Current developments in partners and partnerships.

• Author: Burton, Hughlene A.

EXECUTIVE SUMMARY

* Treasury amended the Sec. 6694 penalties for nontaxshelter transactions.

* The IRS issued three revenue rulings and an announcement regarding interest expense in a trader partnership.

* The Tax Court determined that a deficit restoration obligation does not give rise to at-risk basis.

* Many rulings were issued on TEFRA audits, taxation of partnership income, allocation of contingent liabilities, economic substance, and other areas.

* Effective for 2008 tax returns, the extended due date for Form 1065 will be September 15 instead of October 15.

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This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, foreign source income, debt and income allocations, partnership continuation, and basis adjustments. During the period of this update (November 1, 2007-October 31, 2008), Treasury and the IRS worked to provide guidance for taxpayers on numerous changes that had been made to subchapter K in the past few years. Treasury issued proposed and final partnership regulations about the Sec. 199 deduction, foreign source income, and the substantiality of allocations. The courts and the IRS issued various rulings that addressed partnership operations and allocations.

Form 1065

The IRS has made changes to Form 1065, U.S. Return of Partnership Income, which partnerships use to file their returns. These changes are expected to be effective for tax years ending December 31, 2008. The purpose of the changes was to promote compliance by accurately reflecting the entity's ownership and to minimize the filing burden. To that end, the new forms add additional questions to existing Schedule B, Other Information. The changes focus on partnerships that have complex ownership structures. Form 1065 filers who must file a Schedule M-3, Net Income (Loss) Reconciliation for Certain Partnerships, will also have to provide more information on related-party transactions.

In addition, effective for 2008 tax returns, the extended due date for Form 1065 will be September 15 instead of October 15 (see the discussion below).

Recent Tax Law Changes

Worker, Retiree, and Employer Recovery Act of 2008

The Worker, Retiree, and Employer Recovery Act of 2008, P.L. 110-458, included a provision that increases the penalty for failing to timely file a partnership return or failing to file a partnership return that shows the required information from $85 to $89 a month, for up to 12 months. The penalty will not apply if the partnership can show reasonable cause for not filing its return or filing a return that does not contain the required information.

SBWOTA

A provision from the Small Business and Work Opportunity Tax Act of 2007 (1) (SBWOTA) that affected all taxpayers (including partnerships and their partners as well as tax practitioners) was the expansion of Sec. 6694, under which tax practitioners were required to use a "more likely than not" (MLTN) standard on undisclosed positions. This is in contrast to the "realistic possibility of success" standard that practitioners previously used. The MLTN provision was originally effective for returns prepared after May 25, 2007, and then amended to December 31, 2007. Under this provision, tax preparers were subjected to a higher standard of reporting than taxpayers.

Section 506 of the Tax Extenders and Alternative Minimum Tax Relief Act of 20082 significantly revised the tax return preparer penalty rules under Sec. 6694. The effect of the new law depends in large part on the type of tax position under consideration. For tax positions that are not associated with tax shelters and reportable avoidance transactions, the penalty will not apply if there is substantial authority for the position or if the position is disclosed on the tax return and there is a reasonable basis for it. If the position is associated with a tax shelter or a reportable avoidance transaction, the penalty applies unless it is reasonable to believe that the position would more likely than not be sustained on its merits. The new rules for positions on nontax-shelter returns is retroactive to tax returns filed after May 25, 2007, while the new rules for positions related to tax shelters are effective for returns prepared for tax years ending after October 3, 2008.

AJCA

The American Jobs Creation Act of 2004 (3) (AJCA) changed the rules on amortization of organization and start-up costs under Secs. 195 and 709. The AJCA change allows a deduction for the first $5,000 spent for each type of costs (as long as the total amount spent for each type of cost is $50,000 or less), with the remainder being amortized over 180 months starting the month the partnership began business. This year Treasury issued regulations (4) that update the way the taxpayer elects to deduct these costs. The regulations are effective for costs incurred after September 8, 2008.

TEFRA Issues

In 1982, the Tax Equity and Fiscal Responsibility Act of 1982 (5) (TEFRA) was enacted to improve the auditing and adjustment of income items attributable to partnerships. It requires determining the treatment of all partnership items at the partnership level. Two questions that continue to arise under audit are whether an item is a partnership item and what is the correct statute of limitation period. This year there were several cases that addressed both of these issues.

In Alpha I L.P., (6) the taxpayer transferred its interests in a limited partnership (LP) to four charitable remainder trusts (CRTs). One of the assets owned by the LP was marketable securities. After the transfer of the interest, the LP sold the stock for a loss that was allocated to all the members. The IRS issued a final partnership administrative adjustment (FPAA) in which it reduced the LP's basis in the stock. The adjustment's effect was to convert the loss on the sale to a gain. In addition, the IRS determined that the transfer of the LP interests to the CRTs should be disregarded as an economic sham and that the original owners, not the CRTs, should be treated as the members of the LP.

The members contended that the court lacked jurisdiction to consider whether the transfers to the trusts were shams because the transfer was not a partnership item. The IRS argued that the identity of partners in a partnership was a partnership item or at the very least an affected item. The court found that the identity of partners was neither a partnership item nor an affected item and thus was improperly determined in the FPAA because the transfer of an interest has no effect on either the partnership's aggregate or each partner's share of partnership income or loss.

In another case, (7) the only change in an FPAA was the adjustment to a partner's at-risk basis. The partnership asked the court to reverse the adjustment because the partner's at-risk amount was not a partnership item. The general rule is that the determination of a partner's at-risk amount is not a partnership item but is an affected item. In this situation, the court determined that the FPAA was invalid because the adjustment was the only item in the FPAA and had nothing to do with the calculation of partnership income.

In Petaluma FX Partners, (8) a taxpayer contributed offsetting long and short foreign currency options to a partnership. He increased his basis to reflect the contribution of the long options but did not decrease the basis by the liability related to the short options. The partner withdrew from the partnership two months later by receiving cash and marketable securities. The taxpayer reported a loss on the sale of the marketable securities because his basis was not adjusted for contribution of the short options. The IRS later issued an FPAA that treated the partnership as a sham and reduced the basis of all assets in the partnership to zero, eliminating the loss on the stock sale. The taxpayer claimed that the court lacked jurisdiction to consider what he characterized as nonpartnership items, including the partner's outside basis. The court ruled that whether the partnership was a sham was a partnership item, so the court had the jurisdiction to determine that the partner's outside basis was zero.

In another case, (9) partners owned various direct and indirect ownership interests in an entity that the IRS claimed had engaged in a son-of-boss transaction, by which a capital gain was restructured as a capital loss. The IRS issued an FPAA to the LP and its partners without giving the notice required by Sec. 6223(a). The taxpayers, who were partners of the LP but were not its tax matters partners, chose to elect out of the partnership-level proceeding in their capacity as indirect partners by mailing certain documents to the IRS.

In filing the petition, they asked the court to strike them from the case as indirect partners in recognition of their having elected out. The court granted them relief and rejected the IRS's claim that the petitioners' election, asserted in connection with their status as indirect partners, was ineffective, instead finding that Sec. 6223 allowed partners holding different partnership interests in the same partnership to make different elections for each interest and that their election was otherwise valid. The court held that the taxpayers' election to opt out in connection with their status as indirect partners conformed to the criteria in Temp. Regs. Sec. 301.6223(e)-2T(c) and was effective.

The issue in the Bush and Shelton cases (10) (and approximately 30 other cases) revolved around the interpretation of two sentences in partnership closing agreements. The pertinent sentences allowed losses suspended under Sec. 465 to offset any income earned by the partnership. The suspended losses in question were from passive activities. The taxpayers interpreted the ruling to mean that Sec. 469 would not apply if the partnership created income, so they could offset the...