Current developments in partners and partnerships.

• Author: Burton, Hughlene A.

This article reviews and analyzes recent law changes as well as rulings and decisions involving partnerships. The discussion covers developments in income allocations, disguised sales, partnership distributions, terminations, and basis adjustments. During the period of this update (Nov. 1, 2014-Oct. 31, 2015), Treasury and the IRS worked to provide guidance for taxpayers on numerous changes that had been made to subchapter K over the past few years. The courts and the IRS also issued various rulings and regulations addressing partnership operations and allocations.

Audit Issues

Through 2017, there are three regimes for auditing partnerships. For partnerships with 10 or fewer partners, the IRS generally applies the same audit procedures as for individual taxpayers, while auditing both the partnership and the partner separately. For partnerships with more than 10 partners, the IRS uses the rules under TEFRA (1) to audit partnership returns. TEFRA requires determining the treatment of all partnership items at the partnership level. The third regime relates to partnerships with 100 or more partners that elect to be treated as electing large partnerships.

Effective for partnership tax years beginning after Dec. 31, 2017, Section 1101 of the Bipartisan Budget Act of 2015 (2) replaces the TEFRA partnership audit rules (3) with new rules to streamline the audit process for large partnerships as well as smaller partnerships that do not elect out of application of the new rules. New Sec. 6221(a) requires that:

Any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year (and any partner's distributive share thereof) shall be determined, any tax attributable thereto shall be assessed and collected, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to any such item or share shall be determined, at the partnership level. Under the new provisions, any adjustments determined in an IRS audit will be taken into account by the partnership in the year the adjustment request is made. A key part of the new law is that the additional tax will be paid by the partnership at the highest individual or corporate rate in effect for the reviewed year.

Partnerships will have the option to lower their tax liability if they can prove that the total tax liability would be lower if the adjustments were based on certain partner-level information. In addition, a partnership with 100 or fewer partners can elect out of application of the new rules if each of its partners is either an individual, a C corporation, any foreign entity that would be treated as a C corporation were it domestic, an S corporation, or an estate of a deceased partner.

Congress enacted TEFRA in part to improve the auditing and adjustment of income items attributable to partnerships. In a generic legal advice memorandum (4) in the past year concerning TEFRA audits, the IRS Office of Chief Counsel addressed who is authorized to sign a power of attorney (POA) appointing a representative for a partnership or limited liability company (LLC) being examined in a TEFRA partnership-level examination.

The IRS determined that a general partner (GP) or, in the case of an LLC, a member-manager, may sign a POA for purposes of a TEFRA partnership-level examination or for other tax purposes of the partnership. A POA can also be secured from a limited partner or LLC member for the purposes of securing partnership item information and disclosing partnership information to the POA. In the case of an LLC that has no member who is also a manager, the nonmember manager may sign the POA for purposes of establishing that it would be appropriate and helpful to secure partnership item information, including securing documents and discussing the information with the designated individual.

A question that continues to come up in TEFRA audits is whether an item is a partnership item. This question is important because a partnership item must be settled at the partnership level and will apply to all partners, while a nonpartnership item must be settled at the individual partner level. In 2015, several cases addressed this issue. Russian Recovery Fund Ltd., (5) a TEFRA case, looked at a readjustment of partnership items involving what is known as a distressed asset-debt, or DAD, transaction, in which a tax-exempt entity transfers its losses to a partnership in exchange for an interest in that partnership. After the transfer, the tax-exempt entity sells its partnership interest to another entity that subsequently claims the loss. In this case, a foreign hedge fund transferred distressed Russian sovereign debt to the taxpayer, an LLC taxed as a partnership, in exchange for shares in the taxpayer. The hedge fund then sold the shares to another fund that was a shareholder in the taxpayer. The IRS disallowed approximately $50 million of the losses the taxpayer claimed on its return. (6)

The taxpayer alleged that the IRS had erred in its disallowance of the loss. The IRS contended that the original acquisition of shares in the taxpayer by the foreign hedge fund had no business purpose, that the hedge fund was never a real partner in the taxpayer, and that the swap of assets for the shares should be ignored, as the transfer was a disguised sale.

The Court of Federal Claims had to decide whether the final partnership administrative adjustment (FPAA) adjusting the taxpayer's return correctly concluded that the loss claim was inappropriate, or whether, stated differently, the built-in loss vanished immediately because the transaction was a disguised sale. The court sided with the IRS and found the taxpayer had reason to know that the hedge fund had no real intention of becoming a partner in it. Based on the evidence, the hedge fund was not a partner, and the transaction was a sham lacking economic substance. Thus, the court held, the contribution to the taxpayer should be ignored and the transaction characterized as a sale.

In another case, (7) the Tax Court rejected the taxpayer's contentions that the FPAA issued to it was an improper second FPAA and therefore invalid. The taxpayer argued that the FPAA was a reproduction of a previous FPAA for a partnership in which the taxpayer was a partner and therefore violated the prohibition under Sec. 6223(f) of the IRS's issuing a second FPAA. Alternatively, the taxpayer contended that the court lacked jurisdiction over the current FPAA because all its adjustments were only computational adjustments from the lower-tier partnership's FPAA, and there were no affected items requiring factual determinations at the upper-tier partnership level.

The court found that the second FPAA was not a reproduction of the first, noting that none of the adjustments in the second FPAA were identical to those in the first, and the two FPAAs were issued to different entities. It found that the adjustments in the second FPAA (which involved the basis of assets the taxpayer received from the partnership) were not computational adjustments flowing from the first FPAA because the adjustments required specific factual findings about actions by the taxpayer.

Definition of Partnership and Partner

In the period covered by this update, the IRS addressed whether an entity should be treated as a partnership and who should report partnership income. In Letter Ruling 201515015, the taxpayer, a foreign business entity whose owners included three U.S. persons, terminated when it merged into another foreign entity, of which the three U.S. persons became owners. By default classification, the taxpayer had been an association for federal tax purposes. The taxpayer had intended to be taxed as a partnership; however, it failed to timely file an election to be classified as a partnership.

In the ruling, the IRS granted the taxpayer's request for a 120-day extension to make an election to...