Current developments: this article reviews and analyzes recent rulings and decisions that involve partnerships. This discussion covers developments on anti-abuse rules, partnership formation, investment partnerships, elections out of subchapter K, statute of limitations, basis, income allocation and partnership continuation.

• Author: Burton, Hughlene A.
• Position: Partners & Partnerships

EXECUTIVE SUMMARY

* In several cases, the IRS challenged the valuation of a gifted FLP interest.

* Final and proposed regulations address basis issues for corporate partners.

* The IRS issued final regulations on tax years of partnerships with foreign or tax-exempt partners.

During the period of this update (Nov. 1, 2001-Oct. 31,2002), Treasury issued several sets of proposed and final partnership regulations; the IRS issued revenue procedures to address changes in tax year-ends. There were also various rulings on the operation of the Sec. 701 anti-abuse rules. In the future, the IRS plans to provide guidance on the Sec. 704(b)regulations and on partnership options and convertible instruments. It is also working on regulations defining a Sec. 752 liability.

Classification

Rev. Proc. 2002-59 (1) extends the time for filing a late initial entity-classification election to the due date of the entity's first return (excluding extensions). Rev. Proc. 2002-15, (2) superseded as of Sept. 30, 2002, provided that the election could be filed within six months of the initial election due date.

In Rev. Proc. 2002-69, (3) the IRS issued guidance on the classification of entities owned solely by a husband and wife as community property. Based on this ruling, it will respect a taxpayer's treatment as either a disregarded entity or a partnership.

Anti-Abuse Rules

Several cases arose in which taxpayers tried to circumvent the Sec. 701 anti-abuse rules by using multi-step transactions. In the cases below, the IRS and the courts applied the step-transaction doctrine.

In FSA 200242004, (4) a taxpayer tried to shift the recognition of inherent loss to a third party, by contributing the property to a partnership, selling its interest in the partnership and having the partnership sell the loss property. The IRS ruled that the Regs. Sec. 1.701-2 anti-abuse rules prevented the new partner from recognizing the loss.

Likewise, in Andantech, L.L.C., (5) a limited liability company (LLC) purchased equipment from a third party and simultaneously leased it back to the seller. The IRS and the Tax Court disregarded the sale-leaseback, because it was a prearranged transaction lacking business purpose and economic substance. In addition, the LLC was disregarded as an entity; the taxpayers did not intend to join together for the purpose of carrying on a business as partners or sharing in the profits and losses of a business.

In Saba Partnership, (6) a U.S. taxpayer and a tax-free foreign entity created a partnership that generated over $190 million in tax losses for the U.S. partner based on an actual loss of only $5 million. The Federal Circuit ruled that the elaborate scheme lacked economic substance and created no gain or loss for Federal tax purposes; it remanded the case to decide whether the partnership was a total sham created for the sole purpose of tax avoidance that should be disregarded for Federal tax purposes.

In another situation, (7) a partnership restructured a sale of a partnership interest as a three-step transaction to avoid subpart F income. However, the IRS applied the step-transaction doctrine and recharacterized the transaction as a sale of the partnership interest.

Straddle Transactions

Notices 2002-50 (8) and 2002-65 (9) dealt with multi-step transactions designed to use a straddle, a tiered partnership structure, a transitory partner and the absence of a Sec. 754 election to allow taxpayers to claim a permanent noneconomic loss. The notices alerted taxpayers and their advisers that the tax benefits purportedly generated by these transactions will not be allowed for Federal tax purposes.

Tax Shelters

Treasury and the IRS are concentrating on tax shelters. In accordance with this directive, they issued temporary regulations (10) modifying the rules on filing disclosure statements under Sec. 6011(a). Temp. Regs. Sec. 301.6111-2T also includes conforming changes to the rules on registration of confidential corporate tax shelters under Sec. 6111(d). The temporary regulations were effective Jan. 1,2003.

Taxation on Formation

FLPs

In Rev. Proc. 2002-3, (11) the IRS added the validity of a family limited partnership (FLP) to its no-ruling list when capital is not a material income-producing factor. (12)

The gift of a FLP interest qualifies for the gift tax annual exclusion, and the valuation of the gifted interest may be reduced by using minority-interest and marketability discounts. However, in certain cases, the IRS may challenge the use or amount of the discount. In Est. of Godley, (13) the Fourth Circuit upheld a Tax Court decision not to allow a minority interest discount for a 50% FLP interest...