Partnership taxation developments.

• Author: Burton, Hughlene

EXECUTIVE SUMMARY

* Proposed regulations addressed the calculation of partner basis.

* Sec. 706(b) requires a partnership to have the same year-end as the majority interest, all principal partners or the calendar year.

* Final regulations clarified the treatment of partnership mergers and divisions.

The number of Code sections addressing partner and partnership taxation is quite small; thus, tax advisers must rely on regulations, cases and rulings. During the period of this update (Nov. 1, 2000-Oct. 31, 2001), Treasury issued several sets of proposed and final partnership regulations; the IRS issued a number of revenue procedures as notices to address changes in tax year-ends. There were also various rulings on the operation of the Sec. 701 anti-abuse rules.

The enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 on June 7, 2001, will have little direct effect on partnerships. The new law increased the estate tax exclusion to $1 million and reduced the estate and gift tax rate to 50% beginning in 2002 (1); these changes, when coupled with a slight reduction in the individual income tax rates, (2) will indirectly affect partnerships. The greatest effect will be on choice of entity.

The IRS has announced (3) that it will host a small business Website to help practitioners and taxpayers with important rulings and cases. Also, the IRS Strategic Plan for fiscal years 2000-2005 includes matching 100% of Schedules K-1 to individual returns and scrutinizing passthrough entities for noncompliance (due to rapid growth in the number of and income from these entities). One reason for the rise in the number of passthrough entities is the increase in the number of limited liability companies (LLCs) and limited liability partnerships. This addition to the IRS Strategic Plan will result in more partnership and LLC audits.

Definitions

A "partnership" is any unincorporated organization through which a business is carried on; a "partner" is any member of a partnership. Because of the brevity of these definitions, the question of whether an entity is a partnership must be addressed on a regular basis. Once it has been determined that an entity is a partnership, the next question is whether an investor is a partner.

Anti-Abuse Rules

In the early 1990s, Treasury issued anti-abuse regulations under Sec. 701. Under Regs. Sec. 1.701-2(b), if a partnership is formed or availed of in connection with a transaction, a principal purpose of which is to reduce substantially the partners' aggregate Federal tax liability inconsistent with Subchapter K, the IRS can recast the transaction as appropriate to achieve tax results consistent with Subchapter K.

In a recent ruling, (4) a corporation was created to acquire an interest in leased property and transfer it to other investors. The company transferred its interest in the property to a partnership for an interest therein, then sold the partnership interest to a general partner (GP) at a loss. The IRS determined the partnership investment was transitory and lacked economic substance, as did the loss on the assets contributed to the partnership. The IRS determined the transaction was actually a sale by the corporation directly to the GP. Because the partnership was created to generate losses and avoid Federal tax, the Service used the Regs. Sec. 1.701-2 anti-abuse rules to recharacterize the transaction.

In another ruling, (5) a taxpayer transferred assets to a corporation for its stock. Ten days later, the taxpayer sold the stock to a partnership. Under Sec. 732(b) and (c), the partnership allocated basis to the assets equal to the basis in the corporation's hands, resulting in an increase in the bases of fixed assets and intangibles. The IRS determined that when a transaction is set up solely to use Sec. 732 to increase asset basis, it should be recast under Regs. Sec. 1.701-2.

In Boca Investerings Partnership, (6) the Service tried to reallocate income and loss to partners of a partnership created solely to generate capital losses, which partners could use to offset personal capital gains. Unlike previous pro-IRS rulings, the court found that the parties had acted in good faith and with a business purpose in conducting partnership operations. Thus, the entity was a bona fide partnership and the transaction had sufficient economic substance.

In Salina Partnership LP, (7) the IRS sought to disallow a capital loss from a sham partnership with no business purpose. Like the district court in Boca, the Tax Court ruled the partnership was not a sham, as the partner had invested in the partnership to achieve legitimate business objectives independent of the tax benefits from the capital loss. The investment also produced objective economic consequences outside of the partner's control, permitting use of the capital loss.

Taxation on Formation

Under Sec. 721(a), no gain or loss is recognized on the contribution of property to a partnership for a partnership interest. "Property" includes tangible and intangible property (including cash), but not services. Previously, Rev. Proc. 93-27 (8) had distinguished between receiving a capital interest in a partnership for services and receiving a profits interest. Under Rev. Proc. 93-27, a partner who receives only a profits interest for services generally will not recognize gain or loss on receipt of the interest.

Rev. Proc. 2001-43 (9) clarified the taxability of the receipt of a substantially nonvested profits interest in exchange for services. Under the procedure, the determination of whether a partnership interest is a profits interest is made when the interest is granted, even if the interest is substantially nonvested. As long as the procedure's conditions are met, neither the grant of the interest nor its vesting will be a taxable event. In addition, no Sec. 83(b) election need be filed at the time of grant. The interest's recipient is treated as receiving the interest on the grant date if the partnership treats the service provider as the interest's owner from the grant date and the service provider includes his share of the partnership's income in computing his income tax liability.

The contribution of LIFO inventory to an S corporation triggers a tax on ,the recapture of the LIFO reserve; this rule does not apply to partnerships. In Letter Ruling 200123035, (10) an automobile dealership and its general manager created an LLC. The dealership transferred its assets (including LIFO inventory) to the LLC. The IRS ruled that the exchange would fall under Sec. 721(a) and that the contribution of the inventory would not trigger LIFO reserve recapture. In addition, the Service determined that the LLC would not be required to treat the goods received from the dealership and physically identical goods subsequently acquired as separate items for LIFO purposes. If the subsequently purchased assets were treated as separate items, the contributed property's built-in gain would be triggered when the items were sold, accelerating gain recognition under LIFO. By treating the subsequently purchased goods as the same item, Sec. 721 gain nonrecognition is preserved. The LIFO inventory, however, is Sec. 704(c) property; any built-in gain or loss will be allocated to the dealership on the inventory's subsequent sale.

FLPs

Family limited partnerships (FLPs) are a very popular income and estate planning tool. Parents can create a FLP with business property and gift partnership interests to their children and grandchildren. This type of entity accomplishes two goals: a reduction in the value of the parent's estate and a shift...