Current developments.

• Author: Burton, Hughlene A.
• Position: Partnerships

EXECUTIVE SUMMARY

* Treasury issued final regulations on the assumption of contingent liabilities and proposed regulations on the tax effect to both partners and partnerships of the exchange of equity interests for services.

* Final regulations address a partnership's obligation to withhold tax on effectively connected income allocable to a foreign partner.

* Many rulings were issued on TEFRA audits, guaranteed payments, Sec. 704(c) and partnership conversions, and in other areas.

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This article reviews and analyzes recent developments involving partnerships. The discussion covers partnership formation, subchapter K elections, basis, debt and income allocations, transactions between partners and partnerships and partnership continuation.

During the period of this update (Nov. 1, 2004-Oct. 31, 2005), there was no partnership tax legislation, but Treasury and the IRS provided guidance on the numerous changes made to subchapter K in the past few years. Treasury issued proposed and final partnership regulations on liability allocations, noncompensatory options and disguised sales. The courts and the IRS ruled on partnership operations and abusive tax situations.

Partnership Issues

Classification

To decide whether a partnership exists, it must first 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 therefrom. However, because a written partnership agreement is not required, the question of whether a venture is a partnership or not must be answered repeatedly.

For example, in Allum (1) a taxpayer received a settlement from a lawsuit. The Service determined it was taxable income, because it was not received on account of personal injury. The taxpayer argued that the part of the proceeds used to pay attorneys' fees should not be included in gross income, because a de facto partnership existed between him and his attorney. The Tax Court ruled that there was no partner ship, because there was no partnership agreement.

Entity vs. Aggregate Theory

An issue that often arises in the taxation of partners and partnerships is whether to use the entity theory or the aggregate theory. The entity theory treats the partnership as an entity separate and distinct from its owners; the aggregate theory treats it as an aggregate of its owners. Both of these theories are used in various sections of subchapter K.

In the past, the Tax Court used the entity theory to determine which party could deduct legal expenses. For example, in Craft, (2) a taxpayer deducted legal expenses related to the transfer of stock that he owned through a family limited partnership (FLP). The IRS disallowed the deduction, stating that the expense properly belonged to the FLR because it arose through ownership of the FLP interest and was not directly related to the individual's business activities. The court agreed with the Service, noting that the partnership is a separate entity that must compute its taxable income separate from its partners. Further, to be deductible, those expenses must be those of the taxpayer claiming the deduction. A partner cannot convert a partnership expense into a personal expense simply by agreeing to pay it. This decision could affect any partner who personally pays partnership expenses.

TEFRA

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) was enacted to improve auditing and adjustment of income items attributable to partnerships. It requires determining the treatment of all partnership items at the partnership level. However, a question that continues to arise is whether an item is a partnership item. This dilemma arose in Olsen-Smith, Ltd., (3) in which a general partnership (GP) that was owned by three limited liability companies (LLCs) tried to amend its earnings from self-employment (SE) during the TEFRA audit process. The tax matters partner argued that the GP had no SE earnings as defined in Sec. 1402(c), because neither the partnership nor any of its partners had an individual as an owner. The IRS argued that the court did not have jurisdiction to decide whether the GP had an individual as an indirect partner, because such determination might involve information not usually maintained by partnerships.

The court agreed with the Service. The determination of the ownership of a passthrough entity (an LLC in this case) that is a partner is a nonpartnership item on which the court is not allowed to rule. Importantly, the court did not say that the GP did not have a valid argument, just that it did not have jurisdiction. Partnerships without individual partners (either directly or indirectly) must calculate SE earnings correctly before the audit process begins.

Foreign Partnerships

A growing area is the use of partnerships in international operations. As the number of foreign partner ships that operate in the U.S. increases, so will the number of rulings. In the past year, Treasury issued final regulations (4) on a partnership's obligation to withhold tax on effectively connected taxable income allocable to a foreign partner under Sec. 1446. The regulations' affect all partnerships engaged in a trade or business in the U.S. that have one or more foreign partners. They coordinate the documentation required under Secs. 1441 and 1446, by accepting either (1) Form W-8ECI, Certificate of Foreign Person's Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States, or (2) W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding, for exemption from withholding.

FLPs

One of the advantages of setting up a FLP is to reduce the assets in a taxpayer's estate. In addition, the estate tax value of the FLP interest may be reduced by using minority interest and marketability discounts. In the past, the IRS unsuccessfully challenged the use or amount of the discount taken...