Current Developments in Partners and Partnerships

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


Photo by JamesBrey/iStock

  • Determining the correct application of TEFRA rules, whether a partnership existed, and whether a person or entity was a partner in a partnership were frequent subjects of litigation over the past year.
  • Final regulations require partnerships that have undergone technical terminations when they are still amortizing their startup expenditures to continue to amortize those expenditures using the same amortization period adopted by the terminating partnership.
  • Proposed regulations were issued providing guidance on the allocation of partnership liabilities in substituted-basis transactions, disguised sales, and the treatment of Sec. 751 property.
  • As a number of cases from this period show, the IRS continued to successfully attack transactions that it considers to lack economic substance.

This article reviews and analyzes recent regulations, rulings, and cases involving partnerships, including developments in partnership formation and operations, ­income allocations, and basis adjustments. During the period this update covers (Nov. 1, 2013–Oct. 31, 2014), Treasury and the IRS worked to provide guidance for taxpayers on numerous changes that h ave been made to subchapter K over the past few years.

TEFRA Issues

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) 1 was enacted in part 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 come up in audits are whether an item is a partnership item and the correct statute-of-limitation period. In 2014, several cases addressed these issues.

In Greenwald, 2 the taxpayer owned interests in bona fide partnerships that were subject to TEFRA audit and litigation procedures. The partnerships liquidated, and the partnership items for the year of liquidation were determined in partnership-level proceedings. Following those proceedings, the IRS issued notices of deficiency determining the partners' gain on liquidation of the partnerships at the partner level. The taxpayers filed petitions in response to those deficiency notices, asking that they be dismissed for lack of jurisdiction. They argued that outside basis is a partnership item that should have been determined at the partnership level and that the deficiency notices were invalid. The Tax Court determined that gain or loss on the disposition of a bona fide partnership interest is an affected item that requires partner-level determinations. Therefore, the notices of deficiency were issued appropriately at the partner level and the Tax Court had jurisdiction.

Meanwhile in Ashland, 3 the taxpayers appealed a Tax Court decision dismissing the case for lack of subject matter jurisdiction at the partner level. This case concerned the question of whether the taxpayers properly treated an LLC distribution as a guaranteed payment to Brooke Ashland. Because guaranteed payments are partnership items, the issue of whether the LLC made the payment must be decided at the partnership level. The Ashlands argued that the TEFRA rules should not apply under the "small partnership" exception in Sec. 6231(a)(1)(B)(i). But since one of the LLC's members was another partnership, the "small partnership" exception did not apply. Because guaranteed payments are a partnership-level item, the Tax Court lacked jurisdiction to determine whether the taxpayer treated the payment correctly at the partner level.

In another case, 4 the Tax Court held that payments, which a taxpayer received from an LLC he formed in an attempt to alter his status as an employee and thus reduce his tax obligations, were guaranteed payments for services. The court found that the IRS had properly issued a final partnership administrative adjustment (FPAA) that disallowed management fee deductions the LLC had claimed on its tax return. The court also held that the LLC was negligent because it knew the payments were for services the taxpayer performed, but mischaracterized them as management fees. Although the LLC was allowed to deduct the payments it made to the taxpayer either way, by recharacterizing the payments as guaranteed payments, the taxpayer was personally liable for self-employment taxes.

Lastly, in Bedrosian, 5 the taxpayers had invested in a son-of-boss tax shelter transaction through a partnership that was subject to TEFRA. The IRS issued an FPAA for the partnership that included a notice to the taxpayers of their right to opt out of the TEFRA proceeding. The FPAA was properly mailed, but the taxpayers claimed that they did not receive it in time to file a timely petition to opt out of TEFRA. Although the taxpayers filed a petition, it was late and the Tax Court dismissed it. The Ninth Circuit upheld the ruling.

The IRS also issued a deficiency notice to the taxpayer that included the FPAA adjustments but also included other adjustments. The taxpayers filed a timely petition in Tax Court in response to the deficiency notice, asking the court to rule that all of the items in the deficiency notice, including those that were included in the previously issued FPAA, should be determined at the taxpayer level.

The court held that partnership items did not convert to nonpartnership items under TEFRA because the partnership proceeding was ongoing at the time the IRS mailed the FPAA. In addition, the partnership items did not convert to nonpartnership items because filing a petition in response to a deficiency notice is not substantial compliance with the procedures for opting out of a TEFRA proceeding. As a result, the partnership items in the deficiency notice could not be determined at the taxpayer level.

Statutes of Limitation

Two cases in 2014 and late 2013 concerned the appropriate statute of limitation. In Martin, 6 the taxpayers owned a portion of a company, either outright or through family trusts. The taxpayers formed a tiered partnership structure and started a series of transactions designed to minimize their tax liability from the sale of the company. The IRS audited the tax returns for two partnerships that were involved in the transactions. As part of the audits, the partnerships agreed to extend the statute of limitation for assessing taxes. The IRS then issued an FPAA that increased the taxpayers' tax liability.

The taxpayers challenged the FPAA because they said that it was issued after the statute of limitation had expired. The court in this case determined that some of the adjustments made in the FPAA were partnership items that flowed through to the partners, and that the agreements to extend the partnership's statute of limitation covered some of those adjustments, which therefore permitted the IRS to assess more taxes on the taxpayers.

In Gaughf, 7 the question before the court was whether the assessment period for the taxpayers' return remained open on the date the IRS issued an FPAA. In this case, the court determined that the taxpayers' tax liability came within the Sec. 6229(e) unidentified-partner exception to the Sec. 6229(a) general three-year statute of limitation because the taxpayers were not identified as indirect partners on the partnership's tax return, and information identifying them as indirect partners was not otherwise timely furnished, so the one-year limitation period in Sec. 6229(e) was not triggered. The D.C. Circuit affirmed the Tax Court's determination.

Definition of Partnership and Partner

In the period covered by this update, the courts and the IRS addressed whether entities should be treated as partnerships and who should report partnership income in a number of situations. The Markell Co. 8 case began when the IRS found the remnants of a corporation on an Indian reservation. The tribe claimed not to know how it came to own the corporation's stock. At the time of the audit, little money or property was left in the corporation. The IRS was interested in the corporation's manager, who had engineered a series of complex transactions that bore a resemblance to son-of-boss deals but with a corporate-partner twist.

While there are different varieties of son-of-boss deals, the common theme is a transfer of assets encumbered by significant liabilities to a partnership, with the goal of inflating that partnership's basis. Taxpayers who engage in these deals claim that this allows the partner and the partnership to ignore those liabilities in computing basis. The result is that the partners will have basis in their partnership interest high enough to provide for large noneconomic losses on their individual tax returns.

In this situation, Markell, a corporation, formed a partnership, MC Trading. The partnership bought short and long options of a publicly traded company. Markell then contributed its interest in MC Trading to another partnership, MC Investments, claiming that it bought a partnership interest, and calculated its basis in MC Investments without taking into account MC Trading's contingent liability. The court's primary holding was that MC Investments was not a partnership because the company was not conducting an ongoing enterprise, since it was completely controlled by the manager, and its only activity was one stock purchase. Therefore, the partnership should be disregarded because it was created to carry out a tax-avoidance scheme and never intended to run a business. Since there was no partnership, the subchapter K rules did not apply to the transaction. Instead, the court found that MC Investments was Markell's agent for the purchase of the stock. Because Markell was deemed to buy the stock itself, there was no step-up in basis, and the company owed the additional tax. In addition, because Markell reported a basis more than 400% over the correct amount and showed no honest misunderstanding of the law or reasonable cause, it was subject to a 40% penalty under Sec. 6662(h)(1).

In Letter Ruling 201421001, a trust held a diversified portfolio of securities, which included all the interests in an LLC. The trust formed the LLC to facilitate the management and eventual distribution of trust assets to its remainder beneficiaries. To facilitate distribution of the trust assets, the trustees proposed to form two series of LLCs. One series would be capitalized principally with equity securities from the trust and the LLC, and the other series would be capitalized principally with fixed-income securities from the trust and the LLC. The trust's contribution of marketable securities to the LLCs in exchange for all of the LLCs' ownership interests was disregarded for federal tax purposes because the LLCs would not elect to be classified as associations, and therefore would be disregarded as entities separate from the trust. Thus, as long as the trust remained the single member of the LLCs, items of income, deduction, credit, gains, and losses on the assets held within the LLCs would be reported directly on the trust's federal income tax returns as if the trust continued to hold the LLCs' assets directly.

In another case, 9 the taxpayer was a partner in a law firm. The taxpayer reported his share of partnership income on a Schedule C, Profit or Loss From Business (Sole Proprietorship), and reduced the income by deductions for business expenses. The IRS argued that the taxpayer was not entitled to claim the business expense deductions on Schedule C. The taxpayer countered that if the expenses on the Schedule C were disallowed, they would be deductible as unreimbursed partnership expenses on Schedule E, Supplemental Income and Loss.

The Tax Court disallowed the partnership expenses the taxpayer deducted on the Schedule C. The court reasoned the expenses were not deductible as unreimbursed partnership expenses on either Schedule C or Schedule E because these were expenses the taxpayer chose to incur, rather than ones called for by the partnership agreement, or were expenses that the taxpayer was required to incur but were reimbursable under the partnership's reimbursement policy. The taxpayer appealed the decision. The Fifth Circuit upheld the Tax Court decision.

In Crescent Holdings, 10 a corporate CEO's employment agreement granted him a 2% restricted equity interest in a partnership the corporation was a partner in. The interest was not vested and was forfeitable if the CEO did not remain employed by the corporation for three years. The CEO did not make a Sec. 83(b) election when he received the restricted interest. He was allocated income from the partnership for the first two years after he received the interest but received no distributions. Before the three years was up, the corporation terminated the CEO, and he forfeited his interest in the partnership.

The issues before the court were (1) whether the CEO's interest was a capital or profits interest and (2) whether income should be allocated to the holder of an unvested capital interest. The Tax Court found that the interest was a capital interest because the partner would have liquidation rights when the interest vested. Because the interest was deemed to be a capital interest, the CEO had no income under Sec. 83 when the interest was first granted to him. In addition, he did not have to recognize any undistributed income allocations the partnership made because he did not own the partnership interest. Instead the income must be allocated to the other partners of the partnership.

In Carrino, 11 shortly after the taxpayers legally separated, the husband used community property to fund a partnership that operated a successful hedge fund. The partnership's original tax return did not name the wife as a partner or report any distributions to her. A few years later a state court approved the couple's agreement that 72.5% of the husband's investment in the partnership was community property. In response, the husband filed amended partnership returns for the years the wife was not listed as a partner, identifying the wife as a partner. The IRS assessed tax on the wife for her share of the partnership's income during that time. The wife disagreed, saying she was not a partner until the state court approved the divorce agreement several years later.

The question the court had to address was whether the wife had a present interest in the community-property portion of income the husband earned from the partnership from the beginning of the investment. Under state community-property law, the "character of property as separate or community is determined at the time of its acquisition." Thus, it is irrelevant when an individual actually receives the stream of income from that community asset. And even if one spouse invests community property in a partnership with a nonspouse, the property invested remains community property. Accordingly, the interest in a partnership is not a new kind of property, but takes its character as separate or community property in accordance with how and when it was acquired. The court determined that it did not matter that the husband invested in the partnership after he legally separated from his wife; what was important is that he funded his partnership interest with community property. Therefore, she was subject to tax on her share of the income from the time the investment in the partnership was made.

In Historic Boardwalk, 1 2 the Third Circuit considered whether an investor's stake in the success or failure of a partnership that incurred qualifying rehabilitation expenditures was sufficiently meaningful for the investor to qualify as a partner in that partnership. The agreements governing the Historic Boardwalk transaction ensured that the investor would receive Sec. 47 rehabilitation credits (or their cash equivalent) and a preferred return, with only a remote opportunity for additional profit. Both the Sec. 47 rehabilitation credits and the preferred return were guaranteed as part of the transaction, and the preferred return guarantee was funded.

The Third Circuit determined that the investor's return from the partnership effectively was fixed, and that the investor also had no meaningful downside risk because its investment was guaranteed. The court agreed with the commissioner's reallocation of all of the partnership's claimed losses and tax credits from the investor to the principal, holding that "because [the investor] lacked a meaningful stake in either the success or failure of [the partnership], it was not a bona fide partner."

Last year the IRS issued Rev. Proc. 2014-12, 13 partially in response to the Historic Boardwalk case, to establish the requirements (the safe harbor) under which the IRS will not challenge partnership allocations of Sec. 47 rehabilitation credits. According to the revenue procedure, Treasury and the IRS intend for the safe harbor to provide partnerships and partners with more predictability regarding the allocation of Sec. 47 rehabilitation credits to partners of partnerships that rehabilitate certified historic structures and other qualified rehabilitated buildings.

In Chief Counsel Advice (CCA) 201436049, the IRS addressed whether partners of an LLC taxed as a partnership, which had as its primary source of income fees for providing investment management services, were "limited partners" exempt from self-employment tax under Sec. 1402(a)(13) on their distributive shares of the partnership's income. In this situation, LLC, a management company, served as the investment manager for a family of investment partnerships. The LLC was one of two general partners in the investment partnerships for state law purposes. The LLC had full authority and responsibility to manage and control the affairs and business of each investment partnership with the partners of the LLC providing these services. The primary source of income for the LLC was from fees for providing management services to the investment partnerships. Based on this information, the IRS determined that the LLC's members were not "limited partners" within the meaning of Sec. 1402(a)(13) and were subject to self-employment tax on their distributive shares of income from the LLC. This ruling follows the Renkemeyer decision, which held that practicing lawyers in a law firm organized as a limited liability partnership were subject to self-employment tax and were not limited partners under Sec. 1402(a)(13). 14 Tax professionals should be careful when advising investment partnerships about self-employment taxes.

In another CCA, 15 the taxpayer, an investor in an LLC that was treated as a partnership for federal tax purposes, had zero basis in his partnership interest. The LLC purchased equipment that qualified for the refundable New York State Investment Tax Credit (NYITC). The taxpayer claimed the credit on his personal income tax return and received a refund in year 2 because the credit exceeded his state income tax liability. Although the NYITC refund is not a distribution from the LLC to the taxpayer, the taxpayer would have no right to the NYITC refund except for his investment in the LLC.

The issue was whether the refundable portion of the NYITC paid directly to the investor in an LLC should be treated as an item that increases the taxpayer's outside basis or as a deemed distribution. The IRS argued the refunded portion of the NYITC was taxable as ordinary income and could not be offset by a flowthrough loss from the partnership because the taxpayer did not have basis to claim the loss. The taxpayer had two possible arguments why the refundable portion of the credit was not ordinary income. First, if the receipt of the NYITC refund created outside basis in the taxpayer's interest in the LLC, then the taxpayer's LLC losses are no longer limited, and the taxpayer argued he should be allowed to offset his income from the refundable portion of the NYITC with losses from the LLC. Second, the taxpayer asserted that the NYITC refund was a deemed distribution of money in excess of basis and therefore subject to capital gain rates instead of ordinary income tax rates.

Both of these arguments depend on the NYITC refund's being a partnership item. However, the NYITC refund is paid directly to the taxpayer. The LLC did not receive the refund and did not have a right to receive it. Therefore, the IRS determined that the refund was not a partnership item. Since it was not a partnership item, it could not affect the taxpayer's outside basis in the partnership interest and should not be treated as a distribution from the partnership. Thus, the refundable portion of the NYITC paid to the taxpayer should be treated as ordinary income.

Publicly Traded Partnerships

Sec. 7704(a) provides that, except as provided in Sec. 7704(c), a publicly traded partnership is treated as a corporation. Sec. 7704(b) provides that the term "publicly traded partnership" means any partnership the interests of which are (1) traded on an established securities market or (2) readily tradable on a secondary market (or its substantial equivalent). Sec. 7704(c)(1) provides that Sec. 7704(a) does not apply to a publicly traded partnership that meets the gross income requirements of Sec. 7704(c)(2) (at least 90% of its gross income is "qualifying income") for a tax year and each preceding tax year beginning after Dec. 31, 1987, in which the partnership or any predecessor existed.

Sec. 7704(d)(1)(E) provides that qualifying income includes income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or their products), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber). The conference report 16 accompanying the Omnibus Budget Reconciliation Act of 1987 17 states:

Income and gains from certain activities with respect to minerals or natural resources are treated as passive-type income. Specifically, natural resources include fertilizer, geothermal energy, and timber, as well as oil, gas or products thereof. For this purpose, fertilizer includes plant nutrients such as sulphur, phosphate, potash and nitrogen that are used for the production of crops and phosphate-based livestock feed. 18

The IRS has issued a number of private letter rulings that requested a determination of whether the income a partnership generated would qualify under Sec. 7704(d)(1)(E). For example, in Letter Ruling 201411004, a limited partnership, through affiliated entities, was engaged in mining, processing, marketing, and transportation of natural resources. Its operating assets included renewable identification numbers (RINs), which were codes generated by renewable fuel producers or importers to uniquely identify the fuel in each batch. The RIN that was assigned to a batch of renewable fuel had to be transferred with the underlying fuel until it was blended into a conventional fuel or sold in the retail fuel market, at which point the RIN became freely transferable independent of the underlying fuel.

The partnership accumulated RINs through various methods. Since the partnership sells excess RINs through RIN brokers, the IRS determined that gross income from the sale of RINs and from the partnership's refined fuel delivery services provided to customers engaged in mining of natural resources (excluding any portion of that income derived from the delivery or sale of products to customers who are not engaged in drilling, exploration, and production, or mining activities) was "qualifying income."

In Letter Ruling 201408025, a company intended to form a limited partnership that would be a publicly traded partnership. The partnership would mine and process feedstock to produce a product (the ruling is redacted and among its redactions is a definition of the product). In some cases, the partnership would enhance the effectiveness of the product but would not sell the product at the retail level. The IRS ruled that the gross income derived by the partnership from the mining, processing, marketing, storage, and transportation of the product would constitute "qualifying income" as income or gains derived from the exploration, development, mining or production, processing, refining, transportation, or the marketing of any mineral or natural resource.

Likewise, in Letter Ruling 201412007, a publicly traded partnership provided a full suite of services to customers engaged in the oil and natural gas industry. The partnership intended to acquire another company's business, including customer contracts. Services were an essential element of the partnership's business. The IRS concluded that the gross income derived by the partnership from these services to customers engaged in the production, processing, and transportation of oil and natural gas constituted qualifying income under Sec. 7704(d)(1)(E).

Also in Letter Ruling 201414002, a limited partnership that intended to become a publicly traded partnership expected to generate income from the supply of fresh water for use in the hydraulic fracturing process, the transportation of fracturing fluid to producers' well sites for use in exploration and production activities, and the transportation of flowback produced water and other drilling and production wastes from producers' well sites to third-party disposal facilities. The transportation would be provided by a combination of pipelines, trucks, and other equipment. The partnership expected to own the transportation assets that it would use to provide fluid handling services but might also earn income from the operation of transportation assets another party owned. The IRS again ruled that the gross income derived by the partnership constituted "qualifying income." A similar situation can be found in Letter Ruling 201416003.

Partnership Operations and Income Allocation

Sec. 701 states that a partnership is not subject to tax but instead 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 its taxable income computation. Under Sec. 704(a), partnership items are allocated based on the partnership agreement; however, there are several exceptions to this general allocation rule. Sec. 704(c) requires that a partner's basis adjustment be taken into account in determining the effect on that partner's income, gain, loss, or deduction when property is contributed that has either a built-in gain or loss.

In 2014, Treasury issued proposed regulations 19 that provide guidance on certain provisions of the American Jobs Creation Act of 2004. 20 The proposed regulations modify the basis allocation rules to prevent certain unintended consequences of the current basis allocation rules for substituted-basis transactions. The proposed regulations also provide additional guidance on allocations resulting from revaluations of partnership property. The regulations address four main topics: (1) contributions of built-in loss property (Sec. 704(c)(1)(C)); (2) mandatory basis adjustments; (3) Sec. 755's basis allocation rules; and (4) tracking reverse Sec. 704(c) layers.

The proposed regulations clarify that for a contribution of built-in loss property, the basis in excess of fair market value (FMV) benefits only the contributing partner. Allocations to other partners are to be made as if the asset's tax basis is equal to its FMV. Under the proposed regulations, only the contributing partner will be entitled to a loss on the property. The proposed regulations treat the tax basis in excess of FMV at contribution in a manner similar to a Sec. 743 adjustment.

The proposed regulations provide guidance on the application of the mandatory basis adjustments required for property with substantial built-in losses under Secs. 734 and 743. They also clarify how these rules will be applied.

When a partnership has either a Sec. 734 or Sec. 743 adjustment, the adjustment is allocated under Sec. 755. Currently, when allocating Sec. 743 adjustments in a substituted-basis transaction, an increase in basis is allocated only to built-in gain property, and a decrease in basis is allocated only to built-in loss property, whereas Sec. 743 adjustments in a purchased transaction may be allocated to all assets. The proposed regulations change the current Sec. 743 regulations when a transferor has a "purchased transaction" Sec. 743 adjustment. In this situation, a substitute-basis transaction transferee succeeds to the transferor's basis adjustment. The amount is limited to the amounts attributable to the acquired interest and is intended to prevent "electivity" in the allocation of Sec. 743 adjustments.

With regard to the rules on Sec. 704(c) layers, there is a question of whether the taxpayer should use a netting or a layering approach to a number of Sec. 704(c) adjustments. Because the government is concerned with distortions to income, the proposed regulations require that partnerships use the layering approach.

A partnership may deduct expenses incurred for startup costs and organizational expenses. In 2014, Treasury issued final regulations 21 concerning the deductibility of these expenses for a partnership following a technical termination under Sec. 708(b)(1)(B). The regulations are intended to eliminate uncertainty over whether a partnership is entitled to immediately deduct any unamortized startup and organizational expenses upon a technical termination. Specifically, they provide that the new partnership is required to continue to amortize those expenditures using the same amortization period adopted by the terminating partnership.


A partner calculates his or her basis in a partnership interest according to the rules in Sec. 705. Sec. 705 requires a partner to increase basis by contributions to the partnership and taxable and tax-exempt income and to decrease basis by distributions, nondeductible expenses, and deductible losses. Under Sec. 752, partners are allowed to increase partnership basis by their share of partnership liabilities.

In VisionMonitor Software, LLC, 22 the Tax Court had to determine a partner's basis when he contributed his own note to his partnership for his partnership interest. The court ruled that the contribution of a personal note is not the equivalent of a contribution of cash, and the contribution will not increase the partner's basis in his partnership interest. In this case, the partners had contributed notes to the partnership for a partnership interest. The partners each had no adjusted basis in the notes. Until the notes were paid, the notes were only a contractual obligation to their partnership and not property. Since none of the partners had made any payments on the notes, the partners' bases in their promissory notes during the years in question were zero and, accordingly, the partnership's basis in the contributed notes was zero.

Disguised Sales

Sec. 707(a)(2)(B) provides that a disguised sale occurs (1) when a partner directly or indirectly transfers money or property to a partnership, (2) when there is a related direct or indirect transfer of money or other property by the partnership to that partner, and (3) when viewed together, the transfers are properly characterized as a sale or exchange of property. In all cases, the substance of the transaction governs rather than its form.

In Buyuk, 23 a company was purported to contribute receivables to an LLC in exchange for an interest in the LLC. Afterward, the LLC made distributions to the company. The Tax Court found that the LLC's basis in the receivable was the amount the LLC paid to the company, because the company's transfer of the receivables to the LLC along with the LLC's cash payments constituted a disguised installment sale of the receivables under Sec. 707(a)(2)(B). The cash payments were not dependent on the entrepreneurial risks of the partnership operations. In addition, the court determined it had to disregard the transactions because they lacked economic substance.

In another case, 24 an LLC had transferred property to a limited liability partnership where the LLC used the promise of state tax credits to induce the partnership to make a financial contribution. The LLC exercised proprietary control over the tax credits, and the credits were both valuable and imbued with essential property rights because they could be used or transferred. The court determined that the transfers were properly characterized as a sale of property because the LLC would not have transferred the tax credits but for the partnership's transfer. The transfers did not depend on any entrepreneurial risk. The court ruled that the facts and circumstances confirmed that the LLC and partnership engaged in a disguised sale under Sec. 707(a) rather than a contribution by the LLC to the partnership and a related distribution from the partnership.

In a third case, 25 the court ruled that a partnership was not required to recognize taxable income from transfers of tax credits that were distributions in redemption of equity of a partner, since the managing member of the partner was the actual borrower in a bridge loan agreement for historic preservation projects that generated the credits. The lender's transfer of the bridge loan proceeds directly to the partnership constituted a deemed capital contribution by the member to the partner and then a deemed capital contribution of the proceeds by the partner to the partnership, and thus the transfers of the credits were partnership distributions, which did not warrant recharacterization as disguised sales. The partnership's election to divert rather than receive a portion of the proceeds of a sale of credits to the bridge loan liability rendered that portion includible in the partnership's income.

Treasury jointly issued proposed regulations under Sec. 707 relating to disguised sales and under Sec. 752 relating to the treatment of partnership liabilities. However, currently they are planning to separate the proposed regulations. 26

The proposed regulations under Sec. 707 address a number of issues. The existing disguised sale of property regulations provide a number of exceptions from disguised-sale treatment. The proposed regulations clarify the exception for debt-financed distributions as well as the exception for reimbursement of preformation expenditures. The proposed regulations add a new category of qualified liabilities incurred in connection with the conduct of a trade or business. The proposed regulations also clarify the consequences of an anticipated reduction of a partner's share of a partnership liability and the treatment of liabilities in an assets-over merger. Lastly, the proposed regulations add rules for tiered partnerships.

The proposed regulations under Sec. 752 on debt allocations add new requirements relating to payment obligations for recourse liabilities. They also address bottom-dollar guarantees and extend the net value requirement for recourse debt that previously only applied to disregarded entities. For nonrecourse liabilities, the proposed regulations amend the permissible methods of allocation and provide a new approach to determining a partner's interest in partnership profits.

Sec. 751

Sec. 751 prevents using a partnership to convert potential ordinary income into capital gain. To that end, Sec. 751(a) provides that the amount of any money, or the FMV of any property, received by a transferor partner in exchange for all or part of that partner's interest in the partnership's unrealized receivables and inventory items is considered as an amount realized from the sale or exchange of property other than a capital asset. Further, Sec. 751(b) overrides the nonrecognition provisions of Sec. 731 to the extent a partner receives a distribution from the partnership that causes a shift between the partner's interest in the partnership's unrealized receivables or substantially appreciated inventory items (collectively, the partnership's "Sec. 751 property") and the partner's interest in the partnership's other property.

Whether Sec. 751(b) applies depends on the partner's interest in the partnership's Sec. 751 property before and after a distribution. Current Treasury regulations under Sec. 751(b) fail to provide an accurate determination of each partner's share of ordinary income because they do not take into account current allocation rules. Treasury issued proposed regulations on Oct. 31, 2014. 27 The proposed regulations update the rules for determining whether Sec. 751(b) applies to a distribution by calculating whether a distribution has caused any partner's allocable share of income from the partnership's hot assets to change, including the application of mandatory and optional allocations. The proposed regulations prescribe how a partner should measure its interest in a partnership's unrealized receivables and inventory items, and provide guidance regarding the tax consequences of a distribution that causes a reduction in that interest. The proposed regulations, which take into account statutory changes that have occurred since the existing regulations were issued, will apply to distributions that occur in any tax period ending on or after the date the proposed regulations are finalized.

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. A transaction has economic substance if it has a reasonable possibility of a profit and an independent business purpose other than saving taxes. The IRS has recently been diligent in examining transactions that it considers to lack economic substance or to be shams. The IRS generally has prevailed in most cases on the issue, and in 2010 the IRS got even more help when Congress codified the economic substance doctrine in the Health Care and Education Reconciliation Act of 2010. 28

In 2014, in Kenna Trading, LLC, 29 Brazilian retailers contributed distressed consumer receivables to an LLC. The LLC claimed a carryover basis in the receivables under Sec. 723. Later the LLC contributed some of the receivables to trading companies and contributed the LLC's interest in each trading company to a holding company. The LLC claimed a cost of goods sold for each holding company equal to the basis of the receivables contributed. The LLC then sold an interest in each holding company to an investor. The trading companies claimed bad debt deductions for the receivables. The next year, the LLC contributed more of the Brazilian receivables to main trusts. Each main trust then assigned the receivables to a newly created subtrust. Other investors contributed cash to the main trust in exchange for the beneficial interest in the subtrust. The subtrusts claimed bad debt deductions for the receivables. Asserting that the subtrusts were, for federal income tax purposes, grantor trusts, the investors claimed deductions on their tax returns. The IRS disallowed the bad debt deductions. The Service also levied Sec. 6662(h) gross-valuation-misstatement penalties, Sec. 6662(a) accuracy-related penalties on the amounts of the LLC's underpayments of tax, and a Sec. 6662A listed-transaction-understatement penalty.

The Tax Court held that the Brazilian retailers did not intend to enter into a partnership for federal income tax purposes. In addition, the court found that the LLC had a cost basis in the receivables, not a carryover basis. Also, the transaction was found to lack economic substance. Lastly, because the LLC had understated its income as the IRS proved, the court held the LLC was subject to all three penalties.

In another economic substance case, 30 the taxpayer, a holding company, bought two corporations that had recently realized large capital gains. To avoid paying taxes on the gains it inherited, the taxpayer executed a common tax-avoidance scheme to generate capital losses. Under the scheme, the taxpayer contributed offsetting short-term options to two LLCs it had formed. The taxpayer increased its bases in the LLCs by the cost of the purchased options but did not reduce its bases by the cost of the sold options. This accounting treatment allowed the taxpayer to increase its bases in the partnerships by approximately $75 million while spending only $320,000.

After the options expired, the taxpayer resigned from the LLCs and received stock with nominal FMV but very high bases. The taxpayer sold the stock and recognized capital losses of almost $75 million, which completely offset the gains the taxpayer had inherited from the two corporations. The IRS issued a deficiency notice disallowing the taxpayer's claimed deductions from the stock sales. In addition, the IRS assessed the accuracy-related penalty under Sec. 6662. In this situation, the court held that the taxpayer improperly deducted capital losses on stock whose basis was artificially inflated with a transaction that lacked economic substance. In addition, the taxpayer was liable for the accuracy-related penalty.

Sec. 754 Election

When a partnership distributes property or a partner transfers his or her partnership 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 -3.

In several rulings in 2013 and 2014, 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 failed to do so 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. In three of these rulings, the IRS granted the partnerships the extension for making the Sec. 754 election even though they had relied on one or more professional tax advisers.


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

2 Greenwald, 142 T.C. No. 18 (2014).

3 Ashland, No. 13-71498 (9th Cir. 8/19/14).

4 Seismic Support Services, LLC, T.C. Memo. 2014-78.

5 Bedrosian, 143 T.C. No. 4 (2014).

6 Martin, 739 F.3d 1204 (9th Cir. 2014).

7 Gaughf, 738 F.3d 415 (D.C. Cir. 2013).

8 Markell Co.,T.C. Memo. 2014-86.

9 McLauchlan, No. 12-60657 (5th Cir. 3/6/14), aff'g and remanding T.C. Memo. 2011-289.

10 Crescent Holdings, LLC, 141 T.C. 477 (2013).

11 Carrino, T.C. Memo. 2014-34.

12 Historic Boardwalk Hall, LLC, 694 F.3d 425 (3d Cir. 2012).

13 Rev. Proc. 2014-12.

14 Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011).

15 CCA 201421016.

16 H.R. Rep't No. 100-495, 100th Cong., 1st Sess. (1987).

17 Omnibus Budget Reconciliation Act of 1987, P.L. 100-203.

18 H.R. Rep't No. 100-495 at 946—47.

19 REG-144468-05.

20 American Jobs Creation Act of 2004, P.L. 108-357.

21 T.D. 9681.

22 VisionMonitor Software, LLC,T.C. Memo. 2014-182.

23 Buyuk LLC, T.C. Memo. 2013-253.

24 Route 231, LLC, T.C. Memo. 2014-30.

25 Gateway Hotel Partners, LLC, T.C. Memo. 2014-5.

26 REG-119305-11.

27 REG-151416-06.

28 Section 1409 of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152 (codified at Sec. 7701(o)), provides that for transactions entered into after March 30, 2010, a transaction has economic substance only if it changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, and the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.

29 Kenna Trading, LLC, 143 T.C. 18 (2014).

30 Humboldt Shelby Holding Corp., T.C. Memo. 2014-47.

31 IRS Letter Rulings 201433010 (8/15/14), 201426012 (6/27/14), 201438008 (9/19/14), 201440003 (10/03/14), and 201442003 (10/17/14).


Hughlene Burton is chair of the Department of Accounting at the University of North Carolina–Charlotte in Charlotte, N.C., and is a past chair of the AICPA 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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