1% interest, and LP1 and LP2, its limited partners, had a 94% and a 5% interest, respectively. LP1 was a wholly owned domestic subsidiary of a foreign corporation, XYZ. GP was a wholly owned domestic subsidiary of LP1. LP2 was a domestic partnership that had two partners, each of which owned 50% of the profits and capital interests of LP2, and each of which was a wholly owned domestic subsidiary of a different wholly owned domestic subsidiary of XYZ. Each of the three partners of the partnership contributed capital to the partnership in proportion to their interest in the partnership.

XYZ lent the partnership, on a recourse basis, an amount equal to or greater than the amount contributed to the partnership by its partners. The same day, the partnership distributed a percentage of the proceeds of the loan to GP, LP1, and LP2, in proportion to each partner’s interest in the partnership.

State law provided that, in general, a limited partner was not liable for an LP’s obligations to third parties. However, if a limited partner knowingly received a distribution, which at the time of the distribution caused the liabilities of an LP to exceed the FMV of the assets of the LP, the limited partner would be liable to the LP for the amount of the distribution. The limited partner’s obligation to the partnership expired upon the expiration of three years from the date of the distribution. Based on these facts, the IRS determined that the limited partner must recognize a gain under Sec. 731 to the extent the amount the limited partner received exceeds its basis.

In Wallis, 39 the taxpayer did not include in income (as either capital gain or ordinary income) any of the amount received for his partnership interest. He later conceded that part of the income that was labeled “Schedule C Benefits” should have been included in income but disagreed about the character of the income. The taxpayer contended that this income should be long-term capital gain income, whereas the IRS contended the amounts were ordinary income. Based on the information the taxpayer submitted, the income was not treated as part of the partners’ respective shares of partnership income or partnership property and was not reflected in the partners’ respective capital accounts. Its payment appeared to be a means by which the partnership provided retirement benefits to its equity partners. Thus, the court found that the payment should be treated as a guaranteed payment taxed as ordinary income.

The IRS also contended that all or most of the amount the taxpayer received for his capital account should have been reported as long-term capital gain, based on the fact that the taxpayer’s capital account when he left the partnership was less than $500, according to the calculations on the Schedule K-1 filed with the tax return each year. The taxpayer contended that this amount was a return of basis and therefore was not taxable. He maintained that he had basis in excess of the amount he received from the partnership based on schedules prepared by the partnership that showed the value of the taxpayer’s capital account. Thus, there were two sets of capital account calculations, both created by the partnership in the regular course of its business. In this case, the court accepted the taxpayer’s schedules and found that he had established a reasonable basis to determine that the capital account payments did not exceed his basis in his partnership property and thus were not taxable.

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 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 his or her 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. Secs. 301.9100-1 and -3.

In several rulings this year, 40 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 60 days after the ruling to file the election. In another ruling, 41 an entity was formed as an LLC under the law of state 1. Later one of the members made an additional capital contribution, which the partnership distributed to each of the LLC’s members in proportion to their ownership in a transaction that was treated as a sale of partnership interests under Sec. 707. The LLC then redomesticated to state 2. The LLC intended to make a Sec. 754 election to adjust the basis of partnership property, but its tax preparer inadvertently failed to timely file the election. When the omission was discovered, the LLC asked the IRS to extend the deadline for such an election, and the IRS did so.

In several other instances this year, 42 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 these were inadvertent failures and granted the partnerships 60-day extensions to file the election.


Hughlene Burton is an associate professor in the Department of Accounting at the University of North Carolina in Charlotte, NC, and is chair of the AICPA Tax Division’s Partnership Taxation Technical Resource Panel. For more information about this article, contact Dr. Burton at

1 American Recovery and Reinvestment Act of 2009, P.L. 111-5.

2 Rev. Procs. 2009-19, 2009-14 I.R.B. 747, and 2009-26, 2009 I.R.B. 935.

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

4 Alpha I L.P., 84 Fed. Cl. 209 (2008).

5 Alpha I L.P., No. 06-407 T (Fed. Cl. 3/16/09).

6 LKF X Investments, LLC, T.C. Memo. 2009-192.

7 Samueli, 132 T.C. No. 16 (2009).

8 Napoliello, T.C. Memo. 2009-104.

9 Meruelo, 132 T.C. No. 18 (2009).

10 Tigers Eye Trading, LLC, T.C. Memo. 2009-121.

11 Salman Ranch Ltd., 79 Fed. Cl. 189 (2007).

12 Salman Ranch Ltd., 573 F.3d 1362 (Fed. Cir. 2009).

13 Bakersfield Energy Partners, LP, No. 07-74275 (9th Cir. 6/17/09).

14 Highwood Partners, 133 T.C. No. 1 (2009).

15 REG-138326-07.

16 Chief Counsel Advice 200942047 (10/16/09), 200943036 (10/23/09), and 200943037 (10/23/09).

17 Rev. Proc. 2009-41, 2009-39 I.R.B. 439.

18 IRS Letter Ruling 200921009 (5/22/09).

19 Gateway Hotel Partners, LLC, T.C. Memo. 2009-128.

20 IRS Letter Ruling 200934013 (8/2/09).

21 IRS Letter Ruling 200931042 (7/3/09).

22 Pierre, 133 T.C. No. 2 (2009).

23 REG-144689-04.

24 Hicks, T.C. Summ. 2009-68.

25 Gronbeck, T.C. Memo. 2009-53.

26 Notice 2009-70, 2009-34 I.R.B. 255.

27 Murfam Farms, LLC, No. 06-245T (Fed. Cl. 7/30/09).

28 American Jobs Creation Act, P.L. 108-357.

29 REG-164370-05.

30 Rev. Proc. 2009-37, 2009-36 I.R.B. 309.

31 Furey, T.C. Memo. 2009-35.

32 Garnett, 132 T.C. No. 19 (2009).

33 Thompson, No. 06-211 T (Fed. Cl. 7/20/09).

34 Hegarty, T.C. Summ. 2009-153.

35 Maguire Partners-Master Investments, LLC, No. CV 06-07371-JFW(RZx) (C.D. Cal. 2/4/09).

36 Clearmeadow Investments, LLC, No. 05-1223 T (Fed. Cl. 6/24/09).

37 Robertson, T.C. Memo. 2009-91.

38 CCA 200916023 (4/17/09).

39 Wallis, T.C. Memo. 2009-243.

40 IRS Letter Rulings 200933001 (8/14/09), 200921006 (5/22/09), 200917018 (4/24/09), and 200908018 (2/20/09).

41 IRS Letter Ruling 200922007 (5/29/09).

42 IRS Letter Rulings 200941007 (10/9/09), 200932037 (8/7/09), 200924014 (6/12/09), and 200921013 (5/22/09).

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