Current developments in partners and partnerships

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



  • New partnership audit procedures effective for partnership years beginning in 2018 and after bring many changes. A number of regulations explaining these new procedures were issued in 2018.
  • The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, added several provisions that affect partners and partnerships, including Sec. 199A, which allows a 20% deduction for qualified business income that applies at the partner level.
  • Recent court and IRS rulings provide insight into issues of partners' basis in partnership interests and recognition of partnership losses, as well as basis adjustment elections.
  • After being reviewed under Executive Order 13789, a regulation under Sec. 707 on disguised sales was revoked and the prior regulations under that section were reinstated.
  • In the 2017 case Grecian Magnesite, the Tax Court rejected Rev. Rul. 91-32 and held that the entity, not the aggregate, theory of partnership taxation should apply to the sale of a foreign partner's partnership interest. The TCJA amended Sec. 864(c) to overturn the Tax Court's holding.
  • The TCJA amended Sec. 743(d)(1) to expand the definition of "substantial built-in loss" for purposes of determining whether a basis adjustment is required under Sec. 743.

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, 2017, through Oct. 31, 2018), Congress enacted the law known as the Tax Cuts and Jobs Act (TCJA),1 which made several changes that affect partners and partnerships, and 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.

Tax Cuts and Jobs Act

On Dec. 22, 2017, President Donald Trump signed the TCJA, the first major tax reform in over 30 years. While much of the publicity about the new law focused on the 21% corporate tax rate and the substantial changes to foreign income, the new tax law also included several provisions that will have an impact on partners and partnerships. Some of those provisions include a deduction for qualified business income (QBI), a new limitation on business loss deductions, new rules for income from carried interests, and the elimination of technical terminations of partnerships.

Qualified business income

When Congress reduced the corporate tax rate, it recognized the disparity in the rates between corporations and passthrough entities (PTE), such as partnerships. As a way to reduce the effective tax rate for PTEs, the TCJA introduced a new deduction for QBI under Sec. 199A. In general, the new rule permits a deduction for 20% of QBI from partnerships, proprietorships, and S corporations. It also applies to dividends from real estate investment trusts (REITs), income from publicly traded partnerships (PTPs), and certain payments from cooperatives to their patrons. However, the deduction is limited to taxable income. Taxable income is measured without any QBI deduction and is reduced for any income taxable at capital gain rates, including qualified dividends.2

To qualify as QBI, the income must be effectively connected to a trade or business.3A separate computation of QBI and other limitations are required for each qualified trade or business.4 For partners in a partnership, the determination of QBI and any limitations on the deduction apply at the partner level. The deduction is generally 20% of the QBI from a trade or business. However, the allowable deduction may be reduced by several limitations included in the law. The tentative deduction may be reduced by the limitations based on the amount of W-2 wages paid by the PTE and the amount the PTE has invested in tangible depreciable property (e.g., plant, property, and equipment but not land). In addition, the deduction generally is limited where the PTE's business primarily involves the performance of certain specified services (e.g., accountants, lawyers, doctors, and financial advisers).

The limitations are based on the level of taxable income on a taxpayer's individual tax return. The limitation thresholds depend on the individual taxpayer's filing status. In 2019, for married taxpayers filing joint returns, the threshold is $321,400 and the phaseout range is $100,000. For married taxpayers filing separate returns, the threshold is $160,725 and the phaseout range is $50,000. For single and head-of-household taxpayers, the threshold is $160,700 and the phaseout range is $50,000. Thus, when taxable income does not exceed the threshold, "specified service business" income is QBI and the QBI deduction for any trade or business is not limited by reference to the W-2 wages paid or depreciable property held by the business. When taxable income exceeds the threshold plus the phaseout range, specified service income is not QBI and any other QBI is subject to limits based on W-2 wages paid by the business and the basis of property held by the business at the end of the year. When taxable income exceeds the threshold, but is still within the phaseout range, a portion of each rule applies.

When a business produces a loss for the year, the QBI "deduction" may be negative. This amount does not directly add income to the taxpayer's return, but it does offset the QBI deduction that might otherwise be available. If the negative QBI deduction from one business exceeds the positive QBI deduction for all other businesses, the taxpayer must carry the excess loss forward. This carryforward must offset the taxpayer's QBI deduction in the succeeding year. Any loss that enters into the QBI calculations must have already cleared the limits on deductions of partnership basis, amount at risk, and passive activity losses.

The rules regarding the QBI deduction are quite complex, so Congress granted Treasury specific authority to issue regulations regarding the rules of Sec. 199A. Last year, to help taxpayers navigate the new rules, Treasury issued proposed regulations,5 the purpose of which was to provide taxpayers with computational, definitional, and anti-avoidance guidance regarding the application of Sec. 199A. These proposed regulations contain six substantive sections, each of which provides rules relevant to the calculation of the Sec. 199A deduction. Additionally, the proposed regulations would establish anti-abuse rules under Sec. 643(f) to prevent taxpayers from establishing multiple nongrantor trusts or contributing additional capital to multiple existing nongrantor trusts to avoid federal income tax, including abuse of Sec. 199A.

Excess business losses

Before the TCJA, partners had to clear three hurdles before they were allowed to deduct a loss allocated from a partnership: basis under Sec. 704(d), amounts at-risk under Sec. 465, and passive activity loss under Sec. 469. The TCJA added a fourth hurdle that disallows "excess business losses" for taxpayers other than C corporations. "Excess business losses" means an overall loss in excess of $500,000 for married individuals filing jointly or $250,000 for other individuals. Any excess business loss is treated as a net operating loss (NOL) and carried forward to subsequent years. In the case of a partnership, this provision applies at the partner level and after application of the other three loss limitation rules. Under the new rule, a loss from a partnership may be deductible under Secs. 704(d), 465, and 469 and still be limited on the partner's personal return. This provision is effective for years beginning after Dec. 31, 2017, but is set to expire on Dec. 31, 2025.

Carried interests

Carried interests are part of a standard compensation package for managers of private-equity (PE) funds. PE funds typically buy entire businesses, operate them for some period (longer than one year), and sell them for a profit (at least that is the hope). In return for making investment decisions for the PE fund and handling all administrative tasks, the manager (profits interest or carried interest holder) is usually compensated with a management fee and a "carried interest." The carried interest is usually equal to 20% of the PE fund's profits, if any, after the return of the capital invested by the limited (capital) partners, plus a return on invested capital. Because the PE fund generally holds each investment (typically classified as a capital asset) for more than one year, and because the character of the income generated by the PE fund is determined at the partnership level, any profit generated by the PE fund on the sale of a portfolio company is normally characterized as long-term capital gain.

Congress acknowledged to a certain extent that income from a carried interest might be better taxed as ordinary income by adding Sec. 1061 to the Internal Revenue Code as part of the TCJA. Sec. 1061 changes part of the carried interest income from a long-term capital gain to a short-term capital gain, which may be taxed as ordinary income. Under new Sec. 1061, for carried interest income to be taxed as a long-term capital gain, the holding period must be three years instead of one.

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.6 Taxpayers and practitioners have objected 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 them. In 2018, Treasury issued proposed regulations7 revoking the temporary regulations under Sec. 707 issued in 2016 and reinstating the final regulations that were previously in effect.

Audit issues

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)8 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 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),9 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 TEFRA's electing large partnership regime.

Under the BBA, which applies to partnership tax years beginning after Dec. 31, 2017 (elections to apply the new procedures to earlier years were allowed),10 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. On Jan. 2, 2018, Treasury published final regulations under Sec. 6221(b)11 providing rules for electing out of the centralized partnership audit regime.

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 adjustments 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. Proposed regulations made it clear that a review year partner could claim a refund if the audit adjustments resulted in a decrease in taxes.

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 two percentage points if the partnership elects for partners from the reviewed year to pay.12

Technical corrections: Additionally, Congress enacted the Tax Technical Corrections Act (TTCA),13 which made a number of technical corrections to the rules under the centralized partnership audit regime. The amendments under the TTCA are effective as if included in Section 1101 of the BBA and, therefore, are subject to the effective dates in Section 1101(g) of the BBA.

Before the TTCA technical corrections were enacted, Treasury had issued a number of proposed regulations. In August, Treasury withdrew all proposed regulations that had not been finalized prior to the TTCA and issued proposed regulations reflecting the technical corrections made by the TTCA.14 The TTCA clarified the scope of the new partnership audit regime rules by eliminating the reference to items of income, gain, loss, deduction, or credit of a partnership, and replacing it with a reference to partnership-related items. This change by the TTCA clarifies that the scope of the centralized partnership audit regime is not narrower than the scope of the partnership audit procedures under TEFRA. Rather, the centralized partnership audit regime is intended to have a scope sufficient to address those items that would have been considered partnership items, affected items, and computational adjustments under TEFRA, including the regulations.

Partnership-level determinationsProp. Regs. Sec. 301.6221(a)-1(a) further provides that any consideration necessary to make a determination at the partnership level under the centralized partnership audit regime be made at the partnership level. This would include the period of limitation on making adjustments under Sec. 6235 as well as any facts necessary to calculate any imputed underpayment under Sec. 6225, except as otherwise provided under the centralized partnership audit regime. These determinations previously constituted factors described under former Prop. Regs. Secs. 301.6221(a)-1(b)(1)(ii)(F) and (I).

Partnership representative: The final set of partnership regulations issued during this period15 included rules regarding the designation and authority of the partnership representative under the centralized partnership audit regime. The final regulations also included rules explaining how a partnership can elect to apply the centralized partnership audit regime rules to partnership tax years beginning after Nov. 2, 2015, and before Jan. 1, 2018, under Section 1101(g)(4) of the BBA.

Statute of limitation: Even with the adoption of the new audit rules, there were still several court cases involving TEFRA issues; however, there were not as many as in the past. Two cases dealt with a statute-of-limitation issue. Foster16and Rock17 were cases related to American Agri-Corp (AMCOR) partnerships from the 1980s. These partnerships were found to be tax shelters that did not have economic substance. In Foster,the taxpayers invested in a partnership that owned an interest in an AMCOR partnership. The AMCOR partnership did not file a tax return on a timely basis; thus, the statute of limitation never started for that partnership. The IRS later audited the upper-tier partnership, determining the amount of income each partner should include on its respective tax returns. Once this adjustment was made at the upper-tier level, the IRS adjusted the lower-tier partnership for the items that flowed from the upper-tier partnership. The taxpayer in this case claimed that the assessment was after the statute of limitation ran for the lower-tier partnership.

In Rock,the taxpayer invested in an AMCOR partnership where the tax matters partner signed a consent to extend the statute for the partnership. The IRS issued a final partnership administrative adjustment (FPAA) before the extended limitation period expired. Once the adjustment was made, the taxpayer received a notice of tax adjustment. The taxpayer contended that the adjustment was not valid because the statute of limitation had run for the individual tax return. Both the Foster and Rock taxpayers paid the assessment and sued for a refund in district court. In both cases the court found that the assessment was attributable to a partnership item, and thus the court did not have jurisdiction to decide the case under TEFRA. In both these cases, the taxpayer may have been better off taking the case to the Tax Court.

In another case that dealt with a statute of limitation,18 the taxpayers extended the statute of limitation for their personal tax return but not for any partnership returns. The IRS audited the individual return and assessed additional tax on income from a partnership that ended during the taxpayers' tax year. The taxpayers contended that the income from the partnership should not be included because the statute of limitation had not been extended for the partnership. The court disagreed and held that the taxpayers owed the additional tax because the IRS forms do not extend the statute for returns but for the assessment of income tax due on those returns. The court reasoned that the Code required the partners to report their partnership items on their individual returns, and since the partners consented to extend the limitation period for assessing the income tax due on their personal tax returns, they were liable for the tax on the income from the partnership.

Disregarded partnerships: In Greenberg,19 the taxpayer owned partnerships that entered into transactions similar to a son-of-boss deal in which he claimed very large losses. The IRS issued two rounds of notices of deficiency for losses passed through to the taxpayer from the two partnerships, including an abandonment loss claimed by one of the partnerships related to an interest in a partnership it owned. The taxpayer asserted that the IRS got the procedure wrong when the deficiency notices were issued. He argued that the IRS should have issued notices of FPAA, not notices of deficiency. Since an FPAA was not issued, the IRS missed the statute of limitation. The court held for the IRS, finding that the taxpayer's partnerships should be disregarded because they were created to carry out a tax-avoidance scheme. According to the court, because the partnerships were disregarded, Subchapter K no longer applied and their activities were treated as if the partner engaged in them directly.

Small-partnership exception to TEFRA: In a similar case, Mellow,20 a general partnership was formed by two single-member limited liability companies (LLCs). The IRS determined that Mellow was formed and availed of solely for purposes of tax avoidance and constituted an economic sham. The IRS started a partnership-level proceeding under TEFRA to adjust the partnership items in the partnership return. On completion of the audit, the IRS issued an FPAA setting forth adjustments to the partnership items, disallowing losses from unlawful transactions, and assessing penalties. The partnership filed a petition with the Tax Court challenging the FPAA. It then moved to dismiss the case for lack of jurisdiction, arguing that the FPAA was invalid because the partnership was a "small partnership" exempt from TEFRA's audit and litigation proceedings.

The Tax Court denied the motion ruling that a partnership does not qualify for the small-partnership exception if any of its partners is a "pass-thru partner" under TEFRA Sec. 6231(a)(9) and that disregarded single-member LLCs qualify as passthrough partners. The Tax Court subsequently entered a decision upholding most of the IRS's adjustments to the partnership return and imposing penalties.

On appeal, the partnership asserted that the Tax Court erred in rejecting its contention that it qualified for the small-partnership exception to TEFRA. It argued that, under certain tax-classification regulations, the single-member LLCs' individual owners rather than the LLCs themselves were the partnership's partners for TEFRA purposes and, therefore, the partnership qualified as a "small partnership." The appeals court found instead the single-member LLCs were the partners, not the individual owners. Thus, the partnership was subject to the TEFRA partnership proceedings.

Definition of partnership and partner

In the period covered by this update, the IRS addressed whether entities should be treated as a partnership. In White,21 the taxpayer entered into a verbal agreement with another taxpayer to work in the real estate business. The business had two components, and the taxpayers had different roles and responsibilities. The business was run very informally with the lines between business and personal bank accounts blurred. The business was never profitable and ultimately liquidated. No partnership tax return was ever filed. Instead each of the taxpayers reported his or her income on a Schedule C, Profit or Loss From Business, on individual tax returns. The taxpayers argued that the individuals had agreed to an equal division of profits. However, in reality there was not an equal division of distributions or revenue. Based on the taxpayers' actions, the IRS determined that a partnership did not exist and that the taxpayers underreported income.

The court considered the record as a whole and determined that considering the inconsistencies in the record, the business was not properly classified as a partnership for tax purposes. In addition, the court held that even if the business was a partnership, there was no reliable evidence showing that the partnership's total receipts were different from the amounts the IRS had calculated using the specific-item method

Single-member LLC vs. partnership: In another case,22 the IRS sent a levy notice to an LLC. After receiving the notice, the LLC timely submitted a Form 12153, Request for a Collection Due Process or Equivalent Hearing. The LLC did not ask for a collection alternative and only raised its underlying liabilities in the request. The LLC asserted that it was not a partnership but a single-member LLC owned by a husband and wife that should not be charged a partnership penalty. However, the entity filed a Form 1065, U.S. Return of Partnership Income, and showed two partners.

The court determined the LLC was subject to the penalty because the LLC had represented itself as a partnership on its tax returns and thus could not argue that it was another entity and disclaim its validity later. In addition, although the LLC contended that the owners had elected to be treated as one partner, the court found no evidence of an election under Sec. 761(f).


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. The taxpayer has the burden of proof to establish that it has adequate basis to deduct losses.

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 Enis,23the husband and wife were owners of an LLC that was taxed as a partnership. The taxpayers deducted a loss from the LLC, which the IRS disallowed because the taxpayers had not provided adequate documentation establishing bases in the LLC. The taxpayers contended that their bases were created by LLC expenses that the taxpayers paid personally. However, other than lists of expenses in schedules included with their individual return and the LLC's return, the taxpayers did not provide any additional support to prove that these expenses were paid and were for the LLC. The court found that these returns did not constitute proof of basis.

Lack of basis was also at issue in Shamaley.24 In this case, the taxpayers deducted their share of an NOL from an LLC in a prior year. The IRS disallowed the loss because the taxpayers did not have basis in their LLC interest. The taxpayers agreed with the IRS and adjusted their tax returns for that year. The next year the LLC generated net income. The taxpayers deducted the disallowed loss from the previous year against the income of the current year.

The IRS disallowed the loss, again claiming that the NOL was permanently disallowed under the terms of the previous agreement. The taxpayers contended that the agreement they signed for the previous year prevented them from taking a deduction that year because the partners lacked basis, not because the NOL itself was altered or disallowed. To support this conclusion, the taxpayers provided a letter that was signed by a representative of the IRS that stated that the agreement included changes intended to clarify "that the partnership loss was being 'disallowed as a flow through because of insufficient basis.'" The court found that this letter supported the taxpayers' argument that the agreement disallowed the NOL in the previous year only due to insufficient basis, but left the NOL itself intact for ordinary treatment in future years. Thus, the court held in the taxpayers' favor and allowed the loss.

Basis computation: The TCJA also made a change in how partners compute their basis. Previously, a partner was allowed to deduct his or her distributive share of partnership loss only to the extent of the adjusted basis of the partner's interest in the partnership. However, the IRS had taken the position in a private letter ruling that the Sec. 704(d) loss limitation did not apply to limit a partner's deduction for its share of the partnership's charitable contributions. In addition, regulations under Sec. 704(d) do not address any limitation to a foreign tax credit in lieu of deducting foreign taxes paid by the partnership.

Under Section 13503 of the TCJA, when determining the amount of losses that are deductible on the partner's tax return, the partner's distributive share of partnership charitable contributions and taxes paid or accrued to foreign countries must be taken into account. When the charitable contribution is for capital gain property with a fair market value (FMV) greater than its adjusted basis, the partner's distributive share of the excess is not taken into account.

Economic substance

A basic principle of tax law is that taxpayers are entitled to structure their business transactions in a manner that produces the least amount of tax. However, business transactions must have economic substance. For a transaction to have economic substance, it must have a reasonable possibility of a profit, and there should be an independent business purpose beyond reducing taxes behind the transaction. The IRS has been diligent in examining transactions that it considers to lack economic substance or to be sham transactions. The IRS generally has prevailed on the issue. To help clarify the rules, Congress codified the economic substance doctrine in the Health Care and Education Reconciliation Act of 2010.25 There were still a number of cases during this period that considered whether a partnership had economic substance.

Sham partnerships: In the first case,26 taxpayers invested in a partnership that was formed solely to enter into a son-of-boss transaction that involved offsetting foreign currency options. The taxpayers claimed a short-term capital loss and a nonpassive loss as their share of the loss from the partnership. The IRS disallowed the losses because the partnership lacked economic substance. The IRS determined that the partnership was formed with the principal purpose of reducing the owners' federal income tax liability in a fashion inconsistent with Subchapter K and otherwise constituted shams for federal income tax purposes. The court agreed and ruled that the taxpayers were not allowed the losses on their personal tax returns.

Foreign currency transactions: In a second case,27 two brothers sold their family business at an extremely large gain. They then formed a partnership and entered into a son-of-boss deal to manufacture tax losses to offset gains from the sale of their business. The losses were generated by buying both long and short foreign currency digital options. The brothers deducted huge losses from this partnership the same year they reported the gain on the sale of the family business. The IRS disallowed the loss deduction because the foreign currency transactions did not have economic substance. The taxpayers conceded at trial that this was true, and the court held they did not have a reasonable-cause-and-good-faith defense to the imposition of an accuracy-related penalty based on their reliance on the tax shelter promoter's advice.

No possibility of profit: In a different type of transaction,28 taxpayers invested in partnerships that entered into an investment scheme called Partnership Option Portfolio Securities (POPS). POPS are designed to generate gains in one tax period and offset losses in another. In this case, all of the transactions in question involved paired foreign-currency options. The IRS challenged this transaction as not having economic substance. Thus, it disallowed the loss deductions.

The court determined that the paired foreign currency options had no reasonable possibility of generating an economic profit. The result of the transaction was the partnership simply made a bank deposit and got its money back a year later with interest. There was no evidence that the partnership was formed for anything other than tax avoidance. Thus, the court sustained the IRS's disallowance of the loss deduction.

Distressed asset debt tax sheltersIn an additional case,29 the taxpayers invested in two partnerships that invested in "cookie cutter" distressed asset debt (DAD) tax shelter investments. The taxpayers deducted bad debts that arose from receivables from a foreign entity under Sec. 166. They also deducted expenses from DAD transactions. The IRS disallowed the deductions based on its determination that the transactions lacked economic substance. The court agreed with the IRS, basing its reasoning on the ruling in Superior Trading, LLC,30 which found that similar transactions did not have economic substance.

Technical terminations

One issue that has given taxpayers problems for a number of years relates to technical terminations under Sec. 708(b)(1)(B). Under this section, a partnership is considered terminated if, within any 12-month period, there is a sale or exchange of 50% or more of the total interest in partnership capital and profits. If a technical termination occurs, the partnership is deemed to have contributed all of the partnership assets and liabilities to a new partnership, followed by a deemed distribution of the new partnership interests to the partners. A technical termination closes the old partnership's tax year so a short-period tax return is due. In addition, some of the tax attributes of the old partnership terminate and partnership-level elections cease to apply. These changes have caused problems with partnerships failing to file the short-period tax return on a timely basis and the new partnership failing to make new elections.

To alleviate these problems, Section 13504 of the TCJA repealed Sec. 708(b)(1)(B) for tax years beginning after Dec. 31, 2017. The change is only for technical terminations. The TCJA left intact terminations under Sec. 708(b)(1)(A) when no part of any business, financial operation, or venture of the partnership continues to be carried on by any of the partners in the partnership.

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 a case decided in 2017, Grecian Magnesite,31 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 held 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 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. 864 and 865. However, last year Congress changed Sec. 864(c) in the TCJA. Under new Sec. 864(c), gain or loss from the sale or exchange of a partnership interest is effectively connected with a U.S. trade or business to the extent the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at FMV as of the date of the sale or exchange. In addition, any gain or loss from the hypothetical sale must be allocated to an interest in the partnership in the same manner as nonseparately stated income and loss. This rule applies to sales or exchanges on or after Nov. 27, 2017. For sales after 2017, the transferee of the partnership interest must withhold 10% of the amount realized on the sale or exchange unless the transferor certifies that the transferor is not a foreign person under new Sec. 1446(f).

After the enactment of the TCJA, Treasury issued two notices related to new Sec. 1446(f). In Notice 2018-08 Treasury announced that the IRS was suspending the application of Sec. 1446(f) for the disposition of certain PTP interests until regulations or other guidance was issued. This suspension did not apply to nonpublicly traded partnerships. In Notice 2018-29 Treasury provided interim guidance that nonpublicly traded partnerships required to withhold under Sec. 1446(f) on sales under Sec. 864(c) should use the rules in Sec. 1445 for purposes of reporting and paying the tax required until proposed regulations are issued. The taxpayer must file Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, or 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests, to report the withholding but must include the statement "Section 1446(f)(1) withholding" at the top of the relevant forms.

Sec. 732(f): Sec. 732(f) provides that if a corporate partner receives a distribution from a partnership of stock in another corporation and the corporate partner has control of the distributed corporation immediately after the distribution or at any time thereafter and the partnership's basis in the stock immediately before the distribution exceeded the corporate partner's basis in the stock immediately after the distribution, then the basis of the distributed corporation's property must be reduced by this excess. The amount of this reduction is limited to the amount by which the sum of the aggregate adjusted basis of property and the amount of money of the distributed corporation exceeds the corporate partner's adjusted basis in the stock of the distributed corporation. The corporate partner must recognize gain to the extent that the basis of the distributed corporation's property cannot be reduced. Congress enacted Sec. 732(f) due to concerns that a corporate partner could otherwise negate the effects of a basis step-down to distributed property required under Sec. 732(b) by applying the step-down against the basis of the stock of the distributed corporation.

In 2018, Treasury issued final regulations32 related to Sec. 732(f). Treasury felt that the application of Sec. 732(f) was too broad in some circumstances and too narrow in others. To address these concerns, it issued proposed regulations in 2015 that provided rules governing the application of Sec. 732(f) in two specific sets of circumstances. The first rule would permit consolidated group members to aggregate the bases of their respective interests in the same partnership for purposes of limiting the application of rules that might otherwise cause basis reduction or gain recognition.

The second rule would restrict corporate partners from entering into certain transactions or a series of transactions, such as a distribution followed by a reorganization under Sec. 368(a), that might eliminate gain in the stock of a distributed corporation while avoiding the effects of a basis step-down under Sec. 732(f). In addition, the 2015 proposed regulations required taxpayers to apply those rules to tiered partnerships in a manner consistent with the purpose of Sec. 732(f) that prevent a corporate partner from avoiding corporate-level gain through transactions with a partnership involving an equity interest of the partner. The final regulations adopt the 2015 proposed regulations under Sec. 732(f) without any change.

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. Under Sec. 165(a), a taxpayer generally may take an ordinary loss deduction related to an investment in a partnership if investment in the partnership becomes worthless and sale or exchange treatment does not apply.

Closed or completed transactions: In Forlizzo,33the taxpayer formed multiple partnerships that were operated as special-purpose entities to acquire and develop real property. Many of the partnerships operated at a loss for a number of years. The underlying real estate owned by the partnerships still had value, and the banks had not foreclosed on the property. In addition, the partnerships had not filed for bankruptcy. Even though the partnership was still operating, the taxpayer determined that his interests in the partnerships were worthless and claimed a loss for those interests. Even after he claimed the loss deduction, he did not abandon his interests in the partnerships. The IRS determined the partnership interests were not worthless and disallowed the deductions.

The court noted that a mere decline in the value of assets is not sufficient to establish a closed or completed transaction that is necessary to justify a loss deduction under Sec. 165(a). The taxpayer was not able to prove that his interests in the partnerships had become worthless as the result of a closed and completed transaction. Thus, the court ruled that the taxpayer was not allowed the deductions for the losses relating to the partnership interests.

Sec. 754 election

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

Currently, if a partnership inadvertently fails to file the election, the only way to remedy the failure is to ask for relief under Regs. Secs. 301.9100-1 and -3 either through automatic relief if the error is discovered within 12 months or through a private letter ruling. To be a valid election, the election must be signed by a partner in the partnership. The number of invalid elections has grown as more returns are filed electronically. Last year Treasury proposed an amendment to Regs. Sec. 1.754-1(b)(1) to remove the requirement that the election be signed.34 This change should reduce the number of private letter ruling requests the IRS receives each year.

Extensions of time: In several rulings during this period,35 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.36

Missed elections: The Sec. 754 election is allowed when a partner dies and his or her interest is transferred. In many cases the election is inadvertently missed in this situation. During this period, the IRS granted an extension of time to make the Sec. 754 election in a number of situations where a partner died and the partnership missed making the election.37 The IRS gave the same answer in Letter Ruling 201819010 when the death was in a community property state.38

In a more unique situation,39 an upper-tier partnership (UTP) owned an interest in a lower-tier partnership (LTP). When an owner of the UTP died, the UTP filed a valid Sec. 754 election, but the LTP did not. The IRS granted the LTP relief and gave it 120 days to make the election. It is important to note that each partnership in a chain of partnerships must file its own separate Sec. 754 election.

Assignment of income: In a court case last year,40 a taxpayer transferred stock in a corporation to an LLC when the corporation was negotiating its possible acquisition by a second corporation. On the same day that the two corporations agreed on a sales price, the taxpayer assigned a 36% interest in the LLC to a foreign entity formed to hold segregated account investment reserves in support of an insurance policy on the taxpayer's life. In return, the foreign entity agreed to make specified annual payments to the taxpayer beginning after seven years and continuing for so long as the taxpayer's wife remained alive. The assigned interest in the LLC was valued using the closing price of the original corporation on the date of the assignment. Later the LLC sold its stock to the second corporation. The LLC allocated 36% of its gain to the foreign entity. The IRS disagreed with this allocation and reallocated all of the gain to the taxpayer and his wife.

The taxpayer claimed that, because the IRS did not issue an FPAA until more than three years after the LLC filed its partnership income tax return, the limitation period prevented the additional assessment of tax as a result of the FPAA adjustments. He claimed that, because the LLC made a valid election under Sec. 754 with its prior tax return, the LLC properly reduced its reported gain from its sale of the stock with a Sec. 743(b) basis adjustment allocated to the foreign entity. Thus, the partnership did not omit an amount of gross income sufficient to trigger the six-year limitation period in Sec. 6229(c)(2). The IRS argued that the LLC's purported Sec. 754 election was invalid because the taxpayer's assignment of a portion of his interest in the LLC to the foreign entity must be disregarded under the assignment-of-income doctrine.

The court found that any shift in gain from the taxpayer to the foreign entity that might violate the assignment-of-income doctrine does not justify disregarding altogether the foreign entity's interest in the LLC. It also ruled that the taxpayer's transfer of the LLC interest must be respected for federal income tax purposes and that the LLC made a valid Sec. 754 election in connection with that transfer. Because the LLC had a valid Sec. 754 election in place, the LLC made an appropriate Sec. 743(b) adjustment for the foreign entity's share of the gain and did not omit any gain from its gross income. Lastly, the court held that the IRS could not assess tax attributable to the FPAA adjustments.

Bonus depreciation: The TCJA allows taxpayers to elect to expense immediately 100% of the costs for qualified property acquired and placed in service between Sept. 27, 2017, and Jan. 1, 2023, under Sec. 168(k). Last year Treasury issued proposed regulations41 that added three sentences to regulations under Sec. 743. The proposed regulations allow a partnership to deduct the additional first-year depreciation under Sec. 743(b) even if the partnership made the election under Sec. 168(k)(7) not to deduct the additional first-year depreciation for all other qualified property of the partnership in the same class of property and placed in service in the same tax year, provided the Sec. 743(b) basis adjustment meets all requirements of Sec. 168(k).

Alternatively, the partnership may make an election under Sec. 168(k)(7) to not deduct the additional first-year depreciation for an increase in the basis of qualified property under Sec. 743(b) even if the partnership does not make that election for all other qualified property of the partnership in the same class of property and placed in service in the same tax year. In this case, the Sec. 743(b) basis adjustment must be recovered under a reasonable method. Thus, the proposed regulations will allow the partnership to treat the depreciation taken on the step-up in basis under Sec. 743(b) differently than it treats the depreciation for assets purchased by the partnership in the same year a transaction occurs that triggers the partnership's Sec. 754 election.

Substantial built-in losses: Generally, a partnership does not adjust the basis of partnership property following the transfer of a partnership interest unless the partnership has made an election under Sec. 754. However, partnerships are required to make a basis adjustment if the partnership has a substantial built-in loss immediately after the transfer. Before 2018, under Sec. 743(d)(1), a substantial built-in loss existed if the partnership's adjusted basis in its property exceeded the FMV of the property by more than $250,000. Securitization partnerships and electing investment partnerships were exempt from this rule in certain situations.

For transfers of partnership interests after Dec. 31, 2017, the definition of a substantial built-in loss in Sec. 743(d)(1) was modified by the TCJA. The modified definition adds that a substantial built-in loss exists if the transferee would be allocated a net loss in excess of $250,000 on a hypothetical disposition of all partnership assets in a fully taxable transaction for cash equal to the assets' FMV, immediately after the transfer of the partnership interest.


1P.L. 115-97.

2Sec. 199A(a)(1).

3Sec. 199A(c)(3)(A)(i).

4Sec. 199A(b)(1)(A).


6T.D. 9788.


8Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248.

9Bipartisan Budget Act of 2015, P.L. 114-74.

10T.D. 9780; Temp. Regs. Sec. 301.9100-22T.

11T.D. 9829.

12Sec. 6226(c)(2)(C), effective for tax years beginning after Dec. 31, 2017.

13Tax Technical Corrections Act, Division U of P.L. 115-141.


15T.D. 9839.

16Foster, No. A-06-CA-818-SS (W.D. Tex. 6/19/18).

17Rock, 320 F. Supp. 3d 842 (W.D. Tex. 2018).

18Inman Partners, T.C. Memo. 2018-114.

19Greenberg, T.C. Memo. 2018-74.

20Mellow Partners, 890 F.3d 1070 (D.C. Cir. 2018).

21White, T.C. Memo. 2018-102.

22Argosy Technologies, LLC, T.C. Memo. 2018-35.

23Enis, T.C. Memo. 2017-222.

24Shamaley, No. EP-17-CV-257-KC (W.D. Tex. 5/11/18).

25Health Care and Education Reconciliation Act of 2010, P.L. 111-152.

26Marcy, T.C. Memo. 2018-42.

27RB-1 Inv. Partners, T.C. Memo. 2018-64.

28Endeavor Partners Fund, T.C. Memo. 2018-96.

29Derringer Trading LLC, T.C. Memo. 2018-59.

30Superior Trading, LLC, 137 T.C. 70 (2011).

31Grecian Magnesite Mining, Industrial & Shipping Co., SA,149 T.C. No. 3 (2017).

32T.D. 9833.

33Forlizzo, T.C. Memo. 2018-137.


35E.g., IRS Letter Rulings 201812004, 201826005, 201830010, and 201841003.

36E.g., IRS Letter Rulings 201815002 and 201817018.

37E.g., IRS Letter Rulings 201833007 and 201834004.

38IRS Letter Ruling 201819010.

39IRS Letter Ruling 201823001.

40DTDV, LLC, T.C. Memo. 2018-32.




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