Recent developments.

• Author: Burton, Hughlene A.
• Position: Taxation of partnerships and other pass-through entities

From a tax perspective, 1995 was an intriguing year for partnerships and partners. The use of limited liability companies became more common, leading many partnerships and corporations to convert. Further, the IRS announced the implementation of a partnership Industry Specialization Program. Numerous rulings were issued on classification as a partnership for Federal tax purposes, the tax effects of conversion from one entity to another, special allocations of income and deductions and allocations of liabilities. In addition, regulations under Secs. 701, 704(c) and 737 were issued. This update is presented in six major categories: definition and formation; LLCs; operations; allocations; distributions and dispositions; and other developments.

Definition and Formation

Definition

Secs. 761 (a) and 7701 (a) (2) define a partnership as any unincorporated organization (not a trust, estate or corporation) through which any business, financial operation or venture is carried on. Regs. Secs. 301.7701-2 and -3 set forth rules distinguishing between a partnership and a corporation. Included in these rules are four corporate characteristics: limited liability, centralized management, free transferability of interests and continuity of life. If an organization has a preponderance (i.e., more than two) of these characteristics, it is deemed to be a corporation; otherwise, it is a partnership. Today's entities are so sophisticated that they can make difficult the determination of the existence of a specific characteristic. To help simplify the classification process, the IRS issued Notice 95-14(1) and Rev. Proc. 95-10(2) (discussed below).

Check-the-Box Proposal

Notice 95-14 proposed to simplify the classification of domestic unincorporated organizations by allowing them to make an affirmative, binding election to be treated as a partnership or as an association for Federal tax purposes. This "check-the-box" election would apply to all entities that have two or more associates and an objective to carry on business and divide the gains therefrom. Organizations not making the election would be treated as partnerships; existing organizations would retain their current classification. Any change in classification would be treated as a complete liquidation of the current entity and the formation of a new one. This proposal, if formally adopted, should greatly reduce or eliminate future questions as to proper classification of such entities.

Formation

Under Sec. 721 (a), the contribution of property to a partnership in exchange for a partnership interest is tax-free; according to Regs. Sec. 1.721-1 (b), services generally do not qualify as property. The tax treatment of a contribution of services has differed in the past depending on whether the partner received a capital interest (taxable) or a profits interest nontaxable).(3) Recent rulings follow this reasoning.

In Johnston,(4) the taxpayer became a general partner in and received a 1% interest for services performed in organizing a limited partnership. The partnership agreement stated that the general partner would provide organizational services, make no contribution to capital, and receive a 1% capital and profits interest as compensation for such services. The Tax Court held that the taxpayer realized income on the receipt of his interest because it was a shift in capital from the limited partners to the taxpayer as compensation for services. The court agreed with the IRS that the valuation date of the services was the date the limited partners transferred the interest to the taxpayer, not the date the partnership was formed.

Sec. 721 (a) provides that no gain or loss is recognized on partnership formation; however, Sec. 721 (b) states that that rule does not apply to a partnership that would be treated as an investment company if it were incorporated. In Letter Ruling 9538023,(5) taxpayers contributed marketable investment assets and cash to a new partnership. All the partners transferred the same assets, but in different proportions to their personal portfolios. The transferors represented that the transferred assets would meet the diversification test of Sec. 368(a) (2) (F) (ii). The IRS ruled that the partnership would not have been an investment company if incorporated; thus, no gain or loss had to be recognized on the contribution of securities.

Limited Liability Companies

Classification

Limited liability companies (LLCs) are recognized as such for state law purposes, but are often treated as partnerships for Federal tax purposes. By definition, all LLCs meet the corporate characteristic of limited liability; thus, to avoid corporate classification, the entity cannot have any two of the other corporate characteristics. The IRS issued numerous rulings on LACs in 1995.

In Rev. Proc. 95-10,(6) the IRS specified the conditions under which it would consider a ruling request on the classification of an LLC as a partnership for Federal tax purposes. Generally, to obtain a ruling, an LLC must have at least two members and must lack any two of continuity of life, free transferability of interests and centralized management. Minimum ownership requirements must be met if the entity requests a ruling that it lacks continuity of fife, free transferability of interests or limited liability; in general, member-managers must own at least a 1% interest in each material item of the LLC's income, gain, loss, deduction or credit during the LLC's existence, unless the LLC has total contributions exceeding $50 million. In addition, the member-managers must maintain a minimum capital account balance; other requirements also apply.

In addition, Rev. Rul. 95-37(7) provides that the conversion of a partnership interest to an LLC interest is a partnership-to-partnership conversion subject to the principles of Rev. Rul. 84-52.(8) Thus, the conversion would not cause the partners or the partnership to recognize gain or loss, the partnership would not terminate under Sec. 708, and the partners' bases would not change unless their share of liabilities changed.(9) The results would be the same even if the partnership and the LLC were formed in different states; further, the LLC can use the partnership's taxpayer identification number.

In Rev. Rul. 95-55,(10) the IRS held that a general partnership registered as a New York registered limited liability partnership (RLLP) was a partnership for Federal tax purposes. Because the New York RLLP law does not correspond to the Uniform Partnership Act, the status of the RLLP in question had to be determined under Regs. Sec. 301.7701-2. The New York RLLP law provides that an RLLP is dissolved by the express will of any partner if no definite term is specified in the agreement, or by the express will of any partner when a dissolution would not otherwise be permitted; further, every partner is an agent of the partnership for purposes of its business whose acts bind the partnership. Thus, the RLLP in question lacked continuity of life and centralized management. Finally, under New York RLLP law, no one can become a partner in an RLLP without the consent of all partners, so that the RLLP lacked free transferability of interests. The IRS concluded the RLLP was properly classified as a...