A substantial-authority scorecard and example for excluding Sec. 1202 gain for a carried partnership interest

Editor: Valrie Chambers, CPA, Ph.D.

Federal and state tax return rules are more complex than ever, and differences of opinion on certain rules among tax authorities, tax professionals, and/or taxpayers are not unusual.

A practitioner may not take an unreasonable position on a return and may not prepare or sign a return with an unreasonable position under the Code’s preparer and taxpayer penalty rules; the practitioner rules of Section 10.34 of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10);and theAICPA’s Statement on Standards for Tax Services (SSTS) No. 1, Tax Return Positions. Furthermore, if a tax return preparer prepares a return where any part of an understatement of liability on the return is due to an unreasonable position, and the preparer knew (or reasonably should have known) of the position, the preparer can be subject to penalties under Sec. 6694.

Reasonable positions and weights of authority

A “tax position” means the way a set of facts are treated for tax purposes. Hence, essentially everything on a return represents some position, as do omissions from a return. A position (other than a position with respect to a tax shelter or a reportable transaction to which Sec. 6662A applies) is unreasonable unless either (1) there is or was substantial authority for the position, or (2) the position was disclosed as provided in Sec. 6662(d)(2)(B)(ii)(I) and there is a reasonable basis for the position as required by Sec. 6662(d)(2)(B)(ii)(II). Both substantial authority and reasonable basis are essentially defined as a conceptual level of confidence; that is, as a determined weight of authorities that support the desired tax treatment of the facts of the situation, out of the total weight of authorities that address the facts of the situation (Regs. Secs. 1.6662-4(d)(2), 1.6662-3(b)(3), and 1.6662-4(d)(3)(i)).

It helps to attach hard figures to these conceptual levels of confidence, especially given that their definitions involve a weighting concept; however, exact figures remain undefined under the applicable rules. In relative terms, however, substantial authority is defined as a less stringent standard than “more likely than not” (Regs. Sec. 1.6662-4(d)(2)). “More likely than not” (which is the standard that applies to a tax shelter or a reportable transaction to which Sec. 6662A applies) is defined as being of the reasonable belief that the position would more likely than not be sustained on its merits (Sec. 6694(a)(2)(C)), i.e., at least a bit more than 50% chance of success based on its merits. Because the substantial-authority rules were issued to be more stringent than the preexisting realistic-possibility standard, which is a 33⅓% chance of success based on its merits (see preamble, T.D. 9436 and Regs. Sec. 1.6694-2(b)(1) before amendment by T.D. 9436), a position with “substantial authority” has come to be understood as one having approximately a 40% chance of success based on its merits. In the same vein, 20% is the generally understood chance needed to have a position with a “reasonable basis” (see AICPA, Interpretations of Statement on Standards for Tax Services No. 1, Tax Return Positions, p. 4, citing Joint Committee on Taxation, Study of Present-Law Penalty and Interest Provisions as Required by Section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998 (Including Provisions Relating to Corporate Tax Shelters) (JCS-3-99), Vol. 1, p. 152 (July 22, 1999)).

A certain percentage chance of success does not mean to imply a degree of wishful thinking or guessing. It also does not mean the percentage chance that an IRS examiner will either (1) not pick up on the issue; (2) not be interested in the issue; or (3) ultimately drop the issue. Rather, it is an objective reflection of the merits of the position, including the extent to which there is authoritative support for the position (Regs. Sec. 1.6662-4(d)(3)(i)).

Facts and authorities

To determine whether there is substantial authority, it is necessary to ascertain (1) the pertinent facts and (2) the pertinent authorities. A position of confidence of less than 100% may result where authorities conclude differently from one another, or where the facts are different from those addressed by the pertinent authorities. “Weight of authority” is measured by the impact that the authority has on the confidence level for a concluded position. The weight of an authority takes into account the persuasiveness of the authority and the relevance of the authority to the taxpayer’s particular facts and issues (Regs. Sec. 1.6662-4(d)(3)(ii)).

Authorities, as set forth in Regs. Sec. 1.6662-4(d)(3)(iii), include legislative, administrative, and judicial documents. The various authorities have predetermined potential weights, all else being equal. For example, a statute that clearly and unambiguously applies to the pertinent set of facts carries an almost insurmountable weight of authority. Conclusions of the most “authoritative” treatise or in an opinion of the most revered tax law firm bear zeroweight as an authority, although authorities underlying them, if pertinent, may constitute pertinent authorities.

Keeping a “scorecard” of the weight of authorities on a particular position can be helpful, as illustrated in the following case example.

Case example: Sec. 1202

Sec. 1202 excludes from tax for a noncorporate taxpayer all or a portion of the eligible gain recognized on the sale or exchange of qualified small business stock (QSBS) that is held for more than five years, up to the greater of (1) $10 million, reduced by the aggregate amount of such gain in prior tax years related to QSBS of the same corporation, or (2) 10 times the aggregate adjusted basis of QSBS issued by the corporation and disposed of in the tax year.

QSBS is stock of an active C corporation the business of which is, generally, not a specified service trade or business under Sec. 1202(e)(3) (see there for details), with no more than $50 million of assets at, prior to, and immediately after the time the stock was issued. The stock needs to have been originally issued after Sept. 27, 2010, to be fully excludable in calculating income tax, including from alternative minimum tax and net investment income tax, or after Aug. 10, 1993, for either a 50% or 75% exclusion. QSBS needs to have been acquired at its original issue in exchange for money, property, or services (Sec. 1202(c)(1)(B)).

The stock can be acquired through a partnership or certain other flowthrough entities, as long as (1) the partnership’s stockholding meets the QSBS rules; (2) the requisite holding period is met by the partnership; and (3) the partner-taxpayer holds the partnership interest from the date the partnership acquires the stock until the date of its disposition (Sec. 1202(g)(2)). However, gain can be excluded only to the extent that the partner’s share of the gain does not exceed the share determined by reference to the interest the partner held in the partnership at the time the partnership acquired the stock (Sec. 1202(g)(3)).

An interest in a partnership definitionally includes a profits interest. However, a profits interest not held both on the date the partnership acquires the QSBS and at all times thereafter until the date of disposition of the QSBS does not qualify (Sec. 1202(g)(2)). For qualifying profits interests, the Sec. 1202(g)(3) limitation requires that the excluded gain be limited to that which is allocable to the interest held at the time the partnership acquires the stock.

However, Sec. 1202(g)(3) is ambiguous. Does it mean that gain allocable to a carried interest may be excluded, but only to the extent of (1) what the carry interest in the Sec. 1202 gain would have been at the time of the partnership’s acquisition of the stock, by, for instance, computing the carry’s effective allocable interest at that time based on a hypothetical liquidation calculation; or (2) the smallest effective allocable interest across the entire partner-taxpayer’s holding period (due to the rule in Sec. 1202(g)(2))? There are no regulations or other authorities under Sec. 1202 that clarify this ambiguity in the statute. As such, the scorecard at this point is that either alternative above merits approximately a 50% chance of success.

However, there are final Treasury regulations under Sec. 1045. Under Sec. 1045, taxpayers may roll over Sec. 1202 gain within 60 days if the QSBS was held for at least six months, which is considerably shorter than the five years required under Sec. 1202. All Sec. 1202 rules, including the partnership rules just discussed, apply to Sec. 1045, and so there is the same question for Sec. 1202 gain allocable to a carried interest. T.D. 9353, issued in 2007, provides that under Sec. 1045, (1) only capital interests are taken into account and (2) the smallest percentage held during the QSBS “holding period” is to be used as that capital interest.

In the words of the preamble to T.D. 9353, “this nonrecognition rule follows section 1202(g)(2) and (3) by ensuring that the partner can defer recognition of only the gain that relates to the partner’s continuous economic interest in the QSB stock that was sold” (emphasis added). Taking the preamble to T.D. 9353 into account, the 50% confidence level previously accounted for on the scorecard would be negatively impacted, since a capital interest allocated gain would be eligible for exclusion but a carried interest would not.

Even though Sec. 1202 is ambiguous, a practitioner must consider regulations that interpret it. The Supreme Court in both Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), and Mayo Foundation for Medical Education and Research, 562 U.S. 44 (2011), set forth that tax and other regulations, whether legislative or interpretive, are deferentially valid when they are a reasonable interpretation of an ambiguous statute. This means that the Sec. 1045 regulations constitute authority against which a contrary position may not be taken.

The preamble to T.D. 9353 links Sec. 1045 to Sec. 1202 and cannot be ­ignored, as Treasury regulations and Treasury decisions (including preambles) are regarded as being prepared by the IRS Chief Counsel’s Office, reviewed by the commissioner, and then forwarded for approval to the Treasury secretary (or delegate) (Regs. Sec. 601.601(a)(1); see also Internal Rvenue Manual §32.1.1.2.5).

However, a closer reading of the T.D. 9353 preamble describes the history of, and reveals the intent of, the final Sec. 1045 regulations:

The proposed regulations provided that the amount of gain that an eligible partner may defer under section 1045 may not exceed: (A) the partner’s smallest percentage interest in the partnership’s income, gain, or loss with respect to the QSB stock that was sold, multiplied by (B) the partnership’s realized gain from the sale of such stock. . . . Commentators agreed with the underlying “continuous ownership” requirement in the proposed regulations, but raised concerns that the nonrecognition limitation rule may be difficult to administerwhen a partnership does not have a simple “pro rata” partnership arrangement. . . . Accordingly,to address the commentator’s concerns, the nonrecognition rule has been modified to provide that the amount of gain that an eligible partner may defer under section 1045 may not exceed: (A) the partner’s smallest percentage interest in partnership capital from the time the QSB stock is acquired until the time the QSB stock is sold, multiplied by (B) the partnership’s realized gain from the sale of such stock. The IRS and the Treasury Department believe that this nonrecognition rule in the final regulations will be easier to administer, is consistent with each partner’s economic interest in the partnership, and will not inappropriately limit the amount of gain that can be deferred. [Emphases added]

According to the preamble, but for the commentator’s concerns, an interest that takes into account a profits interest would be consistent with the QSB economic interest rules (i.e., Sec. 1202). Thus, the scorecard is impacted favorably, and there would be substantial authority for a profits interest to be eligible for Sec. 1202 gain exclusion.

However, while apparently explaining why it is addressing the commentator’s concerns, the preamble first asserts that “[t]axpayers that invest through a partnership acquire the requisite interest for purposes of the continuous economic interest requirement by an investment of capital in the partnership. Accordingly, to address the commentator’s concerns, the nonrecognition rule has been modified” (emphasis added). The preamble cites as support for its assertion Sec. 1202(c)(1)(B). The preamble is somewhat inconsistent in its motivation: Is the final rule a reflection of Treasury’s new and final stance on Sec. 1202, or is it a concession under Sec. 1045 to a commentator’s concern, leaving the earlier Sec. 1202 stance intact?

This inconsistency negatively affects the confidence level. Overall, the threshold of substantial authority appears to not be met, given the explicit linking of Sec. 1045 to Sec. 1202 and the absence of explicit counterauthority. However, as a result of the stance’s inconsistency just discussed, a “reasonable basis” appears to exist under Regs. Sec. 1.6662-3(b)(3) because treating a profits interest as eligible for the Sec. 1202 exclusion would thus be reasonably based on one or more authorities, taking into account the relevance and persuasiveness of the authorities and subsequent developments.

Our final scorecard then would be that under Sec. 1202 there is a reasonable basis for excluding the carry portion of the gain to the extent of the smallest effective allocable interest across the entire partner-taxpayer’s holding period, from the time the QSBS is acquired until it is sold, where the partner-taxpayer holds the partnership interest from the date the partnership acquires the stock until the date of the gain. Since this is only a reasonable-basis confidence level, excluding any portion of the carried interest portion of the Sec. 1202 gain would require an adequate disclosure by attaching a Form 8275, Disclosure Statement, to a taxpayer’s return.