Constructive ownership rules and related party transactions.

Facts

Martina, Ivan, Boris and Chrissy, who are brothers and sisters, and Jimmy Hana, Steff and Mats, their respective spouses, own equal 12.5% interests in Land Racket, a partnership that owns several parcels of land. One of Land Racket's properties is Plaidacre, an undeveloped parcel. Land Racket's basis in Plaidacre is $28,000.

Martina would like to purchase Plaidacre for its fair market value, and construct and operate a sporting goods store on the site. Consequently, Plaidacre would not constitute a capital asset in Martina's hands, but would be classified as real property used in her trade or business. She has sought the advice of her family's tax adviser in structuring the transaction.

Issue

Will Land Racket recognized capital gain on a sale of Plaidacre to Martina?

Analysis

Tax benefits are restricted in transactions between partnerships and partners who actually or constructively own interests of more than 50% in the partnership's capital or profits. In determining whether a partner has an interest of more than 50% in partnership capital or profits, both interests owned directly by the partner and interests owned by others whose ownership will be attributed to the partner must be considered.

Under the applicable constructive ownership rules, interests owned directly or indirectly by or for a corporation, partnership, estate or trust are considered owned proportionately by or for its shareholders, partners or beneficiaries. In addition, an individual is considered the owner of interests owned directly or indirectly by or for members of the individual's family, which consists of brothers, sisters, spouse, ancestors and lineal descendants.

Interests owned constructively under the first rule may be reattributed without limitation. For example, if a partnership interest is owned by a subsidiary corporation, ownership of the interest will be attributed to that corporation's parent and then reattributed to the parent's shareholders.

The rule relating to family attribution may not be reapplied. Thus, if a person is considered a construction owner of a partnership interest only if the family attribution rules were applied more than once, that person is not a constructive owner of the interest. For example, if a parent owns a partnership interest (or is treated as the owner other than because of family attribution), the parent's children and grandchildren are treated as owners of the interest, but the family attribution rules are not reapplied to cause a spouse of a child or grandchild to be treated as a constructive owner of that interest.

Martina directly owns 12.5% of the capital and profits interests of Land Racket. Under the constructive ownership rules, Martina is treated as owning an additional 50% of Land Racket - the 37.5% owned by her brothers and sister (Ivan, Boris and Chrissy), and the 12.5% owned by her spouse (Jimmy). Because Martina is treated as owning 62.5% of Land Racket, and because Plaidacre would not be a capital asset in her hands, Land Racket's gain on the sale of Plaidacre to Martina would be taxed as ordinary income rather than capital gain.

For this reason, Martina's tax adviser should suggest other options. For example, if family relationships do not pose problems, Land Racket might sell Plaidacre to Jimmy, Martina's spouse. Because Jimmy would be treated as owning only 25% of Land Racket (his and Martina's interests), the disallowance rule would not apply. Arrangements could then be made between Martina and Jimmy to make Plaidacre available for Martina's sporting goods store.

The tax adviser also might suggest that the partners institute or accelerate family giving programs. For example, Land Racket's partners could make gifts of partnership interests to their children. Because interest owned by Martina's nieces and nephews would not be attributed to her, if Ivan, Boris and Chrissy give interests totaling 12.5% or more to their children, transactions between Land Racket and Martin a would not longer be subject to the related party rules.

Conclusion

In determining whether a partner has a more-than-50% interest in partnership capital or profits, the partner is treated as constructively owning interests owned by certain related individuals and entities. Martina's capital and profits interests total 65.5% when constructively owned interests are considered. For this reason, Land Racket's gain on a sale of Plaidacre to Martina would be taxed as ordinary income.