Current developments: this article reviews and analyzes recent rulings and decisions that involve partnerships. This discussion covers developments on anti-abuse rules, partnership formation, investment partnerships, elections out of subchapter K, statute of limitations, basis, income allocation and partnership continuation. (Partners & Partnerships).
* In several cases, the IRS challenged the valuation of a gifted FLP interest.
* Final and proposed regulations address basis issues for corporate partners.
* The IRS issued final regulations on tax years of partnerships with foreign or tax-exempt partners.
During the period of this update (Nov. 1, 2001-Oct. 31,2002), Treasury issued several sets of proposed and final partnership regulations; the IRS issued revenue procedures to address changes in tax year-ends. There were also various rulings on the operation of the Sec. 701 anti-abuse rules. In the future, the IRS plans to provide guidance on the Sec. 704(b)regulations and on partnership options and convertible instruments. It is also working on regulations defining a Sec. 752 liability.
Rev. Proc. 2002-59 (1) extends the time for filing a late initial entity-classification election to the due date of the entity's first return (excluding extensions). Rev. Proc. 2002-15, (2) superseded as of Sept. 30, 2002, provided that the election could be filed within six months of the initial election due date.
In Rev. Proc. 2002-69, (3) the IRS issued guidance on the classification of entities owned solely by a husband and wife as community property. Based on this ruling, it will respect a taxpayer's treatment as either a disregarded entity or a partnership.
Several cases arose in which taxpayers tried to circumvent the Sec. 701 anti-abuse rules by using multi-step transactions. In the cases below, the IRS and the courts applied the step-transaction doctrine.
In FSA 200242004, (4) a taxpayer tried to shift the recognition of inherent loss to a third party, by contributing the property to a partnership, selling its interest in the partnership and having the partnership sell the loss property. The IRS ruled that the Regs. Sec. 1.701-2 anti-abuse rules prevented the new partner from recognizing the loss.
Likewise, in Andantech, L.L.C., (5) a limited liability company (LLC) purchased equipment from a third party and simultaneously leased it back to the seller. The IRS and the Tax Court disregarded the sale-leaseback, because it was a prearranged transaction lacking business purpose and economic substance. In addition, the LLC was disregarded as an entity; the taxpayers did not intend to join together for the purpose of carrying on a business as partners or sharing in the profits and losses of a business.
In Saba Partnership, (6) a U.S. taxpayer and a tax-free foreign entity created a partnership that generated over $190 million in tax losses for the U.S. partner based on an actual loss of only $5 million. The Federal Circuit ruled that the elaborate scheme lacked economic substance and created no gain or loss for Federal tax purposes; it remanded the case to decide whether the partnership was a total sham created for the sole purpose of tax avoidance that should be disregarded for Federal tax purposes.
In another situation, (7) a partnership restructured a sale of a partnership interest as a three-step transaction to avoid subpart F income. However, the IRS applied the step-transaction doctrine and recharacterized the transaction as a sale of the partnership interest.
Notices 2002-50 (8) and 2002-65 (9) dealt with multi-step transactions designed to use a straddle, a tiered partnership structure, a transitory partner and the absence of a Sec. 754 election to allow taxpayers to claim a permanent noneconomic loss. The notices alerted taxpayers and their advisers that the tax benefits purportedly generated by these transactions will not be allowed for Federal tax purposes.
Treasury and the IRS are concentrating on tax shelters. In accordance with this directive, they issued temporary regulations (10) modifying the rules on filing disclosure statements under Sec. 6011(a). Temp. Regs. Sec. 301.6111-2T also includes conforming changes to the rules on registration of confidential corporate tax shelters under Sec. 6111(d). The temporary regulations were effective Jan. 1,2003.
Taxation on Formation
In Rev. Proc. 2002-3, (11) the IRS added the validity of a family limited partnership (FLP) to its no-ruling list when capital is not a material income-producing factor. (12)
The gift of a FLP interest qualifies for the gift tax annual exclusion, and the valuation of the gifted interest may be reduced by using minority-interest and marketability discounts. However, in certain cases, the IRS may challenge the use or amount of the discount. In Est. of Godley, (13) the Fourth Circuit upheld a Tax Court decision not to allow a minority interest discount for a 50% FLP interest, because there was little to be gained by having control of the partnership and little risk in holding a minority interest.
In several cases this year, courts ruled on whether an estate should include the value of a FLP interest or FLP assets. (If only the assets are included in the estate, the discounts allowed for FLP interests would not apply, thereby increasing the estate's value.) For example, in Est. of Harper, (14) the decedent had created a FLP with his children, but continued to use the FLP assets as if he still owned them personally. The Tax Court held that the assets (not the partnership interest) should be included in his estate under Sec. 2036(a), because he retained the enjoyment of the transferred assets. It came to the same conclusion in a similar situation in Est. of Thompson. (15)
In Shepherd, (16) the transfer of minority shares of leased land through a FLP was ruled to be a transfer of undivided shares of land (instead of a FLP interest), because the sons already held their partnership interests when the father deeded the land to the partnership. The Eleventh Circuit also held that the land's value should not be discounted for the sons' minority interest in the partnership.
Sec. 721(a) provides that no gain or loss is recognized on a contribution of property to a partnership for a partnership interest. Sec. 721(b) provides an exception for a partnership that would be classified as an investment company if it were incorporated.
In Letter Ruling 200210047, (17) family members who owned stock in a publicly traded corporation through various partnerships and trusts created an LLC with cash to centralize the holdings. The LLC, the partnerships and the trusts then contributed the cash and stock to a newly formed partnership in exchange for partnership interests. The cash contributed by the LLC was disregarded in determining whether diversification occurred, because it was an insignificant amount under Regs. Sec. 1.351-1 (c)(5). Thus, the IRS held that the transfer was not to an investment partnership, because all the other property transferred to the new partnership consisted of stock in one company.
Also, in Letter Ruling 200211017, (18) the partners of a partnership that owned stock contributed their partnership interest to an LLC to consolidate their holdings. The IRS ruled that the transfer of the partnership interests was not a transfer to an investment company under Sec. 721 (b).
Electing Out of Subchapter K
In FSA 200216005, (19) a limited partnership formed under a state Revised Uniform Limited Partnership Act (RULPA) could not elect out of subchapter K; the partners did not meet Sec. 761 requirements, because they were not considered co-owners under the state RULPA.
There were various rulings on the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) audit procedures. Most dealt with whether an item was a partnership item or whether the extension of the statute of limitations (SOL) for a partnership extended to its partners.
In Field, (20) a district court ruled that the SOL is a partnership item and, thus, any challenge to its extension must be raised at the partnership level or not at all.
In CC&F Western Operations LP, (21) the question was whether a tax assessment was timely under Sec. 6229(c), which allows a six-year SOL if the return omits over 25% of gross income and does not reveal on its face that this omission has occurred. The First Circuit ruled that the six-year SOL applied, because the return did not sufficiently disclose the omission of a discharged debt in connection with a property sale.
In Blonien, (22) the IRS issued an "affected items" deficiency notice to a taxpayer attributable to his share of partnership income. The taxpayer claimed that an extension of the SOL period agreed to by the tax matters partner did not apply to him, because he never became a partner in the partnership. The Tax Court ruled that whether the taxpayer was a partner could be challenged only at the partnership level. Because he had claimed to be a partner on prior returns and received a Schedule K-1 from the partnership without filing Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, the taxpayer was deemed to be a partner; thus, the SOL extension applied to him.
Partnership Year-End Election
In 2002, Treasury issued final regulations (23) on adoptions, changes and retentions of annual accounting periods. The IRS also issued three revenue procedures on this subject. (24) Rev. Proc. 2002-38 (25) provides exclusive procedures for partnerships to obtain automatic approval to adopt, change or retain their annual accounting period. A partnership that complies with the procedure will be deemed to have established a business purpose under Sec. 706(b) and obtained IRS approval to adopt, change or retain its annual accounting period.
The IRS also issued final regulations (26) on tax years for partnerships with foreign or tax-exempt partners. Regs. Sec. 1.706-1 (b)(5) and (6) generally require partnerships to disregard foreign and tax-exempt partners not subject to U.S. taxation on their partnership income when determining the partnership's tax year-end, thereby eliminating potential income deferral.
An exception in Regs. Sec. 1.706-1(b)(6) (iii) allows foreign partners to be included if the partnership's tax year would be determined by reference to partners who individually hold a lessthan-10% interest (and, in the aggregate, a less-than-20% interest) in the partnership if the foreign partner is disregarded. Under the proposed regulations, partnerships that had previously elected a tax year with reference to a foreign partner may have had to change their year-end. Recognizing that this change could cause some difficulty for U.S. minority partners, the final regulations are mandatory only for partnerships formed after Sept. 22, 2002. Partnerships formed before then may elect to conform.
Treasury issued final Regs. Sec. 1.705-2 (27) to prevent inappropriate changes in a corporate partner's basis resulting from a partnership's disposition of the corporate partner's stock. The regulations apply when (1) a corporation acquires an interest in a partnership that holds stock in the corporation, (2) the partnership does not have a Sec. 754 election in effect and (3) the partnership later sells the stock. Under the final regulations, the allowed increase or decrease to the corporate partner's basis is the gain or loss the partner would have recognized had a Sec. 754 election been in effect when the corporation acquired its partnership interest. The final regulations' purpose cannot be avoided by creating tiered partnerships or other arrangements.
Treasury also issued proposed regulations (28) under Sec. 705 that will provide guidance when (1) a corporation owns an interest in a partnership that owns the corporation's stock, (2) the partnership distributes money or other property to another partner who recognized gain on the distribution during a year the partnership did not have a Sec. 754 election in effect and (3) the partnership subsequently sells or exchanges the stock. Prop. Regs. Sec. 1.705-2(b)(2) would allow an increase in the basis of the corporation's partnership interest by the full amount of any gain resulting from the partnership's sale or exchange of the stock that would not be recognized by the corporation under Sec. 1032.
Treasury issued Regs. Sec. 1.469-7 (29) on the treatment of self-charged income and expense items under the Sec. 469 passive loss rules. The regulations recharacterize a percentage of certain portfolio income and expense as passive income and expense when a taxpayer engages in a lending transaction with a partnership in which he or she owns an interest and the loan proceeds are used in a passive activity. The regulations clarify that the self-charged rules apply to guaranteed payments to a partner for the use of capital. However, they apply only to self-charged interest and income recognized in the same tax year. In addition, even though many commentators pressed to have the regulations extended to other self-charged items, they apply only to self-charged interest.
Under Sec. 706(a), a partner includes in taxable income his or her allocable share of partnership items for the partnership tax year ending within or with the partner's tax year.
The annual accounting can cause problems for partnerships that have regulated investment company (RIC) partners. Rev. Procs. 2002-16 (30) and 2002-68 (31) allow all partners in certain partnerships to take into account on a monthly basis their distributive share of partnership items if the partnership makes a proper election. This rule applies to a partnership that derives at least 95% of its income from tax-exempt assets under Sec. 103. In a related ruling, Rev. Proc. 2001-57 (32) sets forth conditions in which a RIC that owns a partnership interest in a master-feeder structure would be treated as if it directly invested in the assets owned by the partnership.
Sec. 702(a) specifies the items a partner must take into account separately. This year, final regulations offer subpart F guidance to partnerships. (33) Under the final regulations, gross income is characterized at the partnership level. If any part of a partnership's gross income is a type of income that would be subpart F income if received directly by partners that are controlled foreign corporations (CFCs), that part of the partnership's gross income must be separately taken into account by each partner. To the extent the separately stated income results in subpart F income to the CFC partner, it is taken into account in determining the CFC's total subpart F income for the tax year.
Under Sec. 704(a), the allocation of partnership items is made based on the partnership agreement. There are several exceptions to the general allocation rule. Under Sec. 704(c), any built-in gain (BIG) or loss (BIL) attributed to the property before the contribution has to be allocated to the partner making the contribution; the BIG or BIL at the time of the contribution is the difference between the property's fair market value (FMV) and the partner's adjusted basis in the property.
Notice 2002-37 (34) describes regulations Treasury will issue on contributed contracts accounted for under a long-term-contract accounting method. The income or loss allocated to the contributing partner under Sec. 704(c) for the long-term contracts will be the income the partner would have had to recognize had the contract been disposed of immediately before the contribution, less any gain recognized on the contribution of the contract to the partnership.
Continuation of Partnerships
A partnership terminates under Sec. 708(b)(1)(B) when 50% or more of the total interest in the partnership's capital and profits is sold or exchanged within a 12-month period. In Letter Ruling 200222026, (35) the IRS ruled that an LLC terminated as a partnership when it restructured into a single-member LLC. LLC notes to the owner were canceled when the LLC terminated. In this instance, the LLC was treated as paying the flail issue price of the canceled debt, with neither the LLC nor the owner recognizing discharge of debt income under Sec. 108.
Mergers and Divisions
Under Sec. 708(b)(2) (A), a partnership resulting from a merger of partnerships is deemed the continuation of any merging partnership whose members own more than 50% of the capital and profits interests. (36) For a division of a partnership into two or more partnerships, Sec. 708(b) (2) (B) provides that the resulting partnerships (other than a resulting partnership with members having a 50%-or-less interest in the capital and profits of the prior partnership) are deemed continuations of the prior partnership.
In Letter Ruling 200223036, (37) an LLC divided into two LLCs and transferred one half of its marketable securities and other assets to a new LLC. The IRS ruled that the distributee partner's share of net gain after the distribution under Sec. 731(a) and (c) (3) (B) (ii) should include only the partner's share of net gain attributable to the marketable securities held by the original LLC after the distribution.
In another ruling, (38) a liquidation of upper-tier partnerships that owned an interest in Partnership A, followed by A's distribution of interests in lower-tier partnerships holding marketable securities, resulted in A's termination under Sec. 708(b)(2)(B). The termination resulted in a deemed contribution by A of its assets to a deemed new partnership. In addition, the distribution of the interests in the lower-tier partnerships would be treated as a distribution of marketable securities under Sec. 731 (c) for which the partners must recognize any gain.
Sec. 754 Election
When a partnership distributes property or a partner sell his or her 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 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. The election must be filed by the due date of the return for the year the election is effective. Normally, the election is filed with the return.
In a series of rulings (39) this year, the IRS granted an extension of time to make a Sec. 754 election. In each case, the partnership inadvertently omitted the election when filing its return. The Service reasoned that the partnership acted reasonably and in good faith and granted an extension to file the election under Regs. Sec. 301.9100-1 and -3. The partnership had 60 days after the ruling to file the election.
Editor's note: Dr. Burton is a member of the AICPA Tax Division's Partnership Taxation Technical Resource Panel.
For more information about this article, contact Dr. Burton at Haburton@email.uncc.edu.
(1) Rev. Proc. 2002-59, IRB 2002-39, 615, superseding Rev. Proc. 2002-15, IRB 2002-6, 490.
(3) Rev. Proc. 2002-69, IRB 2002-45, 831.
(4) FSA 200242004 (7/19/02).
(5) Andantech, L.L.C., TC Memo 2002-97.
(6) Saba Partnership, 273 F3d 1135 (Fed. Cir. 2001).
(7) CCA 200224007 (6/14/02).
(8) Notice 2002-50, IRB 2002-28, 98.
(9) Notice 2002-65, IRB 2002-41,690.
(10) TD 9017 (10/22/02); see Mendelson, et al., "Tax Shelter Temp. Regs. (Part I)," p. 86, this issue.
(11) Rev. Proc. 2002-3, IR.B 2002-1, 117.
(12) FLPs are a very popular income and estate planning tool. Parents can create a FLP with business property and gift partnership interests to their children and grandchildren. This type of entity accomplishes two goals: a reduction in the value of the parent's estate and a shift of current income to children (who presumably are in a lower tax bracket).
(13) Est. of Fred O. Godley, 286 F3d 210 (4th Cir. 2002).
(14) Est. of Morton B. Harper, TC Memo 2002-121.
(15) Est. of Theodore R. Thompson, TC Memo 2002-246.
(16) J. C. Shepherd, 283 F3d 1258 (11th Cir. 2002).
(17) IRS Letter Ruling 200210047 (3/8/02).
(18) IRS Letter Ruling 200211017 (4/19/02).
(19) FSA 200216005 (4/19/02).
(20) David A. Field, SD NY, 6/12/02.
(21) CCOF Western Operations LP, 273 F3d 402 (1st Cir. 2001).
(22) Rodney Blonien, 118 TC 541 (2002).
(23) TD 8996 (5/17/02).
(24) Rev. Procs. 2002-37, IRB 2002-22, 1030; 2002-38, IRB 2002-1037; and 2002-39, [RB 2002-22, 1046.
(25) Rev. Proc. 2002-38, note 24 supra, clarifying and superseding Rev. Proc. 87-32, 1987-2 CB 396.
(26) TD 9009 (7/23/02).
(27) TD 8986 (3/29/02).
(28) REG-167648-01 (3/29/02).
(29) TD 9013 (8/21/02).
(30) Rev. Proc. 2002-16, IRB 2002-9, 572, modified and superseded by Rev. Proc. 2002-68, IRB 2002-43, 753.
(32) Rev. Proc. 2001-57; IRB 2001-50, 577.
(33) TD 9008 (7/23/02).
(34) Notice 2002-37, IRB 2002-23,1095.
(35) IRS Letter Ruling 200222026 (5/31/02).
(36) For a discussion of the proposed regulations in this area, see Orbach and Heller, "Merger and Division Prop. Regs.," 31 The Tax Adviser 854 (December 2000).
(37) IRS Letter Ruling 200223036 (6/7/02).
(38) FSA 200219008 (1/30/02).
(39) See, e.g., IRS Letter Rulings 200209046 (3/1/02); 200215011 (4/12/02); 200229028 (7/19/02); and 200234057 (8/23/02).
Hughlene A. Burton, Ph.D., CPA Associate Professor University of North Carolina-Charlotte Charlotte, NC
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|Author:||Burton, Hughlene A.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2003|
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