Guidance Is Definitive, Reality Is Frequently Inaccurate: the Lingering Saga of Rev. Rul. 91-32

• Publication year: 2019

Guidance Is Definitive, Reality Is Frequently Inaccurate: The Lingering Saga of Rev. Rul. 91-32

Robert L. Daily
University of Georgia School of Law

GUIDANCE IS DEFINITIVE, REALITY IS FREQUENTLY INACCURATE: THE LINGERING SAGA OF REV. RUL. 91-32

Robert L. Daily^*

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Partnership and international taxation are two of the most mind-numbing and inconsistent areas of the law. Even more confusion occurs when the two intersect, such as when a nonresident sells an interest in a U.S. partnership. Many have wasted precious time and abundant ink to come up with a solution. The IRS first tried in Rev. Rul. 91-32, concluding that a nonresident would be subject to tax if the partnership had assets producing income generated from property in United States. Although the guidance was appropriately criticized for being statutorily inconsistent, this Note argues that it nonetheless got to the right policy outcome. In 2017, the Tax Court disagreed with the long-standing IRS guidance; it declined to defer to the IRS's interpretation and held that a nonresident selling a U.S. partnership interest would not be subject to tax. Fearing abuse, Congress enacted a "look-through" approach in § 864(c)(8) that requires nonresidents to pay tax on the gain from the sale of a U.S. partnership under certain circumstances. Unfortunately, Congress created a burdensome system for nonresidents trying to sell their partnership interest.
This Note recounts the lingering saga of Rev. Rul. 91-32 and illustrates why the intersection of partnership taxation and international taxation remains convoluted, unfair, and unwieldy. This Note also provides recommendations to Congress that will lessen the

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administrative headache and provide for a more equitable way to tax nonresidents.

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Table of Contents

I. Introduction..........................................................................804

II. Nonresidents & Partnerships...........................................807

A. TAXING PARTNERS IN PARTNERSHIPS?............................808
B. WHEN IS A NONRESIDENT SUBJECT TO U.S. TAXATION? .. 810

III. Entity-Aggregate Theory................................................815

A. PRACTITIONER PRESUMPTION.........................................816
B. REV. RUL. 91-32: THE IRS APPLIES THE QUASI-AGGREGATE THEORY..........................................820
C. GMM: TAX COURT APPLIES THE ENTITY THEORY.............824
D. TCJA: CONGRESS APPLIES A LOOK-THROUGH APPROACH 829

IV. What Congress Should do................................................838

A. REPEAL §§ 864(C)(8) & 897(G)........................................838
B. PROVIDE SAFEGUARDS FOR ABUSE VIA § 743(a)..............839
C. SIMPLIFY THE SOURCING RULES.....................................840
D. PROVIDE A COMPOSITE RETURN FOR NONRESIDENTS.....842

V. Conclusion............................................................................843

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I. Introduction

"In my own case the words of such an act as the Income Tax, for example, merely dance before my eyes in a meaningless procession: cross-reference to cross-reference, exception upon exception—couched in abstract terms that offer no handle to seize hold of—leave in my mind only a confused sense of some vitally important, but successfully concealed, purport, which it is my duty to extract, but which is within my power, if at all, only after the most inordinate expenditure of time."¹

The Internal Revenue Service (IRS) and the Department of Treasury want taxpayers to believe that their guidance is definitive, but that may not reflect reality.² With regulations, the IRS and Treasury's interpretation often carries the day. Most courts adopt and agree with the Treasury's and the IRS's definitive conclusion on the law if there is a regulation on point.³ But courts do not give the same level of deference to sub-regulatory guidance. And taxpayers are more willing than ever to challenge the authority and conclusions of this type of administrative guidance.⁴

A recent example of that willingness to question guidance occurred in Grecian Magnesite Mining, Industrial & Shipping Co. v. Commissioner of Internal Revenue (GMM).⁵ The taxpayer questioned a longstanding piece of guidance issued by the IRS, Revenue Ruling 91-32 (Rev. Rul. 91-32).⁶ Published in 1991, Rev,

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Rul. 91-32 classified the gain or loss from the sale of a partnership that has "fixed place of business" or "a permanent establishment in the U.S." as effectively connected income, which is subject to taxation by the united states.⁷

In GMM, the Greek corporation argued that "[w]hile the Ruling may provide a rational policy argument for imposing tax on sales of partnership interests by foreign partners, it does not provide a cogent explanation of how [the iRs] purports to reach that conclusion under current law."⁸ The Tax Court agreed with the taxpayers, issuing a thorough opinion that all but eviscerated the long-standing piece of guidance.⁹

The facts were straightforward. The taxpayer was a Greek corporation that had invested in a U.S. partnership.¹⁰ The U.S. partnership mined and extracted magnesite in various states in the United States.¹¹ The taxpayer redeemed its partnership interest at a significant gain.¹² The taxpayer had no office in the United States, nor did it have any U.S. "office, employees, or business operation" outside of its investment in the U.S. partnership.¹³ The issue was simple: is a nonresident subject to U.S. federal income tax when it disposes or redeems its interest in a U.S. partnership for a gain?¹⁴

The GMM court said the answer to that question depended on partnership tax theory, framed as a debate over the eternal question of whether a partnership should be taxed as an agglomeration of its partners (aggregate theory), or as an entity separate and distinct from its owners (entity theory).¹⁵ The IRS in Rev. Rul. 91-32

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primarily used the aggregate theory and said that the selling partner's gain would be taxable in the U.S. because it would be effectively connected income to the taxpayer.¹⁶ Although many tax lawyers criticized Rev. Rul. 91-32 prior to GMM,¹⁷ most nonetheless accepted it as the law of the land.¹⁸

The IRS unsuccessfully put forward the Rev. Rul. 91-32 argument in GMM.¹⁹ The GMM court sharply criticized the IRS for its revenue ruling, noting that the IRS's position contradicted general theories of partnership taxation.²⁰ The Tax Court instead used the entity theory and held that the gain would not be taxable in the United States.²¹ Yet, this framing only helps so much.²² The GMM court interpreted international tax statutes and regulations based on general theories of partnership tax; in trying to fit these concepts together, the court attempted to answer the unanswerable.

Congress superseded GMMs core holding in the Tax Cuts and Jobs Act (TCJA), codified as I.R.C. § 864(c)(8).²³ The statute uses a

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look-through approach that requires nonresidents to pay tax on any gain they earn from selling an interest in a partnership doing business in the United States.²⁴ But the saga of Rev. Rul. 91-32 remains. The statutes and regulations that apply to the intersection of partnership and international taxation remain convoluted, unfair, and unwieldy. After the TCJA, nonresidents will be unable to comply with their tax obligations without the help of sophisticated tax advisers. Congress should adopt wholesale changes to ensure that foreign individuals and entities are equitably taxed and can comply with their U.S. tax obligations in a non-onerous way.

This Note proceeds as follows: Part II explains core concepts needed to understand the debate over this intersection of partnership and international taxation. Part III then articulates the distinctions between the entity and aggregate theories of partnership. Part III also examines how the entity and aggregate theories have been applied to foreign partner transactions via the practitioner presumption, Rev. Rul. 91-32, the GMM case, and the newly enacted § 864(c)(8). Part IV discusses how Congress can provide a better solution to fix the intersection of partnership and international taxation. Part V concludes.

II. Nonresidents & Partnerships

Before getting into the central debate over entity theory versus aggregate theory, this Note will provide context for the debate about Rev. Rul. 91-32. This part will lay out the statutory and regulatory principles of both partnership and international taxation.²⁵

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A. TAXING PARTNERS IN PARTNERSHIPS?

Start with a basic proposition: partnerships do not pay federal income tax.²⁶ Instead, the partnership calculates its taxable income as if the partnership were an individual and gives its partners a schedule K-1 which shows each partner's share of that income.²⁷ Partners must pay tax on their "distributive share" of income from the partnership.²⁸

But all good things must end. Eventually, a partner sells her interest in the partnership, or the partnership stops operating.²⁹ In either case, a partner will recognize gain on the sale of her partnership interest if her proceeds from the sale exceed her basis in the partnership.³⁰ The partnership interest is considered a capital asset,³¹ but selling that interest is considered a sale of personal property.³² Generally, that gain will be capital, which allows the partner to pay tax at a preferential capital gains rate.³³ A part of the gain, however, will be considered ordinary if the partnership holds assets that produce ordinary income.³⁴

The government's ability to tax a partner disposing of her partnership interest is critical. Partners contributing to a partnership for a partnership interest do not recognize gain or loss on that transaction.³⁵ And partnerships do not recognize gain or loss

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on the appreciation of assets while the partnership is operating.³⁶ A partner is only taxed on the appreciation of the partnership's assets when that partner leaves the...