The consequences of electing out of Subchapter K.

• Author: Seltzer, Bradley M.

1. 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)

2. 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...