IRS flexes its muscles under the partnership anti-abuse rules.

• Author: Belman, Bruce J.

Prior to 1997, taxpayers had to navigate a complex set of rules to determine whether their association was one that would be taxed as a corporation or one that would be taxed as a partnership. In many situations the entity of choice was the limited partnership. High-priced counsel would issue opinion letters stating that the entity would be taxed as a partnership. A key element of counsel's opinion was that the general partner was in substance a partner. Advanced ruling requests from the IRS required a showing that the general partner had at least a 1% interest in profits and losses.

Starting in 1997, the Service simplified the process by permitting unincorporated businesses to elect to be taxed under either subchapter K or subchapter C. Since the adoption of the check-the-box regulations, taxpayers have enjoyed certainty with respect to entity classification for federal income tax. However, these regulations do not provide the same level of certainty in the determination of who is a partner for income tax purposes. Recent activity by the IRS indicates that this is still a real issue and will require taxpayers to analyze whether each member of a partnership or LLC will be treated as a partner for tax purposes.

Determining Who Is a Partner

Chief Counsel Advice (CCA) 200704030 was issued in October 2006 and offers some insight into the approach that the IRS will take to determine who is a partner. The basic transaction described in the CCA was relatively straightforward. The promoters purchased transferable state income tax credits and sold them to investors for a profit. Had the transaction been structured as a straight sale of the credits, the promoters would have recognized ordinary income on the transaction, and the investors would have incurred an itemized deduction that would give them little or no benefit due to the alternative minimum tax.

Rather than an outright sale of the credits, the transaction was structured as a partnership, which improved the transaction's tax result for both parties. The investors in the partnership received a 1% capital account. The investors were allocated all of the credits, but no profits and no cashflow. The promoters received a 99% capital account, all profits and losses and any cashflow generated by the partnership. Because credits allocated to partners have no effect on capital accounts, the capital accounts of the parties remained unchanged after the allocation of the credits to the investors.

The...