Current developments in partners and partnerships

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

PHTOT BY WILDPIXEL/ISTOCK
PHTOT BY WILDPIXEL/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • Final regulations were issued under Sec. 199A, which allows a 20% deduction for qualified business income for owners of passthrough entities including partnerships.
  • Proposed regulations were issued last year that explain how Sec. 163(j), which limits the deductions for business interest, affects partnerships.
  • The IRS issued proposed regulations on the rules for the inclusion of income from qualified opportunity funds (QOFs), including guidance on how the rules apply to partnerships that are QOFs or own an interest in a QOF.
  • After being reviewed under Executive Order 13789, the IRS revoked a temporary regulation on disguised sales and reinstated Regs. Sec. 1.707-5(a)(2).
  • New centralized partnership audit procedures, effective for partnership years beginning in 2018 and after, bring many changes. Final regulations explaining these new procedures were issued in 2019, and a technical corrections act enacted in 2018 also amended them.
  • Several court cases involving years in which TEFRA was in effect addressed various aspects of the law, including its small partnership exception. As in other years, several court cases dealt with the application of the economic substance doctrine to the activities of tax shelter partnerships.
  • Final regulations were adopted that provide guidance on the allocation of bottom-dollar ­guarantees under Sec. 752.

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, 2018, through Oct. 31, 2019), the IRS issued guidance on the law known as the Tax Cuts and Jobs Act (TCJA),1 which was enacted at the end of 2017 and made several changes that affect partners and partnerships. The IRS also provided guidance for taxpayers regarding other changes 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. The law included several provisions that effect partners and partnerships. Some of those provisions include a deduction for qualified business income (QBI), a new limitation on the deduction for business interest, new rules for income from carried interest, and the elimination of technical terminations of partnerships. Last year, Treasury provided regulations regarding the QBI deduction and the limitation on the deduction for ­business interest.

QBI

When Congress reduced the corporate tax rate, it recognized the disparity in the rates between corporations and passthrough entities, such as partnerships. As a way to reduce the ­effective tax rate for passthrough entities, 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. 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.3 A 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 rules regarding the QBI deduction are quite complex, so Congress granted Treasury specific authority to issue Sec. 199A regulations. In 2018, 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 on Sec. 199A. These proposed regulations contain six substantive sections, each with rules for calculating the Sec. 199A deduction.

Treasury received 335 comments regarding the proposed regulations. Commenters asked that the rules be ­simplified and clarified. After considering all of the comments, Treasury issued final Sec. 199A regulations6 adopting many of the rules contained in the proposed regulations. In addition, Treasury added clarifying language and additional examples to make the rules easier to understand.

Limitation on business interest deductions

The TCJA added Sec. 163(j), which limits the amount of business interest an entity can deduct each year. Sec. 163(j)(4) provides special rules for applying Sec. 163(j) to partnerships. Sec. 163(j)(4)(A) requires that the limitation on the deduction for business interest expense be applied at the partnership level and that a partner's adjusted taxable income be increased by the partner's share of excess taxable income, as defined in Sec. 163(j)(4)(C), but not by the partner's distributive share of income, gain, deduction, or loss. Sec. 163(j)(4)(B) provides that the amount of partnership business interest expense limited by Sec. 163(j)(1) is carried forward at the partner level. Sec. 163(j)(4)(B)(ii) provides that excess business interest expense allocated to a partner and carried forward is available to be deducted in a subsequent year only if the partnership allocates excess taxable income to the partner. Sec. 163(j)(4)(B)(iii) provides rules for the adjusted basis in a partnership of a partner that is allocated excess business interest expense.

Proposed regulations issued in 2019 provide guidance regarding Sec. 163(j) partnership deductions and carryforwards.7 To the extent a partnership is subject to the limitations imposed by Sec. 163(j), the limitation will be applied at the partnership level, and any deduction for business interest expense not disallowed will be taken into account in determining the nonseparately stated taxable income or loss of the partnership.8 To the extent a partnership's business interest expense is less than or equal to the partnership's Sec. 163(j) limitation, business interest expense will not be subject to further limitations under Sec. 163(j) at the partner level.9

Excess business interest expense will retain its character as business interest expense at the partner level. In addition, partner-level adjustments, such as a Sec. 743(b) adjustment, will not be taken into account when the partnership determines its Sec. 163(j) limitation. Instead, partner-level adjustments will be taken into account by the partner in determining his or her adjusted taxable income. However, in keeping with the entity approach taken under Sec. 163(j)(4), a partnership will take adjustments made to the basis of its property under Sec. 734(b) into account for purposes of ­calculating its adjusted taxable income.10

Qualified opportunity funds

The TCJA added Sec. 1400Z, which deals with qualified opportunity funds (QOF).11 Last year and at the end of 2018, Treasury issued proposed regulations12 regarding the inclusion in income of gain deferred under Sec. 1400Z-2(a)(1)(A). These rules apply to a QOF owner only until all of the owner's deferred gain has been included in income. The proposed regulations provide, in the case of a partnership that is a QOF or owns an interest in a QOF, that the inclusion rules apply to transactions involving direct and indirect partners of the QOF to the extent of the partner's share of any eligible gain of the QOF. The proposed regulations make clear that Sec. 721 contributions, as long as they do not cause a partnership termination, are not inclusion events and neither is a merger or consolidation under Sec. 708(b)(2)(A). In addition, a distribution of property will be an inclusion event only to the extent that the distributed property has a fair market value (FMV) in excess of the partner's basis in its QOF interest.

Regulations project

In 2017, Trump issued Executive Order 13789 that directed the secretary of Treasury to review all significant tax ­regulations issued on or after Jan. 1, 2016, and to take concrete action to alleviate certain burdens imposed by the regulations. One of the regulations identified was the proposed regulations concerning the allocation of partnership liabilities in a disguised sale under Sec. 707.13 Last year Treasury issued final regulations14 that withdraw the Sec. 707 temporary regulations and reinstate Regs. Sec. 1.707-5(a)(2), which was previously in effect, effective for all transfers occurring on or after Oct. 4, 2019.

Audit issues

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)15 enacted "unified audit rules" to simplify IRS audits of large partnerships by determining partnership tax items at the partnership level. Any adjustments would then flow through to the partners, whom the IRS would assess deficiencies against. Two issues that arose frequently under TEFRA concerned partnership-level 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),16 which amended in its entirety Sec. 6221 et seq. The revised sections 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 of TEFRA. Under the BBA,17 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),18 providing rules for electing out of the centralized partnership audit regime.

A key part of the new audit regime is that the partnership pays tax at the highest individual tax rate. A partnership will pay an imputed underpayment when an audit adjustment results 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 a partnership-favorable audit adjustment related to the reviewed year.

Partners are to be subject to joint and several liability for any partnership tax liability. Partnerships 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 audits each partner separately in separate proceedings.

Any penalties applying to a tax underpayment are 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.19

Technical corrections: Additionally, Congress enacted the Tax Technical Corrections Act (TTCA),20 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.

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.

At the end of 2018, final regulations21 implementing the centralized partnership audit regime were issued and apply to tax years that end after August 2018. Revisions to the final regulations were made to clarify language in the proposed regulations and to take into account the TTCA amendments. In addition, the final regulations clarify the definition of partnership-related items, the requirements for consistency between the partner and partnership returns, and that determinations are made at the partnership level. The final regulations also kept the rules in the proposed regulations related to the calculation of the tax liability.

Partnership-level items

Even with the adoption of the new audit rules, there were still several court cases involving TEFRA issues. Three cases dealt with partnership-level determinations. In Gunther,22the IRS issued affected items notices of deficiency to petitioners following TEFRA proceedings for three years. The issue for consideration was whether the adjustments in the notices of deficiency attributable to the TEFRA audit required partner-level determinations and thus gave the Tax Court jurisdiction over the case. The taxpayers argued partner-level determinations must be made regarding the income tax deficiencies and penalties; thus, the court had jurisdiction over the entirety of the case and the IRS could not assess or collect any tax deficiencies or penalties.

The IRS agreed that partner-level determinations must be made regarding the income tax deficiencies but disputed the court's jurisdiction over the penalties. The IRS believed liability for the penalties was established at the partnership level during the TEFRA proceedings and therefore the taxpayers could not contest them in Tax Court. The court agreed with the IRS and ruled that it had jurisdiction to redetermine the tax deficiencies assessed against an individual following partnership-level proceedings under TEFRA but that it lacked jurisdiction to consider the penalties determined at the partnership level and had no authority to enjoin the assessment or collection of the penalties.

In another case,23 the taxpayer engaged in a tax shelter transaction through a partnership. After the auditor determined that the partnership was a sham, the IRS issued notices of deficiency to the taxpayer relating to stock and foreign currency the taxpayer received in a purported liquidating distribution of the partnership, for which the taxpayer claimed a carryover basis equal to his outside basis in the partnership. The taxpayer sold the stock and currency and determined a gain on the sales based on the assets' carryover bases.

The taxpayer argued that the notices of deficiency were invalid because no partner-level determination was required to adjust a partner's outside basis to zero following a partnership-level proceeding that found the partnership to be a sham. The IRS agreed that a partner's outside basis in a sham partnership is zero, but that did not establish the partner's bases in the assets as zero. The IRS further contended that the adjustments to the loss deductions on the sales of the stock and the foreign currency qualified as affected items that required partner-level determinations and, consequently, the deficiency procedures applied. Thus, the notices were valid, and the court had authority to hear this case.

The court also determined that it had jurisdiction to redetermine a deficiency because the IRS issued valid notices of deficiency. Therefore, the court could enjoin the assessment and the collection of the tax deficiency that the court had jurisdiction to redetermine.

Highpoint Tower Technology24 was a case that involved a son-of-boss tax ­shelter. The IRS issued a final partnership administrative adjustment (FPAA) to the partnership proposing adjustments to partnership items. In the FPAA, the IRS determined that the partnership was formed and availed of solely for the purposes of tax avoidance by artificially overstating basis in the partnership interests of its partners. The IRS determined that the partnership was a sham and lacked economic substance. Accordingly, the IRS determined that the partnership would be disregarded and all transactions engaged in by the partnership would be treated as engaged in directly by its partners. Later, the IRS issued a notice of deficiency to Highpoint, one of the partners in the partnership, based on the disallowed losses from the partnership. Included in the notice of deficiency was a 40% gross-valuation-misstatement penalty. Highpoint filed a motion in Tax Court to redetermine the tax deficiency and to restrain collection of the deficiency.

The IRS argued that while the Tax Court had jurisdiction over the adjustment for the disallowed losses, it did not have jurisdiction over the penalty because the assessment was at the partnership level. Highpoint's position was that because the gross-valuation-misstatement penalty was an affected item that required a partner-level determination, the Tax Court should have jurisdiction over the penalty. The Tax Court agreed with the IRS, and the taxpayer appealed the case.

The Eleventh Circuit upheld the Tax Court decision and ruled that the Tax Court presiding over a partner-level deficiency proceeding does not have jurisdiction over gross-valuation-misstatement penalties imposed at the partnership level. The court noted that TEFRA gives courts in partnership-level proceedings jurisdiction to determine the applicability of any penalty that could result from an adjustment to a partnership item, even if imposing the penalty would also require determining affected or nonpartnership items.

Statute of limitation: One case dealt with a statute-of-limitation issue. As a general matter, FPAAs must be issued within three years of when a taxpayer filed its return. However, the IRS and the taxpayer can agree to extend that period for partnership items so long as any extension agreement expressly provides that it applies to the tax attributable to partnership items. In WHO515 Investment Partners,25 during the audit of the partnership, the tax matters partner executed and filed a consent to extend the time to assess tax on partnership items. The consent form clearly stated that it extended the limitation period for assessing "any tax"attributable to "any partnership items"that would have been due within the reporting period. The taxpayer had fractional years that ended "within"the partners' tax years, so the partners were required to report their distributive shares of the partnerships' gains and losses on their individual returns.

The partnership argued that the proposed adjustments were time-barred because the partnership had fractional years ending before the end of the calendar year in question. The partnership contended that consent to extend the limitation period extended the individual partners' returns but did not extend the period for the partnership returns. The Tax Court found that the consent to extend the statute of limitation applied to the partnerships' fractional years. The D.C. Circuit affirmed the Tax Court decision.

In another case,26 a family owned a commercial printing company, which it sold. Before completing the sale, the family formed a partnership that assumed Treasury obligations, which increased its cost basis. Each of the partners contributed all their shares in the printing company to the partnership. Two months later, the partnership sold 100% of its stock in the printing company at a gain. The partners reported their shares of the gain passed through to them from the partnership. Ten years later the IRS issued an FPAA, which disallowed the tax benefits generated from the partnership because of the increased basis in the partnership interests created by the assumed Treasury obligations. The partnership challenged the FPAA as untimely under Sec. 6501(a), which provides a three-year statute of limitation.

While the partnership filing was pending before the trial court, the partners offered to settle all of the adjustments in the FPAA for $1. The government declined the offer. Previously, the trial court found in favor of the taxpayer and the Federal Circuit affirmed the decision. Afterwards, the taxpayer sued for litigation costs, which the Court of Federal Claims awarded. The government appealed that ruling. The court found that the taxpayer was entitled to litigation costs based on several factors, including that the partnership successfully raised the statute of limitation as a defense, the partnership's settlement offer was timely because it was made during the qualified offer period, and the partnership's offer of $1 was reasonable, since the finding that the FPAA was untimely resulted in zero tax liability for the partners.

Small partnership exception to TEFRA: In Sarma,27 the IRS issued a notice of deficiency arising from the taxpayers' participation in a tax shelter known as a "family office customized partnership." The taxpayer created the tax shelter through a series of transactions executed by a three-tiered set of limited liability companies (LLCs) treated as partnerships. The tax shelter resulted in a series of deemed terminations of the partnerships and deemed formations of new partnerships because of changes in the upper-tier partnership (UTP). Because of the deemed terminations, the partnerships filed tax returns for multiple short tax periods. The lower-tier partnerships were subject to TEFRA rules during a period of time when the taxpayer was only an indirect owner. One lower-tier partnership (LTP) was not subject to TEFRA for the short tax period that the taxpayer held a direct interest in the LTP because it fell within the small partnership exception allowed by TEFRA and did not elect to be subject to TEFRA.

The IRS initially decided to audit the LTP for the short tax period under TEFRA but later changed this decision. The taxpayer argued that the IRS was bound by the initial decision. The court disagreed with the taxpayer. It ruled that the IRS was not bound by the initial decision because it did not make a partnershipwide determination in the audit regarding TEFRA's applicability.

The second issue in the case was whether the TEFRA statute-of-limitation rules applied to the taxpayer. Sec. 6229 allows for an extension of the statute of limitation under TEFRA. The taxpayer argued that the TEFRA rules should not apply to the LTP because it was a small partnership exempt from TEFRA. The court found, however, that the extension of the statute of limitation could apply to a non-TEFRA small partnership where the small partnership had affected items from a TEFRA proceeding.

The court concluded that the extension applied to the taxpayer because the LTP owned an interest in a TEFRA partnership (making the taxpayer an indirect partner in that partnership), and the LTP had an affected item from its participation in the TEFRA partnership related to the loss it passed through to the taxpayer. Accordingly, it held the period of limitation had not expired for the taxpayers' claimed loss.

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 Lipnick,28the taxpayer received his partnership interest as a gift from his father. His father had received debt-financed distributions from the partnership that he used to purchase assets he held for investment. As such, he could deduct his share of the interest the partnership paid on the debt that financed the distribution as investment interest. After the son received the interest, he deducted his share of the interest on the debts used to fund the distributions as an offset of partnership income on Schedule E, ­Supplemental Income and Loss. In an audit, the IRS recharacterized the interest as investment interest, which the son was not allowed to deduct because he had no investment income.

The court held in the taxpayer's favor, noting that the taxpayer did not stand in his father's shoes with respect to the interest. The debts were bona fide partnership obligations that encumbered the partnership interests when he received them from his father. The partnerships did not distribute any loan proceeds to him, and he did not use any partnership distributions to acquire investment property. The fact that he was not personally liable on the loans was irrelevant. Accordingly, his share of the interest could offset his share of partnership income

Foreign partners: At the end of 2018, Treasury issued proposed regulations29 under Sec. 864 to provide rules for treating the gain or loss recognized by a nonresident alien individual or foreign corporation from the sale or exchange of a partnership interest as effectively connected gain or effectively connected loss. The proposed regulations provide that if a foreign transferor owns an interest in a partnership that is engaged in the conduct of a trade or business within the United States, any outside gain or loss recognized by the foreign transferor on the transfer of the interest is treated as effectively connected gain or loss. The proposed regulation limits the amount of outside gain or loss recognized by a foreign transferor that may be treated as effectively connected gain or loss and provides rules on how to determine the amount of gain or loss that is deemed to be effectively connected.

In Chief Counsel Advice 201917007,30 a U.S. transferor transferred an intangible to a foreign corporation and then transferred the stock of the foreign corporation to a domestic partnership. The objective of the transaction was to have the domestic partnership viewed as a U.S. person under the successor rule in Temp. Regs. Sec. 1.367(d)-1T(e)(1). Sec. 367(d) and the regulations thereunder provide that a U.S. person that transfers intangible property to a foreign corporation in an exchange described in Sec. 351 or Sec. 361 must recognize income with respect to the property either annually over the property's useful life (general rule) or immediately upon the direct or indirect disposition of the property (disposition rule). If the domestic partnership is viewed as a U.S. person, the partnership can recognize income under the general rule and allocate the annual inclusion to partners not subject to U.S. tax instead of to the domestic partners.

The question that was raised in this situation was "Does the Commissioner have the authority under Treas. Reg. § 1.701-2(e) to treat a domestic partnership, which purports to succeed to the section 367(d) annual inclusion, as an aggregate of its partners because treating the partnership as an aggregate is appropriate to carry out the purposes of section 367(d)?" The IRS determined that it could make this determination. However, it also concluded that a domestic partnership should not be considered a U.S. person in this situation because this treatment is incompatible with the intent of Sec. 367(d). Thus, the successor rule does not apply in this situation and the income must be allocated to the U.S. transferor.

Regs. Sec. 1.704-1(b)(4)(viii) provides a safe harbor under which allocations of creditable foreign tax expenditures (CFTEs) are deemed to be in accordance with the partners' interests in the partnership. Temporary regulations issued in 2016 revised the rules under this section to clarify the effect of Sec. 743(b) adjustments on the determination of net income in a CFTE category. The temporary regulations also included special rules regarding how deductible allocations and nondeductible guaranteed payments (that is, allocations that give rise to a deduction under foreign law, and guaranteed payments that do not give rise to a deduction under foreign law) should be taken into account for purposes of determining net income in a CFTE category. Finally, the temporary regulations clarified the rules regarding the treatment of disregarded payments between branches of a partnership for purposes of determining income attributable to an activity included in a CFTE category. Last year Treasury finalized the temporary regulations.31 In addition, because the temporary regulations unintentionally deleted Regs. Secs. 1.704-1(b)(4)(viii)(d)(1)(i) and (ii), the final regulations restored those paragraphs without change.

Basis

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 proving that it has adequate basis to deduct losses.

In a ruling32 last year the taxpayer asked the IRS to determine how the taxpayer's interest in a partnership should be determined. In this situation, an LLC intended to elect to be a real estate investment trust (REIT) under Sec. 865. A governmental entity and other nongovernmental partners formed 10 entities, each of which was classified as a partnership for federal tax purposes. The partnerships leased and operated rental properties. The taxpayer intended to acquire the economic rights to partnership interests in each partnership for cash. Only seven of the 10 partnerships maintained capital accounts under Regs. Sec. 1.704-1b(2)(iv). However, those capital accounts did not fairly reflect what the taxpayer would receive upon liquidation of the partnership. For Sec. 856(c) purposes, the taxpayer intended to determine its capital interest by first deeming that the partnership made a distribution in complete liquidation of all of the partners' interests in an amount equal to the FMV of the partnership assets less the partnership liabilities and then computing the percentage of that deemed distribution to which the taxpayer would be entitled.

The IRS determined that solely for purposes of Sec. 856(c) the taxpayer's capital interest in each partnership would equal its percentage share of that partnership; the taxpayer's share of each item of gross income of each partnership would equal the product of the amount of that item and the percentage share determined for that partnership; and the taxpayer's share of each asset of a partnership would equal the product of the value of that asset and the percentage share determined for that partnership. It should be noted that the IRS expressed no opinion regarding the federal income tax consequences of this proposed transaction under the capital account maintenance rules of Sec. 704.

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 are lacking economic substance or are 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 2010.33 Several cases in the past year considered whether a partnership had economic substance.

Sham partnerships: In Tucker,34 the taxpayers entered into a scheme that involved highly complex, interrelated foreign currency option investment transactions. The transaction complied with a literal reading of the Code and generated millions in paper gains and losses. The IRS disallowed the entire loss deduction and assessed a deficiency penalty. The taxpayers challenged the deficiency and the penalty. The Tax Court upheld the deficiency, finding that the taxpayers were not entitled to their claimed deduction because the underlying transaction creating the deduction lacked economic substance. However, the Tax Court did not uphold the penalty.

The taxpayers appealed the Tax Court's decision on the deficiency. The taxpayers argued that the Tax Court erroneously applied the economic substance doctrine because the transaction complied with a literal reading of the Code. The Fifth Circuit found that the Tax Court appropriately applied the economic substance doctrine to determine whether "what was done, apart from the tax motive, was the thing which the statute intended."The Tax Court found that the taxpayer manipulated the rules, which was contrary to Congress's intent. The Tax Court found that the transaction defied objective economic reality because the potential profit was de minimis compared to the expected tax benefit. Therefore, the transaction failed the objective economic prong of the economic substance doctrine, as there was no reasonable possibility of profit and there was no actual economic effect.

Distressed asset debt tax shelters: In another case,35 the taxpayer formed a partnership to which foreign retailers contributed severely distressed or uncollectible accounts receivable in return for interests in the partnership. A distressed asset is an amount owed to a retailer for which there is no prospect of meaningful collection. For tax purposes, the partnership carried the receivables at their face amount, not at the amount any retailer or debt collector would estimate collecting.

The partnership, through a series of transactions, conveyed the receivables to U.S. investors, who treated them as uncollectible and took a bad debt deduction for them. The IRS disallowed the loss based on its determination that the transactions lacked economic substance. The court found that the partnership was a sham and was formed solely to evade taxes and that there was no convincing evidence that the transactions had any objective independent of the shifting of losses from a tax-indifferent party to a tax-motivated party. The court also found that the taxpayer was liable for both the gross-valuation-misstatement penalty and the accuracy-related penalty.

In a related case,36 the court found that a promotor's restructuring of investments in distressed assets into a lead LLC in order to treat the investors as members of the LLC lacked substance and the LLC was not a partnership for federal tax purposes. It noted the record lacked any coherent thread of evidence to support the assertion that a legally enforceable change in ownership occurred. In addition, no economic consequence resulted from the alleged transactions. However, the court upheld an accuracy-related penalty imposed by the IRS for only one of the three years at issue because the requisite supervisory approval for the penalties for the other two years was not obtained.

Sec. 707 transactions

Under Sec. 707(c) to the extent determined without regard to the income of the partnership, payments to a partner for services are considered as made to a person who is not a member of the partnership. These payments are treated as guaranteed payments and are taxable as ordinary income to the partner. In Bolles,37 the husband was a partner in a multimember LLC taxed as a partnership. He received weekly payments for meals and incidentals while he was out of town on partnership business. In addition, the taxpayer received a loan from the partnership where there was no evidence to prove that the taxpayer was under an unconditional obligation to repay the loan amount at a determinable date.

The taxpayer contended that none of these payments were guaranteed payments. The IRS claimed these amounts paid for the meals and incidentals were guaranteed payments because they were payments to a partner for services without regard to partnership income. They also contended that since there was no evidence that the amount loaned to the taxpayer was a valid loan, the loan was also a form of guaranteed payment. The Tax Court agreed with the IRS and determined that both of these items should be treated as guaranteed payments under Sec. 707(c).

Sec. 752 allocations

In 2016, Treasury issued proposed and temporary regulations that determined how to allocate bottom-dollar guarantees and certain other arrangements under Sec. 752. Last year Treasury finalized these regulations with several changes.38 The final regulations are generally effective for liabilities incurred on or after Oct. 5, 2016. The final regulations adopted the definition of "bottom dollar payment obligation" that was included in the temporary regulations. However, the disregarded entity net value requirement was removed and replaced with a broader anti-abuse rule that applies to all partners. The regulations also finalize a list of factors that indicate a plan to circumvent or avoid a payment obligation.

The final regulations implement congressional intent that bottom-dollar payment obligations are not recognized for purposes of determining economic risk of loss under Regs. Sec. 1.752-2(b). In addition, all statutory and contractual obligations must be taken into account when analyzing whether bottom-dollar payment obligations exist. A bottom-dollar payment obligation is recognized if, taking into account an indemnity, reimbursement agreement, or similar agreement, the partner is still liable for at least 90% of the partner's initial payment obligation.

The final regulations also affect Sec. 704(b). They require that any bottom-dollar deficit restoration obligation that is disregarded under Sec. 752 is also disregarded for Sec. 704(b). Deficit restoration obligations are also disregarded if they are not legally enforceable or if the facts and circumstances indicate a plan to circumvent or avoid the obligation based on a list of four factors included in the regulations. This rule is effective at the same time as the rules under Sec. 752, which means that there is no transition relief for deficit restoration obligations already in effect that may be disregarded under this rule.

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. While the current regulations say the election must be signed by a partner, proposed reliance regulations issued in 2017 eliminated that requirement to ease electronic filing (REG-116256-17).

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.

Extensions of time: In several rulings during this period,39 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.40

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. Last year the IRS granted an extension of time to make the Sec. 754 election in several situations where a partner died and the partnership missed making the election.41 In one situation,42 a revocable living trust owned a partnership interest. When the owner of the trust died, the revocable trust split into four trusts. The partnership was granted the same type of extension to make the Sec. 754 election as in the other rulings last year.

In a more unique situation,43 an upper-tier partnership (UTP) owned an interest in a lower-tier partnership (LTP). The UTP had a Sec. 754 election in place; however, the LTP did not. A partner in the UTP sold his interest. The LTP did not make a Sec. 754 election. 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.

In another situation,44 two individuals purchased an interest in the partnership that created a technical termination under Sec. 708(b)(1)(B). The partnership had a Sec. 754 election in place before the termination and reported a Sec. 743(b) adjustment on the new partners' Schedules K-1, Partner's Share of Income, Deductions, Credits, etc. However, the partnership did not make a new Sec. 754 election after the termination. The IRS granted the partnership relief and gave it 120 days to file a new Sec. 754 election.

In an unusual situation,45 the IRS retroactively revoked a private letter ruling,46 which had granted a taxpayer an extension of time to file a Sec. 754 election. The IRS revoked the ruling because the taxpayer had either misstated or omitted a controlling fact in the original request. In the original request, the taxpayer had stated that no party affected by the ruling was under examination before IRS Appeals or before a federal court. However, the IRS later determined that the taxpayer was under examination.

Required downward adjustment: Sec. 743 requires a partnership with a Sec. 754 election or with a substantial built-in loss to adjust the basis of its property upon a transfer of an interest. A partnership has a substantial built-in loss if the partnership's basis in its property exceeds the FMV by more than $250,000. Under Sec. 704, Regs. Sec. 1.752-7 contingent liabilities are treated as Sec. 704(c) property. However, the regulations under Sec. 743 do not expressly provide that contingent liabilities also qualify as property for Sec. 743 purposes. Last year an entity was deemed to contribute all of its assets and liabilities to a second entity in exchange for an interest in the second entity, and immediately thereafter, the first entity was deemed to distribute interests in the second entity to two other taxpayers in liquidation of the first entity. This transaction qualified as an assets-over merger.

The IRS determined47 the amount of mandatory Sec. 743(b) adjustment in this type of transaction. In its ruling, the IRS considered the interaction of the netting rule of Regs. Sec. 1.752-1(f) with the Sec. 743(b) adjustment and the treatment of deferred cancellation-of-debt (COD) income under Sec. 108(i). The IRS determined that a deemed distribution of a partnership interest in an assets-over merger is an exchange that requires a mandatory downward inside-basis adjustment under Sec. 743(b). In addition, the transferee partner's basis in the transferred partnership interest in the liabilities, including the contingent liabilities, are included in the transferee partner's basis. However, deferred COD income should not be included in calculating the transferee partner's share of previously taxed capital because this type of income is not tax gain for purposes of Sec. 743.  

AICPA Resources

Articles

Carney and Lee, "The At-Risk Rules for Partnerships," 227-5 Journal of Accountancy 50 (June 2019),

Godwin, "Risks and Opportunities for Third-Party Partnership Representatives," 50 The Tax Adviser 563 (August 2019),


CPE self-study

Advanced Tax Strategies for LLCs and Partnerships (#745229, text)

Taxation Essentials of LLCs and Partnerships (#746522, text)

For more information or to make a purchase, go to aicpastore.com or call the Institute at 888-777-7077.

Footnotes

1P.L. 115-97.

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

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

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

5REG-107892-18.

6T.D. 9847.

7REG-106089-18.

8Prop. Regs. Sec. 1.163-6(a).

9Prop. Regs. Sec. 1.163-6(c).

10Prop. Regs. Sec. 1.163-6(d)(2).

11Section 13823(a) of Title 1 of the TCJA.

12REG-120186-18. The IRS also issued an earlier set of proposed qualified opportunity fund regulations (REG-115420-18) in October 2018.

13T.D. 9788.

14T.D. 9876.

15Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248.

16Bipartisan Budget Act of 2015, P.L. 114-74.

17T.D. 9780; Temp. Regs. Sec. 301.9100-22T.

18T.D. 9829.

19Sec. 6226(c)(2)(C), effective for tax years beginning after Dec. 31, 2017.

20Tax Technical Corrections Act, P.L. 115-141.

21T.D. 9844.

22Gunther, T.C. Memo. 2019-6.

23Estate of Keeter, T.C. Memo. 2018-191.

24Highpoint Tower Technology Inc., 931 F.3d 1050 (11th Cir. 2019).

25WHO515 Investment Partners, No. 18-1145 (D.C. Cir. 10/25/19).

26BASR Partnership, 915 F.3d 771 (Fed. Cir. 2019), aff'g 130 Fed. Cl. 286 (2017).

27Sarma, T.C. Memo. 2018-201.

28Lipnick, 153 T.C. 1.

29REG-113604-18.

30CCA 201917007.

31T.D. 9871.

32IRS Letter Ruling 201939001.

33Health Care and Education Reconciliation Act of 2010, P.L. 111-152.

34Tucker, 766 Fed. Appx. 132 (5th Cir. 2019).

35Kenna Trading, LLC, 143 T.C. 322 (2018), aff'd sub nom., Sugarloaf Fund, LLC, 911 F.3d 854 (7th Cir. 2018).

36Sugarloaf Fund, LLC,T.C. Memo. 2018-18.

37Bolles, T.C. Memo. 2019-42.

38T.D. 9877.

39E.g., IRS Letter Rulings 201924008, 201929016, 201933002, and 201942010.

40E.g., IRS Letter Rulings 201920010, 201937012, and 201943008.

41E.g., IRS Letter Rulings 201909004, 201919009, and 201934002.

42IRS Letter Ruling 201918011.

43IRS Letter Ruling 201919007.

44IRS Letter Ruling 201919010.

45IRS Letter Ruling 201927012.

46IRS Letter Ruling 201641001.

47Technical Advice Memorandum 201929019.

 

Contributor

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 thetaxadviser@aicpa.org.

 

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