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, 2019, through Nov. 30, 2020), 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.Guidance on TCJA provisions
The IRS made significant progress during this period toward its goal of issuing substantive guidance on TCJA provisions before the end of 2020, in several areas of special interest to partnerships and partners. These areas include the deduction for qualified business income (QBI), the limitation on the deduction for business interest, rules for income from carried interests, and additional depreciation deductions for qualified property.
In general, Sec. 199A, enacted by the TCJA, permits a deduction of up to 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.3A separate computation of QBI and other limitations is 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.
In 2019, Treasury issued final regulations5 to provide taxpayers with computational, definitional, and anti-avoidance guidance on Sec. 199A. During 2020, Treasury issued additional regulations6 that expand on the treatment of suspended losses and QBI. The 2019 final regulations had provided that previously disallowed losses or deductions under Secs. 465, 469, and 704(d) that are allowed in the tax year are generally taken into account for purposes of computing QBI, except to the extent the losses or deductions are disallowed, suspended, limited, or carried over from tax years ending before Jan. 1, 2018. These losses are used for purposes of Sec. 199A on a first-in, first-out (FIFO) basis.
Proposed regulations in 2019 expanded this rule to provide that previously disallowed losses or deductions, regardless of whether they are attributable to a trade or business and whether they would otherwise be included in QBI, are determined in the year the loss or deduction is incurred. In the 2020 final regulations, Treasury and the IRS determined that it is necessary for the FIFO rule to apply for losses included in tax years beginning on or after Jan. 1, 2018, and that the rule must be applied on an annual basis by category (i.e., Secs. 465, 469, etc.). These final regulations also provide that regulated investment company distributions attributable to income from real estate investment trusts (REITs) are eligible as QBI for REIT shareholders (conduit treatment). However, conduit treatment is not extended to qualified publicly traded partnership (PTP) income.
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 the limitation on the deduction for business interest expense to be applied at the partnership level and a partner's adjusted taxable income (ATI) to 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 (EBIE) 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 EBIE.
Final regulations7 under Sec. 163(j) were issued in September 2020. They remove guaranteed payments for the use of capital from the list in proposed regulations of per se interest items. The regulations also add an anti-avoidance rule that allows amounts to be treated as interest if the expense or loss is economically equivalent to interest and a principal purpose is to reduce an amount treated as interest. The anti-avoidance rules in some cases may apply to guaranteed payments.8 This rule applies to transactions entered into on or after Sept. 14, 2020.9
Also included in the final regulations are special rules for how partnerships apply the Sec. 163(j) limitation. Under Sec. 163(j)(1), the business interest expense deduction of partnerships, like that of other taxpayers, is limited to the sum of the partnership's business interest income for the tax year, 30% of ATI for the tax year (zero, if ATI is less than zero), and the partnership's floor plan financing interest expense.10
ATI means the taxable income for the tax year, ignoring business interest income or expense. To that amount, the partnership must add back any net operating loss deduction; Sec. 199A deduction; depreciation, amortization, or depletion (through 2021); capital loss carryback or carryover; or deduction/loss from a nonexcepted trade or business. The partnership must also subtract the recapture of depreciation/amortization, including on the sale of a partnership interest (to match the addback and avoid double-counting). The final regulations also add back to ATI depreciation, amortization, or depletion that is capitalized into inventory under Sec. 263A during tax years beginning before Jan. 1, 2022. The final regulations allow taxpayers to apply these rules retroactively to a tax year beginning after Dec. 31, 2017 (including taxpayers who relied on the 2018 proposed regulations).11
If any EBIE is in the partnership, the final regulations provide that a partner carries the EBIE forward to future years. Any future excess taxable income partnership allocation will unlock the EBIE carryforward on a dollar-for-dollar basis. The unlocked EBIE is equal to the partner's business interest expense in the year unlocked. A partner can use any ATI to deduct unlocked EBIE.
The regulations provide an 11-step process for allocating excess items from the partnership.12 This process describes how to handle the allocation of excess items based on the allocation of Sec. 704(b) and Sec. 704(c) items. Partnerships should tentatively allocate excess items based on the allocation of Sec. 704(b) items comprising ATI and interest income and expense. However, if necessary, the partnership should re-allocate excess items among the partners to effect the principles set forth by Treasury. If all Sec. 704(b) items (and Sec. 704(c) items other than remedial items) are allocated pro rata, there will be no reallocation of excess items.
Treasury also issued proposed regulations13 accompanying the final regulations to provide additional guidance on several other aspects of the deduction limitation, including issues with tiered partnerships and dispositions of a partnership interest. These proposed regulations adopt an entity approach where, if EBIE is allocated to an upper-tier partnership (UTP), the UTP's basis in a lower-tier partnership (LTP) is reduced. However, the UTP partners' bases in the UTP are not reduced until the UTP EBIE is treated as paid or accrued by the UTP.
To reflect the reduction in value associated with the LTP's EBIE, the UTP treats any business interest expense paid or accrued by the LTP as a nondeductible, noncapitalizable expenditure solely for purposes of Sec. 704(b). The UTP treats the UTP EBIE as a nondepreciable capital asset with a value of zero and a tax basis equal to the amount of UTP EBIE. A direct or indirect UTP partner that has a Sec. 704(b) capital account reduction because of UTP EBIE is a "specified partner," and UTP EBIE is tracked to each specified partner and its transferees.
If a partner disposes of a partnership interest, the adjusted basis of the partnership interest is increased immediately before the disposition by the entire amount of the partner's remaining EBIE ("basis addback rule"). Partners also may now add back a proportionate basis on partial sales of partnership interests. The proposed regulations require the partnership to create a new block of "inert" basis in the assets equal to the amount added back on the sale or distribution.
The TCJA generally provides for 100% bonus depreciation for qualifying property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023, under Sec. 168(k). The TCJA expands the property eligible for 100% bonus depreciation to include used property that is not acquired from a related party and meets certain other requirements. Sec. 168(k)(7) allows a taxpayer to elect out of bonus depreciation for any class of property for any tax year.
In November 2020, Treasury issued final regulations relating to Sec. 168(k).14 The final regulations are applicable to depreciable property acquired and placed in service after Sept. 27, 2017, by the taxpayer during a tax year ending on or after Sept. 28, 2017, provided the taxpayer consistently applies all the rules in the final regulations. The taxpayer may alternatively apply the proposed regulations issued in 201915 to depreciable property acquired and placed in service after Sept. 27, 2017, by the taxpayer in tax years ending on or after Sept. 28, 2017, and ending before the taxpayer's first tax year that begins on or after Jan. 1, 2021, as long as the taxpayer does so entirely and consistently. The final regulations adopt the 2019 proposed regulations as modified. Some of the modifications in the final regulations affect partnerships.
First, the proposed regulations included a partnership lookthrough rule, which addresses the extent to which a partner is deemed to have a depreciable interest in property held by a partnership. The partnership lookthrough rule provided that a person is treated as having a depreciable interest in a portion of property prior to the person's acquisition of the property if the person was a partner in a partnership at any time the partnership owned the property. The portion of property in which a partner is treated as having a depreciable interest is equal to the total share of depreciation deductions with respect to the property allocated to the partner as a percentage of the total depreciation deductions allocated to all partners during the current calendar year and the past five calendar years.
Treasury determined that the complexity of applying the partnership lookthrough rule would place a significant administrative burden on both taxpayers and the IRS. For this reason, the final regulations do not retain the rule. Therefore, under the final regulations, a partner is not treated as having a depreciable interest in partnership property solely by virtue of being a partner in the partnership. Treasury also removed the partnership lookthrough rule from the proposed regulations.16
The TCJA expanded the definition of qualified property under prior law to include either original-use property or used property that meets certain requirements, including that it was not used by the taxpayer at any time before its acquisition by the taxpayer.17 Proposed regulations issued in 2018 provide that property is treated as used by the taxpayer (or its predecessor) prior to acquisition only if the taxpayer (or its predecessor) had a depreciable interest in the property at any time before the acquisition. Under final regulations from 2019, a predecessor includes a partnership that is considered as continuing under Sec. 708(b)(2) after a merger or division transaction.
The 2018 proposed regulations provide a special rule for evaluating whether the used-property requirements are satisfied. The rule provides that in the case of a "series of related transactions," the property is treated as directly transferred from the original transferor to the ultimate transferee, and the relation between the original transferor and the ultimate transferee is tested immediately after the last transaction in the series. The 2019 final regulations generally adopt the provisions of the proposed regulations on the treatment of partnership transactions. Under the final regulations, several types of partnership property would not meet the definition of used property, including remedial and "reverse" allocations under Sec. 704(c), any portion of the basis of distributed property determined under Sec. 732, and any increase to basis of depreciable property under Sec. 734(b). However, an increase to the basis of depreciable property under Sec. 743(b) may qualify.
Sec. 168(k)(7), as amended by the TCJA, allows taxpayers to elect out of 100% bonus depreciation. A taxpayer may make an election not to deduct bonus depreciation for any class of property that is qualified property placed in service during the tax year for which the election is made. The 2019 final regulations retain the same classes of property as in prior regulations and add Sec. 743(b) basis adjustments as a new class of property.
Prior to the TCJA, Sec. 743(b) basis adjustments did not meet the original-use requirement. After the TCJA, Sec. 743(b) basis adjustments may satisfy the used-property clause in Sec. 168(k)(2)(A)(ii). Under Regs. Sec. 1.168(k)-2(b)(3)(iv)(D)(1)(ii), an increase to the basis of depreciable partnership property satisfies the requirements of Regs. Sec. 1.168(k)-2(b)(3)(iii)(A). The requirements include that the transferee never had an interest in the property to which the Sec. 743(b) basis adjustment relates and the acquisition meets the requirements of Secs. 179(d)(2)(A), (B), and (C) and Sec. 179(d)(3).
Change in accounting method: The IRS issued Rev. Proc. 2020-25 in 2020 to provide guidance on how a taxpayer may change its depreciation method for qualified improvement property (QIP) placed in service after Dec. 31, 2017, in a tax year ending in 2018, 2019, or 2020. The revenue procedure allows a taxpayer to make a late election or to revoke or withdraw an election. Generally, partnerships may make changes pursuant to Rev. Proc. 2020-25 by filing an amended partnership return by Oct. 15, 2021, an administrative adjustment request, or a Form 3115, Application for Change in Accounting Method.18
The TCJA added Sec. 1061 to the Internal Revenue Code, which governs the treatment of partnership income allocated to a partner that has a carried interest. Generally, income allocated to a carried interest is treated as a short-term capital gain instead of a long-term capital gain.
In July 2020, Treasury released proposed regulations19 under Sec. 1061. They are divided into six sections, which include general definitions, guidance, and rules specific to applicable partnership interests (APIs) and applicable trades or businesses (ATBs); exceptions to the definition of an API; computational and operational rules; rules for certain related-partner transfers of an API; rules for securities partnerships making reverse Sec. 704(c) allocations; and reporting requirements. The proposed regulations spell out that the amount of income to be recharacterized under Sec. 1061 is determined solely by the owner taxpayer. An owner taxpayer and a passthrough taxpayer are each treated as a taxpayer for the purpose of determining the existence of an API under Sec. 1061(c). The proposed regulations also make clear that once a partnership interest is an API, it remains an API and never loses that character, unless one of the exceptions to the definition of an API applies.
The regulations provide a two-prong ATB activity test. The proposed regulations provided that if a partnership disposes of an asset, the partnership's holding period in the asset controls. If a partner disposes of an API, generally, the partner's holding period in the API controls.The proposed regulations also included a limited lookthrough rule, which was then modified by the final regulations issued in January 2021. If the lookthrough rule applies, a percentage of the gain or loss on the sale is potentially subject to Sec. 1061(a) recharacterization based on the relative gain inside the partnership on a hypothetical sale of the partnership's assets at their aggregate fair market value (FMV).
Qualified opportunity funds
The TCJA added Sec. 1400Z-2, which deals with qualified opportunity funds (QOFs).20 In 2019 and at the end of 2018, Treasury issued proposed regulations21 regarding the inclusion in income or exclusion of gain deferred under Sec. 1400Z-2(a)(1)(A). In January 2020, Treasury finalized the regulations.22 The final regulations retain the basic approach and structure of the proposed regulations, with certain revisions. The final regulations refined and clarified certain aspects of the proposed regulations "to make the rules easier to follow and understand." These rules apply to a QOF owner only until all of the owner's deferred gain has been included in income.
The final regulations provide that, in the case of a partnership that is a QOF or owns an interest in a QOF, 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 final regulations make clear that Sec. 721 contributions are not inclusion events, as long as they do not cause a partnership termination, and neither is a merger or consolidation under Sec. 708(b)(2)(A), as long as the partner receives only a partnership interest in the resulting partnership. However, there is an inclusion event to the extent that a partner receives other property that exceeds that partner's basis in the partnership. The final regulations clarify that, when a QOF partner contributes its qualifying investment to a transferee partnership in a Sec. 721 transaction, the transferee partnership recognizes the deferred gain and is eligible for the five- and seven-year basis adjustments. However, the transferee partnership must allocate all such amounts to the contributing partner, applying the principles of Sec. 704(c). The contributing partner no longer will be eligible to make the elections under Sec. 1400Z-2(c) and Regs. Sec. 1.1400Z2(c)-1(b)(2). Instead, the transferee partnership is the sole person eligible to make these elections, and the elections apply to all partners in the transferee partnership for that tax year.
Sec. 1400Z-2 applies to gains that would be taxable under federal law. Treasury determined that it would be unduly burdensome to require a partnership to determine the extent to which a capital gain would be subject to federal income tax by its direct or indirect partners because partnerships do not generally have sufficient information about the tax treatment and positions of their partners to perform this analysis. Thus, in the case of partnerships, the final regulations provide an exception to the general requirement that gain be subject to federal income tax to constitute eligible gain. However, the final regulations include an anti-abuse rule, which disregards partnerships formed with a significant purpose of circumventing the rule, generally requiring eligible gains to be subject to federal income tax.CARES Act
Congress enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act23 in response to the COVID-19 pandemic on March 27, 2020. The CARES Act made several changes to provisions of the TCJA.
One amendment increased the interest deduction limitation from 30% of ATI to 50% for 2018, 2019, and 2020.24 However, some taxpayers may not want to use the 50% limit. In response, the IRS issued Rev. Proc. 2020-22 to provide procedures for electing out of using 50% of the taxpayer's ATI to compute its interest deduction under Sec. 163(j), as allowed by the CARES Act. The procedure describes the time and manner in which a taxpayer can elect (1) out of the 50% ATI limitation for tax years beginning in 2019 and 2020; (2) to use the taxpayer's ATI for the last tax year beginning in 2019 to calculate the taxpayer's Sec. 163(j) limitation for tax year 2020; and (3) out of deducting 50% of EBIE for tax years beginning in 2020 without limitation. However, under a special rule,25 the 50% limitation does not apply to a partnership's 2019 tax year, although 50% of the partnership's 2019 EBIE that is allocated to a partner is treated as paid or accrued in the partner's first tax year beginning in 2020.26 In addition, the procedure provides an automatic extension of time for electing real estate trades or businesses and electing farming businesses, which are effectively exempted from the business interest limitation, to file that election for tax years 2018, 2019, or 2020.27
Interaction between Secs. 163(j) and 168(k)
Another CARES Act change relates to the interaction between Sec. 163(j) and Sec. 168(k). Under the TCJA, Sec. 168(g)(1)(F) requires the alternative depreciation system to be applied to any nonresidential real property, residential rental property, and QIP held by an electing real property trade or business. Sec. 163(j)(7)(B) defines an electing real property trade or business as any trade or business described in Sec. 469(c)(7)(C) that makes an election to be an electing real property trade or business.
Under Sec. 168(k)(2)(D), any real property trade or business that makes this election was not able to take advantage of bonus depreciation under Sec. 168(k) with respect to QIP. However, under the CARES Act amendment to Sec. 168(e)(3)(E)(vii), QIP now meets the definition of "qualified property" for bonus depreciation purposes. Thus, bonus depreciation is available to an electing real property trade or business for property that meets the definition of "qualified property," including QIP.Audit issues
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)28 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, on whom the IRS would assess deficiencies. 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),29 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. Congress then enacted the Tax Technical Corrections Act (TTCA),30 which made a number of retroactive technical corrections to the centralized partnership audit rules.
Statute of limitation: Even with the adoption of the new audit rules, court cases during this period still involved TEFRA issues. One appellate case in 2020 dealt with a statute-of-limitation issue.31 General Mills had sued the government, seeking refunds of interest it paid on corporate income tax underpayments determined by the IRS on partnership audit adjustments. According to General Mills, the IRS erroneously collected more interest than was owed by selecting incorrect "applicable dates" to start the interest accrual. General Mills paid the interest and sued for a refund in the Court of Federal Claims, but the court dismissed the case for lack of subject matter jurisdiction, concluding that General Mills had failed to file its refund claim in a timely manner. In its appeal to the Federal Circuit, General Mills contended that it had two years to file for the refund under Sec. 6511. However, the IRS and the court agreed that the claim had to be filed within six months under Sec. 6230(c). The court based the decision on the fact the interest was assessed on a partnership item adjustment under a TEFRA audit and affirmed the holding of the Court of Federal Claims.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.32 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 shams. 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 this review period considered whether a partnership had economic substance.
Sham partnerships: In a Tax Court case decided in January 2020 involving a son-of-boss tax shelter transaction,34 the taxpayers, Lori Manroe and her husband, Robert Manroe, had contributed essentially offsetting positions (proceeds of short sales of Treasury notes on one side and short positions on Treasury notes on the other) to the partnership. Before the end of the year of contribution, the partnership redeemed the taxpayers' partnership interests. The partnership and the taxpayers took the position that the contributed short positions were not liabilities under Sec. 752 and that the short positions therefore did not reduce the taxpayers' basis in their partnership interests. The taxpayers reported an ordinary loss for Robert Manroe and a short-term capital loss for Lori Manroe on the distribution.
The IRS determined that the partnership was a sham lacking economic substance and made corresponding adjustments. The IRS then issued a notice of deficiency and penalties related to the partnership adjustments. The taxpayers filed petitions challenging the determinations and asserted that the IRS had made premature assessments of the deficiencies determined in the notices. The Tax Court determined that it had jurisdiction to redetermine the income tax deficiencies because they would require partner-level calculations. However, the court did not have jurisdiction to consider the penalties because they were deemed a partnership item under TEFRA.
In November 2019, the IRS announced that it was examining the use of syndicated partnerships related to conservation easement charitable contributions.35 The IRS is looking at whether a conservation easement is given to a charity in perpetuity. Courts in several cases held that partnerships were not allowed a charitable contribution because the easement was not given in perpetuity.36 A number of additional cases regarding this issue are on the Tax Court's docket.Partnership reporting
The IRS issued draft instructions for Form 1065, U.S. Return of Partnership Income, for tax year 2020 that include revised instructions for partnerships required to report capital accounts to partners on Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc.37 The revised instructions indicate that partnerships filing Form 1065 for 2020 are to calculate partner capital accounts using a "transactional approach" to determine tax basis.
Under this method, partnerships must report partner contributions, partners' share of partnership net income or loss, withdrawals and distributions, and other increases or decreases using tax-basis principles, as opposed to other methods such as GAAP or Sec. 704(b). The tax-basis method accounts for partnership transactions or events in a manner generally consistent with calculating a partner's adjusted tax basis in its partnership interest (without regard to partnership liabilities), taking into account the rules and principles of Secs. 705, 722, 733, and 742. The instructions specifically state that Sec. 743(b) basis adjustments are not taken into account in calculating a partner's capital account under the tax-basis method. The revised method is the IRS's attempt to improve the quality of the information reported by partnerships to the IRS and furnished to partners, to facilitate increased compliance.
Prior to 2020, partnerships could report capital accounts determined under multiple methods. The instructions make it clear that partnerships must use the tax-basis principles to report a partner's capital account for the 2020 tax year regardless of the method the partnership used previously. If the partnership maintained tax-basis capital accounts, then it must use the tax-basis method to report beginning capital accounts for tax year 2020. Partnerships that did not use or otherwise maintain tax-basis capital accounts may determine each partner's beginning tax-basis capital account balance for 2020 only by one of four methods: the tax-basis method using the transaction approach, the modified outside basis method, the modified previously taxed capital method, or the Sec. 704(b) method. There is no exception to tax-basis reporting for PTPs. However, the instructions provide special rules on how PTPs determine partners' beginning capital accounts.
In January 2021, the IRS issued a notice providing additional penalty relief for the transition in tax year 2020.38 The notice provides that, solely for tax year 2020, the IRS will not assess a partnership a penalty for any errors in reporting its partners' beginning capital account balances on Schedules K-1 if the partnership takes ordinary and prudent business care in following the form instructions to calculate and report the beginning capital account balances. This penalty relief is in addition to the reasonable-cause exception to penalties for any incorrect reporting of a beginning capital account balance.Partners' income
Under Sec. 701, partnerships are not subject to federal income tax. 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.
Foreign partners: Treasury issued final regulations39 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 an interest in a partnership that is engaged in a trade or business within the United States. The final 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 must be treated as effectively connected gain or loss, subject to the deemed-sale limitation in Sec. 864(c)(8)(B), which limits the amount of outside gain or loss recognized by a foreign transferor that may be treated as effectively connected gain or loss to the lesser of the gain on the sale of the partnership interest or the seller's distributive share of a hypothetical sale of effectively connected property. The regulations illustrate how to determine the deemed-sale limitation.
In addition, Treasury issued final regulations regarding the withholding of tax on a foreign partner's share of effectively connected income from the disposition of a partnership interest.40 These regulations require the transferee to withhold 10% of the amount realized on the sale under Sec. 1446 unless one of six exceptions provided in the regulations applies. The transferee must remit the tax withheld within 20 days of the sale. The transferee must also notify the partnership of the sale and the amount withheld. If the transferee does not withhold the required tax, the partnership must withhold from any distribution to the transferee the amount of the tax plus interest.
Contributions to a partnership: Sec. 721(c) overrides the nonrecognition provision of Sec. 721(a) with regard to gain realized on the transfer of property to a partnership if the gain would be includible in the gross income of a person other than a U.S. person. In 2017, Treasury issued temporary and proposed regulations under Sec. 721(c) that provided guidance on the transfers of appreciated property by U.S. persons to partnerships with related foreign partners. The temporary regulations41 were then removed, and final regulations42 were issued in January 2020 that adopted the proposed regulations with modifications.
The final regulations are intended to override the general nonrecognition rule under Sec. 721 unless the partnership adopts the remedial-allocation method and applies the consistent-allocation method with respect to Sec. 721(c) property. The final regulations changed the definition of "related party" included in the proposed regulation to limit the application of these rules in certain situations. The final regulations also include a modification to the consistent-allocation method when the interim-closing-of-the-books method is applied. This modification is intended to clarify that a U.S. transferor continues to comply with the consistent-allocation method only when the interim-closing method is used and that the proration method is not appropriate for the consistent-allocation method.
Sec. 704(b) allocations: Sec. 704(a) provides that a partner's distributive share of income, gain, loss, deduction, or credit, except as otherwise provided in the Code, must be determined by the partnership agreement. Sec. 704(b) provides that a partner's distributive share of income, gain, loss, deduction, or credit is determined in accordance with the partner's interest in the partnership if the allocation does not have substantial economic effect.
Regs. Sec. 1.704-1(b)(4)(ii) provides that allocations of tax credits and tax credit recapture are not reflected by adjustments to the partners' capital accounts. Thus, these allocations cannot have economic effect under Sec. 704(b), and the tax credits and tax credit recapture must be allocated in accordance with the partners' interests in the partnership when the tax credit or credit recapture arises. If a partnership expenditure that gives rise to a tax credit also gives rise to valid allocations of partnership loss or deduction, then the partners' interests with respect to the credit are in the same proportion as the partners' respective distributive shares of the loss or deduction.
The IRS issued Rev. Proc. 2020-12, which establishes a safe harbor under which the IRS will treat partnerships as properly allocating the credit for carbon oxide sequestration under Sec. 45Q in accordance with Sec. 704(b). The safe harbor is intended to simplify the application of Sec. 45Q for partnerships eligible to claim the credit.
Self-employment income: Under Sec. 1402, general partners in a partnership must pay self-employment tax on their distributive share of partnership income plus any guaranteed payments they receive. Several cases dealt with whether a partner was subject to self-employment tax. Joseph43shows the importance for taxpayers of being able to provide proof of income and deductions. In this case, the taxpayer was disallowed deductions he claimed were made for the partnership because he failed to provide adequate proof to substantiate the expense. In addition, the Tax Court determined that the taxpayer, an ophthalmologist, was subject to self-employment tax on income from a partnership he established to receive income from eye surgeries he performed on behalf of another entity, because he could not prove that he was a limited partner in a limited partnership.
In Thoma,44married taxpayers deducted business expenses, health insurance expenses, payments to a SIMPLE IRA, and half of the husband's self-employment tax, based on the assertion that the husband was a partner in a partnership. The Tax Court found that the taxpayer was an employee, not a partner, because the evidence showed that the firm he worked for was not a partnership for tax purposes. Also, the taxpayer was referred to in agreements as an at-will employee and lacked control over rights to withdraw firm income and capital. In addition, he did not share control or responsibilities with a former partner during the years in question.
The taxpayers alternatively argued that, even if the husband was not a partner, he was carrying on a trade or business as an independent contractor. But the court denied this argument, applying a relevant-factors test. Key factors included that his relationship with the firm was "more permanent than that of an independent contractor," his former partner discharged him from the firm, he had no investment in the firm, and his work was within the firm's regular business. The fact that the firm paid him biweekly whether or not clients paid the firm also figured in the decision.
Basis and loss deductions: A partner calculates basis in a partnership interest according to 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. Sec. 465 further limits the deduction of allocated partnership losses to the amount the partner is at risk. The taxpayer has the burden of proving that it has adequate basis to deduct losses. Several cases dealt with partners' basis and their ability to deduct losses.
In Matzkin,45 the taxpayer had agreed to pay his ex-wife for her share of his interest in a partnership that he held through an S corporation as part of the property settlement in their divorce. Later, in the year in question, the S corporation sold the partnership interest, and the gains passed through to the taxpayer. He used part of the proceeds to pay his ex-wife for the remainder of his obligation under the divorce settlement and in turn reduced the amount of gain he reported on the sale by that amount.
The IRS disallowed the reduction, and the Tax Court agreed. The court determined that the payments the taxpayer made as part of the property settlement to his ex-wife did not increase the S corporation's basis in the partnership interest under Sec. 705(a)(1) because the payments did not affect its distributive share of the partnership's income or deductions. The S corporation's basis was also not increased under Sec. 722 or 752(a) because the payments did not result in the partnership's receipt of any money or other property and the taxpayer did not assume any of the partnership's liabilities. In addition, the payments were not an acquisition cost under Sec. 742 that provided basis because neither the taxpayer nor the S corporation acquired anything by making the payments.
In Frost,46 a taxpayer who was an enrolled agent and former IRS revenue officer was not allowed to deduct losses from a partnership he formed because he did not establish his adjusted basis in the partnership interest. The taxpayer provided as documentation only self-prepared tax returns and Schedules K-1.
In yet another case,47 the Tax Court determined that the IRS met its burden of proof that the taxpayer, a CPA and tax consultant, did not substantiate his basis in his partnership interests and so could not deduct partnership losses attributed to the partnerships. The taxpayer submitted a promissory note and business loan agreement to substantiate his basis; however, the IRS and the court found that neither contract was fully executed, and, even if they were, the loan documents were incomplete and predated the years in question. The taxpayer also failed to establish the partners' outside bases in the partnership, since he provided no capital account, financial, or business records and only incomplete bank account records.
In Duffy,48 the question was whether married taxpayers had established they had been allocated losses from a partnership and whether they had enough basis in the partnership to deduct the losses. The Tax Court disallowed the share of partnership losses claimed by the husband in the first year at issue because all of the partnership's loss had been allocated to another partner on the partnership's amended return for the year. Thus, the taxpayers were not able to establish that the partnership allocated any loss to the husband in the first year in question.
The taxpayers were allowed to deduct their claimed partnership loss in the second year because the court found that they had basis through contributions to the partnership. A claimed loss for a third year was limited under Sec. 704(d) because the taxpayer's basis in his partnership interest was less than the loss allocated, but a sufficient portion of the loss was allowed that, along with other adjustments, the taxpayers had no remaining deficiency for that year.
In addition, the taxpayers were not allowed to deduct unreimbursed expenses the husband allegedly paid for the partnership, because the taxpayers did not substantiate them. Lastly, the taxpayers were liable for self-employment tax on the guaranteed payments received from the partnership in the first year; however, they were not liable for the tax in the second and third years because the losses allowed would offset the amount of the guaranteed payments, so they had no self-employment income in those years.
In another case49 involving a taxpayer who was the sole owner-member of a medical services management company and an LLC, the Tax Court determined that the taxpayer's personal guarantee of a loan to fund the LLC's hospital acquisition established sufficient at-risk amounts under Sec. 465 to entitle him to deduct the LLC's losses for the year. The court determined that the taxpayer was considered personally liable because he bore "ultimate liability," demonstrated by facts including that he was the loan's sole guarantor, creating a direct liability under which the bank could have pursued him directly rather than the LLC.
The IRS argued that, under state law, the LLC's members were not personally liable for its debts. The court dismissed this argument, determining that the taxpayer incurred a personal liability by his guarantee, not because he was a member of the LLC. The court also rejected the IRS's alternate argument that the taxpayer could have been reimbursed by the LLC for any payments on the loan. The court averred that it must presume a worst-case scenario in its analysis, so the issue rather was the taxpayer's responsibility if the LLC and management company were insolvent. In determining whether the loan was recourse or nonrecourse, the court, applying the "constructive liquidation" test, found that the loan became a recourse obligation when the taxpayer guaranteed it and increased his basis by its full amount. In addition, because the taxpayer was able to prove sufficient basis with the loan guarantee, he was allowed to deduct his share of partnership suspended losses.
In a Chief Counsel Advice (CCA) memo,50 the IRS Office of Chief Counsel addressed whether the basis loss limitation under Sec. 704(d) and the at-risk loss limitation under Sec. 465 applied in determining general partners' net earnings from self-employment under Sec. 1402. In the CCA's facts, an LLC had three individual members, A, B, and C, all of whom were treated as general partners. During the tax year, the LLC had a current-year operating loss. All LLC members received guaranteed payments in the tax year.
To determine the amount of net earnings from self-employment subject to Self-Employment Contributions Act (SECA) tax for the tax year, A reduced his guaranteed payment by his individual share of the partnership's losses without applying the basis loss limitation under Sec. 704(d); B reduced his guaranteed payment by his individual share of the partnership's losses without applying the at-risk loss limitation under Sec. 465; and C had sufficient basis and at-risk amounts to apply his share of the partnership loss against his guaranteed payment. A and B contended that the Sec. 704(d) and Sec. 465 limitations did not apply to them, respectively, in determining their net earnings from self-employment subject to SECA tax.
The IRS determined that the basis loss limitation under Sec. 704(d) and the at-risk loss limitation under Sec. 465 do apply in determining a general partner's net earnings from self-employment under Sec. 1402 for SECA tax purposes, to the same extent as these loss limitation rules apply for income tax purposes, unless a specific exclusion applies under Sec. 1402(a). Therefore, A's and B's individual shares of the partnership loss must be disallowed for both SECA tax and income tax purposes because they had insufficient basis and at-risk amounts, respectively.Disposition of partnership interest
Sec. 741 provides that in the case of a sale or exchange of an interest in a partnership, gain or loss is recognized to the transferor partner. This gain or loss is considered to be from the sale or exchange of a capital asset, except as otherwise provided in Sec. 751 (relating to unrealized receivables and inventory items). Sec. 165(g) allows that, if any security that is a capital asset becomes worthless during a tax year, the loss resulting from it is treated as a loss from the sale or exchange, on the last day of the tax year, of a capital asset.
In MCM Investment Management LLC,51a family-controlled LLC was allowed to deduct a loss under Sec. 165 for a worthless partnership interest after the LLC's finances deteriorated. The taxpayer was able to prove his interest in the LLC was worthless by showing that the LLC subjectively determined its worthlessness in the same year and by objective factors that confirmed the absence of substantial value that year. The subjective evidence included the LLC's tax reporting position and the owners' credible testimony that they believed the interest was worthless due to the financial crisis and recession of 2007 through 2009, the company's dwindling revenues and decreasing cash flow projections, its history of operating losses in the current and prior years, and its substantial debt burden. Objective evidence included identifiable events that showed the interest's lack of liquidating value and any potential future value.
Thus, the court allowed the taxpayer the loss deduction on the worthlessness of the LLC interest and rejected the IRS's argument that the LLC's interest had potential future value until foreclosure occurred with respect to each real property interest subject to a recourse mortgage held by the LLC's project entities. The court also found that, contrary to the IRS's arguments, the LLC was not required to provide expert testimony to prove worthlessness and the LLC's loss was bona fide, despite the involvement of related parties.
In NCA Argyle LP,52 a taxpayer LLC entered into several joint ventures with a real estate corporation. Later, however, the other party disavowed the joint ventures. In resulting litigation, the taxpayer was awarded damages for the value of interests in the joint ventures and punitive damages. While the case was on appeal, a settlement was reached, and the real estate corporation paid the taxpayer a lump sum for relinquishing whatever rights it had in the joint ventures. The amount paid was based partly on the estimated anticipated revenue stream of the joint ventures. The taxpayer treated this payment as being in exchange for a partnership interest and reported it as a capital gain. The IRS claimed the payment was ordinary income because it represented estimates of future income or was attributable to punitive damages awarded in the litigation.
The Tax Court held the payment was in exchange for the taxpayer's interest in the joint ventures and, therefore, the income was capital gain income. The court found the capital gains treatment was supported by the settlement agreement, which expressly allocated the payment to the LLC's interest in the joint ventures, which it determined should be respected because the parties were adversarial and negotiated the settlement agreement at arm's length.Sec. 754 election
When a partnership distributes property or a partner transfers its 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 its partnership interest. The partnership must file the election by the due date of the return for the year the election is effective, normally, with the return.
If a partnership inadvertently fails to file the election, the only remedy 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 valid, the election must be signed by a partner.
Extensions of time: In several letter rulings during this period,53 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 it 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. 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.54 The IRS even allowed additional time to file the election where the benefit was for partners in a foreign partnership.55
Missed elections: The Sec. 754 election is allowed when a partner dies and his or her interest is transferred. In many such cases, the election is inadvertently missed. 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.56
8See Regs. Sec. 1.163(j)-1(b)(22)(v)(E), Example (5).
9Regs. Sec. 1.163(j)-1(c)(2).
10In tax years beginning in 2019 or 2020, at the taxpayer's election, the 30%-of-ATI limitation is 50% of ATI. See the section headed "CARES Act" below.
11Regs. Sec. 1.163(j)-1(b)(1)(iii).
12Regs. Sec. 1.163(j)-6(f)(2).
15REG-106808-19, 84 Fed. Reg. 50,152 (Sept. 24, 2019).
16REG-106808-19, 85 Fed. Reg. 71,587 (Nov. 10, 2020).
18Partnerships subject to the centralized audit regime of the Bipartisan Budget Act of 2015, P.L. 114-74, may file an amended return for tax years beginning in 2018 and 2019 under procedures in Rev. Proc. 2020-23.
19REG-107213-18. These proposed regulations were finalized (T.D. 9945) in January 2021, after the period covered by this article. The final regulations, which modified the proposed regulations, will be discussed in the next update. See also Schreiber, "Carried Interests Regulations Are Finalized," The Tax Adviser (Jan. 8, 2021).
21REG-120186-18. The IRS issued the earlier set of proposed QOF regulations (REG-115420-18) in October 2018.
24See "Limitation on Business Interest Deductions," above, for a background discussion of the limitation.
26Rev. Proc. 2020-22 also provided guidance on how partners may elect out of this "50% EBIE rule" under Sec. 163(j)(10)(A)(ii)(II).
27See Secs. 163(j)(7)(B) and (C) and Sections 2.11 and 4 of Rev. Proc. 2020-22.
30Division U of the Consolidated Appropriations Act, 2018, P.L. 115-141.
31General Mills, Inc., 957 F.3d 1275 (Fed. Cir. 2020), aff'g 123 Fed. Cl. 576 (2015).
32See, e.g., Gregory v. Helvering, 293 U.S. 465, 469 (1935) ("The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.").
33Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
34Manroe, T.C. Memo. 2020-16.
35IRS News Release IR-2019-182.
36See, e.g., Oakbrook Land Holdings, LLC,T.C. Memo. 2020-54; Carter, T.C. Memo. 2020-21; Rock Creek Property Holdings, LLC, No. 5599-17 (T.C. 2/10/20) (order granting summary judgment); Railroad Holdings, LLC,T.C. Memo. 2020-22; and Riverside Place, LLC,T.C. Memo. 2020-103.
37See also IRS News Release IR-2020-240.
38Notice 2021-13. See also Bonner, "Partner Capital Account Reporting Gets Transition Penalty Relief," The Tax Adviser (Jan. 20, 2021).
43Joseph, T.C. Memo. 2020-65.
44Thoma, T.C. Memo. 2020-67.
45Matzkin, T.C. Memo. 2020-117.
46Frost, 154 T.C. 23 (2020).
47Sellers, T.C. Memo. 2020-84.
48Duffy,T.C. Memo. 2020-108.
49Bordelon, T.C. Memo. 2020-26.
51MCM Investment Management, LLC, T.C. Memo. 2019-158.
52NCA Argyle LP, T.C. Memo. 2020-56.
53E.g., IRS Letter Rulings 202005014, 202006007, and 202016015.
54E.g., IRS Letter Ruling 201947014.
55E.g., IRS Letter Ruling 201950002.
56E.g., IRS Letter Rulings 201945023, 201949010, and 202015014.
|Hughlene A. Burton, CPA, Ph.D., is an associate professor and the former 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 email@example.com.