The consequences of electing out of Subchapter K.

I. Introduction

Subchapter K of the Code(1*) provides specific rules applicable to the tax treatment of partnerships and partners. The various rules of Subchapter K reflect two disparate theories regarding the fundamental nature of a partnership and its relationship to its partners -- the entity theory, under which the partnership is treated as an entity separate and apart from the partners,(2) and the aggregate theory, under which the partnership as a separate entity is disregarded and each partner is viewed as directly owning an undivided interest in the partnership's assets.(3) Congress expressly provided for application of one or the other theory for purposes of the various Subchapter K provisions, depending upon which theory is more appropriate under the circumstances. Outside of Subchapter K, however, determining which of the two theories should apply is much more uncertain.

Since the enactment of Subchapter K in 1954, certain organizations have been eligible to elect to be excluded from the application of Subchapter K. Until recently, however, the ramifications of such an election and whether the application of the aggregate or entity theory was more appropriate upon the making of such election for purposes of various non-Subchapter K provisions were largely unknown. This article explores a recent technical advice memorandum addressing those issue.(4)

II. Background Regarding Availability and Effect of Section 761(a) Election

A. Do Joint Operating Agreements Create a Partnership for Federal Income Tax Purposes?

The definition of a "partnership" for federal income tax purposes has remained essentially unchanged since 1932.(5) Nevertheless, for an extended period of time, the status of certain joint operating agreements initially used typically only in natural resource extractive industries, but later adapted to the utility industry, was uncertain. Specifically, it was unclear whether such arrangements were properly viewed as mere co-tenancies with each party to the arrangement owning an undivided interest in the jointly held property, or whether the agreement to share the output of the collective venture by distributing it in kind to each co-tenant for its own account demonstrated the requisite joint profit objective" necessary for partnership classification. As a result, such joint ventures were uncertain whether they were obligated to file the annual information returns required of partnerships.

Notwithstanding the enactment of a partnership definition in 1932, both the courts and the Internal Revenue Service occasionally classified these joint operating agreements as co-tenancies rather than as partnerships.(6) The IRS generally considered such arrangements to create "qualified partnerships," the co-owners of which were not required to calculate partnership taxable income and thus could individually elect whether to expense intangible drilling costs. In 1953, however, the Tax Court held in Bentex Oil Corp. v. Commissioner, 20 T.C. 565 (1953), that taxpayers operating under a joint operating agreement had in fact created a partnership. As separate entities, the partnerships were required to make the election regarding the expensing of intangible drilling costs, which election would be binding on the co-owners.(7) The Bentex decision created "a flurry of uncertainty and dismay among oil and gas leasehold owners" who had not treated their operations as partnerships and thus had not made partnership-level elections.(8)

Against this backdrop, the 1954 Code readopted in section 7701(a)(2) the partnership definition from the 1939 Code, but added a new Code provision in section 761(a), which permitted certain unincorporated ventures to elect out of the partnership rules of Subchapter K. Although the Committee Reports with respect to section 761(a) are limited, the generally understood reason for its enactment was the approval of the decision in Bentex, coupled with a mechanism to alleviate the hardships caused by the decision.(9)

B. Availability of Section 761(a) Election

Section 761(a) provides for an election by certain types of partnerships to be excluded from the application of all of Subchapter K,(10) the most prevalent of which are unincorporated organizations that engage in the joint production, extraction, or use of property, but do not jointly sell the services or property produced or extracted.(11) If members of such an organization so elect and the income of the members can be adequately determined without the computation of partnership taxable income, the organization is excluded from the application of Subchapter K. Although enacted for the extractive industries, the IRS has subsequently determined that utilities that jointly construct and own electric generating facilities as tenants in common, taking the power generated in kind to be sold separately to their respective customers had created a partnership under section 761(a) that was eligible to elect to be excluded from Subchapter K.(12)

The election-out is made in one of two ways. The first method is by making a formal election on the partnership tax return (Form 1065) for the first year for which the election is to be effective.(13) In addition, an election will be deemed if the facts and circumstances indicate the members intended to exclude an eligible organization from Subchapter K beginning with its first taxable year. Such intent likely will be found if there is an agreement among the parties manifesting an intent to be excluded from Subchapter K or members owning substantially all of the capital interests report their income (and make elections) on their individual returns in a manner consistent with the exclusion of the organization from Subchapter K and the organization does not file a partnership return. As provided in Treas. Reg. [sub] 1.6031-1(b)(1), once a section 761(a) election has been made (or is deemed made), the organization is under no obligation to file a partnership return; rather, each member computes its income on an individual basis. An organization that continues to meet the requirements of section 761(a) can revoke a section 761(a) election only with the consent of the Commissioner.

C. Effect of Election (Prior to Technical Advice Memorandum No. 9214011)

1. Section 7701(a)(2), Section 761, and Bryant

From its enactment in 1954, there has been uncertainty regarding the effect of a section 761(a) election The uncertainty arises because section 7701(a)(2) defines the term "partnership" for all purposes of the Code, whereas the election-out procedure under section 761(a) by its terms only applies to the partnership rules of Subchapter K. Thus, an organization satisfying the partnership definition under sections 7701(a)(2) and 761(a), but electing out of Subchapter K under section 761(a), arguably will continue to be treated as a partnership for non-Subchapter K purposes.(14)

The partnership definition set forth in section 7701(a)(2), however, is not so absolute. In recognition of the unresolved tension throughout the Code between the treatment of nominal partnerships as partnership entities (the entity theory) and their characterization as aggregations of individual co-tenants (the aggregate theory), section 7701(a)(2) provides that an organization otherwise satisfying the partnership definition will not be treated as such if "otherwise distinctly expressed or manifestly incompatible" with congressional intent. Therefore, even if a venture technically constitutes a partnership under section 7701(a)(2), a further determination must be made whether application of the entity or aggregate theory is more appropriate given the express terms or the purposes of the provision at issue. In other words, section 7701(a)(2) contemplates that an unincorporated entity otherwise satisfying its "partnership" definition will not necessarily be treated as a partnership entity for all purposes of the Code, even in the absence of a section 761(a) election. The presence of such an election only serves to exacerbate this uncertainty.

Until recently, neither the courts nor the IRS had established a definitive rule concerning the effect of a section 761(a) election on the treatment of co-owners of the electing venture. In Bryant v. Commissioner, 46 T.C. 848 (1966), aff'd, 399 F.2d 800 (5th Cir. 1968), the first case to address the effect of section 761(a) outside of Subchapter K, the taxpayers not only conceded that the organization of which they were a member created a "partnership" within the meaning of sections 761(a) and 7701(a)(2), but further conceded that under section 48(c)(2)(D) and its legislative history, in the case of the investment tax credit for used section 38 property, "a partnership and the partners individually are allowed a maximum of $50,000 for partnership assets." 46 T.C. at 863. Nevertheless, the taxpayers argued that by reason of the section 761(a) election, they should be relieved from the express statutory limitation on the maximum allowable credit for partnership assets.

Declaring that "sections 761(a) and 48(c)(2)(D) are not interdependent," the Tax Court determined that, notwithstanding an election-out, the partnership remained a partnership entity for purposes of the limitation on allowable credits for partnerships under section 48(c)(2)(D). The Court of Appeals affirmed, holding that the taxpayers "were in partnership and therefore . . . could not avoid the investment-credit limitation by an election to avoid Subchapter K." 399 F.2d at 806.

2. The "Interdependence" Principle

In a subsequent series of general counsel memoranda, the IRS elaborated on the "interdependence" principle applied in Bryant.(15) Under its approach to interdependence, the IRS employed a section-by-section analysis of each non-Subchapter K Code provision to determine whether it was "inconsistent with the purpose and effect of section 761(a) to continue to recognize the partnership as such" in applying that particular provision. Applying this approach, the IRS has held that the members of a section 761(a) electing venture can individually elect under non-Subchapter K section 616(b) whether to defer or deduct certain mine development costs(16) and whether to deduct or capitalize research and experimental expenditures under section 174(17) and carrying charges under section 266.(18) In addition, the IRS has held that the members can individually make certain depreciation elections under section 168.(19)

The IRS recognized in these rulings and related general counsel memoranda that the aggregate theory should be applied to section 761(a) electing ventures for purposes of at least some non-Subchapter K elective provisions. The use of a section-by-section approach to determine the applicability of the aggregate theory under the interdependence principle, however, left unresolved whether the aggregate theory would be applied to all elective non-Subchapter K provisions or to any nonelective, non-Subchapter K provisions that had not yet been addressed in rulings, particularly absent guidance on how to determine whether use of the entity theory was "inconsistent with the purpose and effect" of a section 761(a) election. This uncertainty was not unintentional; the IRS clearly desired to preserve its flexibility through the use of its section-by-section approach.(20)

3. Lost Opportunity -- Guidance Deferred

Notwithstanding Bryant and the IRS's application of a case-by-case approach in treating the partners as directly owning the property in applying non-Subchapter K elective provisions, there was still no guidance on the rule to be applied in the case of non-Subchapter K provisions that were not elective and did not expressly refer to partnerships. More than 10 years ago, a golden opportunity to obtain such guidance was lost. In Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521 (1979), affd, 633 F2d 512 (1980), several utilities formed a joint venture to construct and operate a nuclear power plant and the venture made a section 761(a) election to be excluded from Subchapter K. The issue before the courts was whether one of the participants could deduct, under section 162 of the Code, the costs o training its current employees to operate the facility. Specifically, the issue was whether such expenditures were incurred in connection with the co-tenant's existing trade or business and thus were deductible or should be treated as capitalized pre-opening costs of the venture. Unfortunately, the co-tenant failed to argue that, by reason of the section 761 election, the expenditures were ordinary and necessary expenses incurred in its existing trade or business. In addressing this oversight, the Tax Court stated:

Since petitioner here makes no contention that an

election-out under sec. 761(a) causes the unincorporated

group not to be a partnership except for purposes

of those statutes which contain a specific reference

to "partnerships," we have not considered

and do not here decide such a possible issue . . . . 72 T.C. at 559 n.9. The Seventh Circuit responded to the taxpayer's attempt to correct this oversight on appeal, as follows:

[The taxpayerl did not argue below that election-out

caused the organization not to be a partnership

for non-Subchapter K purposes, and the Tax Court

declined to decide this possible issue (72 T.C. at 559

n.9). In its alternative position here, however, [the

taxpayer] contends that the holding below is "inconsistent

with the purpose" of section 761(a) (Br.41).

This argument is indistinguishable from an argument

that election-out under section 761(a) negates

partnership status except where the Code explicitly

provides to the contrary. Since the issue was not

raised and decided below, we do not address it here. 633 F.2d at 516 n.2.(21)

Nearly a decade later, the Tax Court reaffirmed that it had not considered the effect of a section 761(a) election where the applicable provision outside Subchapter K does not expressly apply to partnerships. In Cokes v. Commissioner, 91 T.C. 222 (1988), the Tax Court determined that a partner's share of income "from any trade or business carried on by a partnership of which he is a member" was properly includible in net earnings from self employment under section 1402, notwithstanding a section 761(a) election. In commenting on the effect of the election, the court noted:

The discussion of this matter in Madison Gas . . .

sets aside for the future how the Bryant analysis is

to be applied where the controlling statute outside

of Subch. K does not specifically refer to partnerships.

In the instant case, sec. 1402(a) specifically

refers to partnerships; thus the instant case falls

within the Bryant analysis and we have no need to

weigh the considerations discussed in the Madison

Gas footnote. 91 T.C. at 231 n.9.

Thus, the courts had determined in Bryant and Cokes that a section 761(a) election had no effect on the status of a partnership as a separate entity in applying provisions specifically referring to partnerships, and the IRS had ruled that such an election resulted in the application of the aggregate theory with respect to at least certain individual member elections under non-Subchapter K Code provisions. It was not until the issuance of Technical Advice Memorandum No. 9214011, however, that guidance finally came on the issue left unresolved in Madison Gas, Cokes, and the extant rulings: the effect of a section 761(a) election on the application of nonelective, non-Subchapter K Code provisions that did not specifically refer to partnerships.

III. Technical Advice Memorandum No. 9214011

A. Introduction

As previously discussed, the IRS's interpretation of the interdependence principle preserved the IRS's flexibility to decide the effect of a section 761(a) election outside of Subchapter K on a case-by-case basis. As a consequence, the approach afforded taxpayers only limited guidance in areas that had not been explicitly ruled upon, particularly with respect to non-elective provisions outside of Subchapter K that did not specifically refer to partnerships. In sharp contrast, the IRS in Technical Advice Memorandum No. 9214011 adopted an expansive approach. Hence, although presented with a narrow issue on which it could have applied (and, in fact, was invited by the taxpayer to apply) its case-by-case methodology, the IRS invoked a broad, general principle, suggesting that such an election results in the members of such an electing organization owning an undivided, proportionate interest in the underlying assets, at least for purposes of Code provisions, such as those at issue, that do not explicitly refer to partnerships.

The reasoning underlying the technical advice memorandum leaves much to be desired. Nevertheless, if consistently applied, the technical advice memorandum provides long-awaited guidance to the extractive and utility industries by resolving the aggregate/entity debate for such electing organizations with respect to most, if not all, Code provisions. Numerous questions, however, remain about its potential scope.

B. Factual Situation, Issues Presented, and Result

The taxpayer in Technical Advice Memorandum No. 9214011 was a public utility that entered into a agreement with other public utilities to own, construct, and jointly operate the Seabrook, New Hampshire, nuclear power plant ("Seabrook"). The joint operating agreement specifically provided that the parties did not intend to create a partnership, joint venture, trust, association or similar organization, and the parties filed a valid section 761(a) election to exclude the organization from the application of Subchapter K.

As originally conceived, the project contemplated two generating units, but after numerous strikes, construction delays, environmental protests, lawsuits, and escalating costs, the co-owners, under pressure from their respective public utility commissions, voted to cease construction of Unit II, which construction has never been resumed. In addition, under continuing pressure from public utility commissions, taxpayer and certain of the other co-tenants sold their interests in Unit I to a third party at a considerable loss.

The specific issues presented to the National Office were --

(1) whether the taxpayer should be deemed to have

sold a partnership interest, which would generate a

capital loss under section 1221, or a proportionate

interest in the underlying property, which would

generate an ordinary loss under section 1231; and

(2) whether the taxpayer could individually abandon

its interest in the second property or whether an

abandonment loss was available only in the year in

which the "partnership" formally abandoned such

property.

The resolution of these issues, as well as any broader determination of the effect of a section 761(a) election outside of Subchapter K, ultimately requires an inquiry into whether the aggregate or entity theory of partnership taxation will be applied.

In Technical Advice Memorandum No. 9214011, the IRS ruled that (1) the taxpayer sold its proportionate interest in the first property and thus was entitled to an ordinary loss to the extent the underlying assets qualified under section 1231, and (2) the taxpayer was permitted to abandon its individual interest in the underlying assets of the second property regardless of whether or when the organization had abandoned its interest in such property. In resolving these specific issues, however, the IRS appeared to suggest that, except where otherwise provided, the members of an organization electing out of Subchapter K should be viewed as owning undivided proportionate interests in the underlying assets of the electing organization for all purposes of the Code. Thus, without explicitly stating so, Technical Advice Memorandum No. 9214011 adopted the rule that the aggregate theory of partnership taxation applies to organizations electing out of Subchapter K, except to the extent the analysis employed in Bryant and Cokes is applicable -- i.e., where Congress enacted a Code provision that is expressly applicable to "partnerships" as defined in section 7701(a)(2).

C. Reasoning Employed by the IRS

1. History Leading Up to Enactment of Section 761(a) Election (Qualified Partnerships)

The IRS reviewed the historical development of the term "partnership" and its application prior to the enactment of Subchapter K and section 761 in 1954. After reviewing the Bentex decision and Rev. Rul. 54-42, requiring partnership-level elections, the National Office announced that this rule did not apply to "qualified partnerships," i.e., partnerships that later became eligible to elect out of Subchapter K under section 761(a) because they could adequately compute their incomes without filing a partnership return. Even more startling, the IRS announced that under the 1939 Code each partner in a "qualified partnership" was viewed as directly owning its share of the underlying property and, consequently, each partner was required to make all elections with respect to such property.

2. Analysis Under Current Law

The IRS next observed that since section 703(b), which requires that the partnership make all elections affecting partnership taxable income, does not apply to organizations that have elected out of Subchapter K, the members of such organizations must make such elections on their individual returns. The IRS stated that it has consistently treated property held by a partnership electing out of Subchapter K as directly owned by the individual members of such organizations for purposes of making all elections with respect to such property. Concededly, the IRS had in fact previously ruled on several occasions that individual co-owners were to make particular elections. Nevertheless, it is somewhat disingenuous for the IRS to have claimed that it was clear that such an approach would be universally applied. After all, extant general counsel memoranda specifically stated both that the interdependence principle was to be applied on a case-by-case basis in order to preserve the flexibility of the IRS and that the IRS had expressly declined to establish any such universally applicable "rule."

3. Application to Sale or Exchange and Abandonment

While the foregoing conclusion represented a departure from the section-by-section approach of interdependence, it did not by itself represent a significant expansion of settled law. Moreover, adoption of a broader view of elective provisions did not necessarily resolve the specific issues presented by the non-elective provisions potentially applicable to determining the character of the loss upon the sale of an interest in Seabrook and the proper party to establish the abandonment loss. In order to resolve these issues, the IRS relied on two additional grounds to support its application of the aggregate theory.

First, the IRS extrapolated from its position permitting the co-tenants in electing ventures to independently elect cost recovery methods to the conclusion that gain or loss on the sale of the property would be borne by the co-owner. Since the incidence of taxation is always borne by the partners regardless whether the partnership is recognized as such, the relevance of separate cost recovery method elections to the loss characterization issue is questionable. Perhaps the IRS meant to say that since the differing methods of depreciation will be reflected in the differing bases of the co-tenants' interests, the amount of gain or loss is properly determined at the co-tenant level. Even so, that conclusion would not resolve the issue of the proper character of such gain or loss under an aggregate or entity theory.

The IRS also cited Rev. Rul. 56-500, 1956-2 C.B. 464, as additional authority for its position. That ruling specifically addressed whether the sale, exchange, or other transfer of a jointly owned property interest by a member of a section 761(a) electing organization would nullify an election which requires unanimous consent). It held that no nullification would occur so long as the purchaser did not affirmatively indicate to the contrary. The relevance of Rev. Rul. 56-500 is attenuated at best, especially with respect to the proposition that the members of such electing organizations will generally be considered to directly own a proportionate interest in the underlying assets. Nevertheless, the IRS ruled that the taxpayer in Technical Advice Memorandum No. 9214011 would be treated as having sold an undivided interest in the first property and that whether it had abandoned the second property would be determined without regard to whether the organization had abandoned such property.

D. Arguments Presented by Taxpayer

In developing the interdependence principle, the IRS had examined and rejected the broad aggregate approach that was subsequently embraced in Technical Advice Memorandum No. 9214011. It is ironic that the IRS appeared to reexamine and embrace a broad aggregate approach regarding the effect of section 761(a) in a situation in which the aggregate approach could have been narrowly applied to the specific Code sections at issue. Had it done so, it might have avoided numerous questions and uncertainties regarding the supporting analysis and the potential implications of a broad approach, particularly since the taxpayer presented arguments that provided ample support for a narrow decision.

1. Application of the Aggregate Theory Even in the Absence of a Section 761(a) Election

When Congress added Subchapter K into the Code in 1954, it adopted the entity theory of partnership taxation for many purposes, such as sections 707 and 741, and the aggregate theory for many other purposes, such as sections 701 and 751. The legislative history of section 707 confirms that Congress did not intend for one theory to dominate the other in applying provisions throughout the Code. The Conference Report states:

Both the House provisions and the Senate

amendment provide for the use of the "entity"

approach in the treatment of transactions between

a partner and a partnership which are

described above. No inference is intended, however,

that a partnership is to be considered as a

separate entity for the purpose of applying other

provisions of the internal revenue laws if the

concept of the partnership as a collection of

individuals is more appropriate for such provisions. H.R. Rep. No. 2543,83d Cong., 2d Sess. 59 (1954). Congress therefore intended that a partnership within the meaning of section 7701(a)(2) be treated as an aggregate of its co-owners whenever such treatment is appropriate under the terms or purposes of the Code provision at issue, even in the absence of a section 761(a) election.

Consistent with the express terms of section 7701(a)(2) and congressional intent regarding the entity and aggregate concepts, the courts and the IRS frequently have held that application of the aggregate theory was more appropriate to achieve the intent and purposes of the substantive Code provisions at issue.22 Moreover, as demonstrated by section 751, Congress intended that, in order to prevent inappropriate conversions of ordinary income into capital pin, the aggregate theory must be applied in some circumstances in connection with the disposition of partnership interests. Consistent with such intent, the courts have applied the aggregate theory to such characterization issues even when section 751 was not applicable.(23)

2. Application of the Aggregate Theory to the Sale

        and Abandonment of an Interest in an
        Organization Making a Section 761(a) Election

In recent years, Congress strongly suggested that the aggregate theory should be applied in determining the proper tax consequences of a sale or exchange when a section 761(a) election is made. In the Deficit Reduction Act of 1984, Congress specifically addressed the application of the aggregate theory upon the making of a section 761(a) election when it enacted section 1031(a)(2)(D), which precludes exchanges of "interests in a partnership" from qualifying for nonrecognition treatment. The Chairmen of the House Ways and Means Committee and the Senate Finance Committee agreed that exchanges involving section 761(a) electing ventures are properly viewed as direct exchanges of assets by the co-tenants under the aggregate theory for purposes of section 1031.(24) The Joint Committee's General Explanation of the 1984 Act (at pages 246-247) confirmed congressional intent to treat such exchanges as exchanges of interests in the underlying assets and not as exchanges of partnership interests subject to exclusion from section 1031 eligibility.(25) In 1990, Congress amended the Code to confirm that intent.(26) Given the comparable treatment for sales and exchanges throughout the Code, the aggregate theory should be applied in determining the character of the gain recognized upon the sale of an interest in a section 761(a) electing venture.

When Congress added Subchapter K to the Code in 1954, it addressed the concerns raised by the ability of taxpayers under previously decided authorities inappropriately to transform ordinary income into capital gain.(27) Congress thus mandated that while the entity theory generally applies to the sale of a partnership interest under section 741, the aggregate theory applies under section 751 to prevent the inappropriate conversion of ordinary income into capital gain.(28) Application of the aggregate theory where section 751 does not apply because of a valid section 761(a) election ensures consistency of treatment regardless of whether gain or loss is recognized. It also prevents the artificial use of a partnership to alter the otherwise readily determinable and appropriate tax treatment.

For example, if a venture electing out of Subchapter K were always treated as a partnership entity, a taxpayer could alter its tax results by interposing a partnership between itself and assets that normally produce ordinary income upon sale. The taxpayer would thus be able to convert ordinary income into capital gain by electing out of Subchapter K to avoid section 751 and selling a deemed partnership interest under section 1221 to produce capital gain. In contrast, the application of the aggregate theory to the sale of a co-owner's interest in the assets of a venture that has elected out of Subchapter K always will produce the appropriate result. A partner selling his interest in a partnership holding ordinary income assets would not be able to convert ordinary income to capital gain by having the partners make a section 761(a) election. Rather, the proper character of gain and loss would be determined by directly examining the nature and character of each asset and the pin or loss properly attributable to it.

Finally, consider a utility that builds a nuclear power plant on its own. As a result of escalating costs, it is forced to sell a portion of its interest at a loss, which should be characterized as an ordinary loss under section 1231. Assume that the co-tenants file a section 761(a) election. If the first utility is later forced to sell an additional part of its interest to its co-tenant at a loss, is there any sound tax policy rationale for treating the second sale as generating a capital loss on the ground that it involves the sale of a partnership interest?

The answer is no: there is no logical reason for mandating the application of the entity theory to determine the character of the pin or loss recognized upon the sale of an interest in a venture subject to a section 761(a) election. To the contrary, the only way to achieve the proper tax consequences with respect to all such sales, consistent with congressional intent, is to apply the aggregate theory.(29)

E. Conclusion

While the IRS undoubtedly reached the correct result in Technical Advice Memorandum No. 9214011, it clearly could have based its decision on firmer technical and policy grounds. Moreover, given its historical desire to retain flexibility through the use of section-by-section determination, it remains a mystery why the IRS embraced a broader application of the aggregate approach than was necessary to achieve that result in the situation presented.

IV. Potential Implications of the Technical Advice Memorandum

The IRS's broad application of the aggregate approach for organizations electing out of Subchapter K raises many questions. This section of the article reviews some of the issues that might arise in assessing the effect of Technical Advice Memorandum No. 9214011.

A. Provisions Where Entity Treatment Will Prevail

Code provisions that apply specific rules to partnerships and partners, such as those considered in Bryant and Cokes, will continue to apply to electing partnerships unless Congress has expressly provided to the contrary or unless the aggregate theory would clearly be the only appropriate theory to apply to such provisions for reasons independent of a section 761(a) election. For taxpayers with open taxable years in which investment tax credits were claimed, Bryant-type limitations should remain applicable notwithstanding a section 761(a) election. Similar limitations applicable to other types of credits should also remain applicable.30 In addition, analogous provisions imposing limitations on deductions by partnerships and partners should remain applicable to electing partnerships.(31)

B. Provisions Where Aggregate Treatment Should Prevail

Under Technical Advice Memorandum No. 9214011, it is clear that, for purposes of a number of Code provisions that do not specifically refer to partnerships, taxpayers making elections out of Subchapter K should be treated as owning a proportionate interest in the underlying assets of the organization directly. Nevertheless, collateral issues may be raised in at least some situations, thereby making it difficult to gauge the ultimate impact of the IRS's decision to broadly apply the aggregate approach following a section 761(a) election.

1. Impact on Madison Gas Analysis

The broad aggregate approach adopted by the IRS in Technical Advice Memorandum No. 9214011 should alter the result reached in the Madison Gas case, although it is difficult to imagine the IRS readily adopting that position. In Technical Advice Memorandum No. 9214011, the IRS noted that it has consistently applied the aggregate theory to organizations electing out of Subchapter K and thus has treated the members of such organizations as directly owning the underlying assets. Since section 162 does not have any rules specifically governing its application to partnerships, under Technical Advice Memorandum No. 9214011 the Madison Gas "partners," which were already in the electric utility business, should be treated as owning the nuclear generation facility directly rather than through a partnership. Thus, the training expenses should be ordinary and necessary business expenses of the continuing business of the partners, rather than constituting new start-up costs of the venture. Indeed, in Madison Gas itself the IRS conceded for purposes of the litigation that, if the joint venture were not considered a partnership, the training costs would be deductible. 72 T.C. at 557-558.

There is some evidence, however, that the IRS might abandon its concession in Madison Gas and challenge a taxpayer's attempt to deduct such training costs notwithstanding the section 761 election. In Cleveland Electric Illuminating Co. v. United States, 7 Cl. Ct. 220 (Cl. Ct. 1985), the Claims Court adopted the government's contention that an electric utility could not deduct the costs of training its personnel to operate a nuclear power plant in which it was a joint venturer in part because the court viewed the production of electricity by nuclear power to be a new and different trade or business from the taxpayer's historic generation of electricity by more conventional means, i.e., fossil fuel. Prior to Cleveland Electric, utilities had thought they were simply in the electric utility business, regardless of the manner in which that electricity was generated.

Although the decision in Cleveland Electric is illogical, there is some risk that it could be applied in future cases involving comparable facts. Indeed, the court in Madison Gas intimated that it was not necessarily agreeing with the government's concession, though whether the court had a Cleveland Electric-type analysis in mind is not clear from the decision.(32) Therefore, it remains uncertain whether adoption of the aggregate theory applied in Technical Advice Memorandum No. 9214011 would necessarily produce a different result in Madison Gas-type situations.

2. Elections

The IRS has previously ruled that members of organizations electing out of Subchapter K may make certain non-Subchapter K Code elections individually.(33) Such rulings are premised on the theory that such members are treated as directly owning a proportionate interest in the underlying property with respect to which the election is made. Prior to the issuance of Technical Advice Memorandum No. 9214011, however, the IRS had not indicated that it necessarily would apply the aggregate approach for purposes of all non-Subchapter K Code elections. Now that the position of the IRS has been clarified, members of section 761(a) electing organizations should be able to make individual non-Subchapter K Code elections with a greater confidence.

For example, if all the members of an organization that had elected out of Subchapter K sold their proportionate interests in the assets of the organization to a group of parties on an installment basis, each such member should be able to determine separately whether to elect out of section 453 installment reporting with respect to its sale. Prior to the issuance of Technical Advice Memorandum No. 9214011, it was not clear whether the IRS would have required that the organization make a single election that would have been binding on all members.

Similarly, if jointly owned property of an organization electing out of Subchapter K were condemned or destroyed in a manner that would be eligible for involuntary conversion treatment under section 1033, each member of the organization should be able to elect whether the section 1033(a)(2)(A) nonrecognition rule would apply to the extent it received cash and chose to reinvest in similar property.(34) In addition, an aggregate approach presumably would make it easier to acquire suitable replacement property. For example, if the jointly owned property was a large nuclear powered electric generation facility, a smaller fossil fuel-burning electric generation facility acquired or constructed by the individual member might constitute adequate replacement property for that particular member, thus permitting members to rationally address their need to replace their lost capacity rather than having to rely upon the joint venture to replace a large facility in order to qualify for the nonrecognition election.

In contrast, prior to the issuance of Technical Advice Memorandum No.9214011, it was unclear whether McManus v. Commissioner, 65 T.C. 197 (1975), aff'd, 583 F.2d 443 (9th Cir. 1978), cert. denied, 440 U.S. 959 (1979), would control. In McManus, a member of a joint venture that did not consider itself a partnership elected nonrecognition treatment under section 1033(a)(2) with respect to certain reinvested condemnation proceeds. The courts, however, held that because the joint venture was a partnership, such an election had to be made by the partnership entity. Technical Advice Memorandum No. 9214011 suggests, however, that if an eligible partnership has made a section 761(a) election, the individual members of such organization will be treated as if they owned a proportionate interest in the property directly and thus will be able to make appropriate elections under section 1033(a)(2) as well as other non-Subchapter K elective provisions.

The issuance of Technical Advice Memorandum No. 9214011 will not necessarily resolve all issues arising in connection with the elective provisions. Consider, for example, the treatment of organizational and "start-up" expenses of a joint venture that elects out of Subchapter K Section 709, which provides for the amortization of the organizational costs of a partnership in the nature of capital expenditures over 60 months (or such longer time period as the taxpayer elects), obviously would not apply to such a joint venture that had elected out of Subchapter K under section 761(a). It is unclear, however, whether such costs should be properly viewed as nonamortizable capital expenditures or whether such costs should be considered part of the taxpayer's cost basis in its undivided interest in the joint venture property.

A potentially more important, but similar, issue involves the proper application of section 195 to ventures making the section 761(a) election. Section 195 permits taxpayers to elect to amortize the "start-up" expenses of a new trade or business over not fewer than 60 months. Start-up expenses generally are defined in section 195(c)(1) as expenses relating to creating an active trade or business or investigating the creation or acquisition of an active trade or business and that are of a nature that would be deductible in the current taxable year if incurred in connection with an existing trade or business. Section 195(d) provides that a section 195 election must be made not later than the time (including extensions) for filing the taxpayer's return for the taxable year in which the trade or business begins.

The adoption of such a strict filing deadline (which effectively precludes the making of a section 195 election on an amended return) creates a possible whipsaw situation for taxpayers potentially subject to the Cleveland Electric-type analysis. They can make the section 195 election on their initial return, effectively conceding, at least for this purpose, that they are engaged in a new trade or business under Cleveland Electric. Alternatively, if they choose not to make the election and to deduct the expenses under section 162, but are successfully challenged by the IRS, they may well be precluded from deducting any of the start-up costs because of the expiration of the election period under section 195(c).

3. Short Tax Year Issue

Another issue that arises in the context of utility joint ventures and, indeed, is the subject of a pending request for technical advice by a co-tenant in one such venture is whether the so-called short taxable year depreciation rules are applicable in the first year the jointly owned property is placed in service. Under these rules, depreciation is limited to the number of months in the year the taxpayer was engaged in a trade or business.(35) The specific issue is whether this generally applicable limitation for "taxpayers" applies at the "partnership level" (the entity theory), thus limiting the amount of allowable depreciation in the first year, or whether it applies at the "partner level" (the aggregate theory) where it would not limit the allowable first Year depreciation (assuming the utility co-tenants were already engaged in business).

In the absence of a provision expressly applicable to partnerships, the aggregate approach of Technical Advice Memorandum No. 9214011 should be applied to treat the co-tenants as direct owners, thereby precluding application of the short taxable year limitations. Nevertheless, at least some examining agents are apparently relying upon an expansive reading of the Bryant case to invoke the short taxable year rule to electing ventures on the theory that all "limitation-type" provisions remain applicable with respect to such organizations regardless of whether such provisions expressly refer to partnerships.

V. Conclusion

Technical Advice Memorandum No. 9214011 undoubtedly reaches the correct conclusion with respect to the specific issues presented. The memorandum's expansive language potentially provides helpful guidance in other areas where there heretofore has been considerable uncertainty under the interdependence theory. Nevertheless, because of the inadequacy of the analysis purporting to support its conclusions and continuing indications that examining agents may continue to apply the entity theory to section 761(a) electing ventures, it might well be advisable for Congress to consider codification of the applicability of the aggregate theory to such ventures except where it otherwise expressly provides.

Notes

(1) I.R.C. [Sub section] 701-761. (2) See, e.g., I.R.C. [Sub section] 707, 741. (3) See, e.g., I.R.C. [Sub section] 701, 751. (4) Technical Advice Memorandum No. 9214011 (Dec. 26, 1991). (5) See [sub] 1111(a) of the Revenue Act of 1932; [sub] 3797 (a)(2) of the Internal Revenue Code of 1939; I.R.C. [Sub section] 7701(a)(2) and 761(a). (6) See I.T. 2785, XIII-1 C.B. 96 (1934); I.T. 2749, XIII-1 C.B. 99 (1934). For a discussion and compilation of the inconsistent authorities, see J. Taubman, Oil and Gas Partnerships and Section 761(a), 12 Tax L. Rev. 49 (1956); M. Collie & J. Driscoll, Partnership Oil and Gas Operations Under the Provisions of the Internal Revenue Code of 1954, 33 Texas L. Rev. 792 (1955). (7) The IRS subsequently issued Rev. Rul. 54-42, 1954-1 C.B. 64, which adopted the position of the Tax Court in Bentex. (8) See Collie [Sub section] Driscoll, supra note 6, at 795 n.13. (9) Madison Gas & Electric Co. v. Commissioner, 633 F.2d 512 (7th Cir. 1980), aff'g 72 T.C. 521 (1979). (10) With the consent of the District Director, a taxpayer also can elect to be excluded from only certain provisions of Subchapter K. Treas. Reg. [Sub section] 1.761-2(c). (11) Unincorporated organizations used only for investment purposes and not for the active conduct of a trade or business or used by dealers in securities for a short period to underwrite, sell, or distribute a particular issue of securities also are eligible to make a section 761(a) election. (12) Rev. Rul. 68-344, 1968-1 C.B. 569. See also Rev. Rul. 82-61, 1982-1 C.B. 13. (13) Although some commentators have questioned whether the co-tenants can elect out of Subchapter K in any year other than the first taxable year of the electing organization (see M. McMahon, The Availability and Effect of Election Out of Partnership Status Under Section 761(a), 9 Va. Tax Rev. 1, 25-27 (1989)), Treas. Reg. [Sub section] 1.761-2(b)(1) and 1.6031-1(a)(2) contemplate such an election in subsequent years. (14) See Madison Gas & Electric Co. v. Commissioner, 633 F.2d 512, 516 n.2 (7th Cir. 1980). (15) See General Counsel Memorandum 39043 (Aug. 5, 1983); General Counsel Memorandum 38418 (June 20, 1980); General Counsel Memorandum 36982 (Jan. 13, 1977). (16) Rev. Rul. 83-129, 1983-2 C.B. 105. (17) Letter Ruling Nos. 7926088 (Mar. 29, 1979); 7930028 (April 24, 1979); 7930061 (April 25, 1979). (18) Is Letter Ruling No. 7938046 (June 20, 1979). (19) Letter Ruling No. 9013077 (Jan. 4, 1990) (supplementing Letter Ruling No. 8950051 (Sept. 19, 1989)). (20) General Counsel Memorandum 39043. (21) The Seventh Circuit did note, however, that section 7701 applies throughout the Code, whereas section 761 applies only for purposes of Subchapter K, thus suggesting how it might resolve the issue. (22) See, e.g., Casel v. Commissioner, 79 T.C. 424 (1982) (application of section 267); Commissioner v. Whitney, 169 F.2d 562 (2d Cir. 1948) (same). Cf. Bennett v. Commissioner, 79 T.C. 470 (1982) (application of grantor trust rules). See also Rev. Rul. 90-112, 1990-2 C.B. 186; Rev. Rul. 89-85, 1989-2 C.B. 218; Rev. Rul. 81-261, 1981-2 C.B. 60. (23) Holiday Village Shopping Center v. United States, 773 F.2d 276 (Fed. Cir. 1985), aff'g 5 Cl. Ct. 566 (1984) (liquidating distribution of a partnership interest treated as a distribution of partnership property subject to recapture provisions of section 1250, thus preventing the inappropriate conversion of ordinary income into capital gain). The court's holding ultimately was codified in section 761(e). See also Burde v. Commissioner, 352 F.2d 995 (2d Cir. 1965), aff'g 43 T.C. 252 (1964), cert. denied, 383 U.S. 966 (1966) (aggregate theory applied to prevent the taxpayers from achieving capital gain treatment under section 1235 on a sale of a patent to a related partnership). (24) Statement of Rep. Rostenkowski, 130 Cong. Rec. H 7113 (June 27, 1984); Statement of Sen. Dole, 130 Cong. Rec. S 8410 (June 27, 1984). (25) General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess. 241-47 (Jt. Comm. Print Dec. 31, 1984). (26) In light of the fact that section 1031(a)(2)(1) expressly referred to "interests in a partnership," Congress clarified its intent in a technical correction to section 1031(a)(2), which was enacted as part of the Omnibus Budget Reconciliation Act of 1990, P.L. 101-508, [sub] 11703(d) (1990). (27) See Commissioner v. Shapiro, 125 F.2d 532 (6th Cir. 1942); Commissioner v. Smith, 173 F.2d 470 (5th Cir. 1949), aff'g 10 T.C. 398 (1948), cert. denied, 338 U.S. 818 (1949); Commissioner v. Lehman, 165 F.2d 383 (2d Cir.), cert. denied, 334 U.S. 819 (1948). (28) S. Rep. No. 1622, 83d Cong., 2d Sess. 98-99 (1954). In 1984, Congress reaffirmed its commitment to enforcement of section 751 by requiring the reporting of all section 751 transfers. See I.R.C. [sub] 6050K. (29) Indeed, during the pendency of the technical advice request, the IRS released Letter Ruling No. 9130044 in which it ruled, without analysis, that the proposed intercompany sale of another Seabrook co-tenant's interest in connection with an E reorganization would generate section 1231 gain or 108s. (30) See, eg., I.R.C. [Sub section] 40(g)(3) (small ethanol producer credit)", 44(d)(3) (disabled access credit). (31) See, eg., I.R.C. [Sub section] 179 (election to expense depreciable property); 194(b)(2)(B) (amortization of reforestation expenditures; 274(B)(2)(A) (gifts by partnerships). (32) It is also possible, for example, that the court might have thought that such expenditures should be capitalized because of the potential long-term benefit derived from such training. See Indopco v. Commissioner, 112 S. Ct. 1039 (1992). (33) See notes 13-15, supra, and accompanying text. (34) Nonrecognition treatment is elective only if the property is involuntarily converted into cash or dissimilar property and replacement property is acquired within two years. Nonrecognition is mandatory if similar property is directly received as a result of an involuntary conversion. (35) See, e.g., former I.R.C. [sub] 168(f)(5); Treas. Reg. [sub] 1.167(a)-11(c)(2)(iv). A similar issue could arise in determining whether a taxpayer has a taxable year of less than 12 months for purposes of applying the half-year and mid-quarter conventions set forth in section 168(d). See Prop. Reg. [sub] 1.168(d)-l(b)(6).

BRADLEY M. SELTZER is a partner in the Washington, D.C., office of Sutherland, Asbill & Brennan. He received a B.A. degree from the State University of New York in Albany and a J.D. degree from George Washington University's National Law Center. Mr. Seltzer is Vice Chair of the ABA Section of the Taxation's Committee on Regulated Utilities and Chair of its Normalization Subcommittee. He has served on the steering committee of the District of Columbia Bar Tax Section and is a Barrister member of the J. Edgar Murdock Inn of Court (which is dedicated to tax litigation). He has previously written for The Tax Executive.

J. RANDALL BUCHANAN is associated with Sutherland, Asbill & Brennan's Washington, D.C., office. He received his B.A. and J.D. degrees from the University of Virginia where he served on the Virginia Law Review. Mr. Buchanan is a member of the District of Columbia Bar and the ABA Section of Taxation. This is his first article for The Tax Executive.