"Year-end" tax planning for partnerships with tax-exempt partners.

• Author: St. Clair, Scott

With all the potential issues facing partnerships in the 1990s, determining a partnership's correct tax year seems like it should be the least of its troubles. Without a Sec. 444 election or the business purpose exception, all partnerships would determine their tax year based on the year-end of their majority or principal partner(s). However, this does not necessarily hold true when tax-exempt partners enter the picture.

Partnerships generally have a required tax year based on the tax year of the partners. Sec. 706(b)(1)(B) sets forth the rules as follows: " ... a partnership shall not have a taxable year other than--(i) the majority interest taxable year (as defined in paragraph (4)), (ii) if there is no [majority interest tax year], the taxable year of all the principal partners of the partnership, or (iii) [if (i) and (ii) do not apply] the calendar year unless the Secretary by regulations prescribes another period."

A majority interest tax year is defined as the tax year of one or more partners with an aggregate interest in partnership profits and capital of more than 50%. If no such year exists, the year of all partners with an interest of 5% or more in partnership profits or capital (principal partners) is used. If neither of these two years exists, Temp. Regs. Sec. 1.706-1T(a) prescribes a tax year that provides the least aggregate deferral of income to the partners (often the result under the first two options).

Could the fact that a tax-exempt partner holds a majority interest in a partnership have any effect on the year-end? Under Sec. 706, the answer appears clear: The partnership will take on the tax year of that partner. However, temporary regulations are in effect that must also be considered. Temp. Regs. Sec. 1.706-3T directly addresses the situation: "[I]n determining the taxable year (the 'current year') of a partnership under section 706(b) and the regulations thereunder, a partner that is tax-exempt under section 501(a) shall be disregarded if such partner was not subject to tax, under chapter 1 of the Code, on any income attributable to its investment in the partnership during the partnership's taxable year immediately preceding the current year." The regulation coincides perfectly with...