Current Developments in Partners and Partnerships

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



  • New partnership audit rules were enacted last year that will replace the TEFRA rules. Under the new rules, partnership adjustments will be determined at the partnership level, and the partnership will be liable for any underpayment of tax.
  • Legislation enacted during the year changed the due date for a partnership return to the 15th day of the third month following the close of a partnership's tax year.
  • New temporary regulations specify that partners are not employees of a disregarded entity owned by their partnership.
  • The IRS issued regulations regarding disguised sales in general and the allocation of liabilities for purposes of the disguised sale rules. The regulations also address when certain obligations are recognized for determining whether a liability is a recourse partnership liability for Sec. 752 purposes.
  • The Fourth Circuit held that the contribution of money to a valid LLC by a bona fide member of the LLC and the related distribution of tax credits to the member was a disguised sale.

This article reviews and analyzes recent law changes as well as rulings and decisions involving partnerships. The discussion covers developments in allocations of liabilities, disguised sales, partnership audits, and basis adjustments. During the period of this update (Nov. 1, 2015-Oct. 31, 2016), 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 rulings that addressed partnership operations and allocations.

Partnership Audit Issues

Section 1101 of the Bipartisan Budget Act of 20151 (BBA) added Sec. 6221 to the Internal Revenue Code to streamline the audit process for large partnerships. The new version of Sec. 6221 enacted new procedures for auditing large partnerships, which significantly changed existing procedures for determining and assessing deficiencies; who pays the assessed deficiency; and how much tax must be paid. The BBA procedures replace the "unified audit rules" enacted under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)2 as well as the electing large partnership regime. Under TEFRA, determinations of partnership tax items were generally made at the partnership level. Any adjustments to partnership tax items would then flow through to the partnership's partners, and the IRS would assess and collect any deficiencies from those partners.

Under the BBA, which applies to partnership tax years beginning after Dec. 31, 2017 (earlier elections to apply the new procedures are allowed in certain circumstances),3 partnership items generally will be determined in an audit of the partnership. The audit can adjust a partnership's income, gain, loss, deduction, or credit, or any partner's distributive share of these items. A key part of the new law is that the tax will be paid by the partnership at the highest individual or corporate tax rate for the reviewed year. A partnership will pay an imputed underpayment when the audit adjustment(s) result in an increase to income or decrease to deductions. The payment is born by the current partners. Adjustments that do not result in an underpayment of tax must be taken into account in the adjustment year. This requirement allows the current partners to benefit from audit adjustments that are favorable for the partnership related to the reviewed year. Partners from the reviewed year will not receive a refund for the reviewed year if there is a net partnership-favorable IRS audit adjustment.

Partners will not be subject to joint and several liability for any partnership tax liability. A partnership will have the option to lower its tax liability if it can prove that a portion of its imputed underpayment is allocable to a tax-exempt entity that would not owe tax due to its status as a tax-exempt entity, a C corporation subject to a lower tax rate than the individual tax rate, or, in the case of the portion of an imputed underpayment attributable to a long-term capital gain or qualified dividend, allocable to a partner that is an individual.

In addition, a partnership with 100 or fewer partners can elect out of this audit method if each of its partners is either an individual, a C corporation, any foreign entity that would be treated as a C corporation if it were a domestic entity, an S corporation, or an estate of a deceased partner. Elections out of this audit regime must be made each year. As a result of these rules, a partnership could be subject to different audit regimes in different years. If the BBA rules do not apply for any reason, the IRS will audit each partner in separate proceedings.

If penalties apply to the underpayment of tax, they will be determined at the partnership level. Interest may be determined at either the partnership or the partner level. However, the interest rate is increased by 2% if the partnership elects for partners from the reviewed year to pay. Treasury must still answer issues regarding this new audit regime, including how to treat tiered partnerships.

TEFRA was enacted in part to improve the auditing and adjustment of income items attributable to partnerships. A question that continues to come up in TEFRA audits is when the statute of limitation ends for a partner regarding partnership items. In MK Hillside Partners,4 a partner filed a petition for review in Tax Court contesting the IRS's finding that the partnership in which he was a partner was a sham, lacked economic substance, and was formed and used principally to avoid taxes. The partner also asserted the statute of limitation was not still open for these items. The Tax Court rejected the partner's assertion, finding instead that, because the partner had underreported income by more than 25% of his gross income, the statute of limitation was six years, not the normal three years. The court also held that because the Tax Court had jurisdiction to consider the partner's argument about the statute of limitation, it necessarily had jurisdiction to reject it, at least for the purposes of the partnership proceeding.

Definition of Partnership and Partner

In the period covered by this update, the IRS addressed whether entities should be treated as partnerships. In AD Investment 2000 Fund,5 the taxpayer set up several entities as limited liability companies (LLCs) taxed as partnerships. Each of the LLCs entered into a son-of-boss transaction, creating paper losses to offset real gains. Under audit, the IRS determined that the LLCs should be disregarded as partnerships because the transactions lacked economic substance or business purpose; thus, the IRS denied the interest deduction. The taxpayer argued that the LLCs met the test for partnership recognition. It asserted that because the members of each LLC contributed property to the LLC, those assets were pooled, profits and losses were shared in proportion to the members' capital accounts, and, when each member resigned, it received its proportionate share of the fair market value (FMV) of that LLC's assets, there was sufficient support for the LLCs to be recognized as partnerships.

The taxpayer further argued that the LLCs should not be disregarded as partnerships on the ground that the transactions lacked "economic substance" or "business purpose," arguing a disjunctive two-prong test applied. For the first prong, the taxpayer conceded that the transactions were tax-motivated but argued that there was also a desire to make a profit and that was sufficient to satisfy that prong. For the second prong, the taxpayer argued that there was a ­reasonable possibility that the transactions would result in a profit, and it was irrelevant whether any potential profit was far less than the expected tax benefits.

The IRS had three interrelated arguments for not treating the LLCs as partnerships: the sham partnership doctrine, the economic substance doctrine, and the Sec. 701 anti-abuse rules. To support its position, the IRS maintained that (1) the taxpayer was a member of the LLCs for a short time pursuant to a prearranged plan; (2) the tax benefits associated with the LLCs outweighed any other economic benefits; (3) other investments or structures were not considered by the LLCs or their members; (4) creation of the LLCs was unnecessary; (5) the transactions had no reasonable prospect of profit when they were entered into; and (6) there was no nontax business purpose for entering into the transactions. The court agreed with the IRS and found that the LLCs were created solely for tax-avoidance purposes, and, for that reason, the court did not recognize them as entities for federal tax purposes.

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 whose interests 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.

Under Sec. 7704(d)(1)(E), 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 report6 accompanying the Omnibus Budget Reconciliation Act of 19877 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.8

The IRS issued a number of private letter rulings this year that requested a determination of whether the income generated by a partnership would qualify under Sec. 7704(d)(1)(E). For example, in Letter Ruling 201637007, a publicly traded partnership provided fluid, solids, and oilfield waste handling, treatment, and disposal services to customers engaged in exploration and development and production of oil and natural gas. The services included supervising, directing, and controlling personnel in fluid management, transportation, disposal, washout, and storage services, all of which were essential to completion of drilling and fracturing operations. Processing and treatment of flowback fluids and produced water was required by governmental regulations and industry standards and occurred daily. It also provided inter-well site pipeline-based transportation. The IRS found all of the partnership's gross income was "qualifying income" under Sec. 7704(d)(1)(E). In addition, partnership income from hydrocarbon remediation services was also qualifying income as long as the partnership did not sell recovered hydrocarbons to end users at the retail level.

In another ruling,9 a company intended to form a limited partnership that would be a publicly traded partnership. The company indirectly owned all of a limited partnership. The limited partnership owned and operated a liquefied natural gas receiving and regasification terminal. The limited partnership received liquefied natural gas for processing into gas for further transport. Suppliers retained legal title to the natural gas delivered to the terminal at all times; however, possession and control of the liquefied natural gas transferred to the limited partnership upon delivery and remained with the limited partnership during the processing and during transportation to customers. The IRS determined the income was qualifying income under Sec. 7704(d)(1)(E).

Likewise, in Letter Ruling 201611017, a company, an oil and gas venture, formed a limited partnership to own, operate, and separately finance midstream activities such as construction and operation of freshwater distribution pipeline systems, saltwater disposal systems, and gas and oil gathering and processing facilities. The company also conducted pressure pumping services. Following the limited partnership's initial public offering (IPO), the company intended to contribute midstream activity-related assets to the limited partnership. After the IPO, the limited partnership would be a Sec. 7704(b) publicly traded partnership. The limited partnership would provide fluid delivery, handling, treatment, processing, recycling, disposal, and related services to producers. Through its employees or independent contractors, the limited partnership would also transport, store, process, treat, and dispose of waste fluids associated with oil and gas exploration and production.

The IRS ruled in this situation that the gross income from freshwater sourcing and distribution services; water transportation, recycling, and disposal services; marketing of skim oil and other recoverable minerals other than to end users at the retail level; pressure pumping services; and production support services would constitute qualifying income under Sec. 7704(d)(1)(E). In several similar rulings addressing oil and gas operations,10 the IRS also determined that the gross income in question constituted "qualifying income" under Sec. 7704(d)(1)(E).

Partnership Issues

Last year, the Surface Transportation and Veterans Health Care Choice Improvement Act of 201511 included a provision that changed the due date of a partnership tax return. The new due date of partnership returns is the 15th day of the third month following the close of the tax year. Calendar-year partnership returns will be due on March 15 under the new law. The new law allows a six-month extension (until Sept. 15 for calendar-year partnerships) and ­applies to tax years beginning after Dec. 31, 2015.

Partner's Income

Partnerships are not subject to federal income tax under Sec. 701. After items of income and expense are determined at the partnership level, each partner is required to take into account separately on its return its distributive share, whether or not distributed, of each class or item of partnership income, gain, loss, deduction, or credit under Sec. 702. In Lamas-Richie,12 the taxpayer conceded that he held a 41% limited partnership interest in a partnership during the year, and his Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., showed 41% as his distributive share of its profits. The partnership filed a Form 1065, U.S. Return of Partnership Income, reporting ordinary business income. The taxpayer did not report his share of income on his personal tax return because he did not receive any cash distributions in the current year. The Tax Court found that the taxpayer had to report his distributive share of the partnership's profits, even though no distributions were made to him during the tax year. The court also ruled that the partnership's failure to supply the taxpayer with a timely Schedule K-1 did not relieve him of his obligation to include in income his distributive share of the partnership's profits.

Sec. 1402(b) generally provides that the term "self-employment income" means the net earnings from self-employment derived by an individual during any tax year. However, Sec. 1402(a)(13) provides an exclusion for the distributive share of any item of income or loss of a limited partner, other than guaranteed payments for services actually rendered to or on behalf of the partnership. Sec. 1402(a)(13) was enacted before entities such as LLCs were widely used. The applicable statute did not, and still does not, define a "limited partner."Individual partners who are not limited partners are subject to self-employment tax regardless of their participation in the partnership's business or the capital-intensive nature of the partnership's business.

The issue of whether a member of an LLC is a general or limited partner arose in Chief Counsel Advice (CCA) 201640014. In this situation, a franchisee purchased franchise restaurants and contributed the restaurants to a state LLC treated as a partnership for federal tax purposes. The franchisee owned the majority of the partnership. None of the other members of the LLC were involved with business operations, and their status as limited partners was not in dispute.

The franchisee's franchise agreements required him to personally devote his full-time and best efforts to work on the operation of the restaurants. The LLC's operating agreement provided that the franchisee was the LLC's operating manager, president, and CEO, and conducted its day-to-day business affairs. In particular, the franchisee had authority to manage the LLC, to make all decisions, and to do anything reasonably necessary in light of its business and objectives. The franchisee's authority included authority to institute, prosecute, and defend any proceeding in the LLC's name; purchase, lease, and sell property; enter into contracts; lend money and invest LLC funds; hire and fire the LLC's employees; establish pension plans; and hire accountants, investment advisers, and legal counsel on behalf of the LLC.

The LLC made guaranteed payments to the franchisee annually. The LLC treated the franchisee as a limited partner under Sec. 1402(a)(13) and included only the guaranteed payments in the franchisee's net earnings from self-employment, not his full distributive share. The LLC's position was that the franchisee's income from the LLC should be bifurcated for self-employment tax purposes between the franchisee's (1) income attributable to capital invested or the efforts of others, which is not subject to self-employment tax, and (2) compensation for services rendered, which is subject to self-employment tax.

The LLC asserted that, as a retail operation, the LLC required capital investment for buildings, equipment, working capital, and employees, and stated that, in the years at issue, it purchased fixed asset additions. The LLC noted that the franchisee and the LLC had made significant capital outlays to acquire and maintain the restaurants, and argued that the LLC derived its income from the preparation and sale of food products by its employees, not the personal services of the franchisee. The LLC also asserted that the franchisee had a reasonable expectation for a return on his investment beyond his compensation from the LLC. The LLC argued that the franchisee's guaranteed payments represented "reasonable compensation" for his services, and that the franchisee's earnings beyond his guaranteed payments were earnings that were basically of an investment nature. Based on these arguments, the LLC concluded that the franchisee was a limited partner for purposes of Sec. 1402(a)(13).

The IRS answered the question whether the franchisee was a limited partner or a general partner, concludingthat the franchisee was not a limited partner in the LLC within the meaning of Sec. 1402(a)(13) because he actively participated in the partnership's operations and performed extensive executive and operational management services for the partnership in his capacity as a partner. Therefore, he was subject to self-employment tax on his distributive share from the LLC.

Another question that often arises about partners who provide services to a partnership is whether they can be employees. It is fairly settled that partners cannot be employees of their partnerships. However, this year the issue arose for partners working for a disregarded entity that is owned by their partnership. Treasury issued temporary and proposed regulations13 that concluded that partners are not employees of a disregarded entity that is owned by their partnership. The regulation states that even though a disregarded entity is treated as a corporation for employment tax purposes, this rule does not apply for self-employment purposes.

Partnership Basis

A partner calculates its basis in its partnership interest based on Sec. 705, which requires a partner to increase basis by contributions to the partnership, taxable income, and tax-exempt income and to decrease basis by distributions, nondeductible expenses, and deductible losses.

Under Sec. 752, a partner is allowed to increase partnership basis by its share of partnership liabilities. Regulations under Sec. 752 provide rules for determining a partner's allocable share of a partnership liability. The regulations divide liabilities into two groups, recourse and nonrecourse, allocated differently depending on the type of liability. Recourse liabilities are allocated to the partner that bears the economic risk of loss for that liability. Nonrecourse liabilities are allocated to all partners in accordance with the three-tier allocation rules under Regs. Sec. 1.752-3(a).

Treasury issued proposed regulations in 2014 regarding recourse liabilities and the definition of economic risk of loss, taking an "all or nothing" approach. The proposed regulations had seven factors that needed to be satisfied for a partner's payment obligation to be recognized. This year, Treasury issued temporary and proposed regulations14 that reject the all-or-nothing approach of the 2014 proposed regulations. Instead, the new regulations adopt two main rules.

First, the temporary regulations provide that "bottom-dollar payment obligations" will not be recognized in determining who bears the risk of loss. Bottom-dollar payment obligations are any payment obligation where the partner is not liable up to the full amount of the payment obligation in the event the partnership does not pay. The temporary regulations specify that a payment obligation is not a bottom-dollar payment obligation merely because a maximum amount is placed on the partner's or related person's payment obligation, a partner's or related person's payment obligation is stated as a fixed percentage of every dollar of the partnership liability to which the obligation relates (a "vertical slice"), or there is a right of proportionate contribution running between partners or related persons who are co-obligors with respect to a payment obligation for which each of them is jointly and severally liable.

A payment obligation that would otherwise qualify as a bottom-dollar payment obligation will not be treated as one where a partner's payment obligation is not reduced by more than 10% as a result of the arrangement. For example, if a partner guarantees all of a partnership liability and another partner indemnifies the first partner for no more than 10% of the first partner's payment obligation, the first partner's payment obligation is not treated as a bottom-dollar payment obligation.

The temporary regulations include anti-abuse rules that prevent affirmative use of the bottom-dollar payment obligation rule. Information about bottom-dollar obligations must be disclosed on Form 8275, Disclosure Statement. The temporary regulations are effective for liabilities assumed or incurred on or after Oct. 5, 2016.

The proposed regulations contain a second rule that requires a facts-and-circumstances analysis. A partner's payment obligation is not recognized if the facts and circumstances indicate a plan to circumvent or avoid the obligation. The proposed regulations include a nonexclusive list of seven factors that may indicate that such a plan exists. In addition, the regulations provide that a plan to avoid or circumvent an obligation is deemed to exist if the facts and circumstances indicate that there is not a reasonable expectation the obligor will have the ability to make the required payments.

During the period covered by this review of partnership developments, the IRS addressed a number of questions that arose about partnership liabilities. In CCA 201606027, the IRS concluded that a partner's guarantees of a partnership's liabilities that could only be used by the partnership's lenders (commonly referred to as "nonrecourse carve-outs" or "bad boy" guarantees) caused the guaranteed liabilities to be treated as recourse liabilities allocable solely to the guarantor partner. However, shortly afterward, in generic legal advice memorandum (GLAM) 2016-001, the IRS reconsidered the issue.

In this memorandum, the question the IRS considered was: If a partner's guarantee of a partnership's nonrecourse obligation is conditioned on the occurrence of certain "nonrecourse carve-out" events, does the guarantee cause the obligation to fail to qualify as a nonrecourse liability of the partnership under Secs. 752 and 465(b)(6)? Sometimes guarantees of partnership nonrecourse obligations are conditioned upon the occurrence of one or more of the following nonrecourse carve-out events: the borrower fails to obtain the lender's consent before obtaining subordinate financing or transfers the secured property; the borrower files a voluntary bankruptcy petition; any person in control of the borrower files an involuntary bankruptcy petition against the borrower; any person in control of the borrower solicits other creditors of the borrower to file an involuntary bankruptcy petition against the borrower; the borrower consents to or otherwise acquiesces or joins in an involuntary bankruptcy or insolvency proceeding; any person in control of the borrower consents to the appointment of a receiver or custodian of assets; or the borrower makes an assignment for the benefit of creditors, or admits in writing or in any legal proceeding that it is insolvent or unable to pay its debts as they come due.

The fundamental reason for including carve-outs with a nonrecourse liability is to prevent actions by the borrower or guarantor that could make recovery on the debt, or acquisition of the security underlying the debt upon default, more difficult. Because it is not in the economic interest of the borrower or the guarantor to commit the bad acts described in nonrecourse carve-outs, it is unlikely that the bad act will occur. The IRS determined that unless the facts and circumstances indicate otherwise, a typical "nonrecourse carve-out" provision that allows the borrower or the guarantor to avoid committing the enumerated bad act will not cause an otherwise nonrecourse liability to be treated as recourse for purposes of Secs. 752 and 465.

In Letter Ruling 201608005, a partnership that was in the construction business entered into long-term contracts with a third party to construct some facilities. The third party was obligated to make progress payments in accord with a milestone schedule that generally tied compensation to the completion of certain work. However, "Notice to Proceed" payments were required at the time that the third party issued certain notices to the partnership. Before the partnership was entitled to those payments, however, the partnership had to provide guarantees and deliver standby letters of credit securing its obligation to perform. The partnership reported income using the percentage-of-completion method. While progress payments generally correlated with the results of that method, the Notice to Proceed payments did not as they were not linked to performance.

The partnership sought rulings that its receipt of the Notices to Proceed gave rise to liabilities for Sec. 752 purposes. The IRS agreed that the Notices to Proceed created liabilities, noting that the partnership's obligation to proceed with work and to incur costs in performing the work, and its corresponding obligations to satisfy the third party's remedies in the event that the partnership defaulted, constituted liabilities under Sec. 752 to the extent that the partnership received the corresponding Notices to Proceed but had not yet reported the related income.

Sec. 707(a) Transactions

Sec. 707 covers transactions between a partner and a partnership. The general rule provides that if a partner engages in a transaction with a partnership other than in its capacity as a member of the partnership, the transaction shall, except as otherwise provided in Sec. 707, be considered as occurring between the partnership and the partner as if the partner were not a partner.

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 2014, Treasury issued proposed regulations under both Sec. 707, on disguised sales, and Sec. 752, on the treatment of partnership liabilities. The proposed regulations address a number of issues under Sec. 707. This year, Treasury issued final and temporary regulations15 relating to disguised payments for services under Sec. 707(a)(2)(B) that substantially adopt the 2014 proposed regulations under Sec. 707 with a few revisions in response to comments.

The existing regulations under Sec. 707 provide several exceptions, including exceptions for preformation capital expenditures, debt-financed distributions, and the exclusion of qualified debt from consideration. The preformation capital expenditure exception covers capital expenditures incurred by the partner for contributed property within the two-year period before the contribution. Reimbursement cannot exceed 20% of the FMV of the relevant property (as of the time of its transfer). This limitation does not apply if the FMV of the property does not exceed 120% of the partner's adjusted basis in the property at the time of transfer. Under the new regulations, the 20% limit applies on a property-by-property basis (subject to a limited aggregation rule). However, the exception does not apply to capital expenditures funded by an assumed qualified liability to the extent the liability is allocated away from the contributing partner.

With regard to preformation capital expenditures, the new regulations state that the partner steps into the shoes of the transferor in connection with a nonrecognition transaction under Secs. 351, 381(a), 721, and 731. In addition, if the partner transfers property to a lower-tier partnership where the preformation capital expenditure exception was available, and transfers the lower-tier partnership interest to an upper-tier partnership, the transferring partner is deemed to have transferred the relevant property to the upper-tier partnership, and the upper-tier partnership is eligible for the exception to the same extent the partner could have been reimbursed by the lower-tier partnership. In addition, the upper-tier partnership steps into the shoes of the transferor for purposes of determining its eligibility for the exception.

The regulations also provide rules for the treatment of the assumption of a liability to determine the consideration in a disguised sale. Under these rules, a partnership's assumption of a liability is a transfer of consideration to a partner. However, the regulations provide an exception for the assumption of a qualified liability. A partnership is treated as transferring consideration to the partner from whom the liability is assumed to the extent the liability is not allocated to the partner after the transfer if the liability is nonqualified. Qualifying liabilities generally do not result in consideration. In this case, the partnership is treated as transferring consideration in respect of qualified liabilities only if the partnership is treated as transferring other consideration to the transferor partner. In this situation, the amount of consideration is the lesser of the amount of consideration the partnership would recognize if the liability were treated as a nonqualifying liability or the "net equity percentage" of the liability.

Under prior rules, nonrecourse liabilities were allocated under the Sec. 752 regulations, and recourse liabilities were allocated under any of the options under the Sec. 752 regulations' "third tier" rules. Under the new rules for qualified liabilities, a liability that is recourse to the contributing partner is treated as nonrecourse. However, a liability that is recourse to a noncontributing partner is treated as recourse to the noncontributing partner. Nonrecourse liabilities will be allocated only under the general rule of the "third tier" and not the "significant item method" or the "alternative method." These rules are targeted at leveraged partnerships and apply to transactions that occur on or after Jan. 3, 2017.

The existing regulations provided four categories of qualified liabilities. The new regulations add another category. Under the new rules, liabilities are considered incurred in connection with a trade or business in which the transferred property was used, but only if all assets related to the trade or business are transferred (other than assets immaterial to the conduct of the trade or business), and only if the liability was not incurred in anticipation of the transfer. Also, a partner steps into the shoes of the transferor when the partner acquires property and assumes a liability, or takes property subject to a liability in connection with the same nonrecognition transactions as in the preformation exception. Likewise, when a partner transfers its interest in a lower-tier partnership to an upper-tier partnership, the liabilities transferred to the upper-tier partnership are treated as qualified liabilities to the extent they would be qualified liabilities if the lower-tier partnership had transferred them and all of its property to the upper-tier partnership.

The new regulations include an ordering rule. Partnerships are to apply the exception for debt-financed distributions before any other exceptions, such as the reimbursement of preformation capital expenditures.

This year, the Fourth Circuit had to determine whether a disguised sale occurred in Route 231, LLC.16 In that case, an LLC reported capital contributions on its federal tax return that came in part from one of its members, Virginia Conservation Tax Credit FD LLLP. Upon audit, the IRS issued a final partnership administrative adjustment (FPAA), indicating that the LLC should have reported the contribution from this member as gross income and not a capital contribution. After the LLC challenged the FPAA, the Tax Court determined that the transaction was a "sale" and reportable as gross income. The LLC appealed the Tax Court decision, asserting that the Tax Court erred in finding the transfer was not a capital contribution or, alternatively, that any income was not reportable until the next year.

The appellate court agreed with the Tax Court and held that Sec. 707 applied to a transfer of tax credits between an LLC and a member even if the LLC was valid and ongoing and the member was a bona fide member. The court ruled that the disguised sale rules were not limited to illegitimate or sham partnerships or LLCs; that the tax credits were "property" for purposes of Sec. 707; and that the transfer of credits from the LLC to the member constituted a sale under Regs. Sec. 1.707-3(b)(1), so the money the LLC received was taxable income. The court also found that the Tax Court did not err in finding that the LLC would not have transferred the tax credits to the member except for the fact that the member transferred money to the LLC, and the member's right to the tax credits did not depend on the entrepreneurial risks of the LLC's operations. In addition, the income was taxable in the year the LLC received the cash from the member, not the following year.

Sec. 707(b): Related-Party Losses

Sec. 707(b)(1) provides that no deduction shall be allowed for losses from sales or exchanges of property (other than an interest in the partnership), directly or indirectly, between a partnership and a person owning, directly or indirectly, more than 50% of the capital interest, or the profits interest, in the partnership, or between two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital interests or profits interests. Regs. Sec. 1.707-1(b)(1)(ii) provides that if a gain is realized upon the subsequent sale or exchange by a transferee of property for which a loss was disallowed under the provisions of subdivision (i) of this paragraph, Sec. 267(d) shall apply as though the loss were disallowed under Sec. 267(a)(1).

In Letter Ruling 201613002, an LLC owned interests in two funds, both of which were partnerships for which no Sec. 754 elections were made. The LLC sold its interests in the funds to Trusts A, B, and C in equal proportions, and the LLC reported a capital loss on the sale. The bases of assets of the two funds were decreased in the aggregate for the trusts appropriately. In addition, the capital loss was disallowed per Sec. 707(b). Since the sale, the funds have recognized gains on the disposition of assets held at the time of the sale, and the funds may recognize gains on future dispositions. The IRS ruled that, per Sec. 707(b)(1) and Sec. 267(d), upon a sale or other disposition by the funds of property that was the subject of a downward basis adjustment due to sale of the interest, the trust would have to recognize gain only to the extent that it exceeded the disallowed loss properly allocable to the property sold or otherwise disposed of by the funds.

Late Sec. 754 Elections

When a partnership distributes property or a partner transfers its 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 its 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 during the period covered in this article,17 the IRS granted an extension of time to make a Sec. 754 election. In each case, the partnership was eligible to make the election but inadvertently omitted the election when filing its return. The IRS reasoned that the partnership in each case acted reasonably and in good faith, and it granted an extension to file the election under Regs. Secs. 301.9100-1 and -3. In these rulings, each partnership had 120 days after the ruling to file the election. 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.18

In the past year there were some unique instances where the taxpayer inadvertently failed to make a Sec. 754 election. For example, in Letter Ruling 201611008, the taxpayer was formed as an LLC and treated as a disregarded entity for federal income tax purposes. Upon the individual owner's death, the LLC interest passed to a trust. As a result of the transfer, the LLC/disregarded entity became a partnership for federal income tax purposes and was qualified to make an election under Sec. 754 for the year of the owner's death. However, the taxpayer failed to make a timely election. When the taxpayer discovered the omission, it sought relief on representations that it had acted reasonably and in good faith, that granting relief would not prejudice government interests, and that it was not using hindsight in making the election. The IRS granted the relief and granted a 120-day extension of the deadline.

In two rulings,19 an LLC treated as a partnership for federal income tax purposes was terminated under Sec. 708(b)(1)(B) because more than 50% of the partnership's interest was purchased by a buyer. The new LLC filed a partnership return for the short tax year and intended to file an election to adjust the basis of partnership interests under Sec. 754 with that return but failed to do so. The LLC, however, adjusted the basis of partnership property and filed its subsequent tax returns consistent with its having made the election. When it discovered the omission, the LLC sought relief, which the IRS granted.

Lastly, in Letter Ruling 201620002, two LLCs treated as partnerships for federal tax purposes made liquidating distributions to a significant number of members. Though an election under Sec. 754 was available, their tax advisers did not inform them of it. Later the two LLCs merged. After the merger, the surviving LLC became aware of the failure to make the Sec. 754 election for the relevant year and requested an extension of the deadline to make the election. The IRS granted relief, ruling that the LLC had shown that it had reasonably relied on a qualified tax professional who had failed to advise the LLC to make the election, and that a 120-day extension was proper. The IRS conditioned relief on the LLC adjusting the basis of its properties to reflect the adjustments that it would have made if it had made a timely Sec. 754 election and reallocating each member's proportionate share of the adjusted basis.  


1Bipartisan Budget Act of 2015, P.L. 114-74.

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

3T.D. 9780.

4MK Hillside Partners, No. 14-71504 (9th Cir. 6/23/16).

5AD Investment 2000 Fund, T.C. Memo. 2015-223.

6H.R. Rep't No. 100-495, 100th Cong., 1st Sess. (1987).

7Omnibus Budget Reconciliation Act of 1987, P.L. 100-203.

8H.R. Rep't No. 100-495 at 946-947.

9IRS Letter Ruling 201636025.

10IRS Letter Rulings 201636039, 201633020, 201619002, and 201614004.

11Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, P.L. 114-41.

12Lamas-Richie, T.C. Memo. 2016-63.

13T.D. 9776; REG-102516-15.

14T.D. 9788; REG-122855-15. Editor's note: The regulations issued in T.D. 9788 were identified as burdensome by the Treasury Department in July 2017 and are being reviewed for possible modification or withdrawal. See "Treasury Identifies 8 Regulations as Burdensome."

15T.D. 9787 and T.D. 9788.

16Route 231, LLC, 810 F.3d 247 (4th Cir. 2016).

17IRS Letter Rulings 201631006, 201629002, 201622010, and 201630014.

18IRS Letter Rulings 201626007, 201632009, 201638009, 201641001, and 201624020.

19IRS Letter Rulings 201624005 and 201640011.



Hughlene Burton is director of the Turner School of Accounting at the University of North Carolina—Charlotte in Charlotte, N.C. She is a past chair of the AICPA Partnership Taxation Technical Resource Panel and has served on the AICPA Tax Executive Committee. For more information about this article, contact ­


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