Current developments in partners and partnerships.

• Author: Burton, Hughlene A.

EXECUTIVE SUMMARY

* Treasury issued proposed regulations on how Secs. 704(c) and 737 apply to an assets-over partnership merger.

* The first Son of Boss court case was decided in Klamath.

* In Hubert, the Sixth Circuit vacated and remanded the case back to the Tax Court to determine if a deficit restoration obligation might give rise to at-risk basis.

* Many rulings were issued on TEFRA audits, taxation of partnership income, Sec. 704(b), basis adjustments, and other areas.

This article reviews and analyzes recent rulings and decisions involving partnerships. The discussion covers developments in partnership formation, economic substance, income allocations, partnership mergers, and basis adjustments.

During the period of this update (November 1, 2006-October 31, 2007), 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. Treasury issued proposed and final partnership regulations concerning the sale of qualified small business stock by partnerships, how to treat Sec. 704(c) gain in an assets-over merger, and how to treat nonqualified deferred compensation plans. In 2007, the first Son of Boss case was decided, and the IRS issued various rulings that addressed partnerships operations and allocations.

Partnership Issues

The Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA), was enacted on May 25, 2007. The act has a bigger impact on S corporations than it does on partnerships, but there are two sections that partnerships should be aware of. First, SBWOTA added Sec. 761(f) regarding a husband and wife that own a partnership. If both spouses materially participate in the partnership and they are the only partners in the partnership, they can now elect to treat the partnership as a disregarded entity and file the information on two separate Schedule Cs. The income would still be subject to self-employment tax but the provision would reduce the burden of filing a partnership tax return.

Another provision that affects all taxpayers (including partnerships and their partners as well as tax practitioners) is the expansion of Sec. 6694, under which tax practitioners must use a "more likely than not" standard on undisclosed positions. This is in contrast to the "realistic possibility of success" standard that practitioners previously used. This provision was originally effective for tax returns prepared after May 25, 2007; however, the IRS granted an extension in Notice 2007-54 and the provision is now effective for returns due after December 31, 2007. Under this provision, tax return preparers will be subjected to a higher standard of reporting than taxpayers. In addition, the amount of the Sec. 6694 penalty has been increased. The revisions to Sec. 6694 constitute major changes to practice standards and penalties that have been in place for many years. This new standard could affect a return preparer's position on special allocations of income or loss, allocations of liabilities, and basis issues for partners and partnerships.

The IRS is proposing changes to Form 1065, U.S. Return of Partnership Income, which partnerships use to file their returns. The Service unveiled these changes in news release IR-2007-138. (1) The changes are not expected to be effective until tax years ending December 31, 2008. However, the new forms increase the complexity of compliance by adding questions to existing Schedule B. The changes focus on partnerships that have complex ownership structures. In the future these partnerships must identify entities that directly or indirectly own a 10% or greater interest in the partnership and entities in which the partnership directly or indirectly owns a 10% or greater interest.

TEFRA

In 1982, the Tax Equity and Fiscal Responsibility Act, P.L. 97-248 (TEFRA), was enacted to improve the auditing and adjustment of income items attributable to partnerships. It requires determining the treatment of all partnerships items at the partnership level. Two issues that continue to arise under audit are whether an item is a partnership item and thus subject to TEFRA and the correct statute of limitation period for both the partners and the partnership. This year there were several cases that addressed TEFRA's application.

River City Ranches #1 Ltd. (2) addressed the period for making tax assessments attributable to a partnership item. The IRS determined that a partnership had entered into fraudulent transactions under the guidance of its tax matters partner. In order to complete the audit, the IRS requested that the tax matters partner sign a consent to extend the statute of limitation. The tax matters partner signed the consent and the audit was completed. The other partners filed suit, contending that the statute of limitation had run out before the Federal Partnership Administrative Adjustment (FPAA) letter was issued and therefore they were not subject to the adjustments made under the audit. The court partially agreed with the taxpayers, ruling that the IRS knew or had reason to know that the tax matters partner's interest in extending the period within which the IRS could issue the FPAA was in conflict with the investor-partners' interest in not delaying the issuance of the FPAA. Thus, for the first three years under audit, the court concluded that the consent to extend the limitation period was invalid. However, the court ruled that the six-year statute of limitation on assessment was still open for the final three years under audit when the FPAA was issued and that the investor-partners were liable for the changes made to those tax returns.

The question in Goldberg (3) was whether an expense was a TEFRA item. In this case the IRS disallowed every deduction the partnerships claimed because it determined the partnership was a sham without any business purpose. The taxpayers originally contested the IRS's findings but later agreed to a dismissal of the case. In addition to the losses from the partnership, the taxpayers also claimed a deduction for legal, accounting, and consulting fees related to the partnership. The court denied the motion to dismiss the case because it found that the deduction for the legal, accounting, and consulting expenses was not governed by TEFRA but was subject to Sec. 183 or Sec. 212. Because these items were not partnership items or items affected by TEFRA, the court concluded that it retained jurisdiction over the case. In many cases partners pay expenses related to the partnership personally. These items are outside the partnership and thus the partnership audit. Had the partnership paid these expenses in this case, the court would not have had jurisdiction and the case would have been dismissed.

The last issue that the courts addressed this year was whether a partnership was subject to TEFRA. In Nehrlich, (4) the taxpayer claimed that the partnership was a small partnership and thus TEFRA did not apply to it. The IRS disagreed. One requirement for a small partnership is that...