Selling partnerships that own CFCs: a potential trap for the unwary.

• Author: Becker, Jeff
• Position: Controlled foreign corporations

In addition to many other tax benefits, partnerships offer flowthrough treatment for the partners, which generally results in only one layer of tax and a high level of tax efficiency. In the international tax context, partnership structures are widely used, particularly as collective investment vehicles such as private-equity funds, hedge funds, mutual funds, etc. Businesses such as manufacturers and service providers also commonly use partnerships. As businesses seek to avoid corporate taxes, the use of partnerships (and other flowthrough vehicles) has increased.

Partnerships carry a number of traps for the unwary, as the interaction between the technical partnership rules and myriad complex international tax rules is often unclear. Many issues arise because of uncertainty over which theoretical approach to partnership taxation--either the aggregate or entity approach--applies. Under the aggregate theory, a partnership is viewed as an aggregation of its partners, and the partnership is treated as a conduit. In addition, the partners are treated as directly engaged in the partnership's activities. Conversely, under the entity theory, the partnership is treated as an entity separate from its partners, and each partner merely owns an interest in the partnership and is not treated as conducting the activities of the partnership.

The authorities underlying whether to apply the aggregate or entity theory to particular areas of partnership taxation are extensive and outside the scope of this item, but the rules governing which approach to take with respect to a particular provision of the Code generally are based on which theory more appropriately achieves that particular Code section's policy goals.

This item highlights a potential trap in the context of a fairly simple fact pattern--the sale of an interest in a partnership (U.S. or foreign) where the partnership owns stock of a controlled foreign corporation (CFC). Specifically, it addresses whether gain recognized on a sale of a partnership that owns CFC stock should be treated as capital gain or ordinary income.

Sale of Partnership Interests: In General

Under Sec. 741, the sale of a partnership interest is treated as the sale of a capital asset. As such, the partner recognizes a capital gain or loss, depending on the amount realized from the sale and the partner's outside basis in the partnership interest. Thus, Sec. 741 represents an application of the entity theory, with the partner treated as selling an interest in a separate entity. An exception to this general rule is contained in Sec. 751.

Sec. 751(a) generally provides that any amount received by a partner in exchange for all or a part of the partner's interest in the underlying unrealized receivables or inventory items...