Current developments in partners and partnerships

EXECUTIVE SUMMARY

Court cases decided during the reviewed period dealt with issues under the former unified audit rules of the Tax Equity and Fiscal Responsibility Act (TEFRA) that included the statute of limitation and whether an item of income or deduction was properly determined as a partner or partnership item. Other issues addressed included the economic substance of partnership transactions and debt vs. equity characterizations. Final regulations were issued for domestic partnerships with foreign partners. Generally, the regulations extend the treatment of domestic partnerships as aggregates of their partners for purposes of determining income inclusions under Sec. 951 and provisions applicable by reference to it. A number of court cases dealt with the “protected in perpetuity” and substantiation requirements and other issues regarding the validity of taxpayers’ claimed deductions for charitable contributions of conservation easements. As several cases in 2022 indicate, the IRS, in addition to auditing individuals that it believes have taken improper conservation easement deductions, is pursuing criminal cases against promotors of fraudulent syndicated conservation easement schemes. IRS letter rulings addressed late or missed elections under Sec. 754 and those regarding choice of entity and qualified opportunity fund self-certification of assets.

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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, 2021, through Oct. 31, 2022), the IRS issued guidance for taxpayers regarding changes made to Subchapter K over the past few years. Also, the Service issued guidance related to foreign partners. In addition, the courts and the IRS issued various rulings that addressed partnership operations and allocations.

Audit issues

In 1982, the Tax Equity and Fiscal Responsibility Act (TEFRA)¹ 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, against 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),² 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 replaced the unified audit rules as well as the electing large partnership regime of TEFRA. In 2018, Congress enacted the Tax Technical Corrections Act (TTCA),³ 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.

Court decisions under TEFRA

Even with the adoption of the BBA audit rules, cases are still being litigated involving TEFRA issues. Most of these TEFRA cases involve either of two issues: the statute of limitation or whether income or a deduction is a partnership item. During the update period, several cases dealt with a statute-of-limitation issue, two dealt with a partnership item issue, and one dealt with penalties assessed during the TEFRA audit.

Statute–of–limitation issues

During the audit of Rocky Branch Timberlands LLC’s⁴ partnership return for 2017, the IRS determined that it would need an extension of time to complete the audit beyond the three-year statute of limitation. As such, the IRS asked the LLC to extend the statutory period for an additional 15 months and sent the LLC a Form 872-P, Consent to Extend the Time to Assess Tax Attributable to Items of a Partnership, to consent to the extension. The LLC signed the consent but did not return it to the IRS. Later, the LLC told the IRS that it had decided not to extend the statutory period. Before the original statute of limitation lapsed, the IRS sent the LLC a notice of proposed adjustment proposing to disallow a charitable deduction for a conservation easement.

The LLC disagreed with the disallowance and asked for a review from the IRS’s Independent Office of Appeals before the IRS issued its Final Partnership Administrative Adjustment (FPAA). The LLC attached a signed Form 872-P and asked the IRS to execute the form and extend the statutory period so that the LLC could obtain a review by the Independent Office of Appeals before issuance of the FPAA. The IRS refused to extend the statutory period and did not allow an Independent Office of Appeals review before it filed the FPAA. The LLC sued the IRS, seeking relief to stop the IRS’s process.

Before the suit was heard, the IRS issued the FPAA. The LLC amended its complaint, seeking to have everything undone so it could go back and have the review. The court dismissed the case, holding that it did not have subject matter jurisdiction because the FPAA had already been issued. The court explained that it could not order the IRS to rescind an FPAA because it would violate the Anti-Injunction Act. It is interesting to note that if the LLC had agreed to the original request for an extension, it would have been able to have the case reviewed by the Independent Office of Appeals.

Another case, Baxter, dealt with an American Agri-Corp (AMCOR) partnership structure consisting of three partnerships that the IRS determined was an impermissible tax shelter.⁵ The IRS issued FPAAs for all three partnerships to the tax matters partner. The IRS had determined that the partnerships engaged in a series of sham transactions rather than farming activities and proposed adjustments disallowing a number of deductions taken by the partnership. The taxpayers had deducted the losses allocated to them from the partnership.

On audit of the taxpayers’ return, the IRS assessed additional taxes attributable to the limited partnership interests. The taxpayers paid the tax and sued for a refund, arguing that the assessment was untimely under Sec. 6501 because the FPAAs were issued more than three years after the filing dates of their joint individual tax returns that reflected the partnerships’ losses. In addition, they contended that the assessment was invalid because it was not preceded by the issuance of a notice of deficiency, as required under Sec. 6213. The district court ruled in favor of the taxpayers.

The IRS appealed the ruling to the Fifth Circuit.⁶ That court in 2022 reversed the district court’s ruling on both of the issues and remanded the case to the district court, instructing it to dismiss the taxpayer’s case for lack of jurisdiction. Regarding the timeliness of the assessment, the Fifth Circuit observed that in previous cases where taxpayers had made the same argument regarding limitation periods, the court had repeatedly found such claims effectively sought refunds attributable to partnership items that thus were barred under former Sec. 7422(h). Therefore, the Fifth Circuit held that the district court did not have jurisdiction to hear the claim.

Regarding the taxpayers’ claim that the assessment was improper because it was not preceded by a deficiency notice, the Fifth Circuit held that the district court did not have jurisdiction to consider that claim because it impermissibly varied from the taxpayers’ administrative claim. Even if the district court had jurisdiction, the taxpayers’ argument would fail, the Fifth Circuit said, because it involved a misunderstanding of the meaning of the term “deficiency” as defined by Sec. 6211(a).

In another case,7 the IRS issued two FPAAs to a partnership that made adjustments to its tax returns for two years. The only material difference between the FPAAs was that the second FPAA corrected the name of the partnership on the attached schedules. The taxpayers petitioned the Tax Court for a redetermination of federal income tax deficiencies for those years. The Tax Court dismissed the petition as untimely because the taxpayers failed to file the petition within 150 days of when the IRS issued the first FPAA.⁸

The taxpayers argued that their petition was timely because Sec. 6223(f) barred the IRS from issuing more than one FPAA pertaining to a partnership’s tax year. They also argued that the second FPAA was the only valid one and that their petition was filed within 150 days of that FPAA. The Tax Court concluded that the first FPAA was the only valid FPAA and, therefore, the taxpayers’ petition was untimely. The taxpayers appealed the decision to the Fifth Circuit, which found that the Tax Court had properly dismissed the petition as untimely filed.

Partnership item issues

Several court cases decided during the period turned on whether the treatment of an item was properly reported or determined at the partnership level or at the partner level.

In Gluck, the taxpayers sold a condominium and then attempted to complete a like-kind exchange within the meaning of Sec. 1031 by purchasing a partnership interest in an apartment building.⁹ Under Sec. 1031, taxpayers can defer the tax on the gain from a sale of real property held for productive use in a trade or business or for investment if they exchange it for property of a like kind within a certain period. However, a partnership interest is not considered of like kind to real property and thus does not qualify for Sec. 1031 exchange treatment. In this case, the taxpayers filed their tax return and claimed like-kind exchange treatment for their interest in the property purchased to replace their condominium.

The IRS audited the taxpayers’ return and found that they had purchased an interest in a partnership that owned the property, not a direct interest in the property itself. Thus, the IRS determined, the transaction did not qualify as a like-kind exchange, and the gain on the sale was taxable. The IRS based this determination on the tax return that was filed for a partnership that represented that it owned the property and included the taxpayers as a partner. The taxpayers received notice of the partnership tax return having been filed and did not file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), which would have notified the IRS they were taking a position on their tax return that was inconsistent with items on the partnership tax return or that they wanted to challenge the partnership’s characterization of those items. Since the taxpayers had not alleged any inconsistencies with the partnership tax return, the IRS followed the information provided on the Form 1065, U.S. Return of Partnership Income.

The Tax Court rejected the taxpayers’ filing on the grounds that it lacked jurisdiction to hear the petition because the adjustment the IRS made on their tax return was treated as a computational adjustment of an affected partnership item, which required no further determinations at the partner level and thus was outside the Tax Court’s jurisdiction. The taxpayers appealed to the Second Circuit, which upheld the Tax Court’s decision.10 Had the taxpayers properly filed the Form 8082, the Tax Court could have heard the case.

InWarner Enterprises, Inc.,¹¹the IRS had determined accuracy-related penalties in an earlier TEFRA partnership-level proceeding. One of the partners objected to the penalties, contending that the IRS had not complied with the requirement under Sec. 6751(b) to obtain supervisory approval of the penalty. The partner argued that partners were entitled to raise Sec. 6751(b) as a defense at either the partnership level or partner level. The Tax Court disagreed, noting that allowing partners to object to the penalty at either the partnership or partner level would ignore TEFRA’s framework requiring partnership items affecting all partners equally to be determined at the partnership level.

Penalty issues

Another case¹² involved a charitable contribution deduction claimed by Excelsior Aggregates LLC for a conservation easement. The IRS issued the LLC an FPAA disallowing its deduction and determined penalties under Secs. 6662A and 6662. The Tax Court addressed whether the IRS complied with Sec. 6751(b)(1) with respect to these penalties. Sec. 6751(b)(1) requires that the initial determination of a penalty assessment be personally approved in writing by the immediate supervisor of the person making the determination.

The IRS contended that the initial determination of the penalties in question was communicated in the FPAA. Because supervisory approval for the penalties was secured before that date, the IRS argued, the approval was timely. The taxpayer contended that supervisory approval was not timely because the initial determination of the penalties occurred earlier, when the IRS mentioned the possibility of penalties during a phone conference with the LLC’s representative. As part of the phone conference, the IRS faxed an agenda laying out a tentative position on each topic for discussion, including penalties.

The court ruled that the approval for the penalties was timely. The court specifically noted that the IRS submitted a supplemental civil penalty approval form in which the revenue agent recommended the assertion of penalties and that the agent’s supervisor signed the form before the FPAA was issued.

The court found that the earlier phone conference was not an initial determination of penalties because the agenda did not inform the representative that the IRS had completed its work and specifically stated that the results could change before the examination officially concluded. In addition, neither the agenda nor the telephone conference informed the partnership of any unequivocal decision by the IRS to assert penalties.

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.13 However, business transactions must have economic substance. For a transaction to have economic substance, it must have a reasonable possibility of a profit, and the transaction should have a business purpose independent of reducing taxes. The IRS has been diligent in examining transactions that it considers to lack economic substance or that are shams. The IRS generally has prevailed on the issue. To help clarify the rules, Congress codified the economic substance doctrine in 2010.¹⁴ Several cases during the update period considered whether a partnership transaction had economic substance.

Sham partnerships

In some court cases, partnership structures were found to be abusive arrangements or shams.

In Sarma, the taxpayer participated in a tax-avoidance scheme to avoid paying tax on the gain he expected on the sale of his business. This scheme required the creation of a set of three-tiered partnerships with upper, middle, and lower tiers. The partnerships were designed to generate significant artificial losses to offset legitimate taxable income, according to a district court opinion in earlier, related proceedings.15 An essential component of the scheme was a series of offsetting foreign currency exchange forward contracts, or straddles. The IRS audited the partnerships and determined that they were an abusive tax shelter and, thus, disallowed the losses generated. The partnerships filed suit in district court, which found the scheme to be an abusive tax shelter and in a partnership-level proceeding upheld the IRS’s disallowance of the benefits of the losses. The partnership appealed to the Eleventh Circuit, which affirmed the district court’s ruling.¹⁶

As a result of the partnership-level proceeding, the IRS issued a notice of deficiency to the married taxpayers in Sarma, disallowing the loss deduction they reported on their joint tax return from the husband’s participation in the scheme as a partner. The taxpayers sought review by the Tax Court. The taxpayers argued that the statute of limitation expired prior to the IRS’s issuance of the notice to them.

The resolution of this issue hinged on whether the partner’s outside basis in the partnership was an item affected by a partnership item (an “affected item”) under TEFRA’s former Sec. 6229. The Tax Court determined that it was and found the notice to be both timely and valid.¹⁷ In addition, the Tax Court determined that the outside basis of the partnership interest was zero because a partner cannot have any basis in a sham partnership. Thus, the taxpayers were not entitled to the passthrough loss. The taxpayers appealed on both issues to the Eleventh Circuit, which in 2022, after careful review, affirmed the Tax Court’s decision.¹⁸

Partnership definition

Sec. 761 defines a partnership as an entity including any syndicate, group, pool, joint venture, or other unincorporated organization through or by which a business, financial operation, or venture is carried on and that is not by definition a corporation or a trust or estate. During 2022, the question of whether an entity was a partnership was raised in two cases. In one case,¹⁹ shortly after Congress expanded the refined coal tax credit,²⁰ a corporation began developing coal refining technology and set out to launch a coal refining facility. To do so, it formed a new single-member LLC.

The corporation anticipated that the LLC would be able to claim the tax credit but would produce tax losses. The LLC brought in additional investors to allow the original owner to spread its own investment over a larger number of projects and to reduce its overall risk. A secondary reason to expand the ownership was that the original owner could claim only a portion of the refined coal tax credits in any given year; the rest would have to be carried forward. Because money has a time value, it made sense to have partners who could claim the credits sooner. All of the members of the LLC were actively involved in its operation and financed any operating shortfall. For the years in question, the LLC had ordinary business losses and claimed more than $25.8 million in refined coal tax credits. The LLC distributed the credits and losses proportionally among its members.

On audit, the IRS concluded that the LLC was not a partnership because it was formed to facilitate the prohibited transaction of monetizing the refined coal tax credits. Since the LLC was not a partnership, only the original owner could claim the tax credits. The taxpayer petitioned the Tax Court, which ruled that the LLC was a bona fide partnership because all three members made substantial contributions to the LLC, participated in its management, and shared in its profits and losses.²¹

The IRS appealed the ruling to the D.C. Circuit, which agreed with the Tax Court. Factors that the appellate court held showed that the entity met the definition of a partnership included that the founder had legitimate nontax motives for forming it and for recruiting other partners, such as spreading investment risk over a larger number of projects; that there was nothing wrong with the founder’s seeking partners who could apply the tax credits immediately rather than carrying them forward to future tax years; and that all of the partners shared in the partnership’s potential for profit and risk of loss.

In another case,²² a partnership purchased a commercial rental property by financing the property with the proceeds of a loan. The loan document included an “additional interest agreement” that entitled the lender to additional interest of two types — “NCF [net cash flow] interest” and “appreciation interest.” The partnership made regular loan payments that included the NCF interest. Later, the partnership sold the property and, in accordance with the loan documents, paid the appreciation interest. On its tax return, the partnership claimed an interest deduction for the payment of the appreciation interest. The partnership also reported a Sec. 1231 gain on the sale of the property.

A partner in the partnership reported his distributive share of the appreciation interest and the gain on his individual return. The IRS audited his return and disallowed the deduction for the appreciation interest but did not adjust the gain on the sale of the property. The IRS argued that the lender and the partnership were a joint venture, making the appreciation interest a nondeductible return on equity. The Tax Court rejected that argument and found that, based on the facts, it was clear the partnership and the lender did not enter into a joint venture. The facts the court relied on included that there was no contribution by the lender, the parties stipulated that all funds provided to the partnership were loans, the lender did not have a “single equity interest” in its dealings with the partnership, and the records showed the partnership payments were income to the lender for the use of funds it had advanced.

Income included on partner’s return

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 a case²³ decided in 2022, three single-member entities were partners in an accounting firm organized as a partnership. The partners negotiated a buyout of one of the partners in anticipation of the retirement of that partner’s principal owner. The buyout was added to a restated partnership agreement. The partnership agreement also included provisions governing allocations of income and distributions (both liquidating and nonliquidating) to the partners and a qualified income offset provision. The partnership agreement anticipated that a partner could receive a distribution of clients from the partnership and provided a method for valuing such a distribution.

Shortly after finalizing the restated partnership agreement, the other two partners withdrew from the partnership and formed a new partnership. Some of the old partnership’s clients moved to the new partnership. The old partnership reported on its tax return that the two partners that withdrew received distributions in amounts equal to the value of the clients (as determined under the restated partnership agreement) that followed them to the new partnership. The partnership also decreased the withdrawing partners’ capital accounts by the value of the reported distributions, which reduced their capital accounts below zero. To restore their capital accounts to zero, the partnership allocated all of the partnership’s ordinary income to the withdrawing partners pursuant to the qualified income offset provision in the partnership agreement.

The withdrawing partners filed Forms 8082 contesting the income allocations. The IRS audited the partnership return and issued an FPAA that disregarded the distributions and redetermined the allocations of ordinary income, contending that the distributions had not been substantiated and that the corresponding allocations of income lacked substantial economic effect. The partnership petitioned the Tax Court.

The Tax Court agreed with the partnership and rejected the IRS’s determination to disregard the distributions. Instead, the court found that the distribution treatment was correct and that the partnership’s method for valuing the distributions met the definition of fair market value (FMV) under Regs. Sec. 1.704-1(b)(2)(iv)(h)(1). However, the court also found that the partnership’s special income allocations to the withdrawing partners lacked substantial economic effect because the partnership had not maintained capital accounts for the partners. Thus, the distributions did not meet the requirements under Regs. Sec. 1.704-1(b)(2)(iv) for maintaining capital accounts and had to be reallocated in accordance with the partnership interests under Sec. 704(b) and Regs. Sec. 1.704-1(b)(3). In addition, since the withdrawing partners had negative capital accounts at the end of the year and the partnership agreement included a qualified income offset provision, ordinary income had to be allocated first to those partners in the amount necessary to bring their respective capital accounts up to zero.

Character of partner’s loss

The character of a loss was at issue in a case²⁴ in 2022 in which a taxpayer and his colleague formed a partnership that purchased lots for investment purposes. Before any lots were sold or distributed, the partnership did not make any improvements to develop the lots. Later, some of the lots were distributed to the taxpayer, and he sold them at a loss. The taxpayer reported the loss as ordinary.

The character of income reported by a partner is generally determined at the partnership level. In this situation, the IRS determined that the loss on the sale should be capital and not ordinary, as reported. It noted that the lots were purchased by the partnership for investment purposes, not for development; therefore, any losses at the partnership level would have been capital. It also indicated that, even if the lots were initially intended for development, the development plan was abandoned well before the lots were distributed and that no improvements were in fact made. Other factors that indicated the loss was capital included that the sale was an isolated transaction for the taxpayer and that the taxpayer’s regular business was a law practice, not real estate. The facts that the taxpayer hired a broker and advertised the lots for sale were not enough to counter the other facts.

The Tax Court agreed with the IRS and concluded that the lots in the taxpayer’s hands were neither his stock in trade, inventory, nor property held primarily for sale to customers in the ordinary course of business under Sec. 1221(a)(1) and thus were capital. The taxpayer alternatively argued that the lots were inventory as defined in Sec. 751(d) and that, pursuant to Sec. 735(a), they retained their inventory character from the partnership. Therefore, he argued, he was allowed an ordinary loss upon their sale within five years of the partnership’s distribution. The court also rejected this argument.

Final regulations address foreign stock owned through domestic partnerships

In 2018, Treasury and the IRS issued proposed regulations regarding the treatment of domestic partnerships for purposes of determining amounts included in the gross income of their partners with respect to controlled foreign corporations for purposes of Sec. 951A.25 In 2019, these proposed regulations were finalized in modified form²⁶ and additional proposed regulations issued (the 2019 proposed regulations)²⁷ that would extend the treatment of domestic partnerships as aggregates of their partners for purposes of determining income inclusions under Sec. 951 and provisions applicable by reference to it. Then, in 2020, Treasury and the IRS finalized the portions of the 2019 proposed regulations relating to Secs. 951A and 954 addressing the treatment of income subject to a high rate of foreign tax.²⁸

In 2022, Treasury and the IRS finalized an additional portion of the 2019 proposed regulations.²⁹ These final regulations apply to U.S. persons that own stock of foreign corporations through domestic partnerships and domestic partnerships that are U.S. shareholders of foreign corporations. The final regulations generally extend the treatment of domestic partnerships as aggregates of their partners for purposes of determining income inclusions under Sec. 951 and for purposes of provisions that apply by reference to it. The final regulations also clarify that aggregate treatment of domestic partnerships applies for purposes of Sec. 956(a) and any provisions that specifically apply by reference to that provision. Aggregate treatment does not apply, however, for purposes of Sec. 956(c) or (d) (or provisions that apply by reference to these subsections), because treating a domestic partnership as an entity separate from its partners is more appropriate to carry out the purposes of these provisions. Certain existing final regulations treat domestic partnerships as entities separate from their partners for purposes of Sec. 956. The final regulations remove those provisions.

The proposed regulations had requested comments with respect to the application of the passive foreign investment company (PFIC) regime to domestic partnerships that directly or indirectly own PFIC stock, particularly with respect to whether elections and income inclusions are more appropriate at the level of a domestic partnership or at the level of its partners. Treasury and the IRS did not address these issues in the final regulations.

Disallowed deductions

Many disputes arose about deductions, with conservation easements generating a large amount of litigation.

Conservation easements

The IRS has been auditing a number of tax returns for partnerships that took a deduction for a conservation easement through a tax shelter. In many of the cases, the IRS has disallowed the deduction because it believed either the contribution did not meet the “protected in perpetuity” requirement or that the property contributed was overvalued. To deter this type of transaction, Congress as of this writing has included a provision in the proposed Enhancing American Retirement Now (EARN) Act30 that would limit the deduction if the amount exceeds 2.5% times the sum of each partner’s basis in the partnership.

As described below, numerous recent court cases have dealt with the contribution of conservation easements. In most of the cases, the disputed issue is related to the facts of the case; however, some taxpayers have contested the validity of the law, as in Oakbrook Land Holdings LLC.

As background to the decision, taxpayers are allowed a charitable contribution deduction under Sec. 170(h) if they donate an easement in land to a conservation organization. However, the easement’s conservation purpose must be guaranteed to extend in perpetuity to qualify. Treasury issued Regs. Sec. 1.170A-14(g)(6) to address the situation in which unforeseen changes to the surrounding land make it “impossible or impractical” for an easement to fulfill its conservation purpose. In this event, the conservation purpose may still be protected in perpetuity “if the restrictions are extinguished by judicial proceeding and all of the donee’s proceeds . . . from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution.”31 Proceeds are calculated by a formula included in Regs. Sec. 1.170A-14(g)(6)(ii). This is called the proceeds regulation.

In Oakbrook Land Holdings, the LLC challenged the validity of the proceeds regulation. The taxpayer contended that, in developing this rule, Treasury violated the notice-and-comment requirements of the Administrative Procedure Act (APA). The taxpayer also argued that Treasury’s interpretation of Sec. 170 was unreasonable and that the proceeds regulation is arbitrary or capricious. The full Tax Court considered these arguments and found in favor of the IRS.³² In 2022, the taxpayers appealed the case. An appellate court reviewed the case and agreed with the Tax Court, thus affirming the validity of the regulation.³³

In another case,³⁴ the taxpayer took a charitable contribution deduction for a conservation easement. The IRS issued the taxpayer an FPAA disallowing this deduction. In this case, the Tax Court examined two issues: (1) whether the easement deed failed to protect the conservation purpose in perpetuity, and (2) whether the taxpayer’s appraisal and documentation failed to meet the substantiation requirements of Sec. 170(h)(4)(B)(iii). The IRS based its argument on an earlier case35 that found that language in the deed that defined the numerator of the apportionment fraction violated the regulation. However, in this case, the court determined that language in the deed was used differently and that the formula used was consistent with the regulation. The court also found that the question of whether the taxpayer provided appropriate documentation for the appraisal would have to be determined at trial since, even though the taxpayer did not literally comply with the substantiation requirement, there were questions that could not be resolved in a summary judgment.

In a related case,³⁶ the IRS again disallowed the charitable contribution deduction claimed for a conservation easement. Here, the easement deed did not explicitly address judicial extinguishment; rather, it only expressed the parties’ intent that no change in conditions would at any time or in any event result in the easement’s extinguishment and that if circumstances arose that justified a modification of the restrictions, the parties would agree to an appropriate amendment but that in no event would the amendment violate Sec. 170(h). The court found that the partnership had a reasonable argument that the deed did not violate the regulation or statute, even though it did refer to a possibility of eminent domain. The court determined the language was ambiguous and allowed the deduction.

In another case,³⁷ a partnership granted a qualified organization a façade easement on a building that was a certified historic structure, for which the partnership took a charitable contribution deduction. The building in question was subject to five deeds of trust securing loans made to the partnership. The terms of the loans made the lendersbeneficiaries of the deeds of trust on the building. The deeds of trust required the lenders in some circumstances to allow insurance proceeds arising from damage to the building or the proceeds from its condemnation to be used to repair or restore the building. In other circumstances, the lenders could apply the proceeds to satisfy the indebtedness secured by the deeds of trust. The easement deed provided that, in the event of casualty or condemnation, the partnership, the lenders, and the qualified organization were entitled to share any net proceeds remaining after the satisfaction of prior claims.

The IRS denied the deduction because the easement did not meet the requirements of Sec. 170. The IRS said that the easement failed because the mortgages were not subordinated. In this case, the deeds of trust provided lenders with priority rights to use insurance or condemnation proceeds in specified circumstances to satisfy underlying indebtedness, and the lenders did not subordinate their rights to the qualified organization’s right to enforce in perpetuity the easement’s conservation purposes. Thus, the easement did not qualify as having been made exclusively for conservation purposes and, as a result, was not a qualified conservation contribution under Sec. 170(h). In this situation, the court agreed with the IRS.

In Glade Creek Partners, LLC,the partnership donated a conservation easement for which it took a charitable contribution deduction.38 When it executed the deed of easement, the LLC included a provision addressing what would happen if it became impossible to use the property for conservation purposes. The deed provided that, in that situation, a court could terminate or extinguish the easement, and the qualified organization that received the easement would be entitled to a portion of the proceeds from any subsequent sale or exchange of the property. The amount the organization received in this case would be calculated using the easement’s FMV at the time of the sale less any increase in value that was attributable to improvements made after the easement was granted. The amount attributed to improvements would go back to the LLC.

The IRS disallowed the charitable contribution deduction because of the way the conservation easement deed handled the possibility of any future extinguishment proceeds. The Tax Court concluded that the LLC had not properly taken the charitable contribution deduction because the easement deed violated Regs. Sec. 1.170A-14(g)(6) and, as such, failed Sec. 170’s in-perpetuity requirement. The LLC appealed the decision to the Eleventh Circuit.³⁹

In 2022, the Eleventh Circuit vacated and remanded the case for reconsideration, guided by its own recent decision in Hewitt,⁴⁰ where the court had invalidated the regulation in question by determining that the IRS’s interpretation of the regulation was arbitrary and capricious and violated the APA’s procedural requirement. However, taxpayers should be aware that cases brought in other circuits may or may not followHewitt.

In another situation, two taxpayers formed a partnership that donated a conservation easement to a qualified organization. The conservation deed, however, retained various rights for the donors. The partnership reported a charitable contribution for the easement, and the taxpayers deducted their share of the charitable contribution on their personal tax returns. The IRS audited the individual tax returns and disallowed the charitable deductions. As part of the investigation, the IRS mailed each partner a letter and the revenue agent’s report proposing penalties under Sec. 6662 related to the underpayment of tax. Ten days after mailing the letter, the auditor sent the case to his immediate supervisor, who approved the penalties in writing. Eventually, the IRS issued the taxpayers statutory notices of deficiency that described the proposed tax changes and penalties resulting from the audit. Each partner timely petitioned the Tax Court for pre-assessment review of his deficiency.

The Tax Court held that the taxpayers’ arguments failed on the merits because their retained rights under the conservation deed rendered the easement in violation of the granted-in-perpetuity requirement under Sec. 170(h)(2)(C).⁴¹ But it also disallowed the IRS’s asserted Sec. 6662 penalties, holding that the letters and examination reports constituted “initial determinations of assessment” under Sec. 6751(b). Because the IRS had mailed the letters without first obtaining supervisory approval of the penalties, the Tax Court held that the government could never assess those penalties. Both the taxpayers and the IRS appealed the decision.

The Eleventh Circuit⁴² reversed the Tax Court’s decision that the taxpayers were not entitled to a charitable contribution deduction for a conservation easement donation, because of the appellate court’s 2020 decision in Pine Mountain Preserve, LLLP.⁴³ However, the case was remanded to the Tax Court for consideration of whether theprotected-in-perpetuity requirement under Sec. 170(h)(5)(A) was met, as this issue had not been addressed in Pine Mountain Preserve, LLLP. The appellate court also reversed the Tax Court’s decision that the accuracy-related penalties could not be upheld against the taxpayers because the IRS did not meet the Sec. 6751(b) written supervisory approval requirement. The appellate court followed Kroner,44which found that the Tax Court erred in determining in that case that the penalties’ approval was untimely.

Lastly, in another case, the IRS disallowed a charitable contribution deduction claimed for a conservation easement made by an LLCbecause the easement’s conservation purpose was not protected in perpetuity.⁴⁵ The IRS argued that the contribution did not meet this requirement because the deed had a “deemed consent” provision that stripped the donee of its perpetual right to prevent uses of property that were not consistent with conservation purposes. The IRS asked the court for summary judgment on this issue but was denied because the argument raised material-fact issues that were not suitable for summary judgment.

Tax shelter promoters and others: The IRS is still conducting audits of taxpayers that took a charitable contribution for a conservation easement, but now the government is also looking at the promoters of the tax shelters. In 2022, the government charged seven individuals with conspiracy to defraud the United States arising out of their promotion of fraudulent tax shelters involving syndicated conservation easements.⁴⁶ The indictment charged that the syndicated conservation easement transactions were abusive tax shelters lacking in economic substance or a business purpose.

In another situation,⁴⁷ a marketer of a syndicated conservation easement scheme pleaded guilty to filing a false tax return that claimed a fraudulent charitable contribution of a conservation easement. The individual, a CPA and attorney, admitted that he knew the tax shelter did not entitle him to a tax deduction; however, he claimed the false charitable deduction on his personal tax return for the years in question.

In Equity Investments Associates, LLC, the IRS was auditing an LLC related to a charitable contribution deduction for a conservation easement the IRS deemed to be overvalued.⁴⁸ At the same time, there was a criminal investigation of the owners and managers of the LLC related to the tax shelter that provided the deduction. As part of its audit, the IRS issued a summons for information, which the LLC ignored. The LLC sought to quash the summons because the IRS is barred from issuing a summons with respect to any person if a Justice Department criminal referral is in effect. In this case, the LLC argued, the existing criminal referral for its sole agent should be treated as a referral for the LLC as well. The court denied the taxpayer’s request and allowed the IRS to enforce the summons. After the initial court ruling, the LLC’s sole agent was indicted, and the LLC appealed the original ruling. The appeals court upheld the trial court’s decision because it determined that a business entity is a distinct person from its agents.⁴⁹ Since the LLC itself did not have a criminal referral in effect, the LLC was required to comply with the IRS summons.

In a related case,⁵⁰ a group of appraisers filed a suit against the IRS, seeking to challenge the IRS’s increased scrutiny of syndicated conservation easement transactions as tax schemes. Unfortunately for the appraisers, the court dismissed their case because the summons was not served in a timely manner. It should be interesting to see if other parties attempt to sue the IRS on this matter in the future. It appears that the charitable contribution deduction of conservation easements will be an issue that taxpayers and the IRS will be litigating for the foreseeable future.

However, in late 2022, the Tax Court held that Notice 2017-10, which is the notice that identifies syndicated conservation easement transactions as listed transactions, is invalid because the IRS issued it without following the notice-and-comment procedures required by the Administrative Procedure Act.⁵¹ In response, the IRS issued proposed regulations in December identifying certain syndicated conservation easement transactions as listed transactions.⁵²

Other charitable contributions

Beyond conservation easements, other types of charitable contribution deductions have led to disputes as well. In Keefer,⁵³ for instance, the taxpayers purported to assign a partial interest in a partnership that held hotel property to a foundation, the purpose of which was to establish a donor-advised fund. At the time of the assignment, the sale of the hotel was pending. The taxpayers took a charitable contribution deduction on their personal tax return for the assignment. On audit, the IRS disallowed the deduction because the taxpayers did not have a contemporaneous written acknowledgment from the charitable organization showing that the donor-advised fund had exclusive legal control over the assets contributed and the appraisal did not include the appraiser’s identifying number.

The district court agreed with the IRS because the donation was an anticipatory assignment of income. The court noted that it was not the pending sale of the hotel itself that created the assignment of income. Rather, the assignment of income arose because the assignment agreement carved out a portion of the partnership interest before it was donated. In addition, the taxpayers’ deduction failed under Sec. 170(f) because the taxpayers did not obtain a contemporaneous written acknowledgment of the contribution. Although they subsequently obtained a letter properly acknowledging the donation, the letter did not state that the foundation had exclusive legal control of the contributed assets, as is required in Sec. 170(f)(18)(B).

Losses allowed

Other recent litigation has concerned deductions for losses, including whether a partner had adequate basis in the partnership interest to take the loss. Sec. 704(d) allows a taxpayer to deduct losses from a partnership interest as long as the taxpayer has basis in the interest. Any losses in excess of basis are disallowed and carried forward until the partner’s basis is restored.

In a case54 where the taxpayers deducted losses from both the husband’s and the wife’s partnership interests, the IRS disallowed the losses for the wife’s interest because she could not document either a loan or capital contribution she supposedly made to the partnership. The couple claimed that the wife had loaned $200,000 to the partnership. The partnership included the loan on its balance sheet, but the liability was not allocated to any of the partners on the Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc. The only documentation the couple produced to substantiate the loan was a promissory note bearing someone else’s name. The capital contribution documentation also indicated that the contribution came from a different source than the wife. Thus, the court ruled that the wife did not have adequate basis to deduct the loss.

However, it was not a total win for the IRS. The IRS tried to disallow a loss for an additional year by raising as an issue for the first time at trial of the partnership’s opening tax-basis capital account balances that were reported for that year. The court rejected the Service’s attempt to raise the issue as untimely and outside the jurisdiction of the case. The court also noted that even if the issue had been raised timely, the IRS’s argument failed on the merits, as it was predicated on the apparent conflation of a partner’s tax-basis capital account with a partner’s outside basis in a partnership.

Likewise, in Kohout,⁵⁵ married taxpayers engaged in medical funding and real estate business ventures through the husband’s wholly owned S corporation. The S corporation in turn owned 99% of another medical funding business operated as a partnership. The partnership generated losses that were allocated to the S corporation and then to the taxpayer. The taxpayers deducted the losses on their personal tax return. The IRS disallowed the loss deduction because the taxpayers could not document that either the S corporation or the husband, who owned the other 1% of the partnership individually, had sufficient basis in their partnership interest to deduct their pro rata share of the partnership’s loss.

The Tax Court agreed with the IRS. It found that while the S corporation had made contributions to the partnership, based on the record, they were less than the amount claimed by the taxpayers and less than the distributions the partnership made to the S corporation. In addition, no credible evidence in the record showed that the husband had made any contributions to the partnership.

Sec. 754 elections

There have been some recent IRS rulings on elections under Sec. 754 to adjust the basis of partnership property. When a partnership distributes property or a partner transfers his or her interest, the partnership can make a Sec. 754 election. The 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.

In Chief Counsel Advice (CCA) 202240017, the taxpayer made intercompany transfers of interests in tiered partnerships among members of the taxpayer’s consolidated group and did not report any gain on the transactions. As a result of these intercompany transfers, the partnerships adjusted the basis in their respective assets allocable to the transferred interests under Sec. 743(b). The adjustments allowed the taxpayer group to claim increased depreciation and amortization deductions, which significantly reduced its taxable income. In the CCA, the IRS focused on how the Regs. Sec. 1.1502-13 rules applied to the increased deductions the group took on its consolidated tax return.

In this situation, the IRS concluded that Regs. Sec. 1.1502-13 redetermines the taxpayer’s increased deductions to be noncapital, nondeductible amounts. This redetermination is required by the fundamental purpose of Regs. Sec. 1.1502-13: “to clearly reflect the income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (or consolidated tax liability).”56 Thus, the partnerships could not claim increased deductions for depreciation and amortization attributable to the Sec. 743(b) adjustments.

Extensions of time to make the election

A partnership must file the Sec. 754 election by the due date of the return for the year the election is effective, normally with the return. Currently, if a partnership inadvertently fails to file the election, the only way to remedy the failure is to ask for relief under Regs. Secs. 301.9100-1 and 301.9100-3, 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.

In several letter rulings during this period,⁵⁷ 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 301.9100-3. 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.⁵⁸ In most cases, the missed election occurred when a new partner purchases a partnership interest. However, in one situation, the partnership failed to make the election after it had made a liquidating distribution to a partner.⁵⁹

In two situations during 2022, a partnership failed to make the proper election. In the first situation,⁶⁰ one of the owners of an upper-tier partnership (UTP) died. The UTP made the proper Sec. 754 election; however, the lower-tier partnership (LTP) did not. The Service granted the LTP an extension to file the election.

The second situation⁶¹ dealt with a multistep transaction. In this instance, the taxpayer formed an LLC that was classified for federal income tax purposes as a partnership. Afterward, other entities contributed assets to one of the owners of the LLC, which caused the owner to become a partnership for federal income tax purposes. Later, the new members of the partnership sold part of their partnership interests to the other owner of the LLC and had the rest of their interest in the partnership redeemed. The purchase agreement required the partnership to make a Sec. 754 election; however, the partnership failed to make the election. As with the other situations during 2022, the IRS granted the partnership an extension to file the election.

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. 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.⁶²

Extensions of time for other elections

There have also been recent letter rulings on requests to extend the time to make other types of elections, including entity elections and qualified opportunity fund elections.

Entity election

Foreign entities formed as LLCs that want to be taxed as a partnership in the United States must make an election on Form 8832, Entity Classification Election. Without this election, this type of entity defaults to a corporation. In several instances recently, a foreign entity failed to make the election in a timely manner. In each of these instances,⁶³ the IRS allowed the entity 120 days after the ruling to file the election.

In a different situation,⁶⁴ the taxpayer was formed as an LLC and thought it had filed a valid election to be treated as an S corporation. Soon after the election was made, the taxpayer was advised it would be better to be treated as a partnership, so the taxpayer took the steps to change its classification. Later, however, the taxpayer found out that the election to change its initial classification had not been filed timely. The taxpayer had always filed a Form 1065, and its owners had treated the entity as a partnership instead of as an S corporation. The IRS allowed the entity 120 days to file a late entity classification election to be treated as a partnership.

Qualified opportunity funds

Partnerships that qualify as qualified opportunity funds under Sec. 1400Z-2 must also file an election to self-certify their assets using Form 8996, Qualified Opportunity Fund. A number of partnerships missed the deadline for the election during 2022. However, how the IRS handled the missed election depended on how the partnership reported the election. For example, in several situations,⁶⁵ the partnership’s accountant filed a Form 1065 along with the Form 8996 after the due date of the tax return. The IRS accepted the tax return and determined the election was timely filed. In other instances,⁶⁶ the partnership filed Form 1065 timely but failed to include Form 8996. In this situation, the IRS granted the partnership 60 days to file either an amended tax return or Administrative Adjustment Request to make the election. In the last factual variation, partnerships did not file either a Form 1065 or Form 8996⁶⁷ and requested additional time to file the election. In this instance, the partnerships were granted only 45 days after the ruling to file the election.

Footnotes

¹Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248.

²Bipartisan Budget Act of 2015, P.L. 114-74.

³Tax Technical Corrections Act, Title II, Division U, of the Consolidated Appropriations Act of 2018, P.L. 115-141.

⁴Rocky Branch Timberlands, LLC, No. 1:21-cv-2605-MLB (N.D. Ga. 6/21/22).

⁵Baxter, No. H-09-1271 (S.D. Tex. 3/17/21), rev’d, No. 21-20258 (5th Cir. 8/31/22). AMCOR offered loss-generating structures for investors that the IRS began investigating in the 1980s, giving rise to extensive litigation. See, e.g., Keener, 76 Fed. Cl. 455 (2007), and Foster, No. A-06-CA-818-SS (W.D. Tex. 6/19/18), aff’d, 801 Fed. Appx. 210 (5th Cir. 2020).

⁶Baxter, No. 21-20258 (5th Cir. 8/31/22).

⁷SNJ Ltd., 28 F.4th 936 (9th Cir. 2022), aff’g Stevens, T.C. Memo. 2020-118.

⁸Stevens, T.C. Memo. 2020-118.

⁹Gluck, T.C. Memo. 2020-66.

¹⁰Gluck, No. 21-867 (2d Cir. 3/17/22).

¹¹Warner Enterprises, Inc., T.C. Memo. 2022-85.

¹²Excelsior Aggregates, LLC, T.C. Memo. 2021-125.

¹³See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935).

¹⁴Including under Secs. 6662(b)(6) and 7701(o), as enacted by §1409 of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152.

¹⁵Kearney Partners Fund, LLC, No. 2:10-cv-153-FtM-37CM (M.D. Fla. 3/6/14), aff’d, 803 F.3d 1280 (11th Cir. 2015).

¹⁶Id.

¹⁷Sarma, T.C. Memo. 2018-201.

¹⁸Sarma, 45 F.4th 1312 (11th Cir. 2022).

¹⁹Cross Refined Coal, LLC, No. 20-1015 (D.C. Cir. 8/5/22).

²⁰By the Energy Improvement and Extension Act of 2008, P.L. 110-343, which repealed a requirement that the taxpayer’s sale price of refined coal be at least 50% more than the market value of unrefined coal.

²¹Cross Refined Coal, LLC, No. 19502-17 (bench opinion, decision entered, Tax Ct. 10/16/19).

²²Deitch, T.C. Memo. 2022-86.

²³Clark Raymond & Co., T.C. Memo. 2022-105.

²⁴Musselwhite, T.C. Memo. 2022-57.

²⁵REG-104390-18.

²⁶T.D. 9866.

²⁷REG-101828-19.

²⁸T.D. 9902.

²⁹T.D. 9960.

³⁰Enhancing American Retirement Now Act, S. 4808.

³¹Regs. Sec. 1.170A-14(g)(6)(i).

³²Oakbrook Land Holdings, LLC, 154 T.C. 180 (2020).

³³Oakbrook Land Holdings, LLC, 28 F.4th 700 (6th Cir. 2022).

³⁴Corning Place Ohio, T.C. Memo. 2022-12.

³⁵Carroll, 146 T.C. 196 (2016).

³⁶Morgan Run Partners, LLC, T.C. Memo. 2022-61.

³⁷901 South Broadway Limited, T.C. Memo. 2021-132.

³⁸Glade Creek Partners, LLC, T.C. Memo. 2020-148.

³⁹Glade Creek Partners, LLC, No. 21-11251 (11th Cir. 8/22/22).

⁴⁰Hewitt, 21 F.4th 1336 (11th Cir. 2021).

⁴¹Carter, T.C. Memo. 2020-21.

⁴²Carter, No. 20-12201 (11th Cir. 9/14/2022).

⁴³Pine Mountain Preserve, LLLP, 978 F.3d 1200 (11th Cir. 2020).

⁴⁴Kroner, No. 20-13902 (11th Cir. 9/13/22).

⁴⁵Pickens Decorative Stone, LLC, T.C. Memo. 2022-22.

⁴⁶Department of Justice Press Release 22-178.

⁴⁷Department of Justice Press Release 22-905.

⁴⁸Equity Investments Associates, LLC, No. 3:21-CV-170-GCM (W.D.N.C. 8/16/21).

⁴⁹Equity Investments Associates, LLC, 40 F.4th 156 (4th Cir. 2022).

⁵⁰Benson, No. 2:21-CV-74-SCJ (N.D. Ga. 6/6/22).

⁵¹Green Valley Investors, LLC, 159 T.C. No. 5 (2022).

⁵²REG-106134-22.

⁵³Keefer, No. 3:20-CV-836-B (N.D. Texas 7/6/22).

⁵⁴Genecure, LLC, T.C. Memo. 2022-52.

⁵⁵Kohout, T.C. Memo. 2022-37.

⁵⁶Regs. Sec. 1.1502-13(a)(1).

⁵⁷IRS Letter Rulings 202215008, 202216007, and 202219010.

⁵⁸E.g., IRS Letter Rulings 202150011 and 202222002.

⁵⁹IRS Letter Ruling 202201004.

⁶⁰IRS Letter Ruling 202219004.

⁶¹IRS Letter Ruling 202144016.

⁶²E.g., IRS Letter Rulings 202147007, 202211003, 202215001, and 202220004.

⁶³E.g., IRS Letter Rulings 202145001, 202152008, 202210003, and 202236001.

⁶⁴IRS Letter Ruling 202219003.

⁶⁵E.g., IRS Letter Rulings 202149003, 202151003, 202213007, and 202239001.

⁶⁶E.g., IRS Letter Rulings 202205020 and 202209009.

⁶⁷E.g., IRS Letter Rulings 202144010, 202203007, and 202233011.