"Year-end" tax planning for partnerships with tax-exempt partners.

With all the potential issues facing partnerships in the 1990s, determining a partnership's correct tax year seems like it should be the least of its troubles. Without a Sec. 444 election or the business purpose exception, all partnerships would determine their tax year based on the year-end of their majority or principal partner(s). However, this does not necessarily hold true when tax-exempt partners enter the picture.

Partnerships generally have a required tax year based on the tax year of the partners. Sec. 706(b)(1)(B) sets forth the rules as follows: " ... a partnership shall not have a taxable year other than--(i) the majority interest taxable year (as defined in paragraph (4)), (ii) if there is no [majority interest tax year], the taxable year of all the principal partners of the partnership, or (iii) [if (i) and (ii) do not apply] the calendar year unless the Secretary by regulations prescribes another period."

A majority interest tax year is defined as the tax year of one or more partners with an aggregate interest in partnership profits and capital of more than 50%. If no such year exists, the year of all partners with an interest of 5% or more in partnership profits or capital (principal partners) is used. If neither of these two years exists, Temp. Regs. Sec. 1.706-1T(a) prescribes a tax year that provides the least aggregate deferral of income to the partners (often the result under the first two options).

Could the fact that a tax-exempt partner holds a majority interest in a partnership have any effect on the year-end? Under Sec. 706, the answer appears clear: The partnership will take on the tax year of that partner. However, temporary regulations are in effect that must also be considered. Temp. Regs. Sec. 1.706-3T directly addresses the situation: "[I]n determining the taxable year (the 'current year') of a partnership under section 706(b) and the regulations thereunder, a partner that is tax-exempt under section 501(a) shall be disregarded if such partner was not subject to tax, under chapter 1 of the Code, on any income attributable to its investment in the partnership during the partnership's taxable year immediately preceding the current year." The regulation coincides perfectly with the intent of Congress to require a year that provides the least aggregate deferral of income to the partners.

In determining a tax-exempt entity's effect on the year-end, it is important to note that unrelated business income tax (UBIT) assessed by Sec. 501(b) falls under Chapter 1, which covers Secs. 1 through 1399.

Example 1: T, a tax-exempt partner who pays no tax, owns 51% of partnership TP. P, a wealthy individual, owns the remaining 49%. T has a taxable year ending January 31 and P files on a calendar year. TP has average taxable income of $1,000,000, consisting of dividends and interest, which do not constitute UBI. According to Temp. Regs. Sec. 1.706-3T, T's year-end is disregarded in determining TP's tax year and December 31 is TP's required year-end.

Example 2: Assume the same facts as in Example 1. In addition, TP also has a small trade or business activity that requires T to pay a minor amount of UBIT. Under this scenario, T's year-end is not disregarded and January 31 is assigned as TP's tax year, creating a substantial income deferral. T pays a small amount of UBIT and is indifferent as to TP's year-end. P, however, has obtained an 11-month deferral on income of $490,000.

When structuring a partnership arrangement involving a tax-exempt partner with a fiscal year-end, the partners should consider the advantages of having trade or business income constitute a portion of the partnership's income. This will allow the tax-exempt entity's year to be considered in determining the partnership's tax year, effectively deferring income recognition for other partners.

Just as with any tax-planning idea, this can be a trap for the unwary if all facts are not considered before proceeding. If the partnership will generate losses in the initial years, a deferral may be undesirable. Also note that in certain situations, partners with small ownership percentages may receive an acceleration.