Partnerships and
Disregarded Entities
Howard E. Abrams
Professor of Law
Biography of Howard E. Abrams
Howard E. Abrams, Professor of Law at Emory Law School in Atlanta, GA,
is a partnership and corporate tax specialist, receiving his B.A. from the
University of California (Irvine) and his J.D. from Harvard University. He has
written four books, the BNA Tax Management Portfolio on Disregarded
Entities, and more than fifty articles on taxation. Professor Abrams has
been at Emory University since 1983, spent the 1999-2000 academic year
with the national office of Deloitte Tax as the Director of Real Estate Tax
Knowledge, and from January of 2003 through August of 2004 was of
counsel to Steptoe & Johnson in Washington, DC. He teaches regularly at
Leiden University in the Netherlands and is a member of the American Law
Institute and the DC Bar. Prior to joining the Emory faculty, Professor
Abrams was a law clerk to Chief Judge Theodore Tannenwald, Jr., of the
United States Tax Court and practiced in Los Angeles with the firm of
Brobeck, Phleger & Harrison. Professor Abrams has taught as a Visiting
Professor at USD, Cornell, Berkeley and Yale Law Schools. Professor
Abrams will spend the 2013-14 academic year as a Visiting Professor at
Harvard Law School.
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Topics
Regarding a Disregarded Entity
Springing and Disappearing Debt
Holding a Partnership Interest Through a
Disregarded Entity
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Regarding a Disregarded Entity
Overview of Disregarded Entities
• Eligible entity
• Single owner
• No election to be taxed as a corporation
When a Disregarded Entity Is Regarded
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Prior tax obligations
Assessment and collection issues
TEFRA unified audit procedures
FBAR reporting
Anti-Conduit financing regulations
Gift tax valuation
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Overview: Eligible Entity
Must be a “business entity”
• Not an entity formed merely to share expenses
- Note: there is no requirement that a business entity have
customers or offer goods or services for sale. Madison Gas
& Elec. Co. v. Commissioner, 72 T.C. 521 (1979), aff’d, 633
F.2d 512 (5th Cir. 1980).
• Not a trust or estate
- Note: A trust formed to operate a business, with
management vested in one or more trustees and operated
for the benefit of one or more beneficiaries, may be classified
as a business entity, especially if the trust units are freely
transferable. Examples include the Massachusetts Business
Trust and the Delaware Statutory Trust.
• Not a per se corporation
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Overview: Single Owner
Must have a single owner
• An owner who has no interest in profits, losses, or capital will be
ignored if the owner is in place only to prevent voluntary
bankruptcy.
• An owner who has no real risk of loss and whose return is
guaranteed or will arise only from tax benefits will not be treated
as an owner.
• An owner that is itself a disregarded entity (including a QSUB or
a Qualified REIT Subsidiary) will be ignored and its interest
imputed to its owner. So, for example, a partnership formed by a
QSUB and its parent will be treated as having a single owner
and so will be a disregarded entity.
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Overview: No Election to Be Treated as a
Corporation
A domestic eligible entity defaults to non-corporate
classification.
A foreign entity defaults to non-corporate
classification only if all owners have unlimited
liability for the debts of the entity.
An entity that is not a per se corporation and that is
organized in the US and in a foreign jurisdiction is
treated as a domestic entity.
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A Regarded Entity: Prior Tax Obligations
If a disregarded entity was a regarded entity for a
prior tax period, the DE will be treated as distinct
from its owner with respect to tax obligations arising
from the prior period.
• Example 1: Regarded T Corp. merges into a DE, owned by P
Corp. A redetermination of T’s tax liability for a prior period will
cause DE to be treated as regarded for the redetermination.
• Example 2: Regarded partnership becomes a DE when all but
one partner exits. An audit of DE will cause it to be treated as a
regarded entity for the partnership-level audit.
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A Regarded Entity: Assessment and
Collection Issues
Certain Excise Taxes
Employment Tax Purposes: A disregarded entity is
treated as a corporation for employment tax issues
and related reporting requirements.
• Suppose the owner of DE is also an employee of DE. Is the
salary paid by DE to owner treated as self-employment income
or employee compensation? Should be self-employment.
• Suppose DE is owned by a partnership, and one of the partners
is an employee of DE. Can the partner be treated as an
employee of DE and thereby receive a W-2?
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Incentive Partnership Interests
P
Q
DE
Q
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A Regarded Entity: TEFRA Audits
The TEFRA unified audit rules do not apply to
partnerships having 10 or fewer partners, each of
whom is (a) an individual other than a nonresident
alien, (b) an estate of a deceased partner, or (c) a C
corporation.
In Rev. Rul. 2004-88, 2004-2 C.B. 165, the IRS ruled
that this small partnership exception does not apply
if any of the otherwise-qualifying partners owns the
partnership interest through a disregarded entity.
This conclusion seems wrong.
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A Regarded Entity: International Issues
FBAR Reporting: Because FBAR reporting
requirements are not imposed under the Internal
Revenue Code, an otherwise-disregarded entity is
regarded for FBAR reporting.
Anti-Conduit Financing: For purposes of the anticonduit financing rules in section 881, an entity that
is regarded for treaty purposes will be treated as a
“person” under the anti-conduit regulations.
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A Regarded Entity: Gift Tax Valuation
In Pierre v. Commissioner, 133 T.C. 24 (2009), the
taxpayer created a disregarded entity and then
transferred interests in the DE to family members.
Held, that the gifts will be treated as gifts of
partnership interests rather than undivided interests
in the underlying assets, thereby qualifying the
transfers for minority and lack of marketability
discounts.
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Disappearing Debt
Debt-For-Equity Swaps
Distribution/Cancellation of Partnership Debt
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Debt-For-Equity Swaps: The Partnership
Section 108(e)(8): The contribution of partnership
indebtedness in exchange for an interest in the
venture is treated to the partnership as if the
partnership satisfied the obligation with cash equal
to the value of the partnership interest received by
the creditor.
• The partner and partnership can elect to treat the value of the
partnership interest as its initial liquidation value.
• To minimize the COD income to the partnership, give the
creditor significant capital account credit but reduced share of
profits going forward.
• Note: if the creditor receives a profits interest, do not make the
valuation election.
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Debt-For-Equity Swaps: The Creditor
Although the partnership recognizes COD income,
the partner is precluded from claiming a bad debt
deduction.
For the creditor/partner, the transaction is treated as
a contribution under section 721. Accordingly, basis
in the debt is pushed into the partnership interest.
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Springing Debt
Springing Debt: If a second member joins a
disregarded entity when the entity’s assets are
encumbered, how is the transaction taxed?
Example: X owns a disregarded entity DE and
makes equal equity and debt contributions to DE of
$100. DE then purchases depreciable property for
$200, and after $110 of depreciation has been
claimed and the property is worth $150 (though still
encumbered by the debt of $100), X sells a 50%
interest in the entity to Y for fair market value of $25.
X is treated as selling a portion of the property to Y.
But what portion of the property is deemed sold?
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Springing Debt Example
Start: X owns property with adjusted basis of $90
and fair market value of $150.
End: X owns a note with face value of $100 as well
as $25 of cash along with a partnership interest
worth $25.
Analysis:
• Did X sell one half of the property to Y for cash of $25 plus half
the debt? If so, gain recognized of $30?
• Since Y is out of pocket only $25, did Y purchase $25/$150 (that
is, one-sixth) of the asset for $25, producing a gain to X of $10?
Or a gain of $25 under Rev. Rul. 84-53? Either way, the debt
shift of $50 will be tested under the disguised sales rules.
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Distribution/Cancellation of Partner Debt
Example: In year 1, XYZ loans $1,000 to X. In year 3,
XYZ cancels the debt.
• Analysis One: COD to X and bad debt deduction to XYZ.
• Analysis Two: COD to X and no bad deduction to XYZ.
• Analysis Three: Deemed distribution of $1,000 cash to X,
followed by deemed repayment by X to XYZ.
• Note: If the fair market value of the debt is less than face, then
the difference must be COD to X.
What if the note was contributed to XYZ?
• Under Oden v. Commissioner, T.C. Memo 1981-184, X received
no basis credit for the note.
• If the contribution is reversed, no income should result.
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