CHAPTER 11 TAX PARTNERSHIPS FOR NONTAX PROFESSIONALS
| Jurisdiction | United States |
(May 1990)
TAX PARTNERSHIPS FOR NONTAX PROFESSIONALS
Holme Roberts & Owen
Denver, Colorado
and Thomas P. Briggs
Deloitte & Touche
Denver, Colorado
TABLE OF CONTENTS
Page
Introduction
Classification of Operating Agreements as Associations Taxable as Corporations
Early History
Morrissey Case
Post-Morrissey Developments
I.T. 3930 and I.T. 3948
Current Treasury Regulations
Cases Decided Under I.T. 3930 and I.T. 3948
Service's Current Position
neffective Take In Kind Provision
Treatment of a Joint Operating Agreement or Farmout Agreement as a Partnership for Federal Income Tax Purposes
General
Treatment of Carried Interest Arrangements (Farmout Arrangements) as a Partnership for Federal Income Tax Purposes
Tiered Tax Partnerships
Election Out of Subchapter K
Election Out of Subchapter K for First Taxable Year
No Formal Election Filed
Election Out of Subchapter K Following First Taxable Year
Irrevocability of Election Out of Subchapter K
Partial Election Out of Subchapter K
Effect of Election Out of Subchapter K
Effects of Treating the Joint Operating Agreement as a Tax Partnership
Special Allocations of Tax Items
"Formation" of Tax Partnership
Method of Accounting and Taxable Year
Tax Elections
Deemed Termination of Tax Partnership
Increase in Basis with Respect to Purchase of Working Interest
Depletable Basis
[Page 11-ii]
Consistent Treatment of Tax Items
Notification of Transfer of Working Interest
Registration as a Tax Shelter
Termination of Tax Partnerships
Economic Consequences
Recapture Items
Section 704(c)
Cash Distributions in Excess of Basis
Percentage Depletion
Basis of Distributed Properties
Closing of the Partnership Year
Means of Avoiding the Use of Tax Partnerships
Intangible Drilling Costs
Revenue Ruling 77-176
Material Provisions of Tax Partnership Agreements
Name of Partnership and Identity of Partners
Priority of Provisions
Relationship of the Parties
Election with Respect to Subchapter K
Capital Contributions
Method of Accounting and Tax Year
Other Elections
Maintenance of Capital Accounts
Allocations
Dispositions
Termination and Winding Up
Restriction on Transfers
Tax Matters Partner
Amendments and Modifications
———————
[Page 11-1]
Introduction
The parties to an oil and gas joint operating agreement generally treat their relationship for state-law purposes as a co-ownership arrangement.1 For federal income tax purposes, however, the relationship created by a joint operating agreement that includes an appropriate take in kind provision is treated as a partnership.2 Nevertheless, under the relevant provisions of the Code3 the co-working interest owners under an oil and gas joint operating agreement may elect to exclude their arrangement from the operation of Subchapter K4 of the Code.
The purpose of this paper is to discuss the important federal income tax issues arising from the treatment of oil and gas operating agreements or farmout agreements as partnerships for federal income tax purposes. As originally conceived by the authors, this paper was not intended to set forth a discussion suitable for an oil or gas tax professional. However, because of the complexity of the issues presented, many (but certainly not all) portions of
[Page 11-2]
this paper as drafted may be suitable for that purpose. The authors' inability to draft a paper that explains tax partnerships in simple terms may be a testament to the fact that the title of this paper ("Tax Partnerships for Nontax Professionals") is a misnomer—perhaps a tax professional should always be involved when a tax partnership is used.
This paper first examines the single most important tax issue relating to the utilization of a joint operating agreement: the determination of whether the arrangement constitutes an association taxable as a corporation. Second, the paper examines the treatment of an operating agreement or farmout agreement as a partnership for federal income tax purposes. Third, the paper examines the election out of Subchapter K. Fourth, the paper examines the tax consequences where the parties do not elect to exclude the arrangement from Subchapter K. Fifth, the paper examines the consequences of the termination of a tax partnership. Sixth, the paper examines the circumstances under which tax partnerships are used, and when their use can be avoided. Finally, the paper examines a typical tax partnership form and identifies those provisions of a tax partnership that the authors consider of primary importance.
Classification of Operating Agreements as Associations Taxable as Corporations
Early History. As originally conceived and implemented, the federal income tax laws treated corporations as separate taxable entities. Accordingly, a corporation is taxed on its earnings,5 and the earnings are in most circumstances taxed again when distributed to the shareholders.6 By contrast, no separate tax is imposed on a co-ownership arrangement, such as that existing under a joint operating agreement; rather, each co-owner is individually responsible for tax on his share of income arising from the co-ownership arrangement.
Shortly following the enactment of the first income tax laws, enterprising tax advisors ascertained that partnerships, trusts and other state law organizations that were not corporations could be imbued with corporate characteristics and yet retain their character as noncorporations under state law. Therefore, with the hope
[Page 11-3]
that double taxation could be avoided, many taxpayers attempted to conduct business through organizations that provided limited liability and other corporate characteristics, but were not corporations under state law. To preserve the integrity of the corporate tax, Congress, in 1918, provided that business "associations" were to be treated as corporations for federal income tax purposes.7 The term "association" was not then, and has never been, defined by statute. The Department of the Treasury early on exercised its regulatory authority and provided that the term "association" was to be broadly interpreted.8 However, the resultant regulations were more a statement of the government's litigating position than a substantive exposition of definitional guidelines. Consequently, the determination of whether a business enterprise should be treated as an association taxable as a corporation was largely left to the courts.
Morrissey Case. The courts did not develop a consistently-employed set of definitional parameters until the Supreme Court issued its decision in Morrissey v. Commissioner.9 In Morrissey, the court enumerated a number of corporate characteristics that could be utilized to test corporate resemblance. The principal corporate characteristics enumerated were: the existence of persons who had voluntarily associated themselves together to conduct business (referred to as "associates"); the existence of a common or "joint" profit objective; the centralization of the management of the entity; the continuance of the life of the organization despite changes in those owning interests in the organization (referred to as "continuity of life") and limited liability of the persons owning interests in the organization.
Post-Morrissey Developments. Following Morrissey, the classification of a business entity for federal income tax purposes was entirely dependent upon the factual circumstances surrounding the organization and operation of the entity. This case-by-case approach led to varied results.10 In the
[Page 11-4]
years following Morrissey, however, the classification of the relationship created by a typical joint operating agreement was apparently settled. One year prior to the decision in Morrissey, the Internal Revenue Service (then, the Bureau of Internal Revenue) issued I.T. 2749.11 Although I.T. 2749 does not specifically address whether a common joint oil and gas ownership arrangement constituted an association, the Bureau ruled that such arrangements constituted partnerships, a conclusion inconsistent with the characterization of such arrangements as associations taxable as corporations. In any event, the industry treated I.T. 2749 as holding that joint oil and gas ownership arrangements would not be classified as associations taxable as corporations.12 And, apparently, the Bureau did not seek to classify such joint ownership arrangements as associations taxable as corporations.13
I.T. 3930 and I.T. 3948. In 1948, however, the Bureau issued I.T. 3930.14 In I.T. 3930, the Bureau examined a typical joint operating agreement to determine under what circumstances the relationship created by the joint operating agreement would be treated as an association taxable as a corporation. Based upon its examination of the applicable case law and its own regulations, the Bureau concluded that a business organization could be characterized as an association taxable as a corporation only if four requirements were satisfied: (1) the enterprise must have associates, (2) the object of the organization must be joint profit, (3) the organization must possess the corporate characteristic of continuity of life, and (4) there must be centralized management of the affairs of the group.
The Bureau noted that joint operating agreements constitute mining partnerships,15 and analyzed the
[Page 11-5]
relationship created by a joint operating agreement on that basis. Because the "life of such agreements is not interrupted by the death of a participant nor by the transfer of an interest," the Bureau reasoned that "the organizations commonly created by such agreements have continuity of life."16 In the Bureau's view, the typical joint operating agreement possessed the corporate characteristic of associates because two or more persons had voluntarily joined together to conduct a business.17 Finally, the Bureau concluded that because management was "centralized in the majority interest or in the operator...
To continue reading
Request your trial