Current Developments in Partners and Partnerships

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




  • Among last year’s developments in partnership taxation, the Tax Court held that determining a partner’s outside basis is a partnership item that can be addressed in a final partnership administrative adjustment (FPAA).
  • The Tax Court held that where a partnership failed to identify two indirect partners on a partnership tax return, the fact that the IRS obtained their identity during its investigation did not trigger the one-year statute of limitation in Sec. 6229(e).
  • The IRS issued final regulations under Sec. 108(e)(8) governing the treatment of COD income when a partnership’s debt is satisfied by transferring a partnership interest and the application of Sec. 721 to a contribution of a partnership’s indebtedness by a creditor to the partnership in exchange for a capital or profits interest.

This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, income allocations, and basis adjustments. During the period of this update (Nov. 1, 2011–Oct. 31, 2012), 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. This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, income allocations, and basis adjustments.

TEFRA Issues

In 1982, the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) 1 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 during audits are whether an item is a partnership item and the correct statute of limitation period. This year, several cases addressed these issues.

In the past couple of years the courts have ruled on the issue of whether basis was a partnership item or not in the Petaluma cases, which held that determining whether a partnership was a sham was a partnership item, but that determining the partners’ outside basis was not. 2 This year, in the Tigers Eye Trading 3 case, the IRS successfully disallowed losses in a son-of-boss transaction. The partnership claimed that Petaluma established that outside basis was not a partnership item that could be determined in a final partnership administrative adjustment (FPAA) and therefore the IRS did not have jurisdiction to make the adjustment. However, the court rejected the ruling in Petaluma and focused instead on the Supreme Court’s Mayo Foundation 4 holding and other recent cases, such as Chevron . 5

The court based its reasoning that Petaluma did not apply on a number of factors. First, it asserted that Petaluma was based on a government concession that should not apply in other cases. Second, since Tigers Eye Trading had filed a partnership return, it determined that TEFRA applied and the court had jurisdiction to find that it was not a partnership and to determine all items that would have been partnership items. Third, as Tigers Eye Trading acted as an agent for its partners, its disregarded entity status afforded a basis for computational adjustments disallowing losses and credits claimed in connection with it and adjustments of all such items to zero. Next, any partner’s basis in distributed property was the partnership’s cost basis therein. Lastly, it was proper to apply TEFRA regulations that satisfied the Chevron analysis rather than the contrary Petaluma ruling and to decide “outside basis” given these facts. Thus, the IRS was correct in making the determination of outside basis and could disallow the losses.

In a case 6 that involved two lower-tier source partnerships held by a family partnership, the partners engaged in the short-sale variant of a son-of-boss tax shelter. They used several newly formed entities, arranged in a tiered structure, each of which sought to be characterized as a partnership for tax purposes. The entities engaged in tax shelter transactions, which generated large losses. The family partnership claimed a loss from overstating its basis in the partnership interests upon their sale. These overstated bases supposedly flowed through to the family partnership, which used them to generate the losses.

The IRS issued an FPAA to the family partnership that included the adjustments shown on the two source partnership FPAAs, but the FPAA was issued to the family partnership before the completion of the two source partnership proceedings. The court determined that the family partnership’s FPAA was invalid because it was issued before the partnership-level proceedings in the source partnership cases were completed. It should be noted that the court did not address whether the IRS’s assessment was correct or not because it found that the FPAA was issued too early.

In another case, 7 a taxpayer challenged a deficiency issued by the IRS, claiming that the IRS should have issued an FPAA to the partnership rather than a notice of deficiency to the individual taxpayer. The taxpayer, a U.S. citizen, filed territorial income tax returns with the Virgin Islands Bureau of Internal Revenue (BIR). The taxpayer did not file tax returns with the IRS, claiming that he qualified for the gross income tax exclusion under Sec. 932(c)(4).

Because he did not file a federal return, the IRS conducted a nonfiler examination and determined that for those years, the taxpayer did not qualify for the exclusion. The IRS, therefore, issued a notice of deficiency. In a turnaround from the normal case, the taxpayer maintained that this case involved a partnership item and therefore the IRS should have issued an FPAA to the tax matters partner of the entity instead of issuing a notice of deficiency to the taxpayer. The court held that the TEFRA procedural rules did not apply in this case because the entity did not file a partnership return with the IRS and was not classified as a partnership for TEFRA purposes. The entity’s return filed with the BIR did not constitute the filing of a return with the IRS. Thus, the notice of deficiency to the taxpayer was valid.

In Superior Trading LLC, 8 the taxpayers requested the court reconsider or vacate earlier judgments that upheld the IRS’s adjustments to partnership items in an FPAA. The IRS had denied tax benefits from distressed asset/debt (DAD) tax shelters that involved a Brazilian retailer and an offshore entity that serviced distressed consumer receivables. The IRS had argued that the tax shelters were devices to transfer high-basis/low-value assets from “tax-indifferent” to “tax-sensitive” parties. The court had previously held 9 that the two entities had not formed a bona fide partnership for federal tax purposes, that no valid contribution of receivables had occurred, that carryover basis treatment per Sec. 723 was improper, and that the claimed contribution and subsequent redemption was properly collapsed into a single transaction and treated as a sale of the receivables. The taxpayers sought post-judgment relief, which the court denied. The court characterized the motions as a curious mixture of “a regurgitation of unfounded assertions and half-baked theories” 10 that the court had already rejected, combined with a criticism of the court’s holdings and baseless claims of newly discovered evidence.

Statute of Limitation

There was also a case in 2012 that concerned the appropriate statute of limitation. In Gaughf Properties , 11 the IRS assessed a tax on income from the expiration of a currency option that the partnership had not included in gross income. The partnership argued that the statute of limitation had expired before the assessment of the tax. The IRS argued, and the court agreed, that the statutory period for assessing tax attributable to partnership items was still open on the day the FPAA was issued because the partnership’s indirect partners had failed to satisfy the requirements of Sec. 6229(e) by not listing certain information identifying themselves as partners on the partnership’s tax return. Because the partners treated partnership items on their personal returns in a manner that was inconsistent with their treatment on the partnership return, and they did not notify the IRS of this inconsistent treatment, the indirect partners also failed to comply with Sec. 6222(b). The court also found that the information required by Sec. 6229(e) and its regulations identifying the indirect partners was not furnished to the IRS, and the fact that the IRS obtained and used this identifying information during the investigation did not trigger the running of the one-year period described in Sec. 6229(e). Thus, the statute of limitation was still open, and the taxpayers were liable for the additional taxes assessed.

Definition of a Partnership and a Partner

In Chief Counsel Advice 201235015, 12 the IRS addressed several questions regarding entities that should be treated as partnerships. Whether a partnership exists for federal tax purposes is a matter of federal, not state or local, law. Under federal law, an entity separate from its owner must exist before the IRS will recognize it as a partnership. In addition, if the entity files a Form 1065, U.S. Return of Partnership Income , the TEFRA partnership procedures apply regardless of whether the entity is a partnership, unless the small partnership exception to TEFRA applies or the only reason for filing the return was to make a Sec. 761(a) election.

In the same CCA, the IRS said that while Sec. 704(b) determines a partner’s distributive share of income, gain, deduction, loss, and credit, the sharing of income between a husband and wife holding a partnership interest as tenants by the entirety is governed by local law.

In Historic Boardwalk , 13 a case that hinged on who was a bona fide partner, the IRS held that a limited liability company (LLC) was simply a vehicle to transfer credits from a tax-exempt entity to a corporation and that any credits allocated to the corporation should be reallocated to the tax-exempt entity . The Tax Court allowed the corporation, through its membership interest in the LLC, to receive the historic rehabilitation tax credits generated by a renovation, rejecting the IRS’s determination that the corporation should not have been treated as a bona fide partner in the LLC because the corporation did not have a meaningful stake in the partnership’s success or failure and it was certain to recoup the contributions it had made to the LLC and to receive the primary benefit it sought—the historic rehabilitation tax credits or their cash equivalent. The Tax Court held that the corporation was a partner in the LLC, but the appellate court agreed with the IRS and reversed the Tax Court decision. The case was remanded to the Tax Court for further proceedings.

Electronic Filing of Schedules K-1

The IRS issued Rev. Proc. 2012-17, 14 which provides procedures for furnishing substitute Schedules K-1 in electronic format. A partnership may furnish Schedules K-1 electronically rather than on paper if certain requirements are met:

  • The recipient must affirmatively consent to receive the Schedule K-1 in an electronic format and not withdraw that consent before the statement is furnished;
  • The partnership must provide a clear and conspicuous disclosure statement that says that the partnership will furnish a paper Schedule K-1 if the recipient does not consent to receive the electronic version;
  • The partnership must inform the recipient of the scope and duration of the consent to receive the electronic version;
  • The partnership must explain how to get a paper version of the Schedule K-1 after the recipient has consented to an electronic version;
  • The partnership must explain what a recipient must do to withdraw the consent;
  • The partnership must inform the recipient of the conditions under which the partnership will cease furnishing electronic statements;
  • The partnership must inform the recipient of the procedures for updating contact information the partnership will need to furnish the electronic statement to the recipient; and
  • The partnership must describe the hardware and software requirements needed to print and retain the Schedule K-1.

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. The IRS was asked if a person who owns 100% of the membership interest in a disregarded entity could split his interest into separate classes of interests and then allocate income, loss, deductions, credits, and basis among those classes. The IRS determined that the owner could not split the interest and allocate income, loss, deductions, or credits to the various interests because this type of arrangement could be used to create or manipulate an “outside basis” in the disregarded entity interest for federal tax purposes that should not be there. 15

In Brennan , 16 a taxpayer was a member in a partnership when the partnership restructured. The issue in this case involved to what extent the taxpayer had to recognize capital gain income from the sale of certain partnership assets. The taxpayer argued that he was not a partner when the partnership sold the assets and, thus, he should not have to recognize his share of the gain. However, as part of the restructuring agreement that liquidated his partnership interest, he was entitled to receive 44.985% of the net proceeds from the sale of the assets. The partnership received proceeds from the sale of the assets in years after the partner claimed his interest was liquidated but never distributed any amount of the sale proceeds to that partner. The court ruled, however, that the partner had to take into account his distributive shares of the capital gain income from the sales as set forth in the restructuring agreement even though he did not get any of the actual sales proceeds.

In another case, 17 the question that arose was whether the taxpayer’s distributive share of income from an LLC was includible in his gross income. The taxpayer and his business partner organized a restaurant as an LLC, which was treated as a partnership for tax purposes. Later, the taxpayer’s partner shut him out of the business and refused his request for the LLC’s records. The taxpayer received a Schedule K-1 reporting his distributive share of the LLC’s income for the tax year in question.

The court found that the IRS established a sufficient evidentiary foundation linking the taxpayer with the income-producing activity by showing that he held a 40% interest in the LLC before he was locked out. Thus, the IRS’s determination of unreported income was entitled to the presumption of correctness. The court held that the fact that the taxpayer did not receive any distribution from the LLC because of his partner’s alleged wrongdoing did not change the general rule that he was taxable on his distributive share, whether or not he received any payment. However, the court held that the taxpayer was not subject to the accuracy-related penalty because he acted in good faith by attempting to access the partnership’s records. Further, he had his return prepared by an accountant in a good-faith attempt to properly assess his tax liability.

In McLauchlan, 18 the IRS disallowed business and partnership expenses to an attorney who was a member of a partnership. The taxpayer had claimed the partnership expenses on a Schedule C on his personal tax return. Included on the Schedule C, Profit or Loss From Business, were indirect partnership expenses he had related to the partnership operations. The court ruled that the indirect partnership expenses were deductible only if they were unreimbursable and were actually incurred. In this case, the indirect partnership expenses were reimbursable under the partnership agreement, and the taxpayer failed to show any specific expense for which the partnership denied him reimbursement.

The court also found that even if his travel, meals, and entertainment expenses were deductible as unreimbursed partnership expenses, the deductions would still be disallowed under the strict substantiation rules of Sec. 274(d). Thus, the court ruled that the taxpayer was not entitled to the deduction for the indirect expenses. In addition, the court found that the IRS met the burden of production to sustain the accuracy-related penalty because the IRS established that the taxpayer’s deficiency resulted in a substantial understatement of income tax for each of the years at issue and he had no reasonable cause for the understatements.

Sec. 704(c) Allocations

One of the exceptions to Sec. 704(a) is Sec. 704(c), which requires a partnership to 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). One of the stipulations of Regs. Sec. 1.704-3(a)(2) is that Sec. 704(c) applies on a property-by-property basis. However, Regs. Sec. 1.704-3(e)(3) allows certain securities partnerships to make Sec. 704(c) and reverse Sec. 704(c) allocations on an aggregate basis.

In Letter Ruling 201216019, 19 two securities partnerships qualified to make a Sec. 704(c) allocation on an aggregate basis. To align business objectives and achieve economies of scale, the partners intended to merge the two partnerships in an assets-over merger. The parties intended for the transferee partnership to acquire all of the assets as well as assume all of the liabilities of the transferor partnership. It was uncertain which partner ship would be the transferee partnership.

The IRS ruled that, whichever was the transferee partnership, both partnerships could aggregate the built-in gains and losses from the qualified financial assets contributed upon the merger of the two partnerships with gains and losses from revaluations of qualified financial assets held by the transferee partnership for purposes of making both Sec. 704(c) and reverse 704(c) allocations and could continue to use the aggregation method used by the transferee partnership.

COD Income

Treasury issued final regulations 20 relating to the application of Sec. 108(e)(8) to partnerships and their partners. These regulations provide guidance regarding the determination of discharge of indebtedness income of a partnership that transfers a partnership interest to a creditor in satisfaction of the partnership’s indebtedness and the application of Sec. 721 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 final regulations address how a partnership’s discharge of indebtedness income is allocated as a minimum gain chargeback under Sec. 704.

Sec. 108(e)(8) provides that for purposes of determining income of a debtor from discharge of indebtedness (COD income), if a debtor partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of its recourse or nonrecourse indebtedness, the partnership will be treated as having satisfied the indebtedness with an amount of money equal to the FMV of the partnership interest. In the case of a partnership, any COD income recognized under Sec. 108(e)(8) is included in the distributive shares of the partners in the partnership immediately before the discharge. Generally, the amount by which the indebtedness exceeds the FMV of the partnership interest transferred is the amount of COD income required to be included in the distributive shares of the partners that were partners in the debtor partnership immediately before the discharge.

The proposed regulations provided that, for purposes of determining the amount of COD income, the FMV of the partnership interest transferred to the creditor in a debt-for-equity exchange is the liquidation value of the partnership interest if four requirements are satisfied. Liquidation value equals the amount of cash that the creditor would receive with respect to the debt-for-equity interest if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going-concern value, and any other intangibles) for cash equal to the FMV of those assets and then liquidated.

The four conditions of the liquidation value safe harbor in the proposed regulations were that (1) the debtor partnership determines and maintains capital accounts; (2) the creditor, debtor partnership, and its partners treat the FMV of the indebtedness as being equal to the liquidation value of the debt-for-equity interest for purposes of determining the tax consequences of the debt-for-equity exchange (consistency requirement); (3) the debt-for-equity exchange is an arm’s-length transaction (arm’s-length requirement); and (4) subsequent to the debt-for-equity exchange, neither the partnership redeems nor any person related to the partnership purchases the debt-for-equity interest as part of a plan at the time of the debt-for-equity exchange which has, as a principal purpose, the avoidance of COD income by the partnership (antiabuse provision).

The IRS and Treasury made several changes and clarified other issues in the final regulations. First, they decided to remove the capital account maintenance requirement from the liquidation value safe harbor because the maintenance of capital accounts is not necessary to the determination of the liquidation value of the partner’s interest. Second, they added the condition that the partnership must apply a consistent valuation methodology to all equity issued in any debt-for-equity exchange that is part of the same overall transaction.

Third, they clarified that the liquidation value safe harbor should be available where the transaction involves related parties and provided that, as long as the debt-for-equity exchange has terms that are comparable to terms that would be agreed to by unrelated parties negotiating with adverse interests, the third requirement is satisfied even if the transaction is between related parties. Lastly, the final regulations added a restriction on subsequent purchases of the debt-for-equity interest by a person related to any partner (in addition to purchases by a person related to the partnership) as part of a tax-avoidance plan. Thus, under the final regulations, the partnership cannot redeem, and no person related to the partnership or to any partner can purchase, the debt-for-equity interest as part of a plan at the time of the debt-for-equity exchange that has as a principal purpose the avoidance of COD income by the partnership.

The final regulations also address the application of the liquidation value safe-harbor rule to a partnership (upper-tier partnership) that directly or indirectly owns an interest in one or more partnerships (lower-tier partnership(s)). The final regulations provide that, with respect to interests held in one or more lower-tier partnerships, the liquidation value of an interest in an upper-tier partnership is determined by taking into account the liquidation value of the lower-tier partnership interest.

In addition, the final regulations provide that if the FMV of the debt-for-equity interest does not equal the FMV of the indebtedness exchanged, then general tax law prin ciples apply to account for the difference.

The final regulations generally provide that Sec. 721 applies to the debt-for-equity exchange. Under this provision, the creditor does not recognize a loss or a bad debt deduction in the debt-for-equity exchange. The creditor’s basis in the debt-for-equity interest is increased under Sec. 722 by the adjusted basis of the indebtedness. However, the final regulations provide that Sec. 721 does not apply to the transfer of a partnership interest to a creditor in satisfaction of a partnership’s recourse or nonrecourse indebtedness for unpaid rent, royalties, or interest on indebtedness (including accrued original issue discount). Therefore, a debtor partnership will not recognize gain or loss upon the transfer of a partnership interest to a creditor in a debt-for-equity exchange for unpaid rent, royalties, or interest that accrued on or after the beginning of the creditor’s holding period for the indebtedness.

Lastly, the final regulations provide that COD income arising from a discharge of a partnership or partner nonrecourse indebtedness is treated as a first-tier item for minimum gain chargeback purposes under Regs. Secs. 1.704-2(f)(6), 1.704-2(j)(2)(i)(A), and 1.704-2(j)(2)(ii)(A).

The IRS in Rev. Rul. 2012-14 21 provided guidance on how to measure a partner’s insolvency under Sec. 108(d)(3). In this situation, a partnership borrowed funds secured by real estate valued in excess of the amount owed. The note was a nonrecourse liability under Regs. Sec. 1.752-1(a)(2). The value of the real estate fell below the outstanding amount of the note, and the lender agreed to reduce the principal amount of the loan. The partnership agreement provided for income to be allocated equally to the two partners, and the partners shared nonrecourse liabilities equally. The partnership’s only asset was the real estate subject to the note, and its sole liability was the note. Relying on Rev. Rul. 92-53, 22 the IRS determined that a partnership’s discharged excess nonrecourse debt is treated as a liability of the partners for purposes of measuring the partners’ insolvency under Sec. 108(d)(3) based upon how the COD income with respect to that portion of the debt is allocated among the partners under Sec. 704(b) and the regulations thereunder.

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 diligent in examining transactions that it considers to lack economic substance or that are sham transactions. The Service generally has prevailed in most cases on the issue, and it got even more help with the matter when the economic substance doctrine was codified in Sec. 7701(o) by the Health Care and Education Reconciliation Act of 2010. 23

This year in Alpha I, LP , 24 a taxpayer and the IRS appealed a Court of Federal Claims decision that dismissed for lack of jurisdiction the IRS’s determination that individual taxpayers’ transfers of their partnership interests to charitable remainder unitrusts (CRUTs) in a son-of-boss arrangement were sham transactions, and that accuracy-related penalties applied. In this case, the partnerships paired short-sale losses with capital gains to reduce their tax liability. The Court of Federal Claims ruled it lacked jurisdiction to determine the identity of the true partners in the partnership at issue. 25 The Federal Circuit reversed that decision, holding that such a finding was appropriately determined at the partnership level because partnership identity could affect the dis tributive shares reported to the partners.

The IRS had determined that the losses should be disregarded, or at least not be deductible, and that the transfers of the partnership interests to the CRUTs were shams, so none of the transactions of the partnership increased the amount considered at-risk for an activity under Sec. 465(b)(1). The lower court found that the taxpayers’ concession, based on the at-risk rules in Sec. 465, of the IRS’s adjustments rendered the valuation misstatement penalties moot. The appellate court vacated that decision and remanded the case to the lower court because the underpayment of tax was attributable to the alleged valuation misstatement and Sec. 465 did not provide a valid basis for the partnership’s concession. The appellate court determined that the lower court erred when it granted the taxpayers summary judgment on the issue of whether a 20% penalty should apply, because whether a negligence penalty applied was premature until the lower court determined whether the 40% gross valuation misstatement penalty applied.

In a case on remand from the Fifth Circuit, 26 a district court found that expenses related to foreign currency transactions were tax deductible because the partners controlled the partnership at the time the expenses were incurred. The court had found in the original case that the partners had made an investment in the partnership for the primary purpose of earning a profit. However, the court also determined that the transactions entered into by another partner lacked economic substance and would be disregarded, but that the partners had acted in good faith and, therefore, were not subject to any penalties.

The appellate court remanded the issue to the lower court to determine if other expenses such as management fees, state filing fees, and state taxes were deductible. The appellate court had made clear that the crucial issue to determine whether the expenses were deductible was which partner controlled the partnership’s activities at the time the expenses were incurred. Since the lower court found that the partners in question controlled the partnership at the time the expenses were incurred, they would be deductible.

Two cases decided in 2012 looked at the penalties the taxpayers would face when a partnership was determined to be a sham or lacked economic substance. One case was actually decided on the merits in 2009. In Blak Investments, 27 two partners borrowed Treasury securities and sold them in the open market at a loss in a short sale. They contributed the short-sale proceeds and the obligation to cover the short sale to their partnership in exchange for interests in the partnership. The two partners claimed that their bases in the partnership were increased by the short-sale proceeds but were not reduced by the obligation to cover the short sale. The partnership then redeemed the two partners’ interests in the partnership. On their federal income tax returns, the partners claimed significant losses for the redemption and subsequent sale of assets received in the redemption. Neither the partnership nor the partners disclosed their participation in the short-sale transaction on their tax returns. In the 2009 decision, the Tax Court ruled that the partnership was a sham.

In 2012, the tax matters partner for Blak Investments conceded that the partnership was a sham and lacked economic substance and that the partnership would be disregarded for federal income tax purposes. 28 However, the partner disputed the IRS’s determination that the partnership was subject to a 40% accuracy-related penalty under Sec. 6662(h). The court noted that the U.S. courts of appeals were divided on the issue of when and under what circumstances the 40% penalty applied. However, the Ninth Circuit had held that when a deduction or credit was disallowed in full, the resulting underpayment was not attributable to a valuation overstatement, and the smaller 20% accuracy-related penalty under Sec. 6662(a) applied. 29 The partnership was a California partnership, so an appeal of the case would lie in the Ninth Circuit. Thus, the Tax Court applied the Ninth Circuit precedent and held that the partnership would be subject to the lower 20% penalty instead of the 40% penalty for a gross valuation misstatement.

Also, in SAS Investment Partners , 30 the sole issue for decision was whether the partnership had a valid reasonable-cause defense to the penalties the IRS had determined as a result of a son-of-boss transaction. The court had previously determined that the transaction at issue lacked economic substance. The partnership claimed that it relied on advice from numerous professionals and therefore had a reasonable-cause defense. However, the record revealed that the partnership was not created for the purpose of carrying on a trade or business but rather as part of a tax shelter that would allow the partner to receive partnership property with an inflated basis.

Any reliance on advice from certain professionals lacked good faith because there was no question that one of those professionals was a “promoter” of the son-of-boss transaction. He participated in structuring the transaction, arranged the entire deal, provided a copy of the opinion letter, and profited from selling the transaction to numerous clients. He also based his fee on a percentage of the tax benefits he produced. Because that professional promoted the transaction and the partner knew of his conflict of interest, the partner, on behalf of the partnership, could not rely on the promoter’s advice or an opinion letter he obtained in good faith. Thus, the court determined that the partnership was subject to penalties the IRS assessed.

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 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 301.9100-3.

In letter rulings in 2012, 31 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 301.9100-3. Each partnership had 120 days after the ruling to file the election. In several other rulings with similar facts, 32 the IRS granted the partnership an extension for making the Sec. 754 election even though the partnership relied on a professional tax adviser.

In another instance, 33 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.

In Letter Ruling 201213006, 34 a partnership was technically terminated under Sec. 708(b)(1)(B). The partnership inadvertently failed to timely file a Sec. 754 election with the return for its tax year ending on the termination date. It claimed that in relying on its tax adviser it had acted reasonably and in good faith, that relief would not prejudice government interests, and that it had not used hindsight in making the election. The IRS granted relief and allowed an additional 120-day period within which to make the omitted election.


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

2 Petaluma FX Partners LLC, No. 08-1356 (D.C. Cir. 1/12/10).

3 Tigers Eye Trading LLC , 138 T.C. No. 6 (2/13/12).

4 Mayo Found. for Med. Educ. and Research, 131. S. Ct. 704 (2011).

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

6 Rawls Trading, LP, 138 T.C. 271 (2012).

7 Huff, 138 T.C. 258 (3/19/12).

8 Superior Trading LLC, T.C. Memo. 2012-110.

9 Superior Trading LLC, 137 T.C. 70 (2011).

10 Superior Trading LLC, T.C. Memo. 2012-110 at *8.

11 Gaughf Properties, LP, 139 T.C. No. 7 (2012).

12 CCA 201235015 (8/31/12).

13 Historic Boardwalk Hall LLC, No. 11-1832 (3d Cir. 8/27/12).

14 Rev. Proc. 2012-17, 2012-1 C.B. 453.

15 AM 2012-001 (2/9/12).

16 Brennan, T.C. Memo. 2012-209.

17 Martignon, T.C. Summ. 2012-18.

18 McLauchlan, T.C. Memo. 2011-289.

19 IRS Letter Ruling 201216019 (1/4/12).

20 T.D. 9557.

21 Rev. Rul. 2012-14, 2012-1 C.B. 1012.

22 Rev. Rul. 92-53, 1992-2 C.B. 48.

23 Health Care and Education Reconciliation Act of 2010, P.L. 111-152.

24 Alpha I, LP, 682 F.3d 1009 (Fed. Cir. 2012).

25 Alpha I, LP, 93 Fed. Cl. 280 (2010).

26 Klamath Strategic Investment Fund, LLC, No. 5:04-cv-278 (E.D. Tex. 9/24/12).

27 Blak Investments, 133 T.C. 431 (2009).

28 Blak Investments, T.C. Memo. 2012-273.

29 Keller, 556 F.3d 1056 (9th Cir. 2009).

30 SAS Investment Partners, T.C. Memo. 2012-159.

31 IRS Letter Rulings 201240008 (10/5/12) and 201238001 (9/21/12).

32 IRS Letter Rulings 201229009 (7/20/12), 201214006 (4/6/12), and 201213024 (3/30/12).

33 IRS Letter Ruling 201222012 (6/1/12).

34 IRS Letter Ruling 201213006 (12/15/11).


Hughlene Burton is an associate professor and chair of the Department of Accounting at the University of North Carolina–Charlotte in Charlotte, N.C., and is the former chair of the AICPA Tax Division Partnership Taxation Technical Resource Panel. She currently serves on the AICPA Tax Executive Committee. For more information about this article, contact Dr. Burton at .


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