Current developments in partners and partnerships

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



  • Two partnership regulations were reviewed under Executive Order 13789.
  • In Grecian Magnesite, the Tax Court rejected Rev. Rul. 91-32 and ruled that the entity theory should apply to the sale of a foreign partner's partnership interest.
  • The Tax Court again addressed the issue of whether members in an LLC were limited partners whose income was excluded from self-employment income under Sec. 1402(a)(13).

This article reviews and analyzes recent law changes as well as rulings and decisions involving partnerships. The discussion covers developments in the determination of partners and partnerships, gain on disposal of partnership interests, partnership audits, and basis adjustments. During the period of this update (Nov. 1, 2016, through Oct. 31, 2017), the Treasury Department 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.

Regulations project

Executive Order 13789 directed the secretary of the Treasury to review significant tax regulations issued on or after Jan. 1, 2016, and submit a report identifying regulations that impose an undue financial burden on taxpayers, add undue complexity to the federal tax law, or exceed the IRS's statutory authority. Notice 2017-38 identified two partnership regulations that either impose an undue financial burden on taxpayers or add undue complexity to the federal tax law: the temporary regulations under Sec. 752 regarding "bottom-dollar payment obligations" and the temporary and final regulations under Sec. 707 regarding a partner's share of liabilities for disguised-sale purposes.1 There have been some objections from taxpayers and practitioners to both of these regulations. On Oct. 2, 2017, Treasury issued a "Second Report to the President on Identifying and Reducing Tax Regulatory Burdens." In it, Treasury and the IRS stated that, upon further review, they believe the Sec. 752 regulations relating to bottom-dollar payment obligations should be retained and that they do not plan to propose substantial changes to those regulations. However, Treasury and the IRS stated that they were considering whether the temporary regulations under Sec. 707 should be revoked, with the prior regulations reinstated.

Audit issues

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)2 enacted "unified audit rules" to simplify IRS audits of large partnerships. Under TEFRA, determinations of partnership tax items generally were 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 deficiencies against and collect them from the applicable partners. Two issues that arose frequently under TEFRA concerned partnerships' items of income and the statute of limitation for the partners and the partnership.

In an effort to streamline the audit process for large partnerships, Congress enacted Section 1101 of the Bipartisan Budget Act of 2015 (BBA),3 which amended in its entirety Sec. 6221. The revised section instituted new procedures for auditing partnerships, affecting issues including determining and assessing deficiencies, who pays the assessed deficiency, and how much tax must be paid. The BBA procedures replace the unified audit rules as well as the electing large partnership regime. The IRS issued proposed regulations implementing the new partnership audit regime in June 2017.4

Under the BBA, which applies to partnership tax years beginning after Dec. 31, 2017 (earlier elections to apply the new procedures were allowed),5 partnership items generally will be determined in an audit of the partnership at the partnership level. 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 partnership will pay the tax at the highest individual tax rate. A partnership will pay an imputed underpayment when the audit adjustment(s) result in an increase to income or a decrease to deductions. The payment is borne 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 the partnership-favorable audit adjustment related to the reviewed year. It was not clear from the BBA if partners from the reviewed year would be able to receive a refund for the reviewed year if there is a net partnership-favorable IRS audit adjustment. The proposed regulations made it clear that review year partners could claim a refund if the audit adjustments resulted in a decrease in Chapter 1 taxes.6

Partners will not be subject to joint and several liability for any partnership tax liability. Partnerships will have the option to lower their tax liability if they can prove that the total tax liability would be lower if the adjustments were calculated on a partner-level basis. In addition, partnerships with 100 or fewer partners can elect out of this section if each of their partners is either an individual, a C corporation, any foreign entity that would be treated as a C corporation if it were domestic, an S corporation, or an estate of a deceased partner. Elections out of the regime must be made each tax year. Under this scenario, a partnership could be subject to different audit regimes in different years. If the BBA rules do not apply, the IRS would audit each partner separately in separate proceedings.

Any penalties applying to a tax underpayment 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.7

In December 2017, the IRS issued proposed regulations (REG-120232-17) addressing how passthrough partners and tiered partnership structures take adjustments into account.

This year, there were not as many TEFRA issues as in the past. However, Russian Recovery Fund8 dealt with the statute of limitation. In this case, the taxpayer, Russian Recovery Fund (RRF), which was a partnership, reported on its 2000 tax return a large loss on foreign currency transactions.This loss was allocated to the RRF's direct and indirect partners in 2000. One of the taxpayer's direct partners, FFIP, which was also a partnership, reported a substantial amount of the 2000 loss allocated to it from RRF on its 2001 tax return, thereby allocating the loss to its individual partners in 2001.

The IRS audited the 2001 return for FFIP in 2005 and did not make any adjustments. Later that year, the IRS issued a final partnership adjustment agreement (FPAA) to RRF disallowing the 2000 loss, which in turn disallowed the loss to its direct and indirect partners. The taxpayer filed suit in the Court of Federal Claims disputing whether the FPAA was timely issued and whether it suspended the limitation period for adjustments and assessments of the partnership's indirect individual partners' tax returns. The court determined that if the 2000 losses from RRF could be traced to the individuals' tax returns, the IRS could assess the additional taxes, as the FPAA validly suspended the statute of limitation for the indirect partners.9

RRF appealed to the Federal Circuit and argued that the attempt to collect tax from the indirect partners was time-barred because the IRS did not issue an FPAA to the direct partner for 2001 and later years. According to RRF's argument, the FPAA applied only to its 2000 return because an FPAA cannot apply to two partnerships or to two years. The Federal Circuit rejected both these arguments and held that the Court of Federal Claims had correctly determined that losses claimed by the individual indirect partners on their 2001 tax returns were attributable to the loss claimed by RRF on its 2000 tax return, for which the statute of limitation was suspended by the FPAA.

Congress created the role of a tax matters partner (TMP) to increase the efficiency of partnership taxation. Under TEFRA, the TMP served as the partnership's central representative before the IRS and the courts.10As the central representative of the partnership, the TMP possessed important powers and responsibilities, including (1) keeping all partners informed of the status of the administrative or judicial proceedings involving the adjustment of partnership items; (2) having priority in choosing the forum in which the partnership will seek judicial review; and (3) binding other partners to the terms of a settlement the partnership reaches with the IRS.

This role came up as an issue in Cambridge Partners.11 In this case, the operation of two limited partnerships was taken over by a state-court-appointed receiver. However, the receivership was later terminated. At the time of the termination, none of the limited partners was willing to become the TMP for the partnerships. Prior to the termination, the receiver filed refund claims for several years for the partnership, but the IRS dismissed the claims because the TMP did not sign the petitions. The taxpayer filed a petition with the Tax Court. The court refused to hear the case, and thus the refund claims were dismissed because there was no representative of the limited partnerships to maintain and prosecute the case after the termination of the receiver, as there was no TMP. If one limited partner had been willing to act as the TMP, the partnerships may have been able to receive the refunds as filed.

Definition of partnership and partner

In the period covered by this update, the IRS addressed whether entities should be treated as a partnership. In Nwabasili,12 the taxpayer reported income and expenses from two businesses, resulting in a net loss on a Schedule C, Profit or Loss From Business, in his personal tax return. The IRS disallowed all of the expenses reported on the Schedule C because it determined they were not ordinary and necessary business expenses. The taxpayer made the payments to his brother and not to vendors and other third parties.

He petitioned the Tax Court, where he claimed that he and his brother were partners in a partnership and that he reimbursed his brother for his own share of the partnership expenses. No partnership return was filed, and there was no written partnership agreement. The Tax Court found that the brothers did operate the businesses as a partnership. However, the court agreed with the IRS and disallowed the losses because the taxpayer did not provide adequate information to determine the income of the partnership or the taxpayer's adjusted basis in his partnership interest. Thus, Sec. 704(d) precluded the taxpayer from deducting any part of the partnership loss.

It should be noted that the first time the taxpayer asserted that the business was a partnership was at trial, which made the determination much harder. Had the taxpayer instructed his accountant that the business was actually a partnership and not a sole proprietorship, the outcome may have been different, as the taxpayer could have filed a partnership return, which would have helped determine the allocable loss and the partner's basis.

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 in the partner's return a distributive share, whether or not distributed, of each class or item of partnership income, gain, loss, deduction, or credit under Sec. 702. In Mack,13 the taxpayer conceded that the partnership in which he was a partner had income on its partnership return. 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. In addition, because he received no income from the partnership, he did not have the money to pay his tax liability. The Tax Court found that the taxpayer had to report his distributive share of the partnership's profits, even though he received no distributions during the tax year. The court also found that the inability to pay was not relevant; thus, the taxpayer was liable for the accuracy-related penalty under Secs. 6662(a) and (b)(2) for the substantial understatement of income tax.

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, as such, other than guaranteed payments for services actually rendered to, or on behalf of, the partnership. Sec. 1402(a)(13)was originally enacted before entities such as limited liability companies (LLCs) were widely used. The applicable statute 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.

In Castigliola,14 the taxpayer was a member-manager of a professional LLC (PLLC). The taxpayer reported his income from the PLLC and paid the income tax. However, he did not report it as self-employment income, based on the exception under Sec. 1402(a)(13). The IRS disagreed and assessed the self-employment tax. The taxpayer filed suit in the Tax Court. The court agreed with the IRS, stating that all partnerships must have at least one general partner who is subject to the self-employment tax. In this situation, none of the partners claimed to be a general partner. In testimony, the partners testified that all members participated equally in all decisions and that all members had the same rights and responsibilities. The court held that all the PLLC members would be treated as general partners and could not exclude any part of their shares of income from self-employment income under Sec. 1402(a)(13).


A partner calculates basis in a partnership interest based on Sec. 705, which 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, in that order. Sec. 704(d) limits the deductibility of a partner's distributive share of partnership losses to the extent of the partner's adjusted basis.

Under Sec. 752, partners can increase partnership basis by their 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. The amount of liabilities a partner is allocated depends on the type of liability. Recourse liabilities are allocated to the partner that bears the economic risk of loss with respect to that liability.15 Nonrecourse liabilities are allocated to all partners in accordance with the three-tier allocation rules under Regs. Sec. 1.752-3(a). Under Sec. 752(b), any decrease in the partner's share of partnership liabilities is treated as a distribution of money by the partnership and results in recognition of capital gain to the extent the distribution exceeds the partner's adjusted basis.

The Tax Court decided two cases during this period where the taxpayers could not prove they had basis to take a deduction for their share of partnership losses. First, in Hargis,16the IRS disallowed losses from two LLCs because the taxpayer had not provided adequate documentation establishing basis in them. The taxpayer contended that her basis was increased by two loans taken out by the partnership. However, the taxpayer's Schedules K-1, Partner's Share of Income, Deductions, Credits, etc., did not report the share of partnership liabilities allocated to her for the year. The taxpayer provided evidence that the LLCs had loans outstanding, and a witness testified that the liabilities were allocated among members according to ownership percentages. The court noted that the existence of the notes generally supported a finding that the taxpayer should have been allocated some share of the debt. However, she did not provide any evidence or numeric calculation of how the loan was allocated to the members. Because the taxpayer has the burden of proof in this situation, the court ruled that the taxpayer had not provided adequate documentation of her basis in the LLCs and that the IRS was justified in treating her basis as zero. Thus, none of the losses allocated to her were deductible.

A similar situation arose in Namen.17 In this case, the taxpayer deducted a loss from an LLC on his personal tax return. The IRS disallowed the loss because the taxpayer did not have basis in the LLC interest. At trial, the taxpayer attempted to establish his basis by asserting that he was personally liable for the partnership's debt. However, he had no evidence to support his testimony. The court relied on Hargis, stating that the taxpayer's uncorroborated testimony was inadequate to establish basis in his LLC interest. As in Hargis, the court found that the taxpayer had insufficient basis to deduct the losses allocated to him from the LLC.

In Kohn,18 the taxpayer was a partner in a partnership, which settled all of its debt for less than its basis, resulting in discharge-of-indebtedness income. The IRS determined that the taxpayer must report ordinary income from the discharge of indebtedness. In addition, the taxpayer had a capital gain for the deemed cash distribution related to the decrease of his share of the partnership's liabilities. Lastly, because the taxpayer's basis would be reduced to zero by the deemed cash distribution, the taxpayer would not have had adequate basis to deduct the loss allocated to him by the partnership.

The taxpayer argued that he was not personally liable for any of the partnership's debts, and as a result, he had no partnership liability from which he could have been relieved. He contended that because he was not personally liable for the debt, the discharge-of-indebtedness income that the partnership allocated to him lacked substantial economic effect under Sec. 704(b)(2). Therefore, this income should be reallocated to the other partners. Likewise, because he was not liable for the debt, the taxpayer argued, he did not receive a deemed cash distribution triggered by Sec. 752(b).

The court found that the taxpayer's contention had no merit. Thus, the court found that the taxpayer must report his share of the discharge-of-indebtedness income. Likewise, the court found that under Sec. 752, a partner does not have to be personally liable to be allocated his or her share of partnership debt; thus, the taxpayer would have to report a capital gain for the deemed cash distribution, which exceeded his basis. Because the deemed cash distribution reduced his basis to zero, none of the loss allocated to him by the partnership was deductible under Sec. 704(d).

Sec. 707(a) transactions

Sec. 707 covers transactions between a partner and partnership. The general rule provides that if a partner engages in a transaction with a partnership other than in a capacity as a member of such 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

In Herrmann,19 the Court of Federal Claims had to address a question that turned on the timing of income received. The taxpayer received a payment from her employer, a European limited liability partnership (LLP). The LLP ordered the payment on Dec. 31, 2008, but the taxpayer did not receive it until January 2009. The taxpayer did not receive any 2008 documentation related to this payment. The taxpayer reported the income and paid foreign taxes, which were higher than the U.S. taxes, on the payment in 2009. When the IRS audited the LLP, the Service determined that the taxpayer was a partner in the LLP and that the payment was a partnership distribution that she should have reported in 2008. The taxpayer argued that the payment should not have been a partnership distribution, either because she was not a bona fide partner in the LLP or because the payment was for services rendered outside her capacity as a partner under Sec. 707(a)(2)(A).

The taxpayer testified that she had worked for the owner of the LLP in the United States as an employee prior to transferring and becoming a member of the foreign LLP. She noted that the services she performed for the foreign LLP were the same as when she worked in the United States for the company. In fact, the taxpayer's job duties at the foreign LLP continued to center on the U.S. business. She relocated only to have easier access to European investment opportunities for the U.S. company and became a member of the LLP so that the LLP could avoid certain foreign tax obligations. In her work at the LLP, the taxpayer did not perform any services on behalf of the LLP itself, but rather the partnership served as a European conduit for her to perform the same services she had performed as an employee in the United States. Based on these facts, the court determined that the payment should be categorized as for services outside her capacity as a partner, not as a partnership distribution.

The court found several facts that supported this position. First, the court noted that the circumstances surrounding the issuance and receipt of the payment indicated that it was not a partnership distribution, as her compensation arrangement, which remained the same as before she transferred from the U.S. company to the foreign LLP, was not tied to the success of the LLP in any way. Second, the payment was not issued in accordance with the terms of the partnership agreement. Lastly, the payment was disproportionate to the taxpayer's actual ownership of the partnership. Since the payment should have been properly classified under Sec. 707(a)(2)(A), the amount was taxable to the taxpayer in the year she received it.

Sec. 707(a)(2)(B) provides that under regulations prescribed by the IRS, if (1) there is a direct or indirect transfer of money or other property by a partner to a partnership; (2) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner); and (3) those transfers, when viewed together, are properly characterized as a sale or exchange of property, such transfers are treated either as a transaction described in Sec. 707(a)(1) or as a transaction between two or more partners acting other than in their capacity as members of the partnership.

Regs. Sec. 1.707-5(a)(1) provides that, if a partnership assumes or takes property subject to a qualified liability of a partner, the partnership is treated as transferring consideration to the partner only to the extent provided in Regs. Sec. 1.707-5(a)(5). By contrast, if the partnership assumes or takes property subject to a liability of the partner other than a qualified liability, the partnership is treated as transferring consideration to the partner to the extent that the amount of the liability exceeds the partner's share of that liability immediately after the partnership assumes or takes subject to the liability, as provided in Regs. Secs. 1.707-5(a)(2), (3), and (4).

Regs. Sec. 1.707-5(a)(6)(i)(E) provides that a liability assumed or taken subject to by a partnership in connection with a transfer of property to the partnership by a partner is a qualified liability of the partner only to the extent the liability was not incurred in anticipation of the transfer of the property to a partnership, but was incurred in connection with a trade or business in which property transferred to the partnership was used or held, but only if all the assets related to that trade or business are transferred, other than assets that are not material to a continuation of the trade or business.

In IRS Letter Ruling 201714028, the taxpayer, a company, jointly owned a special class of interests in a publicly traded partnership. The partnership owned all of the interests in a disregarded entity. The taxpayer planned to transfer cash, all of its material operating assets, and the special class of interests to the partnership in exchange for additional limited partner units and a new special class of interests in the partnership. In connection with the transfer, the partnership would assume part of the taxpayer's liabilities. The partnership's limited partnership agreement was amended to provide that distributions in respect of the new special class of interests would be reduced each year for the first three years following the transfer, depending on whether the partnership's total cash distributions for each year exceeded its distributable cash flow. The assumed liabilities were incurred for operating purposes, and none of the liabilities were in default. None of the assumed liabilities were incurred in anticipation of the transfer, and the taxpayer would have incurred the liabilities without regard to the transfer to the partnership.

The taxpayer had also regularly distributed cash to its members in proportion to their ownership interests. Those cash distributions, however, were less than the taxpayer's earnings. There was no shift in the ownership of the capital of the partnership associated with the transfer, and the amount of cash deemed to be distributed under Sec. 752(b) (if any) upon the assumption of the ­liabilities did not exceed the taxpayer's basis in its interests in the partnership. There was no reduction in the taxpayer's interests in the partnership's unrealized receivables and inventory items. Based on the information the taxpayer provided, the IRS determined that the liabilities assumed by the partnership would constitute qualified liabilities under Regs. Sec. 1.707-5(a)(6)(i)(E). Thus, the transfer of the liabilities would not result in a disguised sale under Sec. 707(a)(2)(B).

Sec. 708 transactions

In IRS Letter Rulings 201710007 and 201710008, several general partnerships owned diversified stock portfolios and small amounts of cash. All the partnerships were owned by identical or related parties in substantially similar proportions. To reduce administrative costs and burdens, the partnerships planned to merge, with the terminating partnerships contributing assets and liabilities to the surviving partnership for interests in the surviving partnership. The partnerships represented that the resulting partnership would be deemed to be a continuation of the surviving partnership under Regs. Sec. 1.708-1(c). The merger would take the form of an assets-over merger as described in Regs. Sec. 1.708-1(c)(3). The surviving partnership qualified as a "securities partnership" and continued to use the partial netting approach allowed by Regs. Sec. 1.704-3 for making reverse Sec. 704(c) allocations.

The IRS held that the terminating partnerships' transfers of assets to the surviving partnership would not result in portfolio diversification, and no Sec. 721 gain would be recognized. The IRS further found that, assuming the assertions the partnership made were correct, the surviving partnership's use of the partial netting approach for reverse Sec. 704(c) allocations was reasonable under Regs. Sec. 1.704-3(e)(3), and if the surviving partnership used the partial netting approach to make Sec. 704(c) allocations, including reverse Sec. 704(c) allocations, the same would be a reasonable method under Regs. Sec. 1.704-3(a)(1) and was permitted by Regs. Sec. 1.704-3(e)(4)(iii).

Sec. 731 transactions

Secs. 731(a) and 736(b)(1) treat a redemption gain as a gain from the sale of a partnership interest. Sec. 741(a) states that gain from a sale of a partnership interest is considered a gain from the sale of a capital asset, except as otherwise provided by Sec. 751.

In Grecian Magnesite,20 a foreign corporation acquired an interest in a U.S. partnership that engaged in U.S. mining. Several years later, the U.S. partnership redeemed the foreign corporation's interest in the U.S. partnership. The question raised in this case was whether the gain recognized by the foreign corporation on the redemption from the U.S. partnership was effectively connected income and thus U.S. taxable income. The foreign corporation did not report any of the gain as effectively connected income, even though the parties agreed that approximately one-third of the gain was attributable to a U.S. real property interest treated as U.S.-source income under Sec. 897(g). The IRS determined that all of the gain should be taxable in the United States under Rev. Rul. 91-32.

In Rev. Rul. 91-32, the IRS ruled that the gain or loss from the sale of a foreign partner's interest in a partnership that engaged in a U.S. trade or business is effectively connected with a U.S. trade or business to the extent attributable to effectively connected property of the partnership. The ruling separates the gain or loss from a partnership interest attributable to effectively connected assets from gains or losses not attributable to effectively connected assets. This separation is justified by applying the "aggregate" theory to partnerships under Subchapter K.

In Grecian Magnesite,the Tax Court ruled that the gain resulting from the redemption of the taxpayer's partnership interest in real property was subject to U.S. income tax. However, the court ruled that the remaining gain was a capital gain that was not U.S.-source income and was not effectively connected with a U.S. trade or business under Secs. 731(a), 736(b)(1), 741, and 865 because the gain arose from personal property in the form of an indivisible capital asset.

The Tax Court rejected Rev. Rul. 91-32; instead, it determined that the entity theory applied to gains and losses under Sec. 741. The court ruled that there is no explicit exception to the entity treatment for purposes of applying Secs. 865 and 864. The court then considered the application of Sec. 864(c)(5). The court found that the office of the U.S. partnership was not a material factor in Grecian's recognition of gain from the redemption. Because the court held that the disputed gain was not attributable to a U.S. office or other fixed place of business, it was therefore not U.S.-source income under Sec. 865(e)(2)(A) and not taxable in the United States.

Sec. 741 transactions

Sec. 741(a) requires taxpayers to recognize as capital all gains or losses realized in the sale or exchange of a partnership interest — except to the extent Sec. 751 applies. A noncorporate taxpayer may deduct capital losses currently against capital gains and up to $3,000 of ordinary income. Sec. 165(a) provides that taxpayers are allowed ordinary loss deductions for abandonment losses. To qualify for an abandonment loss, a taxpayer must demonstrate that (1) the transaction does not constitute a sale or exchange, and (2) the taxpayer abandoned the asset, intentionally and affirmatively, by overt act.21

In Watts,22two brothers owned a golf business. They agreed to sell a majority interest in the business but would retain an equity interest and stay on board to manage the day-to-day operations. To effect the sale, the taxpayer, one of the brothers, through his two wholly owned flowthrough entities, formed a partnership whose sole purpose was to own the business. The taxpayer and the purchaser entered into an agreement to sell the purchaser a majority interest in the newly formed partnership. The taxpayer invested a portion of the payment into the partnership. Under an amended agreement, the purchaser would own a preferred partnership interest, and the taxpayer would own a common partnership interest. The preferred and common classes voted together as a single class, but the two classes diverged by way of the rights, powers, and privileges exclusively granted to the owner of preferred interests. The preferred partner held the power to appoint three of five board members, exclusive rights of first refusal on resales of partnership interests, and the ability to convert its preferred interests to common interests at its discretion or in the event of an initial public offering. The agreement also entitled the preferred partner to exclusive guaranteed annual payments, a retirement obligation payment, and preferential priority in partnership liquidating distributions subordinate to creditors but superior to the common partners. In addition, the preferred partner had exclusive power to approve or veto any amendment to the partnership agreement, any issuance of additional partnership interests, or the partnership's engagement in any "exit/reorganization" transaction. The preferred partner was also provided "drag-along" rights empowering it to force the minority partners to sell their interests to the preferred partner's chosen purchaser.

Several years after the purchase, the entire partnership was sold to a third-party buyer. The purchase price included payment of the partnership's debt and cash to the partnership. Only the preferred partner received any of the cash proceeds. The taxpayer's accountant determined that the sale of the partnership interest should be treated as an abandonment of the interest, and the taxpayer accordingly reported it on his tax return as an ordinary loss. Under audit, the IRS agreed with the amount reported on the tax return but determined that the loss should be a capital loss from the sale of a partnership interest.

The taxpayer put forth two arguments for the loss to be classified as ordinary. First, he used an incentive theory approach, asserting that the partnership had two potential buyers. He urged the preferred partner to accept the lower offer because it would preserve his partnership-related stream of rental income and would save the jobs of the employees. As an inducement to the preferred partner to accept the lower bid, the taxpayer agreed to surrender to the preferred partner any sale proceeds. Under this incentive theory, the taxpayer argued that the form of the sale, as documented and originally reported, failed to comport with its economic reality. He argued that the court could ascertain economic reality only by looking through the sale and urged the court to examine the transaction as a series of component steps and to find the existence of an undocumented oral agreement with the preferred partner. In the alternative, the taxpayer argued that the court should recognize the transaction as an ordinary abandonment loss under Sec. 165(a).

The court found that the taxpayer's incentive theory relied on a presumption that the terms of an agreement guaranteed him rights to a pro rata share of sale proceeds, which he had surrendered, giving rise to the tax benefit he sought. However, the court rejected the theory because it determined the taxpayer's presumption was at odds with the terms of the governing agreement; thus, the taxpayer had failed to satisfy his burden of proof.

Regarding the taxpayer's alternative argument, the court found that ordinary losses for the abandonment of a partnership interest may arise only in a narrow circumstance where a partner was not personally liable for the partnership's recourse debts or was limited in liability and not exposed to any economic risk of loss for the partnership's nonrecourse liabilities. Finding that neither of these situations applied to the taxpayer, the court concluded that the taxpayer's loss on the disposal of interests in the partnership was capital under Sec. 741 rather than ordinary under Sec. 165.

The IRS sought to impose an accuracyrelated penalty under Sec. 6662(a) on the taxpayer, but the court held that the taxpayer was not liable for a penalty because he reasonably relied on advice from his longtime accountant.

Sec. 754 election

When a partnership distributes property or a partner transfers his or her interest, the partnership can elect under Sec. 754 to adjust the basis of partnership property. A Sec. 754 election allows a step-up or step-down in basis under either Sec. 734(b) or Sec. 743(b) to reflect the fair market value at the time of the exchange. This election has the advantage of not taxing the new partner on gains or losses already reflected in the purchase price of his or her partnership interest. The partnership must file the election by the due date of the return for the year the election is effective, normally with the return. If a partnership inadvertently fails to file the election, it can ask for relief under Regs. Secs. 301.9100-1 and -3.

In several rulings during this period,23 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 had 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. In some cases, the IRS granted the partnerships the extension even though they had relied on a professional tax adviser or preparer when they failed to timely make the election.24

In each of two rulings,25 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 interest was purchased by a buyer. The new LLC intended to make an election under Sec. 754 in connection with the sale; however, the LLC did not file a timely partnership return for the short tax year making the election. When the omission was revealed, the LLC sought relief, which the IRS granted.   


1T.D. 9788.

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

3Bipartisan Budget Act of 2015, P.L. 114-74.


5T.D. 9780, Temp. Regs. Sec. 301.9100-22T.

6Preamble to REG-136118-15 and Prop. Regs. Sec. 301.6227-3(b)(2).

7Sec. 6226(c)(2)(C), effective for tax years beginning after Dec. 31, 2017.

8Russian Recovery Fund Ltd., 851 F.3d 1253 (2017).

9Russian Recovery Fund Ltd.,101 Fed. Cl. 498 (2011).

10Note that under the new partnership audit rules, the "tax matters partner" designation was repealed and replaced by the "partnership representative."

11Cambridge Partners, LP,T.C. Memo. 2017-194.

12Nwabasili, T.C. Memo. 2016-220.

13Mack, T.C. Memo. 2016-229.

14Castigliola, T.C. Memo. 2017-62.

15Regs. Sec. 1.752-2(a).

16Hargis, T.C. Memo. 2016-232.

17Namen, T.C. Memo. 2017-24.

18Kohn,T.C. Memo. 2017-159.

19Herrmann, 132 Fed. Cl. 459 (2017).

20Grecian Magnesite Mining, Industrial & Shipping Co., SA,149 T.C. No. 3 (2017).

21Regs. Sec. 1.165-2; Citron, 97 T.C. 200 (1991).

22Watts, T.C. Memo. 2017-114.

23E.g., IRS Letter Rulings 201718013 and 201722013.

24E.g., IRS Letter Rulings 201742001 and 201717038.

25IRS Letter Rulings 201717038 and 201729015.



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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