Current developments in partners and partnerships

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

February 1, 2024

IMAGE BY EUGENE MYMRIN/GETTY IMAGES

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Partnership & LLC Taxation

This annual update surveys recent federal tax developments involving partnerships. The discussion covers notable law changes, IRS rulings, and court decisions during the one-year period ending October 2023.

Among the items in this update are final regulations clarifying aspects of the centralized partnership audit regime, guidance on transfers of interests in foreign partnerships, and various court and IRS rulings that addressed deductions for charitable contributions of conservation easements, as well as partnership transactions, allocations, and elections.

Audit issues

In December 2022, Treasury issued final regulations regarding the centralized audit regime.¹ Before discussing these regulations, some background may be helpful. In 2015, Congress sought to streamline the audit process for large partnerships by enacting Section 1101 of the Bipartisan Budget Act (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 replace the unified audit rules as well as the electing large partnership regime of the Tax Equity and Fiscal Responsibility Act (TEFRA).³ In 2018, Congress enacted the Tax Technical Corrections Act (TTCA),⁴ which made a number of technical corrections to the rules under the BBA’s 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.

In Treasury’s December 2022 final regulations related to BBA audits, the most significant change concerns Sec. 6241(11), under which Treasury can issue regulations related to “special enforcement matters.” This allows Treasury to prescribe special rules or provide exclusions from the general centralized regime. Under the regulations, one such exclusion applies when (1) a person other than the partnership is under examination; (2) the IRS proposes an adjustment to an item that is not a partnership-related item; and (3) that adjustment would require an adjustment to a partnership-related item. Under the final regulations, a partnership and other partners are not bound to any determination made regarding a partnership-related item resulting from a partner-level proceeding to which they are not a party. In addition, the regulations clarify the conditions that must be met for the IRS to adjust partnership-related items outside the centralized partnership audit regime.

Under the regulations, “if a positive adjustment to an item is related to, or results from, a positive adjustment to another item, one of the positive adjustments will generally be treated as zero solely for purposes of calculating any imputed underpayment.” This change should allow partnerships to resolve problems that may arise when an imputed payment is imposed in a different year than the year audited, especially because partnerships can also request that the IRS modify an imputed underpayment so that it more closely approximates the amount of tax that would have been due had the partnership item been properly reported in the year under audit.

In a related matter, a 2023 U.S. Government Accountability Office study⁵ recommended strengthening audit processes for large partnerships. The study found that the number of large partnerships increased almost 600% from 2002 to 2019. Of the 20,000 large partnership returns filed in 2019, only 54 were audited, for a 0.3% audit rate. This rate is a decrease from 2007, when the audit rate was 1.4%. Eighty percent of the large partnership audits from 2010 through 2018 resulted in no change, twice as high as the no-change rate for large corporate audits. The average adjustment was negative $264,000, compared to $4.5 million for large corporate audits. A possible explanation for the differences in the results is the complexity of Subchapter K and the limited in-house knowledge of partnership tax law in the IRS. Relatedly, the Service has announced that it will be auditing a larger percentage of partnership returns in the future.

Court decisions under TEFRA

Even with the adoption of the BBA audit rules eight years ago, cases are still being litigated involving TEFRA issues. Most remaining TEFRA cases revolve around either a statute of limitation or whether the income or deduction is a partnership item. In the period covered by this article, several TEFRA cases dealt with a statute-of-limitation issue, while others involved partnership items, penalties assessed during the TEFRA audit, and other matters.

Statute-of-limitation issues

In Seaview Trading LLC,⁶ the issue involved whether the limitation period was open-ended because the taxpayer had failed to file a return. The IRS notified the taxpayer before the statute of limitation ended that it had no record of a tax return being filed. The taxpayer claimed to have filed the return, so the IRS agent asked the LLC to send him a copy of the return as well as proof of the original mailing. The LLC originally claimed that it mailed tax returns for two related entities in the same envelope, but it could not prove that the IRS received both returns. It also mailed a copy of the return to an IRS attorney’s office.

The IRS issued a final partnership administrative adjustment (FPAA) based on the audit of the return for the year in question two years after the normal statute of limitation would have ended. The LLC argued that the FPAA was improperly issued after the statute of limitation expired. The IRS countered that there was an open-ended limitation period because no return had been filed.

The Tax Court agreed with the IRS. The LLC appealed in the period covered by this update. The Ninth Circuit, sitting en banc, agreed with the Tax Court that the issuance of the FPAA was not time-barred because neither the copy faxed to the IRS agent nor the copy mailed to the IRS attorney complied with the place-for-filing requirement. Also, neither method of submission qualified as a “filing” of the partnership’s return. The court further noted that the place-for-filing requirement is for all returns, even those that are filed late.

The IRS lost a statute-of-limitation case in American Milling LP.⁷ That litigation involved tiered TEFRA partnerships and tax shelter transactions. The question the Tax Court had to answer was whether the statute of limitation on assessments had expired for the owner of an upper-tier partnership (UTP), who was thus an indirect owner of the lower-tier partnership (LTP), when the FPAA for the LTP was issued. The IRS argued that former Sec. 6229(e)(2)(A)’s “unidentified partner” provision applied to an indirect partner, holding open the limitation period. The Tax Court disagreed, saying that for the indirect-partner rules to apply, the items in question had to be affected items that would need to be determined at the partner level, not at the partnership-level proceeding. Here, it was already decided that adjustments in the FPAA were partnership items of the LTP, not merely affected items flowing from the LTP to the UTP to the indirect partner.

In another case involving a limitation period, Goldberg,⁸ the IRS assessed the taxpayer tax on items from his two partnerships. He contested the assessment because he claimed that the statute of limitation had expired. The Tax Court upheld the IRS’s determination to levy the tax. Because the tax adjustments that were made on the partnership returns were related to partnership items, any statute-of-limitation objection would need to have been made at the partnership level, not the partner level.

The taxpayer did not make any objections at the partnership level. However, he claimed that he had been unable to participate in the partnership-level proceedings because the IRS did not send adequate notice when it started the partnership audit. The Tax Court found, however, that the IRS did send FPAAs when the partnership proceedings were still ongoing and that the taxpayer was provided with certain remedies that he did not pursue. The Seventh Circuit affirmed the Tax Court’s decision because the taxpayer had received notice and had a prior opportunity to contest the partnership tax assessment but did not do so.

Other issues in TEFRA cases

In Keene-Stevens,⁹ the taxpayers did not file an individual return for a number of years. Because of large losses allocated to them from partnerships they owned, the Tax Court concluded that the taxpayers owed no deficiencies or penalties for those years because the partnership losses claimed for those years exceeded the IRS’s adjusted nonpartnership deficiencies.

Disagreeing, the Ninth Circuit ruled that the unsigned, unfiled tax returns on which the partnership losses were reported were legally invalid because they had not been filed and therefore could not be used to offset nonpartnership income in an individual deficiency proceeding. Accordingly, the appellate court reversed the Tax Court’s deficiency determinations for those years and remanded the case to the Tax Court with instructions to determine the taxpayers’ deficiencies without regard to any partnership losses claimed on the legally invalid tax returns.

Another unusual situation occurred in AD Global Fund, LLC,¹⁰ a case that had been pending for approximately 19½ years in the Court of Federal Claims and had been stayed for 16 years awaiting the outcome of a parallel Tax Court partner-level case. In the period covered by this update, the Court of Federal Claims dismissed the case over the opposition of the taxpayer, who wanted to continue to litigate the effect of an FPAA on Sec. 6501(a). Previously, the parties had said that further proceedings in the Court of Federal Claims would be necessary only if the Tax Court ruled in favor of the taxpayers. The Tax Court ultimately ruled against the taxpayers in 2018, two appellate courts affirmed, and the Supreme Court refused to hear the case. The Court of Federal Claims determined that the issue in question had been resolved, and the taxpayer did not establish any valid reason to continue the case.

In Estate of Keeter,¹¹the IRS issued deficiency notices to bond-linked issue premium structure (BLIPS) tax shelter partners that adjusted losses they reported from sales of stock and euros they had received from a TEFRA partnership. The taxpayers argued that, instead of using the deficiency procedures, the IRS should have used abbreviated procedures for the computational adjustments. However, the Tax Court found that the record showed that the IRS was required to make partner-level determinations to adjust the taxpayers’ reported losses and related itemized deductions. Thus, the deficiency procedures were held to have been proper.

The partner-level determinations were needed to establish several issues including (1) whether the stock and the euros received from the partnership were the same ones the taxpayers later sold; (2) the taxpayers’ adjusted bases in those assets; (3) the taxpayers’ holding periods; and (4) the character of the gain or loss on the sale of the stock. The adjustments to the itemized deductions depended on the same partner-level determinations as for the stock and euros. The Eleventh Circuit agreed with the Tax Court and affirmed its decision.

In Rocky Branch Timberlands, LLC,¹² an LLC filed a complaint seeking injunctive and declaratory relief after the IRS issued an FPAA that disallowed a charitable deduction for a conservation easement. The district court dismissed the case because the relief the taxpayer sought was barred by the Anti-Injunction Act (AIA) and the tax exception to the Declaratory Judgment Act.

The Eleventh Circuit agreed with the district court, determining that the AIA clearly applied because the FPAA disallowed a stated deduction that resulted in the underpayment of taxes, which the IRS would not be able to collect if the relief the LLC requested were granted. The court also noted that the AIA’s equitable exception did not apply because the LLC had another adequate remedy (i.e., Tax Court), and no showing had been made that the IRS could not prevail on the merits of the case.

Definition of publicly traded partnership

During this article’s update period, an IRS letter ruling¹³ addressed the use of a qualified matching service to trade limited partnership interests. As background, Sec. 761 defines a partnership as an entity that includes a syndicate, group, pool, joint venture, or other unincorporated organization that is used to carry on any business, financial operation, or venture and that is not by definition a corporation or a trust or estate. Sec. 7704(b) defines a publicly traded partnership (PTP) as any partnership where the interests are traded on an established securities market or on a secondary market (or substantial equivalent). Regs. Sec. 1.7704-1 states that interests in a partnership will not be treated as readily tradable on a secondary market or the substantial equivalent thereof unless (1) the partnership participated in the establishment of the market or the inclusion of its interests thereon, or (2) the partnership recognized transfers made on that market.

Letter Ruling 202339002 specifically addressed whether a bulletin board operated by an LLC would be an established market. More specifically, the LLC, through a subsidiary, would provide a venue for buying and selling limited partnership interests through a bulletin board that was intended to satisfy the requirements under Regs. Sec. 1.7704-1(g) to be a qualified matching service. The bulletin board would not be a national securities exchange, a foreign securities exchange, or an interdealer quotation system that regularly disseminates firm buy or sell quotations by identified brokers or dealers by electronic means or otherwise. The taxpayer noted that the bulletin board would be an online platform that would be accessible only by clients of the LLC and its subsidiaries, who also were either accredited investors, qualified purchasers, or both. The bulletin board would not be accessible by members of the general public.

The IRS determined that the bulletin board was not an established securities market under Regs. Sec. 1.7704-1(b) but that it did meet the requirements to be a qualified matching service under Regs. Sec. 1.7704-1(g).

Partnership’s election to use different tax year

In an IRS letter ruling¹⁴ issued during this article’s period, an LLC classified as a partnership sought relief from a failure to follow the correct procedure in making an election regarding its tax year.

Under Sec. 706(b)(1)(B)(i), a partnership’s required tax year is its “majority interest tax year,” unless the taxpayer elects under Sec. 444 to use a tax year other than its required tax year. Regs. Sec. 1.706-1(b)(7) provides that a newly formed partnership may adopt, in accordance with Regs. Sec. 1.441-1(c), its required tax year or a tax year elected under Sec. 444 without the consent of the IRS. Sec. 444(a) provides that, except as otherwise provided in Sec. 444, a partnership may elect to have a tax year other than its required tax year.

Secs. 444(b)(1) and (2) provide that an election under Sec. 444(a) may be made only if the deferral period of the tax year elected is not longer than the shorter of three months or the deferral period of the tax year being changed. Temp. Regs. Sec. 1.444-3T(b)(1) provides that Form 8716, Election to Have a Tax Year Other Than a Required Tax Year, must be filed by the earlier of (1) the 15thday of the fifth month following the month that includes the first day of the tax year for which the election will first be effective, or (2) the due date (without regard to extensions) of the tax return.

In Letter Ruling 202321001, the LLC intended to adopt a tax year that met the requirements under Sec. 444. The taxpayer informed its tax adviser of this intention and provided instructions to file the LLC’s return with this tax year. The adviser was not aware of the need to file Form 8716 or Form 8752, Required Payment or Refund Under Section 7519, to effectuate a tax return year end other than the required tax year and thus did not file either form. The taxpayer timely filed its Form 1065, U.S. Return of Partnership Income, on a year end consistent with its intent, and the members reported the income/loss on their individual tax returns consistently. The taxpayer also timely filed Form 8752 for Year 2 and Year 3 and was current with the required payments under Sec. 7519. The taxpayer did not file the Form 8752 for Year 1.

The taxpayer received a letter from the IRS notifying it that the Service did not have a record of the Form 8716 being filed and therefore could not process the Form 8752 for Year 2. When the taxpayer asked the adviser why the form was rejected by the IRS, the adviser reviewed records and determined that Form 8716 and Form 8752 for Year 1 had not been filed. The taxpayer responded to the IRS that the adviser had failed to file Form 8716 and asked for an extension of time to file Forms 8716 and 8752 for Year 1. The IRS found the LLC had acted reasonably and in good faith and granted the LLC a 60-day extension from the date of the letter ruling to file Forms 8716 and 8752.

Partner’s income

Partnerships are not subject to federal income tax under Sec. 701. After items of income and expense are determined at the partnership level, each partner is required to take into account separately in the partner’s return a distributive share, whether or not distributed, of each class or item of partnership income, gain, loss, deduction, or credit under Sec. 702.

Income included on partner’s return

In Skolnick,¹⁵ the taxpayers owned a partnership with between seven and 10 employees operating a horse farm that bought, sold, bred, and raced horses. When the taxpayers deducted losses on their tax returns, the IRS disallowed the deductions under Sec. 183, determining that the partnership’s horse-related activity was not engaged in for profit.

Factors showing lack of profit objective included that (1) the activity had a substantial history of losses; (2) the records kept by the taxpayers were inaccurate; (3) the partnership lacked a business plan for the years at issue; (4) the partnership paid for personal expenses; and (5) the taxpayers had significant income from other sources. The taxpayers argued that the losses arose because of adverse market conditions and changes in breeder award requirements. The Tax Court did not find any of the taxpayers’ arguments persuasive and held the activity was not engaged in for profit. The Third Circuit affirmed the Tax Court’s decision.

In Keeton,¹⁶ the taxpayers owned an interest in both an LLC and a C corporation. During the years in question, the taxpayers deducted a loss from the partnership that was related to their allocable share of a business bad debt deduction claimed by the LLC for unrepaid advances it made to the C corporation. The IRS disallowed the loss because it determined that the advances were not a loan but instead additional capital contributions.

The evidence the IRS used to make this determination included the fact that all loans that the taxpayers extended to the C corporation directly or through the LLC were canceled via a unanimous consent resolution and converted to equity. Additional evidence included that the LLC’s advances were captioned “investment” in its records and not reflected in any debt instrument.

The taxpayers argued that because the LLC was not a shareholder of the C corporation, any loan from the LLC to the C corporation was not canceled by the unanimous consent resolution. They also argued that the advances were a working line of credit. The Tax Court did not find the taxpayers’ arguments to be convincing and ruled that the taxpayers were not entitled to the passthrough loss for the business bad debt.

Foreign partnerships

In 2020, Treasury issued final regulations¹⁷ relating to withholding on the transfer of an interest in a PTP under Sec. 1446(f). More recently, the IRS provided additional guidance on this subject in Notice 2023-8.

Understanding the notice requires some background. The 2020 final regulations included withholding requirements under Sec. 1446(f)(1) that generally require a broker that effects a transfer of a PTP interest on behalf of a transferor to withhold on the payment made to the transferor. However, a broker is not required to withhold, or may withhold at a reduced rate, if it can rely on:

A certification from the transferor that claims an exception or reduction to withholding (generally provided on a valid Form W-8¹⁸ or W-9, Request for Taxpayer Identification Number and Certification); or
A representation made by the PTP on a qualified notice indicating that the exception under Regs. Sec. 1.1446(f)-4(b)(3)(ii) applies (10% exception).

A broker is also not required to withhold when it makes the payment of an amount realized to a qualified intermediary, or a U.S. branch treated as a U.S. person, that assumes primary withholding responsibility under Sec. 1446(f)(1).

Notice 2023-8 provides additional guidance for brokers to comply with the provisions of the final regulations under Sec. 1446(f). According to the notice, Treasury and the IRS intend to issue proposed regulations that would amend the final regulations to implement this additional guidance. The proposed regulations would apply to a transfer or distributions made on or after Jan. 1, 2023.

As discussed in the notice, Treasury and the IRS have concluded that the burden on brokers to determine whether a foreign entity that trades on a foreign market is a PTP for U.S. tax purposes would likely be disproportionate to the amount of gain subject to Sec. 864(c)(8) on transfers of interests in such entities. They intend to issue proposed regulations that would amend the final regulations to provide withholding relief to brokers on the sale of an interest in an entity that is organized outside the United States and that trades solely on a foreign established securities market or foreign secondary market (foreign-traded entity).

This proposed amendment would allow a broker that effects a sale of an interest in a foreign-traded entity to presume that the entity is not a PTP for U.S. tax purposes unless the broker has actual knowledge otherwise. However, because it would be inappropriate to allow a broker that knows that a foreign-traded entity is a PTP for U.S. tax purposes to presume that the PTP does not have effectively connected income, Treasury and the IRS do not intend to include such a presumption in the proposed regulations.

Under the 2020 final regulations, a broker may rely on a certification from a transferor that claims an exception or reduction to withholding. However, a broker generally may not rely on a certification if it is received earlier than 30 days before a transfer or at any time after a transfer. Taxpayers and other stakeholders have requested an allowance for brokers to rely on late certifications that claim an exception or reduction to withholding on the transfer of a PTP interest. According to the notice, Treasury and the IRS have determined that it is appropriate to allow brokers to rely on late certifications for purposes of withholding under Sec. 1446(f) in order to reduce overwithholding and claims for refund and to better coordinate with the documentation rules under Secs. 1441 and 1471.

Deductions for charitable contributions of conservation easements

The IRS has been auditing a number of tax returns of partnerships that took a deduction for a conservation easement through a tax shelter.¹⁹ These cases usually involve one or more of three issues: (1) the purpose of the contribution must be protected in perpetuity under Sec. 170(h)(5); (2) basis of the contributed property must be substantiated under Sec. 170(f)(11); or (3) before the Service assesses a penalty, its individual initially determining the penalty must first obtain written supervisory approval under Sec. 6751(b).

Easement must be protected in perpetuity

In two cases, the IRS disallowed a conservation easement deduction because it believed the contribution did not meet the protected-in-perpetuity requirement. In Cattail Holdings, LLC,²⁰ the LLC granted an open-space conservation easement for land the LLC owned. The easement deed stated that its interpretation was governed by state law and noted that the taxpayer intended for the land to “be retained forever in its undeveloped, natural, scenic, farm land, forested and/or open land condition.” The deed generally prohibited commercial, industrial, or residential development. But it reserved certain rights for the LLC, including rights to engage in forestry and recreational activities and to build structures for the recreational activities.

The IRS determined that because of certain other rights given to the LLC in the deed, the contribution did not meet the requirements of Sec. 170(h)(5) and disallowed the deduction. The IRS came to this conclusion because the deed gave the LLC a contingent right to engage in surface mining in violation of Sec. 170(h)(5)(B)(i).

The Tax Court disagreed with the IRS’s interpretation of the deed, stating it did not retain to the LLC any qualified mineral interest or right to engage in any mining-related activity. The court therefore denied the IRS’s motion for summary judgment on this issue. The LLC also asserted that the IRS agent had not obtained written permission for the penalties assessed before the FPAA was issued. However, the court determined the IRS had followed the rules of Sec. 6751(b) and granted the IRS’s motion for summary judgment on this issue.

In North Donald LA Property LLC,²¹ the LLC granted a conservation easement to a land conservancy. The IRS again denied the deduction because the easement did not meet the protected-in-perpetuity requirement. The Service contended that the grant included a limited warranty deed that allowed the former owners to retain the right to mine surface clay, violating Sec. 170(h)(5).

The taxpayer argued that the former owners intended to transfer all rights to access and exploit the clay on the land and reserved rights to only 75% of subsurface liquid and gaseous minerals. The Tax Court denied the IRS’s motion for summary judgment on this issue, noting that the former owners executed a quitclaim deed amending the easement deed and relinquishing any rights in surface minerals located on the land, including clay. However, as in Cattail Holdings, the court agreed with the IRS that its assertion of accuracy-related penalties satisfied Sec. 6751(b) and granted the IRS summary judgment on that issue.

The Tax Court in 2023 reheard a remanded 2020 case in which an LLC donated a conservation easement for which it took a charitable contribution deduction. 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 IRS disallowed the charitable contribution deduction because of the way the conservation easement deed handled the possibility of any future extinguishment proceeds. In 2020, the Tax Court agreed with the IRS,²² finding that the deed failed to specify that the easement donee would receive a share of extinguishment proceeds equal to the amount provided under Regs. Sec. 1.170A-14(g)(6)(ii)²³ and thus did not satisfy the protected-in-perpetuity requirement of Sec. 170(h)(5).

The LLC appealed the Tax Court’s decision that it improperly took the charitable contribution deduction.²⁴ The Eleventh Circuit vacated the Tax Court’s holding and remanded the case for reconsideration without relying on the regulation because in a prior case,²⁵ the Eleventh Circuit had invalidated the regulation, concluding that the IRS’s interpretation of it was arbitrary and capricious and violated the Administrative Procedure Act’s (APA’s) requirements.

On remand, the Tax Court determined that the LLC would be allowed a deduction for the conservation easement.²⁶ However, the amount of the deduction did not equal the easement’s fair market value (FMV) as the LLC claimed but, rather, was limited to the LLC’s adjusted basis in the property because the property was inventory, not investment property, in the hands of the LLC. The classification as inventory was supported by the fact that the S corporation that formed the LLC to hold the easement property had reported the contribution on its tax return as reducing its inventory. Although the S corporation’s reporting of the asset’s character was not binding on the LLC, the LLC otherwise did not present convincing evidence that it held the property as an investment, the Tax Court stated.

Substantiation requirements

The second issue identified above, substantiation of basis, arose in at least one conservation easement case concerning whether the taxpayer’s appraisal and documentation met the requirements of Sec. 170(f)(11). In Murfam Enterprises LLC,²⁷ a partnership had been granted the right by the state to conduct hog farming activities on land it owned. Instead, it donated a conservation easement on the land to a qualifying charity. The partnership relied on a professional appraisal when taking the deduction. The appraiser valued the land on the basis of the forgone value of the hog farming rights that were rendered useless by the easement. In addition, the partnership did not report its basis in the land.

The IRS determined the deduction should be reduced but not totally disallowed because the land should be valued based on its use as timberland, without any value for the hog farming rights. The original FPAA did not assert any penalties and did not claim that the deduction should be denied for failure to comply with the substantiation and reporting requirements for charitable contribution deductions under Sec. 170(f)(11). However, in its amended answer to the partnership’s petition in Tax Court, the IRS asserted accuracy-related penalties and argued that the deduction should be entirely disallowed for failure to comply with the Sec. 170(f)(11) substantiation requirements.

Because the IRS had raised the substantiation issue as a “new matter,” the Tax Court held that it had the burden of proof to show the absence of reasonable cause and did not meet this burden. While the court found that the partnership had failed to comply with the substantiation and reporting requirements, the failure was due to reasonable cause. Therefore, the court allowed the partnership a deduction. The court, however, also held that the deduction should be reduced slightly to more accurately reflect the forgone value of the hog farming rights.

Supervisory written approval of penalties

The third issue discussed here relates to whether the IRS followed required procedure for penalties it asserted in a number of conservation easement cases. Under Sec. 6751(b)(1), an IRS agent must have written supervisory approval before any penalties can be assessed. Besides Cattail Holdings, LLC, and North Donald LA Property LLC, discussed previously, the Tax Court addressed this rule in several other cases. In Nassau River Stone, LLC,²⁸ the IRS revenue agent determined that the deduction for a conservation easement should be disallowed and that an accuracy-related penalty should be assessed. The agent emailed his supervisor to obtain permission for assessing the penalty. The supervisor then emailed back with her approval. After receiving her approval, the agent sent a report to the LLC explaining his proposed adjustments and penalty recommendations. The information was also sent to the IRS Office of Chief Counsel for review, where a senior counsel recommended that the revenue agent also assert a civil fraud penalty. An associate area counsel who was the senior counsel’s manager approved her determination. Once the agent received the recommendation from the Office of Chief Counsel, he prepared the FPAA and mailed it to the LLC.

The LLC filed suit with the Tax Court because it disagreed with the disallowance of the deduction. In the filing, it also questioned the assessment of the penalties, arguing that the revenue agent and the Office of Chief Counsel did not make the initial determination of the penalty and/or lacked authority to make the determination. Thus, the LLC contended, their supervisors were not the proper people to approve the penalties. The IRS asked the court for a partial summary judgment regarding the penalty assessment. The court found in favor of the IRS, denying the LLC’s arguments as unsupported and without merit.

In a similar case,²⁹ the court also ruled in favor of the IRS. In this case, the LLC argued that there was a discrepancy in the date of the IRS agent’s immediate supervisor’s digital signature on the penalty approval form and the date on the face page of the information sent to the LLC. The court disagreed with the LLC and stated that the IRS met the requirement because the agent’s immediate supervisor approved the penalties at the time when she had discretion to grant the approval, which was before the issuance of the FPAA.³⁰

Likewise, in Dorchester Farms Property, LLC,³¹ the Tax Court agreed with the IRS, holding that the Service established that it met the requirements of Sec. 6751(b) by providing a copy of the penalty approval form that listed all penalties, included the agent’s name as examiner, and showed digital signatures of the agent’s immediate supervisor prior to the issuance of the FPAA. The LLC’s argument that the agent did not give sufficient consideration to whether the penalties were appropriate or that higher-level personnel than the examiner had made the initial determination of the penalty did not have merit, the court concluded.

The Tax Court in LakePoint Land II, LLC,³² reached a different conclusion. In this case, the IRS claimed that it established the penalty with a lead sheet that listed all penalties. The lead sheet included the agent’s name as examiner and had a digital signature of the agent’s immediate supervisor with a date prior to the issuance of the FPAA. Based on these representations, the Tax Court granted the IRS’s motion for partial summary judgment that the penalties had been properly approved.

However, new evidence presented with the parties’ motions for reconsideration showed that multiple versions of the lead sheet existed, including one that was signed by the supervisor several months later and an amended version of the lead sheet on which the supervisor approved additional penalties and backdated her signature. Based on this new evidence, the court held that it was not clear whether the approval process was valid and met the requirements of Sec. 6751(b). Accordingly, it vacated its order granting the IRS partial summary judgment on the issue. It also approved sanctions against the IRS but left it until after trial of the case to determine the amount of the sanctions.³³

Court invalidates notice identifying syndicated conservation easements as listed transactions; regulations proposed

A new issue came up during this update period related to conservation easements. In two cases,³⁴ the taxpayers asked that Notice 2017-10, which identified syndicated conservation easement transactions as “listed transactions” beginning Jan. 1, 2010, be set aside when determining penalties. The taxpayers contended that Notice 2017-10 is invalid in these situations because the IRS did not comply with the notice-and-comment procedures under the APA, and, thus, the imposition of penalties under Sec. 6662A was prohibited.

The IRS argued that it was not subject to the notice-and-comment procedures because Notice 2017-10 was only an interpretive rule. It also argued that Congress had exempted the Service from the APA when it enacted Sec. 6707A, which provides for a penalty for failing to include information about a reportable transaction with a return. The Tax Court in Green Valley Investors rejected both of the IRS’s arguments, determining that because the notice exposed taxpayers and their advisers to new reporting obligations and penalties for noncompliance, it was a legislative rule. In addition, the court stated that Congress could have exempted agencies from the APA but did not clearly do so in this instance; therefore, the IRS must comply with the requirements. In Green Rock, LLC, a district court similarly held that the IRS was bound by the APA’s notice-and-comment procedures and set aside Notice 2017-10.

Partly in response to Green Valley Investors, Treasury issued proposed regulations³⁵ that identify certain syndicated conservation easement transactions and substantially similar transactions as listed transactions. Material advisers and certain participants in these listed transactions would be required to file disclosures with the IRS and are subject to penalties for failure to disclose. The proposed regulations exclude qualified organizations from being treated as participants or parties to a prohibited tax shelter transaction subject to excise tax; however, the notice requests comments on whether the final regulations should remove this exclusion for qualified organizations that facilitate syndicated conservation easement transactions.

Receipt of a partnership interest

Sec. 721(a) provides that the receipt of a partnership interest in exchange for property is generally not a taxable event. However, where a person receives a partnership interest in exchange for a contribution of services, nonrecognition is not always guaranteed. Under Regs. Sec. 1.721-1(b)(1), the receipt of a partnership capital interest in exchange for services is taxable to the service provider. The treatment of the receipt of a profits interest is not as clear in the regulation. The IRS addressed the issue in Rev. Proc. 93-27, which provided guidance on the treatment of the receipt of a profits interest for services provided to, or for the benefit of, the partnership. In this revenue procedure, the IRS cited Regs. Sec. ١.٧٢١-١(b)(١) and stated that the receipt of a capital interest for services is taxable as compensation. On the other hand, the receipt of a profits interest is not treated as a taxable event if certain requirements are met.

In ES NPA Holding, LLC,36 the question arose of whether the partner received a capital or profits interest for his services. In this case, a corporation contributed substantially all of its business assets to LLC 1 in exchange for all three classes of units in LLC 1 (A, B, and C). The corporation then contributed all three classes of units in LLC 1 to LLC 2 as a capital contribution. The next day, a third LLC purchased all of LLC 1’s Class A units from LLC 2, and ES NPA acquired all of LLC 2’s Class C units in exchange for payment to the corporation of $100,000 and services provided or to be provided. ES NPA’s acquisition of the Class C units in LLC 2 reflected an indirect interest in the Class C units of LLC 1. After all of the transactions, the records showed that the LLC 1 Class A units held by the third LLC had a capital contribution of $20,985,509; the LLC 1 Class B units held by LLC 2 had a capital contribution of $8,993,790; and the LLC 1 Class C units held by LLC 2 had a capital contribution of zero.

ES NPA did not report any gain on the receipt of the LLC units in this transaction because it contended that its interest in LLC 2 was a profits interest, the receipt of which was not taxable under Rev. Proc. 93-27. On audit, the IRS determined that ES NPA had income on the receipt of the interest in LLC 2. The IRS argued that the revenue procedure did not apply in this situation because ES NPA received a taxable capital interest in LLC 2. The Tax Court disagreed and found that the receipt of LLC 1 units via an interest in LLC 2 qualified as a profits interest under Rev. Proc. 93-27; thus, ES NPA did not have any gain on the transaction. The court stated that it did not matter that the units were held indirectly.

Economic substance

A basic principle of tax law is that taxpayers are entitled to structure their business transactions in a manner that produces the least amount of tax. However, business transactions must have economic substance. For a transaction to have economic substance, it must have a reasonable possibility of a profit and an independent business purpose beyond reducing taxes. The IRS has been diligent in examining transactions that it considers to lack economic substance or to be a sham, and it 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 2010.³⁷ Several court decisions in this update period considered whether a partnership transaction had economic substance.

Losses disallowed for economic substance

Sec. 704(d) allows a taxpayer to deduct losses from a partnership interest if 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 case³⁸ where the taxpayers owned an S corporation that was a member in an unsuccessful rental LLC, they deducted the entire loss that was allocated to the S corporation. The IRS allowed only a portion of the loss because the taxpayers could not provide documentation to substantiate their basis in the LLC interest. The taxpayers argued that they had made additional capital contributions to the LLC on behalf of the S corporation and that other members had agreed to gift portions of their interests in the LLC to the S corporation. However, that assertion was not supported by the evidence in the case, the Tax Court held. The court agreed with the IRS and determined that the taxpayers were not allowed to deduct the entire loss.

In Dunn,³⁹ married taxpayers owned a real estate rental and investment management partnership that allocated them losses that they deducted on their joint personal tax return. On audit, the IRS disallowed the losses because the taxpayers did not have basis in the partnership interest. The Tax Court agreed because the taxpayers were not able to show that they had sufficient basis in their partnership interest to deduct their pro rata shares of the partnership’s losses. They also failed to show that any amounts in respect of their rental real estate activities were at risk under Sec. 465.

The taxpayers also tried to argue that they should be allowed to deduct the losses as real estate professionals under Sec. 469(c)(7). Again, the court rejected their argument because the taxpayers did not provide any evidence to show that they qualified as real estate professionals. The court noted that the taxpayers failed to show that half of their time was spent performing services in real property trades or businesses or that either of them met the 750-hour test.⁴⁰ Although the taxpayers provided time logs of hours they spent on real estate activities, those records provided only “vague and misleading estimates,” the court held.

Likewise, in another case,⁴¹ the IRS disallowed a married couple’s partnership loss deduction for lack of substantiation. The losses were from a purported catering business. However, aside from one spouse’s testimony, no evidence was presented showing a connection by the taxpayers with the business. The Tax Court agreed with the IRS and disallowed the deduction.

In GSS Holdings (Liberty), Inc.,⁴² the taxpayer entered into a set of complex transactions that resulted in a partnership loss that was allocated to the taxpayer. The IRS determined that the transactions should be treated as a single transaction under the step transaction doctrine and disallowed the deduction under Sec. 707(b)(1) as a loss from the sale of property between a partnership and a person owning more than 50% of the capital interest in the partnership. The taxpayer took the case to the Court of Federal Claims. The court denied the deduction under the step transaction and economic substance doctrines.

On appeal to the Federal Circuit, the taxpayer argued that the Court of Federal Claims had made two independent errors. First, the court applied an “erroneous hybrid legal standard that conflated the step transaction doctrine and the economic substance doctrine,” and second, the court violated the principle of party presentation. The taxpayer argued that, in analyzing the step transaction doctrine, the court improperly used the economic substance doctrine’s rule by looking only at the step that creates the tax benefit.

The Federal Circuit agreed with the taxpayer and found that the Court of Federal Claims did conflate the two separate doctrines. The appellate court found that the lower court started its analysis by correctly recognizing that the parties advocated for an analysis under the step transaction doctrine, and it correctly recognized that the end-result test, which determines whether the step transaction doctrine applies, involves assessing the intent of the taxpayer from the outset. However, rather than proceeding to assess intent from the outset as required, the lower court focused on the transaction giving rise to the alleged tax benefit, as required by the economic substance doctrine.

As a result, the Federal Circuit vacated the Federal Claims Court’s decision and remanded it, charging the lower court to make a determination using the correct legal standard. The lower court was advised that under the end-result test, it was required to examine whether the transactions were really component parts of a single transaction intended from the outset to be taken for purposes of reaching an ultimate result.

Sale of a partnership interest

Sec. 741 provides that “[i]n the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items).” Sec. 1221(a)(1) provides that “the term ‘capital asset’ means property held by the taxpayer (whether or not connected with his trade or business),” but does not include “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

In Chief Counsel Advice memorandum 202309015, the IRS agent asked for a determination as to the character of the gain on the sale of partnership interests. In this situation, the taxpayer directly, and indirectly through entities the taxpayer owned and managed, engaged in the promotion and sale of interests in LLCs. The only asset held by each of the LLCs was land. However, the LLCs did not sell land. The taxpayer reported long-term capital gain from the sales of the LLC interests. The taxpayer reported no other source of income than that generated from the promotion and sale of the LLC interests.

The issue was whether (1) Sec. 1221 applied to treat the taxpayer’s gain on the sales of LLC interests as ordinary income because the taxpayer held the LLC interests primarily for sale to customers in the ordinary course of a trade or business, or (2) whether Sec. 741 and Secs. 751(d)(1) and (d)(3) applied collectively to treat the taxpayer’s gain on the sales of LLC interests as ordinary income because the taxpayer was engaged in a trade or business of selling land. The Chief Counsel’s Office determined that despite Sec. 741, Sec. 1221 would apply to treat the taxpayer’s gain on the sales of LLC interests as ordinary income because the taxpayer held the LLC interests primarily for sale to customers in the ordinary course of a trade or business. In addition, Sec. 741 and Secs. 751(d)(1) and (d)(3) did not apply because the taxpayer was not engaged in a trade or business of selling land.

In a Tax Court case,⁴³ a nonresident alien was a partner in a U.S. partnership. In 2008 (i.e., before the 2017 effective date of Sec. 864(c)(8)), the taxpayer sold her interest in the partnership. Part of the sale was attributable to inventory items for purposes of Sec. 751(a)(2). This part of the gain should be treated as ordinary income, the IRS asserted in a notice of computational adjustment. However, the taxpayer had treated the entire gain on the sale as a capital gain under Sec. 741. She argued that the gain would be treated as income from the sale of a single asset (the partnership interest) that was personal property under the general rule of Sec. 865(a)(2) and was therefore non–U.S.-source income.

The IRS determined that Sec. 751(a)(2) governs the gain attributable to inventory items and provides an exception from the general rule of Sec. 741. Therefore, this portion of the gain would be ordinary income, the IRS argued. Moreover, the Service argued, for purposes of the sourcing rules, “income derived from the sale of inventory property” falls under the exception in Sec. 865(b) from the general rule of 865(a)(2) and therefore in this case was U.S.-source income.

The Tax Court agreed with the IRS, finding the taxpayer’s underlying theory — that proceeds were treated as gain from the sale of a single capital asset under Sec. 741 that would be income sourced outside the U.S. under Sec. 865(a)(2) — failed because Sec. 741’s general rule for analyzing the sale of a partnership interest as a singular capital asset rather than evaluating the gain on an asset-by-asset basis is superseded by Sec. 751(a)(2)’s specific provision treating the portion attributable to inventory items as from property other than a capital asset. As a result, the court held that Sec. 865(b)’s specific sourcing rule for inventory property, not Sec. 865(a)(2)’s default rule, applied.

Sec. 754 election to adjust basis of partnership property

When a partnership distributes property or a partner transfers an 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 a new partner on gains or losses already reflected in the purchase price of the partnership interest.

The 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. If a partnership inadvertently fails to file the election, the only way to remedy the failure is to ask for relief under Regs. Secs. 301.9100-1 and -3 either through automatic relief, if the error is discovered within 12 months, or through a private letter ruling. To be valid, the election must be signed by a partner.

Extensions of time to make the election

In several private letter rulings during this period,⁴⁴ the IRS granted an extension of time to make a Sec. 754 election. In each case, the partnership had been eligible to make the election but inadvertently omitted the election when filing its return. The IRS reasoned that the partnership in each case acted reasonably and in good faith and granted an extension to file the election under Regs. Secs. 301.9100-1 and -3.

In these rulings, each partnership had 120 days after the ruling to file the election. In some cases, the IRS granted the partnerships the extension even though they had relied on a professional tax adviser or preparer when they failed to timely make the election.⁴⁵ In one situation,⁴⁶ the partnership thought it had a Sec. 754 election in place, so when a partnership interest was transferred, no election was made. Once the partnership realized it did not have an existing election, the partnership asked for an extension. The IRS allowed the partnership 120 days to make a valid Sec. 754 election.

In an unusual situation,⁴⁷ an LLC owned several LTPs. One of the owners of the LLC transferred an interest. The LLC’s return preparer made the proper Sec. 754 election for the LTPs but did not make the election for the LLC itself. The Service granted the LLC an extension to file the election.

Missed Sec. 754 elections

The Sec. 754 election is allowed when a partner dies and the partner’s 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.⁴⁸ In one such instance,⁴⁹ an owner of a UTP died. Neither the UTP nor the LTPs made a Sec. 754 election. The IRS allowed all of the partnerships 120 days to file a valid election.

In another situation,⁵⁰ a taxpayer owned an interest in a partnership through a grantor trust. The taxpayer died, and the trustee distributed the partnership interest to the taxpayer’s three children. The partnership did not make a timely Sec. 754 election. After the children received the interests, they contributed the interests to a second partnership. In addition, the children owned interests in a third partnership. In the next two years, two of the three children died. Neither the second nor third partnership the children owned made a Sec. 754 election. In this ruling, the IRS allowed all three partnerships 120 days to make a valid Sec. 754 election for the appropriate years.

Other 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, a foreign entity failed to make the election in a timely manner. In each of these instances,⁵¹ the IRS allowed the entity 120 days after the ruling to file the election.

In one situation,⁵² the taxpayer was formed as an LLC and elected to be treated as an S corporation subsequently. Several years later, a new owner acquired more than 50% of the S corporation and wanted to change the entity’s classification to a partnership. 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 (QOFs) under Sec. 1400Z 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. However, how the IRS handled the missed election depended on how the partnership reported the election. For example, in several situations,⁵³ the partnership’s accountant filed a Form 1065 along with the Form 8996 after the due date of the tax return. In these instances, the IRS accepted the tax return and determined the election was timely filed. In other instances,⁵⁴ the partnership filed Form 1065 timely but failed to include Form 8996. Here, the IRS granted the partnership 60 days to file either an amended tax return or administrative adjustment request to make the election. In other situations, partnerships did not file either a Form 1065 or Form 8996⁵⁵ and requested additional time to file the election. These partnerships were granted only 45 days after the ruling to file the election.

In a more complicated situation,⁵⁶ a corporation was formed and timely self-certified as a QOF for its second tax year. In Year 3, another entity was formed as an LLC that was treated as a partnership for tax purposes. The LLC also made a timely QOF election. Later, the LLC acquired a percentage of the corporation and converted the corporation to an LLC classified as a partnership and changed the name of the company. The new LLC was meant to be a QOF as soon as it was formed, but the election was not timely made. The IRS considered the late-filed election to have been timely made.

Contributor

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 at Charlotte in Charlotte, N.C. She is a past chair of the AICPA Partnership Taxation Technical Resource Panel and has served on the AICPA Tax Executive Committee. For more information about this article, contact
thetaxadviser@aicpa.org.

Footnotes

¹T.D. 9969.

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

³Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248.

⁴Tax Technical Corrections Act, P.L. 115-141.

⁵U.S. Government Accountability Office, Tax Enforcement: IRS Audit Processes Can Be Strengthened to Address a Growing Number of Large, Complex Partnerships, Rep’t No. GAO-23-106020 (July 2023).

⁶Seaview Trading, LLC, 62 F.4th 1131 (9th Cir. 2023), aff’g T.C. Memo. 2019-122. See also Beavers, “Ninth Circuit Again Addresses Return Filing,” 54-6
The Tax Adviser 58 (June 2023).

⁷2023-83.

⁸Goldberg, 73 F.4th 537 (7th Cir. 2023), aff’g T.C. Memo. 2021-119.

⁹Keene-Stevens, 72 F.4th 1015 (9th Cir. 2023), vacating and remanding T.C. Memo. 2020-118.

¹⁰AD Global Fund, LLC, No. 4-336T (Fed. Cl. 9/28/23).

¹¹Estate of Keeter, 75 F.4th 1268 (11th Cir. 2023), aff’g T.C. Memo. 2018-191.

¹²Rocky Branch Timberlands, LLC, No. 22-12646 (11th Cir. 9/6/23).

¹³Letter Ruling 202339002.

¹⁴Letter Ruling 202321001.

¹⁵Skolnick, 62 F.4th 95 (3d Cir. 2023), aff’g T.C. Memo. 2021-139.

¹⁶Keeton, T.C. Memo. 2023-35.

¹⁷T.D. 9926.

¹⁸Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals), or Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities).

¹⁹See IRS News Release IR-2023-67, identifying syndicated conservation easements as one of the “Dirty Dozen” “bogus tax schemes” that it “will continue to scrutinize.”

²⁰Cattail Holdings, LLC, T.C. Memo. 2023-17.

²¹North Donald LA Property, LLC, T.C. Memo. 2023-50.

²²Glade Creek Partners, LLC, T.C. Memo. 2020-148.

²⁴A property right with a fair market value at least equal to the proportionate value of the donation to that of the property as a whole at the time of the gift.

²³Glade Creek Partners, LLC, No. 21-11251 (11th Cir. 8/22/22).

²⁵Hewitt, 21 F.4th 1336 (11th Cir. 2021).

²⁶Glade Creek Partners, LLC, T.C. Memo. 2023-82.

²⁷Murfam Enterprises LLC, T.C. Memo. 2023-73.

²⁸Nassau River Stone, LLC, T.C. Memo. 2023-36.

²⁹Salacoa Stone Quarry, LLC, T.C. Memo. 2023-68.

³⁰For further discussion of the case, see Mostofizadeh, “Penalties Against LLC Approved by IRS Supervisor, Tax Court Holds,” 54 The Tax Adviser 17 (November 2023).

³¹Dorchester Farms Property, LLC, T.C. Memo. 2023-92.

³²LakePoint Land II, LLC, T.C. Memo. 2023-111.

³³See also Beavers, “IRS Sanctioned in Penalty Case,” 54 The Tax Adviser 48 (November 2023).

³⁴Green Valley Investors, LLC, 159 T.C. 5 (2022), and Green Rock, LLC, No. 2:21-cv-01320-ACA (N.D. Ala. 2/2/23).

³⁵REG-106134-22. While disagreeing with the Tax Court in Green Valley Investors, Treasury and the IRS stated in the preamble it was issuing the proposed regulations “to eliminate any confusion and ensure consistent enforcement of the tax laws throughout the nation.”

³⁶ES NPA Holding, LLC, T.C. Memo. 2023-55.

³⁷At Sec. 7701(o). Health Care and Education Reconciliation Act of 2010, P.L. 111-152.

³⁸Simpson, T.C. Memo. 2023-4.

³⁹Dunn, T.C. Memo. 2022-112.

⁴⁰Sec. 469(c)(7)(B).

⁴¹Kamal, T.C. Memo. 2023-80.

⁴²GSS Holdings (Liberty), Inc., No. 2021-2353 (Fed. Cir. 9/21/23), vacating and remanding 154 Fed. Cl. 481 (2021).

⁴³Rawat, T.C. Memo. 2023-14.

⁴⁴E.g., Letter Rulings 202244002, 202308002, 202328003, and 202341007.

⁴⁵E.g., Letter Ruling 202252003.

⁴⁶Letter Ruling 202252002.

⁴⁷Letter Ruling 202252005.