Current developments: this article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, foreign-source income, debt and income allocations, partnership continuation and basis adjustments.

• Author: Burton, Hughlene A.

EXECUTIVE SUMMARY

* Treasury issued a notice and proposed, final and temporary regulations on the application of Sec. 199 to flowthrough entities.

* Many rulings were issued on TEFRA audits, taxation of partnership income, Sec. 704(b), partnership conversions, basis adjustments and in other areas.

* The IRS is studying the current Sec. 751(b) regulations and considering alternative approaches to achieve Sec. 751's purpose in a simpler way.

**********

Treasury and the IRS have worked to provide guidance on numerous changes made to subchapter K in the past few years. During the period of this update (Nov. 1, 2005-Oct. 31, 2006), proposed and final partnership regulations were issued on the Sec. 199 deduction, foreign-source income and the substantiality of allocations. The courts and the Service also issued various rulings addressing partnership operations and allocations.

Partnership Issues

Classification

When deciding if a partnership exists, it must be determined whether the partners intended to join together for the purpose of carrying on a trade or business and to share the profits and losses of that venture. However, a written partnership agreement is not required. Because a partnership can exist without a written partnership agreement, the question "Is the venture a partnership or not?" must be answered repeatedly.

In two letter rulings, (1) two unrelated entities were tenants-in-common as to certain real estate. The owners had entered into a management agreement with an affiliate of one of them. The tenants-in-common agreement provided that each party would receive 50% of all income and was obligated to pay 50% of all expenses. Each owner could sell its share of the property pursuant to a buy-sell agreement. The owners requested a ruling that the property's ownership did not create a partnership, so that they could determine whether the property qualified as replacement property under Sec. 1031(a). The IRS concluded that the taxpayers' co-ownership arrangement satisfied all the conditions in Rev. Proc. 2002-22, (2) including those regarding voting, hiring of a manager and managing operations. Thus, the co-ownership of the property did not constitute a partnership.

TEFRA Issues

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) was enacted to improve the auditing and adjustment of income items attributable to partnerships. It requires determining the treatment of all partnership items at the entity level. A question that continues to arise is whether an item is a partnership item. This year, several cases addressed TEFRA issues.

In PK Ventures, Inc., (3) the parties agreed that the characterization of transfers from a partner to a TEFRA partnership as debt or equity was a partnership item that could be adjusted only on the issuance of a Federal partnership administrative adjustment (FPAA). If the Service does not issue a valid FPAA for a specific year, neither it nor the court can adjust partnership items for those years. In this case, transfers were made by a partner to the partnership for 1986-1990, but an FPAA was issued only for 1991. The IRS determined that the earlier transfers were capital contributions, not debt; thus, it disallowed the interest deduction taken by the partnership for 1991. The court agreed.

Another issue was whether the taxpayers had sufficient basis in their partnership interests to deduct losses from the partnership from 1990-1995. Because an FPAA was issued only for 1991, the court determined that any transfers made in that year should be reclassified as equity in the calculation of the taxpayers' basis; however, the transfers before and after 1991 could not be changed and, for basis purposes, had to be treated consistently with the reporting on the partnership's tax returns.

Two cases (4) addressed whether an FPAA was timely filed, and analyzed the interaction between the statute of limitations (SOL) that applies to partnership proceedings under Sec. 6229 and the general three-year SOL on assessments under Sec. 6501. In both cases, the FPAA was issued after the general SOL expired. The taxpayers argued that Sec. 6229 establishes a limitations period separate and apart from that described in Sec. 6501. Thus, if an FPAA is issued after the general statute has run, changes cannot be made to a partner's tax return. The IRS argued that the two provisions act in tandem and that Sec. 6229 can extend the Sec. 6501 period for assessment, but can never shorten it.

In both cases, the Court of Federal Claims agreed with the Service and found that the FPAA was issued timely; the IRS could adjust the partnership return as needed and then proceed against the partners for the tax consequences of that adjustment. In each case, the court relied on the language in the statute and committee reports to arrive at this conclusion.

In another situation, (5) the Service considered whether a payment made by an affiliated group member to a partnership in which it was not a partner was a partnership item. In the ruling, a subsidiary was a partner in a partnership. The subsidiary's parent made a payment to the partnership in the ordinary course of business, not in its capacity as an agent for the consolidated group or on the subsidiary's behalf. The partnership treated the payment as income and the parent took a deduction. The IRS disallowed the deduction and recharacterized it as a loan to the partnership. Because the group filed a consolidated return, the parent was severally liable for the tax liability attributable to partnership items allocated to the subsidiary as a partner. Under Sec. 6231 (a) (2) (B), the parent would be treated as a partner for TEFRA partnership procedures purposes. However, the TEFRA procedures only apply to the specific items that the partnership is required to determine under Code subtitle A. Thus, if the TEFRA procedures do not apply to the adjustment of an item, the item is not a partnership item.

It was determined that the parent's payment was not a partnership item and that its status as a partner for Sec. 6231(a) (2) (B) purposes did not make it a partner for subchapter K purposes. Accordingly, the parent's deduction for its payment to the partnership was not subject to the TEFRA procedures.

Foreign Partnerships

A growing area is the use of partnerships, instead of corporations, in international operations. As the number of foreign partnerships that operate in the U.S. increases, so...