Current developments.

• Author: Burton, Hughlene A.
• Position: Regarding the taxation of partnerships

EXECUTIVE SUMMARY

* Final regulations were issued to address basis adjustments under Secs. 734(b) and 743(b).

* The IRS issued proposed and temporary regulations on the assumption of contingent liabilities.

* Final regulations discuss basis issues for corporate partners.

This article reviews and analyzes recent rulings and decisions on partnerships. It covers developments on partnership formation, election out of Subchapter K, statute of limitations, basis, debt and income allocation, transactions between partners and partnerships and partnership continuation.

During the period of this update (Nov. 1, 2002-Oct. 31, 2003),Treasury issued numerous sets of proposed and final partnership regulations, including one set on noncompensatory options. In addition, the IRS plans to provide guidance on partnership compensatory options and convertible instruments in the future. There were also various causes and rulings on the formation and operations of a partnership and abusive tax situations.

Classification

To decide if a partnership exists, it must 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 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.

This year, there were two such cases, with differing results. In Ballantyne, (1) two brothers owned a partnership that operated two separate businesses. The partnership did not maintain a separate set of records, but did file a return each year. By oral agreement, each brother operated one of the businesses and withdrew profits therefrom. However, for tax purposes, they agreed to report income and losses equally. When one of the partners died, the family contested the allocation of income. The Eighth Circuit ruled that, because the partnership did not have a written agreement, the facts and circumstances surrounding the operation would determine whether the oral agreement set the partners' distributive shares. The court ruled that the oral agreement of an equal partnership was valid, based on the way the prior tax returns had been filed.

In another case, (2) two parties conducted foreign trade shows. As in Ballantyne, there was no written partnership agreement; in addition, no separate books and records were kept and no partnership returns were filed. In addition, the parties did not have joint control of the venture's capital and profits and there was no evidence of a profit-sharing agreement. Based on these factors, the Tax Court ruled there was no partnership.

These two cases also point out the importance of a written partnership agreement. If partners want a venture to be respected as a partnership with an oral agreement, the venture must be operated as such, with separate books and records maintained and partnership tax returns filed.

In a different situation, (3) a taxpayer exchanged his interest in several lots with another individual for an interest in a parcel of land. The taxpayer contended that the two individuals were partners in a partnership that owned all of the land and that his receipt of the interest in the parcel was a nontaxable partnership distribution. However, no partnership returns were filed. The IRS argued that no partnership existed; thus, the transaction was a taxable exchange between two individual taxpayers. The Tax Court agreed with the IRS, because the partnership did not own the land.

Abusive Tax Situations

Straddle Transactions

Notice 2003-54 (4) extended the 2002 rulings that dealt with multi-step transactions designed to use a straddle, a tiered-partnership structure and a transitory partner to allow a taxpayer to claim a permanent noneconomic loss. In this situation, the transaction involved the use of a common trust fund that invested in economically offsetting gain and loss positions in foreign currencies and then allocated the gains to a tax-indifferent party and the losses to a taxable party. The notice alerted taxpayers and their advisers that the tax benefits purportedly generated by this transaction would not be allowed for Federal tax purposes and that this and similar transactions are now listed transactions under the tax shelter regulations. (5)

Tax Shelters

For the past few years, Treasury and the IRS have been concentrating on tax shelters. Accordingly, they issued final regulations in February 2003 modifying the rules on filing disclosure statements under Sec. 6011(a). In addition, Rev. Proc. 2003-24 (6) provided exceptions applicable to certain loss transactions, and Rev. Proc. 2003-25 (7) provided exceptions applicable to certain transactions with significant book-tax differences.

Taxation on Formation

FLPs

The gift of a family limited partnership (FLP) interest qualifies for the gift tax annual exclusion and the value of the gifted interest may be reduced by using minority interest and marketability discounts. However, in certain cases, the IRS may challenge the use or amount of the discount. In McCord, (8) a family formed a FLP and the parents assigned interests in it to their children, to trusts for the children's benefit and to two charitable organizations. The children...