With partnership debt, son does not have to step into father’s shoes

PARTNERS & PARTNERSHIPS
By James A. Beavers, CPA, CGMA, J.D., LL.M.

The Tax Court held that a taxpayer, who received interests in four partnerships from his father by gift or bequest, did not step into his father's shoes with respect to interest on certain partnership loans, and thus the taxpayer was not required to treat the interest on the loans as investment interest, as his father had before the transfers of the partnership interests.

Background

Maurice Lipnick owned interests in four real estate partnerships that took out loans, which were nonrecourse to Maurice and the other partner in the partnerships, using the proceeds to make distributions (the debt-financed distributions) to Maurice and the other partner. Maurice used the funds he received from the debt-financed distributions to purchase money market fund shares and other investment assets. Accordingly, Maurice treated his distributive share of the interest paid by the partnerships on the loans, as reported to him on Schedules K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc., from the partnerships, as investment interest and reported the interest expense on his income tax return as an itemized deduction, subject to the limitation on investment interest in Sec. 163(d).

In 2011, Maurice transferred interests in three of the partnerships to his son William Lipnick by gift. In 2013, Maurice died, leaving his interest in the fourth partnership to William in his will. William did not become personally liable on any of the four partnerships' loans for the debt-financed distributions.

After the transfers, the loans for the debt-financed distributions remained outstanding. The interest on the loans, which had been passed through to Maurice before the four partnership interests were transferred, afterward passed through to William as the new partner in the partnership. William, however, did not treat the interest as investment interest, as his father had. He treated the loans as properly allocable to the partnerships' real estate assets and treated the interest expense passed through to him by the partnerships on Schedule E, Supplemental Income and Loss, as an offset to the real estate income passed through to him from the partnerships.

The IRS did not agree with William's treatment of the interest. On audit, it determined that the interest William received was investment interest, deductible under Sec. 163(d)(1) to the extent of his net investment income. The IRS, in essence, argued that because William received the interests in the partnerships through gift and bequest from his father, he stepped into his father's shoes with respect to the interest on the loans and was bound to treat the interest expense in the same manner as his father.

In 2013 and 2014, if the interest was investment interest, William did not have sufficient investment income to deduct any of the interest. Therefore, the IRS issued a notice of deficiency for those years in which it denied William the deductions he had taken for the interest on the loans for the debt-financed distributions. William challenged the IRS's determination in the Tax Court.

The Tax Court's decision

The Tax Court held that William had made a debt-financed acquisition of the partnership interests he received, so the interest from the loans was allocable to the real estate assets of the partnerships and was fully deductible. The court found that there was no support for the IRS's argument that William was required to treat the interest in the same way as his father "in the statute, the regulations, or the decided cases."

William and the IRS agreed that for 2013 and 2014, because William had little investment income, if the interest on the loans used to make the debt-financed distributions to his father was investment interest, it would be nondeductible. If it was not investment interest, the parties agreed that William's treatment of the interest, as reportable and deductible on Schedule E, was correct.

For the interest on the loans to be investment interest in William's hands, the court stated that William had to have received, like his father, a debt-financed distribution and invested the funds distributed in investment property. Observing that William did not receive directly or indirectly any of the debt-financed distributions his father received from the partnerships or invest any distributions from the partnership in investment property, the court found that the interest expense that passed through to William from the partnerships was not investment interest.

The Tax Court determined that, when he received the four partnership interests, rather than receiving a debt-financed distribution, William had made a debt-financed acquisition of the interests. A taxpayer makes a debt-financed acquisition if the taxpayer assumes a debt in consideration for the sale or use of property or takes property subject to a debt, and no debt proceeds are disbursed to the taxpayer. In a debt-financed acquisition, the outstanding balance of the debt at the time of transfer of the property is treated as being paid for the property. The Tax Court found that William had made a debt-financed acquisition of the partnership interests because he had received his father's interests in the four partnerships and the partnerships were liable for the loans used to make the debt-financed distributions.

The IRS argued he had not made a debt-financed acquisition, because, when acquiring the partnership interests from his father, William did not "assume a debt" or "take property subject to a debt." The IRS contended he had not done so because the loans were nonrecourse and the liens held by the lenders ran against the partnerships' real estate assets, not against William's partnership interests. Citing its own precedent in Smith, 84 T.C. 889 (1985), and the IRS's ruling in Rev. Rul. 80-323, the Tax Court concluded that a transferred partnership interest is considered subject to its share of the nonrecourse liabilities of the partnership, so William had taken property subject to a debt, as required for a debt-financed acquisition.

The interest tracing rules in Notice 89-35 provide that, under Temp. Regs. Sec. 1.163-8T, if an interest in a passthrough entity is acquired in a debt-financed acquisition, the interest expense associated with the debt used to make the acquisition is "allocated among all the assets of the entity." Accordingly, the Tax Court determined that, with respect to William, the interest paid on the loans was properly allocated to the partnerships' real estate assets.

The Tax Court then analyzed whether the interest on the loans was investment interest for William if the interest was allocated to the partnerships' real estate assets. Under Sec. 163(d)(3)(A), investment interest is interest "paid or accrued on indebtedness properly allocable to property held for investment." The court found that the partnerships' real estate assets were actively managed operating assets that were not property held for investment, and, thus, the interest on the loans was not investment interest.

Having determined that the interest was not investment interest in William's hands under the temporary regulations and other IRS guidance, the Tax Court addressed the IRS's argument that William was nonetheless bound to treat the interest as investment interest because, having acquired the partnership interests from his father, he stepped into his father's shoes and was required to treat the interest as his father did. The IRS claimed that the court should adopt a "once investment interest, always investment interest" rule because taking any other approach would "place a myriad of additional administrative burdens on both taxpayers and the government."

The Tax Court dismissed this argument, finding that it was contrary to the temporary regulations and IRS guidance, which clearly provide for different tax results for a partner for debt-financed distributions and debt-financed acquisitions. The court also noted that when a partnership interest is transferred, allocating interest on partnership debt based on the transferee partner's use of the debt (as William did) "is no more cumbersome than allocating debt for any other purpose under subchapter K."

Reflections

The crux of the Tax Court's opinion is its determination that a gift or bequest of a partnership interest subject to a nonrecourse liability is a debt-financed acquisition of the partnership interest, or equivalent to the purchase of a partnership interest, because Notice 89-35 defines debt-financed acquisitions as debt-financed contributions to the capital of, and purchases of interests in, passthrough entities. While that point is debatable, as the court stated, there is no support for the IRS's proposition that because William received the property by gift or inheritance from his father, he was required to treat the interest from the loans in the same way that his father treated it.

Lipnick, 153 T.C. No. 1 (2019)   

Newsletter Articles

TAX REFORM

Traps for the unwary: Tax Cuts and Jobs Act changes

By now many of us are familiar with the various provisions of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Here is a list of changes together with (perhaps) unexpected nuances.

DEDUCTIONS

Qualified business income deduction regs. and other guidance issued

The package includes final regulations, guidance on how to calculate W-2 wages, a safe-harbor rule for rental real estate businesses, and new proposed rules on the treatment of previously suspended losses.