CHAPTER 4 FEDERAL PARTNERSHIP TAX TREATMENT IN MINING AGREEMENTS: SELECTED BASIC CONCEPTS
| Jurisdiction | United States |
(May 1991)
FEDERAL PARTNERSHIP TAX TREATMENT IN MINING AGREEMENTS: SELECTED BASIC CONCEPTS
Professor of Law Director, Villanova University Graduate Tax Program
Villanova, Pennsylvania
Rocky Mountain Mineral Law Foundation
Special Institute on Mining Agreements III
Summary of Contents
Page
I. Overview of Federal Tax Concepts
A. Characterization of Transactions
B. Classification of Taxpayers
C. Choice of Entity
D. Major Tax Attributes of Mineral Operations
II. Use of Partnerships in Mineral Enterprises
A. Tax Treatment of Partnerships and Partners
B. Take-in-kind Enterprises
C. Election Out of Partnership Status
III. Partnership Agreement: Tax Considerations
A. Capital Contributions
B. Transfer of Partnership Interests and Assets
C. Allocations and Distributions
D. Other Tax Matters
E. Management
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I. Overview of Federal Tax Concepts
A. Characterization of Transactions
1. The common law of federal taxation causes a transaction to be characterized by reference to its substance, if that departs from its form. State or local law is not necessarily determinative. Federal tax law, both statutory and decisional, controls.1
2. Terminology used by the parties does not necessarily establish the character of the transaction.2 However, the parties' view of the transaction may be evidence of its character.3
3. The substance of a transaction is generally determined by identifying the economic relationships created by the parties.4 As a general proposition, while the Service is free to attempt to ferret out the substance of the transaction, the taxpayer may have scant latitude in attempting to impeach the form he has chosen.5
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4. The intent of the parties may be evidence of the substance of the transaction, but the ultimate test is what they actually did.6
B. Classification of the Taxpayer
1. The Internal Revenue Code recognizes four categories of taxable persons: individuals, corporation, trusts, and estates. Partnerships and S Corporations are not taxpayers; instead they are flow-through entitles whose tax attributes are reported by their taxpayer-owners. To some extent, the Code's tax rates and rules apply differently to each kind of taxable person. Accordingly, it may be necessary to classify a particular person or entity in order to determine its treatment for tax purposes.
2. The Code does not concisely define a corporation,7 partnership,8 or trust.9 Since a partner is defined as a member of a partnership,10 all four categories of taxable persons can be partners, as can another partnership.
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3. In the absence of useful statutory definitions, the classification of an organization as a corporation or a partnership has been fleshed out by regulations, rulings and court decisions. As a practical matter, the most common classification problem is distinguishing between a partnership and a corporation.
a) A partnership is identified by reference to a test established by the Supreme Court: "whether, considering all the facts...the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise."11 Among the factors that post-Culbertson decisions have taken into account in making the classification determination are evidence of an intent for joining together in the enterprise to share profits as coproprietors, sharing of losses, joint capital ownership, joint participation in management, and contribution of services to the partnership.12
b) Because of the amorphous nature of the partnership classification factors, a number of profit-based relationships resemble partnerships, yet are distinguished from them. In the context of the current topic, three deserve note.
i) Employees and independent contractors may be entitled to a share of the net profits of an enterprise, yet that fact alone does not make them partners, or the enterprise a partnership. While there is no bright-line test, the absence of overall managerial control, or the lack of an interest in the capital of the enterprise, or an insulation from its liabilities tends to signal non-partner status.13
ii) A lessor's rental income may be measured by a portion of the net or gross income of the partnership. That fact alone does not signal a partnership arrangement. But
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additional participation in the enterprise by the lessor may add up to partnership status.14
iii) Property co-ownership arrangements are sometimes difficult to distinguish from partnerships. On one hand, mere co-ownership of property does not create a partnership. On the other hand, if the co-owners engage in a significant amount of joint activity with a view to sharing the resulting profit, a partnership may exist.15
b) A corporation in the classic sense is a fictitious person that owes its existence to a formal charter issued by the state or federal government. In addition, for federal tax purposes, an association of persons that is not formally organized or chartered can be taxable as a corporation. As a result, an enterprise that is in form a partnership, in substance can be treated as an association taxable as a corporation.
i) The regulations establish six characteristics to be referred to in determining whether an association is to be classified as a corporation:16 associates, an objective to carry on a business and divide the gains derived from it; continuity of life; centralization of management; liability for corporate debts limited to corporate property; and free transferability of interests.
ii) Of those factors, since the presence in an enterprise of associates and a business objective are common to both corporations and partnerships, the regulations treat the remaining four factors as determinative, giving each factor equal
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weight. The presence of a preponderance of the factors signals corporate status.17
4. For purposes of determining the classification of an enterprise, the Code and not local law controls. For example, a particular organization might be classed as a partnership under local law, but be treated as an association taxable as a corporation for federal tax purposes. At the same time, local law governs in identifying and determining the legal relationships between the parties to the enterprise.18
C. Choice of Entity
From a federal tax standpoint a key threshold question is the form of the operating or investment enterprise.
1. Individual taxpayers normally use a cash method of accounting and the calendar year as their taxable year. As a result, an individual taxpayer reflects in income currently the direct tax attributes arising from his investment or activities. If the taxpayer is a royalty holder his income may qualify for long term capital gain treatment under sections 631(c) and 1231. If he pays advance minimum royalties, to be currently deductible they must meet the uniform payment rules of Reg. sec. 1.612-3(b)(3), and if those royalties are paid with the view of subleasing the mineral, they may be treated as part of the individual's cost of goods sold.19 If the individual invests directly in the mineral, ordinarily he can claim percentage (or cost) depletion, but he will not be entitled to capital gain treatment on the resulting income.20 Other deductions arising from his direct interest, such as exploration and development costs, may be available to him, and the at risk and passive activity loss limitation rules may apply.21
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2. Since a corporation is itself a taxpaying entity, operating in corporate form bottles up at the entity level the tax attributes of mineral operations, and the current tax benefit of losses and deductions do not end up in the hands of its shareholders. In addition, special rules apply to corporations that can diminish or limit their use of some mineral-related deductions.22 On the other hand, if the mineral operation is carried on through multiple corporations, as is often the case, the affiliated group may file a consolidated return. It permits losses of one member of the group to be offset against the income of other members of the group, capital gain or loss and section 1231 gain or loss is determined on a consolidated basis, and the recognition of realized gain from certain intercompany transactions may be deferred.23
3. An S corporation offers its shareholders the advantage of limitation of liability, but it is treated for Code purposes as a flow-through entity. Its shareholders report the income and loss of the S corporation on their returns, thereby eliminating the double corporate tax and causing income to be taxed at the somewhat lower individual rates. The S corporation's income or loss is attributed to its shareholders on the basis of their proportionate share interests.24 One of the sometimes-unnoticed results of that treatment is that it tends to avoid a number of audit issues that the Service's agents routinely raise on audits of closely held corporations.
4. Because a partnership is a flow-through entity, its tax incidents are passed through to its partners to be picked up on their own returns. The treatment of those items at the partner level depends on the tax classification of the partner. The partnership form permits special allocations of income, deduction or credit, which will be honored so long as they have
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"substantial economic effect."25 As a result, the partnership form of operation may allow somewhat more latitude for fine-tuning the economic interrelationships of the partners in the enterprise. The tax aspects of operating in partnership form are discussed somewhat more fully below.
5. Co-ownership of a mining operation, different from partnership or corporate status, occurs where each party owns an undivided fractional interest in the mineral property. In effect, it is a kind of co-tenancy which resembles a partnership, but does not encompass the...
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