* Treasury issued final regulations on the assumption of contingent liabilities and proposed regulations on the tax effect to both partners and partnerships of the exchange of equity interests for services.
* Final regulations address a partnership's obligation to withhold tax on effectively connected income allocable to a foreign partner.
* Many rulings were issued on TEFRA audits, guaranteed payments, Sec. 704(c) and partnership conversions, and in other areas.
This article reviews and analyzes recent developments involving partnerships. The discussion covers partnership formation, subchapter K elections, basis, debt and income allocations, transactions between partners and partnerships and partnership continuation.
During the period of this update (Nov. 1, 2004-Oct. 31, 2005), there was no partnership tax legislation, but Treasury and the IRS provided guidance on the numerous changes made to subchapter K in the past few years. Treasury issued proposed and final partnership regulations on liability allocations, noncompensatory options and disguised sales. The courts and the IRS ruled on partnership operations and abusive tax situations.
To decide whether a partnership exists, it must first be determined if the partners intended to join together for the purpose of carrying on a trade or business and to share the profits and losses therefrom. However, because a written partnership agreement is not required, the question of whether a venture is a partnership or not must be answered repeatedly.
For example, in Allum (1) a taxpayer received a settlement from a lawsuit. The Service determined it was taxable income, because it was not received on account of personal injury. The taxpayer argued that the part of the proceeds used to pay attorneys' fees should not be included in gross income, because a de facto partnership existed between him and his attorney. The Tax Court ruled that there was no partner ship, because there was no partnership agreement.
Entity vs. Aggregate Theory
An issue that often arises in the taxation of partners and partnerships is whether to use the entity theory or the aggregate theory. The entity theory treats the partnership as an entity separate and distinct from its owners; the aggregate theory treats it as an aggregate of its owners. Both of these theories are used in various sections of subchapter K.
In the past, the Tax Court used the entity theory to determine which party could deduct legal expenses. For example, in Craft, (2) a taxpayer deducted legal expenses related to the transfer of stock that he owned through a family limited partnership (FLP). The IRS disallowed the deduction, stating that the expense properly belonged to the FLR because it arose through ownership of the FLP interest and was not directly related to the individual's business activities. The court agreed with the Service, noting that the partnership is a separate entity that must compute its taxable income separate from its partners. Further, to be deductible, those expenses must be those of the taxpayer claiming the deduction. A partner cannot convert a partnership expense into a personal expense simply by agreeing to pay it. This decision could affect any partner who personally pays partnership expenses.
The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) was enacted to improve auditing and adjustment of income items attributable to partnerships. It requires determining the treatment of all partnership items at the partnership level. However, a question that continues to arise is whether an item is a partnership item. This dilemma arose in Olsen-Smith, Ltd., (3) in which a general partnership (GP) that was owned by three limited liability companies (LLCs) tried to amend its earnings from self-employment (SE) during the TEFRA audit process. The tax matters partner argued that the GP had no SE earnings as defined in Sec. 1402(c), because neither the partnership nor any of its partners had an individual as an owner. The IRS argued that the court did not have jurisdiction to decide whether the GP had an individual as an indirect partner, because such determination might involve information not usually maintained by partnerships.
The court agreed with the Service. The determination of the ownership of a passthrough entity (an LLC in this case) that is a partner is a nonpartnership item on which the court is not allowed to rule. Importantly, the court did not say that the GP did not have a valid argument, just that it did not have jurisdiction. Partnerships without individual partners (either directly or indirectly) must calculate SE earnings correctly before the audit process begins.
A growing area is the use of partnerships in international operations. As the number of foreign partner ships that operate in the U.S. increases, so will the number of rulings. In the past year, Treasury issued final regulations (4) on a partnership's obligation to withhold tax on effectively connected taxable income allocable to a foreign partner under Sec. 1446. The regulations' affect all partnerships engaged in a trade or business in the U.S. that have one or more foreign partners. They coordinate the documentation required under Secs. 1441 and 1446, by accepting either (1) Form W-8ECI, Certificate of Foreign Person's Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States, or (2) W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding, for exemption from withholding.
One of the advantages of setting up a FLP is to reduce the assets in a taxpayer's estate. In addition, the estate tax value of the FLP interest may be reduced by using minority interest and marketability discounts. In the past, the IRS unsuccessfully challenged the use or amount of the discount taken when valuing a FLP interest. As a result, it has a new tactic; it argues that the full value of the properties transferred to the FLP should be included in the estate under Sec. 2036(a). For example, in Est. of Wayne C. Bongard, (5) the decedent and a trust had formed a FLP by transferring LLC membership units in exchange for the partnership interests. The FLP did not perform any activities after formation, and the decedent made all its decisions. The court held that an implied agreement existed between the decedent and the FLR allowing him to retain a Sec. 2036(a) interest in the LLC property, and the bona fide sale exception did not apply. Thus, the value of the membership units had to be included in the estate. (6)
In the early 1990s, Treasury issued anti-abuse regulations under Sec. 701. According to Regs. Sec. 1.7012(b), if a partnership is formed or availed of in connection with a transaction, a principal purpose of which is the substantial reduction of the partners' aggregate Federal tax liability inconsistent with subchapter K, the IRS can recast the transaction to achieve tax results consistent with subchapter K.
In Santa Monica Pictures, LLC, (7) taxpayers formed an LLC supposedly for the purpose of producing and distributing film entertainment products. Some of the taxpayers became partners by contributing receivables with high tax bases, but very little (if any) value. These same partners exited the partnership a few weeks later.
The Tax Court ruled that the contributions' purpose was to transfer tax attributes associated with the high-basis, low-value receivables to the LLC tax free. It relied on Sec. 701 and the substance-over-form doctrine to rule that these taxpayers never became partners, but instead, sold the assets to the LLC. The court also found no business reason for setting up the LLC, and ruled the transaction a sham.
Under Sec. 721(a), no gain or loss is recognized on the exchange of property for a partnership interest. Services are not property for this purpose. Thus, a partner providing services for an interest would have income to report and, based on a literal reading of the Code, so would the partnership. In 2005, Treasury issued a proposed regulation (8) on the tax treatment of certain transfers of partnership equity for the performance of services.
According to the proposed rule, the receipt of a partnership interest by a partner in exchange for services is governed by Sec. 83. Further, there are rules coordinating Sec. 83 with partnership principles. The proposed regulation allows the partner and partnership to determine the value of the partnership interest received (and thus, the amount of taxable income to the partner), based on liquidation value. The regulation does not distinguish between the receipt of a capital interest and a profits interest. In addition, a partnership would recognize no gain or loss on the transfer of an interest in exchange for services.
Electing Out of Subchapter K
Partnership rules require that income not be included in a partner's income until the last day of the partnership's tax year. Unfortunately, an annual inclusion can be incompatible with money market and certain bond funds; thus, many tax-exempt-bond partnerships try to elect out of subchapter K. However, these partnerships do not meet Sec. 761(a)'s requirements.
To solve these problems, several rulings were issued in the past. Rev. Proc. 2003-32 (9) allowed certain regulated investment companies (RICs) to treat interest income as exempt from tax under Sec. 103. The partnership interests were referred to as synthetic tax-exempt variable-rate bonds. Eligible partnerships were allowed to make an election to permit consenting partners to take into account their partnership income on a monthly basis. The IRS later issued Rev. Proc. 2003-84, (10) allowing tax-exempt-bond partnerships an election to enable partners to take exempt income into account on a monthly basis. More recently, it issued Rev. Proc. 2005-20,11 which describes the conditions under which a RIC that holds a partnership interest would be treated as if it had directly invested in the assets held by the partnership. This procedure amplifies and supersedes Rev. Proc. 2003-32, to extend its treatment to consenting partners and partnerships described in Rev. Proc. 2003-84.
Under Sec. 752(a), an increase in a partner's share of a partnership's liabilities is deemed a contribution of money that increases the partner's outside basis. Sec. 752(b) provides that a decrease in a partner's share of liabilities is treated as a cash distribution. No liability is created unless the partnership is currently obligated to repay funds or other property advanced. Specifically, a partnership obligation that is subject to "contingencies that make it unlikely that the obligation will ever be discharged;' is disregarded for tax purposes.
Regs. Sec. 1.752-7 (12) deals with a partnership's assumption of contingent liabilities from a contributing partner. It provides rules to prevent the duplication and acceleration of loss through the partnership's assumption of such liabilities. The rules are similar to those for corporations contained in Sec. 358(h). However, Regs. Sec. 1.752-7 does not contain Sec. 358(h)'s "substantially all" exception. This regulation applies to certain fixed or contingent obligations to make payments not described in Regs. Sec. 1.752-1(a)(1). The Regs. Sec. 1.752-7 liability is treated as having a built-in loss (BIL) equal to the amount of the liability at the time of its assumption by the partnership. When the liability is satisfied, the deduction for the BIL is allocated to the partner who contributed the liability. Regs. Sec. 1.752-7 applies to contingent liabilities assumed after June 23, 2003.
Partnership Operations and Income Allocation
Sec. 702 specifies the items a partner must take into account separately; Sec. 703 provides that any election affecting the computation of partnership taxable income must be made by the entity. Under Sec. 704(a), the allocation of partnership items is made based on the partnership agreement; however, there are several exceptions to this general rule.
The American Jobs Creation Act of 2004 (AJCA) created new limits on the deductibility of losses relating to exempt-use property under Sec. 470. The Service issued Notice 2005-29 (13) to provide transition relief for partnerships and other passthrough entities. According to the notice, for tax years beginning after 2005, it will not apply Sec. 470 to disallow losses associated with property treated as exempt-use property solely because the partnership made an unqualified allocation of a partnership item to a partner that is an exempt entity.
Sec. 704(b) allows a partnership to make special allocations if they have substantial economic effect. One of the requirements is the maintenance of capital accounts. Regs. Sec. 1.704-1(b)(2)(iv) allows capital accounts to be revalued in certain instances. In 2005, final regulations (14) revised Regs. Sec. 1.704-1(b)(2)(iv) (b) to take into account all liabilities to which the contributed or distributed property is subject, not just liabilities described in Sec. 752. This change occurred concurrently with the finalization of Regs. Sec. 1.752-7.
In a letter ruling, (15) a taxpayer requested advice as to whether an allocation had substantial economic effect under Sec. 704(b). Eight partnerships had merged into one under Regs. Sec. 1.708-1(c)(3)(i). The partnership agreement included all the requirements under Regs. Sec. 1.704-1 for allocations to have substantial economic effect. The partnership maintained a separate capital account for each partner and adjusted them using simulated cost depletion. In addition, simulated gains and losses were allocated to the capital accounts so that they were proportionate to their respective percentage interests. The partnership agreement allocated the profits and losses to the partners' capital accounts in accordance with their percentage interests. Partnership tax credits were allocated in the same manner. The Service determined that the partnership allocations met the requirements for substantial economic effect under Regs. Sec. 1.704-1(b)(2)(ii).
Final regulations (16) were issued under Secs. 704(c) and 737 on the tax treatment of installment obligations acquired via a contract.The proposed regulations amend Regs. Sec. 1.7043(a)(8) to clarify that if a partnership disposes of Sec. 704(c) property in an installment sale, the installment obligation is treated as Sec. 704(c) property. In addition, if a partner contributes a contract to the partnership that is Sec. 704(c) property, any property the partnership acquires under that contract is also Sec. 704(c) property if less than all the built-in gain or BIL is recognized. The new regulations apply to installment obligations acquired after Nov. 23, 2003.
Sec. 704(c) Rulings
In Rev. Rul. 2004-43, (17) the IlLS addressed whether Sec. 704(c)(1)(B) would apply to Sec. 704(c) gain or loss created in an assets-over partnership merger. It ruled that Sec. 704(c) (1) (B) applied to newly created Sec. 704(c) gain or loss on property contributed by the transferor partner. However, it did not apply to any reverse Sec. 704(c) gain or loss created from a revaluation of property in the continuing partnership. Likewise, for Sec. 737(b) purposes, net pre-contribution gain includes the newly created Sec. 704(c) gain or loss from the property contributed by the transferor partnership, but not the reverse Sec. 704(c) gain or loss created by the revaluation of assets in the continuing partnership.
After receiving numerous comments, the IRS revoked Rev. Rul. 2004-43, (18) and stated that it would issue proposed regulations (19) that will apply its principles to property distributions following assets-over partnership mergers. The regulations will also apply to distributions of property with newly created Sec. 704(c) gain or loss, whether or not that gain is treated as reverse Sec. 704(c) gain or loss. The regulations will also apply to distributions of property with original Sec. 704(c) gain or loss that existed on contribution to the transferor partnership. If the transferor partnership in an assets-over merger holds contributed property with original Sec. 704(c) gain or loss, the seven-year period in Secs. 704(c)(1)(B) and 737 does not restart. The regulations will not apply to newly created Sec. 704(c) gain or loss in an assets-over merger involving partnerships owned by the same owners; and, for Sec. 737 purposes, net pre-contribution gain does not include newly created Sec. 704(c) gain or loss.
Three items determine whether a partner can deduct a share of partnership losses currently: (1) partnership interest basis under Sec. 704(d); (2) Sec. 465 amount at-risk; and (3) Sec. 469 passive activity income. In PK Ventures, Inc., (20) the question was whether the partners had sufficient basis under Secs. 704(d) and 465 to deduct their share of partnership losses. Specifically at issue was the allocation of the partnership's nonrecourse debt and purported loans from a partner to the partnership.
The Tax Court held that the taxpayers could increase their basis by their share of nonrecourse debt under Sec. 752, but not for the transfers made by the partner to the partnership, because they did not represent a bona fide debt. In addition, the court found that the nonrecourse debt gave the taxpayers Sec. 465 basis, because it was secured by real property. Thus, the partners could deduct losses to the extent of their basis with the nonrecourse debt included.
Transactions Between Partnership and Partner
Under Sec. 707, if a partner engages in a transaction with a partnership other than in his or her capacity as a partner, the transaction will be considered as occurring between the partnership and a nonpartner. Sec. 707(a) (2)(B) applies to disguised sales of partnership interests. If there is a property transfer between the partnership and the partner that is properly characterized as a sale or exchange of property, the transaction should be viewed as occurring between two unrelated parties. This provision prevents partners from selling their partnership interests and treating the sale as a nontaxable distribution. Treasury issued proposed regulations (21) on disguised sales of partnership interests.
According to these rules, a transfer of money, property or other consideration by a purchasing partner to a partnership, and a transfer of consideration by the partnership to a selling partner, constitute a sale only if, based on all the facts and circumstances, the transfer by the partnership would not have been made had the partner not made the contribution to the partnership, and any subsequent transfer does not depend on the partnership's operations. The proposed regulations keep the rule that any transfer of consideration by a purchasing partner to a partnership, and any transfer of consideration by the partnership to a selling partner made within two years of each other, are presumed to be a sale.
In a ruling, (22) a company wanted to sell a building. Instead of selling it directly, its tax adviser had the company contribute it to a limited partnership (LP), while the potential buyer contributed cash to the partnership. The partnership then borrowed additional cash. Soon afterward, most of it was distributed to the company. The IRS determined this series of transactions to be a disguised sale under Sec. 707(a); the company would have to recognize a gain on the building's sale.
To the extent distributions to partners are not determined by partnership income, the payments are deemed made to an unrelated party under Sec. 707(c) (guaranteed payments). Partners are required to include guaranteed payments in taxable income; the partnership can deduct the payments. In Notice 2005-8, (23) the IRS clarified that, if a partnership makes a contribution to a partner's health savings account, it can be treated either as a distribution under Sec. 731 or as a guaranteed payment under Sec. 707(c), depending on the way the agreement is written. However, if the contribution is treated as a guaranteed payment, it must be included in the partner's SE income. Thus, tax advisers should be very careful in drafting such an agreement.
Also, in Whitman & Ransom, (24) partners from two partnerships formed a new one. Some of the partners of the old firms did not become partners in the new venture. Those partners had severance agreements that called for them to be repaid their capital accounts net of capital loans. These amounts were paid to liquidate the partners' interests. Several years later, the partnership made adjustments to eliminate the negative capital account balances of the withdrawn partners and treated the adjustments as guaranteed payments. The Tax Court ruled that, because the individuals were not partners at the time the adjustments were made, such payments could not be treated as guaranteed payments under Sec. 707(c).
The two events that terminate a partnership for tax purposes under Sec. 708(b) are (1) no part of its business or venture continues to be carried on by any partners or (2) within a 12-month period, there is a sale or exchange of 50% or more of the total interests in partnership capital and profits. In a letter ruling, (25) a GP converted into an LE Afterward, each partner owned the same percentage interest as before. The IRS determined that, assuming there was no change in the partners' respective share of liabilities, neither the partnership nor the partners would recognize gain or loss on the conversion, and the partnership would not be deemed terminated under Sec. 708(b)(1)(B). In addition, the partnership would be allowed to retain its Federal taxpayer identification number (TIN).
Sec. 754 Elections
When a partnership distributes property or a partner transfers an 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 under either Sec. 734(b) or 743(b) to reflect the fair market value (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 the partnership interest. The election must be filed by the due date of the return for the year the election is effective and normally is filed with the return. If a partnership inadvertently fails to file the election, it can ask for relief under Regs. Sec. 301.9100-1 and-3.
In a series of rulings, (26) the IRS granted extensions to make a Sec. 754 election. In each case, the partnership was eligible to make the election, but inadvertently omitted it when filing its return. The Service reasoned that the partnership in each case acted reasonably and in good faith and granted an extension to file the election under Regs. Sec. 301.9100-1 and -3. Each partnership had 60 days after the ruling to file the election. The extension was granted even when the partnership relied on a tax professional to file its return. (27)
In several situations, (28) complex litigation regarding a partner's estate prevented a timely filed Sec. 754 election. The Service granted a 60-day extension to file the election. However, as a condition of the late election relief, any allowable depreciation deducted for the first year had to be computed using a property basis unadjusted for Sec. 743(b). Any depreciation deducted for the second year and thereafter had to be computed using a property basis adjusted for the Sec. 754 election.
Another instance (29) presented a tiered-partnership issue. An individual owned an interest in a partnership that owned an interest in a second partnership. After he died, the upper-tier partnership made a Sec. 754 election, but the lower-tier partnership did not. The IRS concluded that it was an inadvertent failure and granted the lower-tier partnership a 60-day extension to file the election.
In the past, basis adjustments made under either Sec. 734 or 743 were elective. However, when there is a substantial basis reduction, AJCA Section 833(c) requires a basis adjustment under Sec. 734(b) for certain distributions from partnerships when no Sec. 754 election is in effect. This section requires an adjustment if there is a substantial basis reduction (defined as a downward adjustment of more than $250,000 that would have been made to the basis of partnership assets if a Sec. 754 election had been in effect). Likewise, AJCA Section 833(b) requires a basis adjustment under Sec. 743 for transfers of partnership interests when there is a substantial BIL. This exists when a partnership's adjusted basis in its property exceeds the property's FMV by more than $250,000.
Notice 2005-32 (30) provides interim procedures for taxpayers to comply with the mandatory basis adjustments. Until further guidance is provided, taxpayers must comply with Regs. Sec. 1.734-1(d) as if a Sec. 754 election had been in effect at the time of the distribution. If an adjustment is required by AJCA Section 833(b), taxpayers must follow Sec. 1.743-1(k), assuming a Sec. 754 election is in effect.
The AJCA does not require electing investment partnerships (EIPs) to make these basis adjustments. Rather, it imposes special loss-disallowance rules at the partner level. Under Notice 2005-32, a partnership can make the election to be treated as an EIP by attaching a written statement to an original or amended return for the year the election is effective. The statement should include the name, address and TIN of the partnership making the election and a representation that the partnership is eligible to make the election and to be treated as an EIP.
For more information about this article, contact Dr. Burton at Haburton@email.uncc.edu.
Editor's note: Dr. Burton is a member of the AICPA Tax Division's S Corporation Taxation Technical Resource Panel.
Hughlene A. Burton, Ph.D., CPA
University of North Carolina-Charlotte
(1) Robert L. Allum, TC Memo 2005-177.
(2) Ronnie O. Craft, TC Memo 2005-197.
(3) Olsen-Smith, Ltd., TC Memo 2005-174.
(4) TD 9200 (5/13/05).
(5) Est. of Wayne C. Bongard, 124 TC 95 (2005).
(6) For more details, see Satchit, "Bongard: Tax Court Incorrectly Expands Sec. 2036(a)'s Application," 36 The Tax Adviser 476 (August 2005).
(7) Santa Monica Pictures, LLC, TC Memo 2005-104.
(8) REG-105346-03 (5/24/05); for details, see Cantrell, Personal Financial Planning, "Partnership Interest for Services Regs. Offer Estate Planners a 'Bona Fide' Solution," 36 The Tax Adviser 636 (October 2005).
(9) Rev. Proc. 2003-32, 2003-1 CB 803.
(10) Rev. Proc. 2003-84, 2003-2 CB 1159.
(11) Rev. Proc. 2005-20, IRB 2005-18, 990.
(12) TD 9207 (5/24/05).
(13) Notice 2005-29, IRB 2005-13, 796.
(14) See TD 9207, note 12 supra.
(15) IRS Letter Ruling 200530013 (7/29/05).
(16) TD 9193 (3/21/05).
(17) Rev. Rul. 2004-43, IRB 2004-18, 842.
(18) See Rev. Rul. 2005-10, IRB 2005-7, 492.
(19) See Notice 2005-15, 2005-IRB 2005-7, 527.
(20) PK Ventures, Inc., TC Memo 2005-56.
(21) REG-149519-03 (11/26/04).
(22) Chief Counsel Advice 200513022 (11/15/04).
(23) Notice 2005-8, IRB 2005-4, 368.
(24) Whitman & Ransom, TC Memo 2005-172.
(25) IRS Letter Ruling 200538005 (9/23/05).
(26) IR.S Letter Rulings 200541030 (10/14/05); 200537008 (9/16/05); 200524018 (6/17/05); and 200509017 (3/4/05).
(27) IRS Letter Rulings 200530018 (7/29/05) and 200507007 (2/18/05).
(28) IRS Letter Rulings 200531015 and 200531016 (both dated 8/5/05), and 200530015 (7/29/05).
(29) IRS Letter Ruling 200537016 (9/16/05).
(30) Notice 2005-32, IRB 2005-16, 895.
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|Author:||Burton, Hughlene A.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2006|
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