Partner in trader partnership may claim partnership's, operating expenses as trade or business expense.

T is a partnership, acting as a trader in securities. T is a partner in other partnerships that are traders in securities. Some such partnerships are, in turn, partners in additional partnerships that are investors in securities. For Year 1, T claimed $a of trade or business expenses and $b of portfolio expenses. For Year 2, T claimed $c of trade or business expenses and $d of portfolio expenses. In both years, the portfolio expenses resulted from T's investments in partnerships in which it held an indirect interest.

Analysis

For a partnership involved in securities transactions, there is a distinction between a securities "dealer" and all other partnerships. A securities dealer is a taxpayer that regularly purchases securities from (or sells securities to) customers in the ordinary course of a trade or business. Based on the assumption made for purposes of this advice, T is not a securities dealer partnership.

To the extent a partnership is not a securities dealer partnership, it may be a trader or investor partnership. In general, a trader buys and sells securities with reasonable frequency in an endeavor to catch the swings in the daily market movement and profit thereby on a short-term basis. A trader can be engaged in a trade or business if the activity is conducted with continuity and regularity and with a primary purpose of producing income or profit; expenses incurred in the trading activity would constitute trade or business expenses. An investor purchases securities for capital appreciation and income, usually without regard to short-term developments that would influence the price of the securities on the daily market. Investing is not a trade or business, regardless of the amount and regularity of the activity; expenses incidental to investing are not deductible as having been paid or incurred in a trade or business. Based on the assumption made for purposes of this advice, T is a trader partnership.

Trade or Business Expenses

The taxable income of a partnership is computed in the same manner as an individual, except that certain items described in Sec. 702 must be separately stated and certain itemized deductions for individuals are not allowed to the partnership. In determining his income tax, each partner is required to take into account separately his distributive share of the partnership items of income, gain, loss, deduction and credit. Sec. 212 expenses are separately passed through to (and accounted for by) the partners under Sec. 702(a)(7). In general, non-separately stated business expenses are netted against gross income to determine net income.

The character of any item of loss or deduction is determined as if the item were incurred in the same manner as incurred by the partnership. In general, the character of each item of partnership income or expense is determined at the partnership level, in the absence of a specific statutory provision to the contrary. However, if a partnership is a trader partnership, the partnership is engaged in a trade or business and the partners are entitled to treat their distributive share of partnership expenses as trade or business expenses. Generally, a trade or business expense is deductible. For noncorporate taxpayers (and a few specially defined corporations), interest expense attributable to a trade or business activity is deductible subject to the limits of Sec. 469. The deduction for interest expense attributable to an investment activity, however, is not subject to the Sec. 469 limits, but is instead subject to Sec. 163(d)(1) for noncorporate taxpayers. Under Sec. 163(d)(5)(A)(ii), certain interest expense attributable to trade or business activity will be characterized as investment interest expense if the taxpayer does not materially participate in the activity but is required to treat the activity as nonpassive. Thus, it is not sufficient for a taxpayer simply to allocate interest expense between a trade or business activity and an investment activity. A further determination must be made as to whether the trade or business interest expense will be subject to Sec. 469 or will instead be characterized as investment interest expense under Sec. 163(d)(5)(A)(ii).

Passive Activity Loss

An individual generally is not allowed a passive activity loss or credit. A passive activity is any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. The term "passive activity loss" means the amount by which the aggregate losses from all passive activities for a tax year exceed the aggregate income from all passive activities for such year.

In the context of a partnership, Sec. 469 does will not affect the partners' ability to characterize their distributive share of partnership trade or business expenses as Sec. 162 deductions. However, if partners do not materially participate in the trade or business activity, their ability to deduct their share of the expenses will be subject to the limits of Sec. 469.

In the present case, T is assumed to be a trader. While the ability to deduct losses attributable to the conduct of a trade or business is normally subject to Sec. 469, a special exception exists for the activity of trading personal property for the account of owners of interests in the activity. Under Temp. Kegs. Sec. 1.469-1T(e)(6), such an activity is not a passive activity, without regard to whether the activity is a trade or business activity. Personal property is any personal property of a type that is actively traded. Thus, T's activity is not a passive activity and the income or losses derived from the activity cannot be passive income or losses.

Interest Expense

In general, a deduction is allowed for all interest paid or accrued in a tax year on debt. For taxpayers (other than corporations), a deduction for personal interest paid or accrued during the tax year is not allowed. Interest paid or accrued on debt properly allocable to a trade or business (other than the trade or business of performing services as an employee) is not personal interest; there is no limit on a deduction for such interest. Investment interest is not personal interest. However, a deduction for investment interest for taxpayers (other than corporations) is limited to the amount of net investment income for the tax year. The determination of whether interest is investment interest is made at the level of the partnership that incurs the interest.

Investment interest is any interest allowable as a deduction that is paid or accrued on debt properly allocable to property held for investment. Property held for investment includes any property that produces income of a type described in Sec. 469(e)(1). Sec. 469(e)(1) income includes gross income from interest, dividends, annuities or royalties (not derived in the ordinary course of a trade or business), as well as gain or loss from the disposition (not in the ordinary course of business) of property that produces income of that type. A trader generates income of this type in the ordinary course of business.

Interest (and other expenses) must be allocated as appropriate between investing and trading if T engaged in both activities. Rules for allocating interest expense for purposes of applying Secs. 163(d), 163(h) and 469 are found in Temp. Regs. Sec. 1.163-8T. In general, interest expense on a debt is allocated in the same manner as the debt to which the interest expense relates is allocated. The debt is allocated by tracing disbursements of the debt proceeds to specific expenditures.

These expenditures may be classified as "trade or business," "passive activity," "investment," "personal" or "portfolio." The facts do not indicate how the debts incurred by T and the other partnerships should be traced. It is assumed that a portion of T's interest expense is allocable to its investment activity and a portion to its trading (trade or business) activity. Because it is generated in the ordinary course of business, the interest expense attributable to T's trading activity will not be considered investment interest expense under Sec. 163 (d)(5)(A)(i). For certain partners, however, such interest expense may be treated as an investment interest expense under Sec. 163(d)(5)(A)(ii), which indicates that "property held for investment" also includes any interest held by a taxpayer in an activity involving the conduct of a trade or business that is not a passive activity and with respect to which the taxpayer does not materially participate.

As indicated, due to Temp. Regs. Sec. 1.469-IT(e)(6), T's trading activity is a nonpassive activity without regard to the degree of participation by T's partners. Thus, partners who do not materially participate in the trading activity will treat their interests in T'S trading activity as property held for investment. Such partners will be subject to the Sec. 163(d) limit on their distributive share of T's interest expense attributable to its trading activity. In addition, to the extent T has interest expense not attributable to its trading activity, such interest expense would be treated as investment interest expense under the normal operation of Sec. 163(d)(5)(A)(i). Because the trade or business determination is made at the partnership level, T's distributive share of interest expense from partnerships that do not qualify as traders would not be treated as a trade or business expense to T. Rather, such interest expense would be characterized as investment interest expense to T. Thus, when such interest passes through to T's partners, their ability to deduct the expense would be subject to the limits of Sec. 163(d)(1).

All noncorporate partners of T will be subject to the limits of Sec. 163(d) on their distributive share of T's investment interest expense. Whether noncorporate partners of T are also subject to Sec. 163(d) on their share of T's trading interest expense will depend on each partner's participation. Therefore, depending on a partner's degree of participation, Sec. 163(d) could limit the deductibility of the interest expense associated with the partnership's trading activity for some partners and not others. Regs. Sec. 1.702-1(a)(8)(ii) requires that each partner take into account separately his distributive share of any partnership items that, if separately taken into account, would result in an income tax liability for that partner different from that which would otherwise result. Thus, T's interest expense associated with its trading activity must be separately passed through to (and accounted for by) T's partners.

IRS LETTER RULING (FSA) 200111001 (9/13/00)

IN THIS DEPARTMENT

Partners & Partnership

* Trader partnership's operating expenses: FSA 200111001; p. 562.

Procedure & Administration

* Frivolous return positions based on foreign-based-income argument: Notice 2001-40; p. 565.

The reports of cases, rulings, etc., except for the Reflections, are edited versions of the relevant court opinion, published ruling, etc.

* This development, concerning related matters, is covered in the Reflections to the report of the principal item.