Partnership Tax Watch Newsletter (Current), 322, PARTNERSHIP TAX
PLANNING and PRACTICE , (Aug. 26, 2014)
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Partnership Tax Watch TM
CCH Tax Law Editors Charles R. Levun, Esq., Consultant
HEADLINES
• Final Rules on Start-Up Expenses After Technical Termination
• IRS to Issue Covered Asset Acquisition Regulations
• Interest Expense by Corps. Owning 10 Percent of P’ship Addressed
• Transfer of Royalty Interest Violated Assignment of Income Doctrine
• Treating Securities as Options Was Change in Accounting Method
• Excluded Gain Not Passive Activity Gross Income for PALs
• The Newly Proposed Code Sec. 704(c)(1)(C) Regulations and Gifts
• Improvements Needed to Address Partnership Noncompliance
• IRS Finalizes Material Advisor Penalty Regs
• Insight into Proposed REIT Real Property Regulations Provided
• Arizona: LLC Members Not Entitled to Deduct Expenses Paid on Behalf of LLC
• California: Filing and Payment Requirements for Business Entity Members of Multiple-Member LLCs
Addressed
• Pennsylvania: Nonresident Partners Liable for Tax on Debt Discharged Because of Foreclosure
ANNUAL PARTNERSHIP, LLC & S CORPORATION TAX PLANNING
FORUM and “FUNDAMENTALS OF FLOW-THROUGH” TAX SEMINAR
CCH, a Wolters Kluwer business, in collaboration with Charles R. Levun, JD, CPA, and Michael J. Cohen, JD,
LLM, MBA, CPA, presents the Twenty-Eighth Annual Partnership, LLC & S Corporation Tax Planning Forum and
the Nineteenth Annual "Fundamentals of Flow-Through" Partnership, LLC & S Corporation Tax Seminar.
The 2014 two-day Forum utilizes a transactional approach to cover the hottest passthrough entity tax issues and
planning concepts. Forum dates: Sept. 18—19, Boston; Oct. 23—24, Las Vegas; Oct. 30—31, Chicago; Nov. 13
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The 2014 "Fundamentals of Flow-Through" Tax Seminar is tailored for professionals who would like a solid
understanding of the essential elements of passthrough entity taxation, or those who just need a refresher.
Seminar dates: Oct. 20—21, Las Vegas; Oct. 27—28, Chicago; and Nov. 10—11, Washington, D.C.
To register or for more information, please call 1-800-286-4760 or check the website atwww.taxforums.com.
FEATURED DEVELOPMENTS
Final Rules on Start-Up Expenses After Technical Termination
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The IRS has finalized regulations providing for the treatment of start-up expenditures and organizational
expenses following a technical termination of a partnership. The final regulations adopt proposed regulations
(NPRM REG-126285-12) issued on December 9, 2013, with a minor clarification.
The new regulations amend Reg. §1.708-1 to provide that a new partnership formed after a technical
termination under Code Sec. 708(b)(1)(B) must continue amortizing start-up expenses (as provided in Code Sec.
195) and organizational expenses (as provided in Code Sec. 709) over the remainder of the amortization period
originally established by the terminating partnership. The final regulations differ from the proposed regulations
by changing the phrase "using the same amortization period adopted by the terminating partnership" to "over
the remaining portion of the amortization period adopted by the terminating partnership" to make clear that the
amortization period does not restart.
The regulations only apply to the technical termination of a partnership under Code Sec. 708(b)(1)(B)), wherein
50 percent or more of a partnership’s interests are disposed of in a 12-month period, not to other terminations
of partnership, such as cessation of a trade or business. The amendments are intended to align the treatment
of start-up and organization expenses with the treatment of Code Sec. 197 intangibles transferred to a new
partnership resulting from a technical termination under Code Sec. 708(b)(1)(B), which are also amortized using
the same amortization period adopted by the terminated partnership.
The regulations apply to technical terminations that occur on or after December 9, 2013.
T.D. 9681, ¶15,382
IRS to Issue Covered Asset Acquisition Regulations
The IRS will issue regulations under Code Sec. 901(m), applicable to the disposition of assets following covered
asset acquisitions (CAAs) and CAAs involving the acquisition of interests in a partnership that has elected an
optional adjustment to the basis of partnership property under Code Sec. 754. The regulations will generally
apply to dispositions occurring on or after July 21, 2014.
Under Code Sec. 901(m), in the case of a CAA, the disqualified portion of a foreign income tax determined with
respect to the gain or loss on certain relevant foreign assets (RFAs) may be deducted, but not credited against
U.S. tax. A CAA is defined as:
(1)
(2)
(3)
(4)
A qualified stock purchase, defined under Code Sec. 338(d)(3), to which Code Sec. 338 applies;
A transaction that is treated as an acquisition of assets, for U.S. income tax purposes, and an
acquisition of corporate stock, for foreign income tax purposes;
An acquisition of an interest in a partnership that has elected Code Sec. 754; and
Any similar transaction, as provided by the IRS.
The disqualified portion of the tax, with respect to a CAA, is the ratio of: (1) the aggregate basis differences for all
RFAs (i.e., the differences between the adjusted basis of the asset, after and before the CAA), to (2) the income
on which the foreign income tax is determined.
The regulations will address concerns over the application of the statutory disposition rule under Code Sec.
901(m)(3)(B)(ii). Under the rule, unless provided otherwise by the IRS, when there is a disposition of an RFA, the
basis difference allocated to the tax year of the disposition is the excess of the asset’s basis difference over the
asset’s aggregate basis difference allocated to prior tax years. No basis differences are allocated to any later tax
years.
According to the IRS, application of the statutory disposition rule is appropriate when gain or loss is fully
recognized for both U.S. and foreign income tax. In cases where gain or loss is recognized for U.S., but not
foreign income tax purposes, or if no gain or loss is recognized for either U.S. or foreign income tax purposes, it
may not be appropriate to take unallocated basis differences into account. The IRS is aware that taxpayers have
engaged in transactions shortly after a CAA in order to invoke the rule and avoid Code Sec. 901(m).
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An example is provided that involves a foreign subsidiary’s acquisition of a foreign corporation’s stock in a Code
Sec. 338 CAA. Subsequently, the foreign corporation becomes a disregarded entity, resulting in a deemed
liquidation for which no gain or loss is recognized. The taxpayers claim that basis differences with respect to
RFAs are allocated to the foreign corporation’s final tax year and no basis differences with respect to the RFAs
are allocated to later years.
The regulations will provide that a disposition means an event that results in gain or loss being recognized
with respect to an RFA, for purposes of a U.S. income tax, a foreign income tax, or both. The portion of the
basis difference taken into account as a result of a disposition will be determined pursuant to two rules. If the
disposition is fully taxable, for both U.S. and foreign income tax purposes, the disposition amount is equal to
the unallocated basis. If the disposition is not fully taxable for both U.S. and foreign income tax purposes, there
will be a disparity in the U.S. and foreign basis and the RFA will continue to be subject to Code Sec. 901(m).
The unallocated basis difference may be taken into account, to the extent the basis disparity is reduced upon
disposition. Specific rules apply, depending upon whether there is a positive or negative basis difference and the
jurisdiction in which the gain or loss is recognized.
Code Sec. 901(m) continues to apply until the entire basis difference in the RFA has been taken into account.
The IRS is considering whether and to what extent Code Sec. 901(m) should apply to an asset received in
exchange for an RFA in a transaction in which the basis of the asset is determined by reference to basis of the
RFA transferred.
Special rules apply for Code Sec. 743(b) CAAs, including where the RFA is subject to multiple CAAs.
Notice 2014-44, ¶15,383
Interest Expense by Corps. Owning 10 Percent of P’ship Addressed
The IRS has released final regulations, and removed and amended temporary regulations, under Code Sec.
861 addressing the allocation and apportionment of interest expense by corporations that own a 10-percent
or greater interest in a partnership. The regulations also cover the allocation and apportionment of interest
expense using the fair market value method. Finally, the regulations update the interest allocation regulations
to conform to statutory changes made by the Education Jobs and Medicaid Assistance Act (P.L. 111-226)
(EJMAA), affecting the affiliation of certain foreign corporations for purposes of Code Sec. 864(e).
Allocation of Interest Expense. The regulations under Code Sec. 861 adopt an aggregate or look-through
approach to apportioning a partner’s share of partnership interest. This approach applies to corporations with
a 10-percent or greater interest in the partnership, individual general partners, and individual limited partners
with a 10-percent or more interest. Other partners are excepted from aggregate treatment. Interest is allocated
based on the partner’s interest in the partnership. The IRS published proposed and temporary regulations
in 1988 (T.D. 8228), as well as in 2012 (NPRM REG-113903-10 and T.D. 9571). The temporary regulations
clarified that a corporate partner with a 10-percent or greater interest was required to allocate its direct interest
expense to all of its assets, including its proportionate share of partnership assets. The IRS indicated that this
aggregate approach is consistent with the approach that applies to apportioning the partner’s distributive share
of partnership interest expense.
Asset Method. The allocation and apportionment of interest expense must be made on the basis of assets,
not gross income. Interest is apportioned among groupings of gross income in proportion to the value of assets
within each grouping. Taxpayers can elect to value assets based on their fair market value, tax book value,
or alternative tax book value. When a corporate partner with a 10-percent or greater interest uses either book
value method, the partner uses the partnership’s inside basis in its assets. In determining basis, the temporary
regulations allowed the inside basis to include any adjustments made under Code Secs. 734(b) and 743(b)
(optional adjustments to the basis of partnership property).
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Fair Market Value Method. The existing regulations set forth a multi-step method for determining the fair
market value of a taxpayer’s assets, which looked at the values of tangible and intangible assets. The IRS has
stated its concern with the approach of some taxpayers, who were taking related-party debt into account as a
liability for valuing stock in the related person, but were not treating the related-party debt as an asset in the
creditor’s hands. The IRS believed that this distorted the relative value of assets assigned to each grouping. The
temporary regulations required that related-party debt be an asset that must be taken into account whether held
by the taxpayer or a related person.
Affiliated Groups. The interest expense of each member of an affiliated group is allocated and apportioned
as if all members of the group are a single corporation. The existing regulations provided rules for treating
foreign corporations as affiliated corporations if 80 percent of the corporation’s stock was owned by members
of an affiliated group, and more than 50 percent of the corporation’s gross income was effectively connected
with a U.S. trade or business. The EJMAA incorporated these regulatory rules into Code Sec. 864(e)(5). The
regulations have been revised to reflect these statutory changes. The final regulations adopt the proposed
regulations issued in connection with the 2012 temporary regulations, as well as portions of the 1988 temporary
regulations that were not amended in 2012, with no substantive change.
Comment. The regulations apply to individuals who are general partners and to individual limited partners that
own a 10-percent interest in the partnership. The asset or aggregate approach does not apply to other partners;
the allocation of interest is based on the partner’s interest in the partnership.
The final regulations are effective July 16, 2014.
T.D. 9676, ¶15,384
Transfer of Royalty Interest Violated Assignment of Income Doctrine
Partners’ transfer of certain overriding mineral royalty interests through a complicated transaction was an
improper assignment of income and, therefore, the transaction was properly disregarded for tax purposes and
royalty income was assigned to the partnership. The partners transferred royalty interests from their oil and gas
properties using controlled entities into segregated accounts that were set up using offshore asset protection
trusts.
The partners transferred the principal and interest earned on offshore cash-value life insurance policies and used
these accounts to shield their assets. The partners paid premiums on the various policies and the insurance
companies charged management fees and transferred the balance of the premium in the separate accounts.
The district court properly held that partners’ transfer of their royalty interests to the entities was an anticipatory
assignment of income because they controlled the entities throughout the transaction. The private annuities were
eventually payable to the partners and, hence, the financial benefit did not change with the transfer.
Although the partnership argued that it suffered financially since it lost royalty income that was transferred to the
partners’ entities, the money finally was received by the partners who controlled those entities, which violated
the assignment of income doctrine. Contrary to the partnership’s claim, the royalty interest transfer was not a
property transfer because the partnership retained beneficial ownership of the mineral interests and ultimately
received the proceeds.
The partners controlled the royalty interests held in the segregated accounts because they decided how the
funds were to be invested and distributed as loans. The risk-shifting associated with an annuity was not present.
Finally, the transaction lacked economic substance because the transfer of the partnership’s mineral interest to
the partners did not change hands and was merely carried out to evade income taxes. There was no real profit
motive in the transaction since the partners controlled the transaction at every step.
Affirming an unpublished DC Tex. case.
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Salty Brine I, Limited, CA-5, ¶16,384
Treating Securities as Options Was Change in Accounting Method
The IRS Chief Counsel has concluded that, when a taxpayer ceased treating securities as options, that
constituted a change in accounting method requiring adjustments to avoid distortions. The taxpayer was an
LLC, regularly engaged in securities trading involving "barrier basket transactions." In the basket transactions,
the taxpayer made an upfront payment of 10 percent, while a bank paid 90 percent, to acquire a "basket" of
securities. The contract between the taxpayer and the bank gave the taxpayer the option to receive a cash
settlement amount when the contract (for at least a year) expired or was terminated.
The taxpayer did not recognize gain, loss, income or deductions but, instead, deferred recognition of tax
consequences until the transaction expired or terminated, when the taxpayer recognized gain equalling the
difference between the settlement amount and the upfront payment made.
After examination by the IRS, the taxpayer was required to recognize tax consequences when the basket was
acquired and could no longer defer gain or loss. This constituted a change in accounting method under Code
Sec. 446, which required adjustments under Code Sec. 481, the computation and recognition of which were
needed to eliminate any distortions such as duplications or omissions of income or deductions caused by the
accounting method change.
CCA 201426025, ¶15,380
Excluded Gain Not Passive Activity Gross Income for PALs
The gain excluded from gross income under Code Sec. 121 was not an item of passive activity gross income
for purposes of Code Sec. 469, passive activity losses (PALs). The losses from the rental activity, including
the suspended passive activity losses, to the extent they exceed any net income or gain for the tax year of the
disposition from all other passive activities will be treated as not from a passive activity.
The taxpayer purchased a principal residence and lived in it for two years before converting the residence into
a rental property. The property was converted to a rental activity that was the taxpayer’s only passive activity,
and the taxpayer had net losses every year under Code Sec. 469. Within three years of renting the property,
the taxpayer sold it to an unrelated party, and the taxpayer’s net gain from the sale was excluded from his gross
income as allowed by Code Sec. 121. The excluded gain from the sale does not offset the suspended passive
activity losses from the property.
CCA 201428008, ¶15,381
THE PARTNER'S PERSPECTIVE by Charles R. Levun, Esq.
The Newly Proposed Code Sec. 704(c)(1)(C) Regulations and Gifts
*
By Charles R. Levun, Esq. The American Jobs Creation Act of 2004 (“2004 Tax Act”) made several statutory changes designed to
eliminate the deductibility of “inappropriate losses.” Among the changes were the addition to the Code of (1) the
mandatory downward basis adjustment rules that apply in certain “built-in loss” situations (contained in Code
Secs. 734 and 743) and (2) the rules of Code Sec. 704(c)(1)(C), which are designed to prevent any tax benefits
with respect to built-in loss property contributed to a partnership from being obtained by any partner other than
the contributing partner.
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Approximately ten years later, on January 15, 2014, Treasury issued proposed regulations (the “Proposed
Regulations”) addressing the foregoing topics, as well as covering the manner in which a basis adjustment is
allocated in a substituted basis transaction, a topic that was covered in the June 2014 Partner’s Perspective
column (at ¶9805). This month’s Partner’s Perspective column will cover another aspect of those January
Proposed Regulations, specifically the manner in which Code Sec. 704(c)(1)(C) applies to a gift of a partnership
interest and the planning that might be considered to prevent its provisions from coming up to bite the taxpayer.
This column also will briefly discuss a “theoretical” potential holding period issue that can arise under the
provisions of Code Sec. 704(c)(1)(C).
Code Sec. 704(c)(1)(C)
The 2004 Tax Act added Code Sec. 704(c)(1)(C) effective for property contributions to a partnership made after
October 22, 2004. This new Code section provides:
(C) if any property so contributed has a built-in loss—
(i)
such built-in loss shall be taken into account only in determining the amount of items
allocated to the contributing partner, and
(ii)
except as provided in regulations, in determining the amount of items allocated to other
partners, the basis of the contributed property in the hands of the partnership shall be treated
as being equal to its fair market value at the time of contribution.
For purposes of this subparagraph (C), the term “built-in loss” means the excess of the adjusted basis
of the property (determined without regard to subparagraph (C)(ii)) over its fair market value at the time
of contribution.
So let’s take a look at a garden-variety family situation in which the foregoing provision could apply. Assume that
Brayden formed RP LLC, an investment LLC to which he contributed the following securities:
Security A
Security B
BASIS
VALUE
$2,000,000 $3,800,000
1,700,000 1,500,000
$3,700,000 $5,300,000
He made a small gift to his favorite charity, and he is now planning on making a gift of non-managing LLC
interests to a trust for the benefit of his family members, Dylan, Nicole, Hailey, Arielle and Drew. (As discussed in
prior Partner’s Perspective columns, adding a non-family member with certain veto rights that prevent unilateral
access to the LLC’s assets by the family members may strengthen the availability of discounts when gifts of
LLC interests to family members are being considered. See, e.g., Partner’s Perspective at ¶9674.) Brayden has
received an appraisal indicating that gifts of non-managing LLC interests would be valued by applying 30 percent
valuation discounts, so that if, for instance, 100 percent of the LLC interests were non-managing LLC interests,
the total value of the interests would be $3,710,000. Brayden’s tax professional has queried whether there is
any tax impact to present and future LLC members by reason of contributed Security B having a value less than
basis at the time of its contribution to the LLC.
The essence of Code Sec. 704(c)(1)(C) set forth above is that when a person contributes property to a
partnership having a built-in loss, i.e., property having a basis in excess of fair market value, the tax items
attributable to the built-in loss remain with the partner who contributed the property (who is referred to in the
Proposed Regulations as the “section 704(c)(1)(C) partner”). This partner then obtains tax benefits from the
“excess basis” via what is referred to in the Proposed Regulations as a “section 704(c)(1)(C) basis adjustment.”
From the partnership’s perspective, the amount of tax items allocated to partners other than the section 704(c)(1)
(C) partner is based on the fair market value of the property at the time of its contribution to the partnership.
As a general concept, if a section 704(c)(1)(C) partner transfers his partnership interest, the portion of the section
704(c)(1)(C) basis adjustment attributable to the transferred partnership interest is eliminated, i.e., the transferee
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does not step into the shoes of the section 704(c)(1)(C) partner with respect to the transferred interest. Proposed
Reg. §1.704-3(f)(3)(iii)(A). An exception to the rule that the section 704(c)(1)(C) basis adjustment disappears on
the transfer of a partnership interest by a section 704(c)(1)(C) partner is in the case of a transfer of a partnership
interest in a nonrecognition transaction. Proposed Reg. §1.704-3(f)(3)(iii)(B)(1). The scope of what constitutes a
nonrecognition transaction is not defined; however, the examples that follow in the Proposed Regulations include
(1) a transfer of the partnership interest to another partnership in a Code Sec. 721 transaction and (2) a transfer
of the partnership interest to a corporation in a Code Sec. 351 transaction.
However, the above Proposed Regulation provides that the nonrecognition exception does not apply to a gift
transaction. See Proposed Reg. §1.704-3(f)(3)(iii)(B)(2) and Proposed Reg. §1.704-3(f)(3)(iii)(C) Ex. 5. As a
result of the above rules, consider, for example, what occurs if Brayden makes discounted gifts of 100 percent of
the LLC interests (but remains as the Manager), Security A’s value doesn’t change, the value of Security B goes
up in value to $1,700,000 (i.e., its original basis), and Security B is then sold.
(1)
(2)
The LLC will generate a $200,000 gain on the sale of Security B, because the LLC’s basis in Security
B would be limited to $1,500,000 (i.e., its fair market value on the date of its contribution to the LLC)
under the Code Sec. 704(c)(1)(C) rules.
The impact of the gain in 1. above would be offset by a later capital loss, but only on the liquidation of
the LLC:
Value of securities on date of contribution
Basis of contributed securities
Built-in gain as of date of contribution
Basis of gifted LLC interest
Gain on sale of Security B
Gain on sale of Security A (if sold)
Aggregate basis of LLC members
$5,300,000
(3,700,000)
$1,600,000
$3,700,000
200,000
1,800,000
5,700,000
*
Proceeds from sale of securities
Capital loss
(5,500,000) $ 200,000
* As increased by $200,000 increase in value of Security B.
And, of course, in many circumstances, the capital loss on liquidation might not be occurring in a year in which
there is capital gain that can be offset by the loss.
Alternative Planning Consideration
On the other hand, in a non-discount situation, consider what would happen had Brayden gifted the securities
directly to his descendants. The basis of Security B would be controlled by Code Sec. 1015(a), which provides
that the basis of the property for loss purposes is its fair market value as of the date of the gift. However, its basis
for gain purposes would continue to be carryover basis. Consequently, a sale of Security B after it had gone
back up in value to what its basis was at the time of the gift would be a non-gain generating transaction, and the
capital loss whipsaw described above would not occur.
And in a discount situation, such as described in the facts of this column, Brayden could consider a sale
of Security B before creating the LLC. In this manner, the loss would be recognized by Brayden prior to
the contribution to the LLC. He could then contribute Security A and the $1,500,000 of sale proceeds (or
repurchased Security B, subject to the wash sale rules of Code Sec. 1092) to the LLC, following which he could
make discounted gifts of LLC interests, much in the same manner as at the outset of this column.
The “Theoretical” Potential Holding Period Issue
Let’s change our facts, and now assume that Brayden has owned a small Code Sec. 704(c)(1)(C) office building
for a few years that has run into a bit of bad luck with several major vacancies occurring at the same time. He
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has persuaded Dylan to contribute $500,000 to RP LLC in exchange for a 50 percent LLC interest to hold off the
bank and provide working capital, at a time when single-member RP LLC has the following simplified balance
sheet:
Real property
Friendly Bank
Owner's equity
BASIS
VALUE
$ 4,500,000
$ 3,200,000
$ 2,700,000
$ 2,700,000
1,800,000
500,000
$ 4,500,000
$ 3,200,000
Armed with the working capital, the LLC is able to attract new tenants at favorable lease rates. After nine
months, the property increases in value to $4,000,000 and the LLC decides to sell the property, resulting in a
book gain of $800,000 and a tax loss of $500,000. (Assume, for simplicity, that no depreciation was taken during
the nine-month period and none of the cash infusion has yet to be spent on leasehold improvements.)
Brayden has contributed Code Sec. 704(c)(1)(C) property to the LLC because the property’s $4,500,000 tax
basis exceeded its $3,200,000 value as of the date of contribution. Proposed Reg. §1.704-3(f)(1)(ii), which
essentially parrots Code Sec. 704(c)(1)(C)(ii), provides:
In determining the amount of items allocated to partners other than the section 704(c)(1)(C) partner, the
initial basis of section 704(c)(1)(C) property in the hands of the partnership is equal to the property’s fair
market value at the time of contribution. (Emphasis added.)
As part of the Proposed Regulations’ implementation of the Code Sec. 704(c)(1)(C) provisions, Proposed Reg.
§1.704-3(f)(2)(iii) creates a section 704(c)(1)(C) basis adjustment that is personal to the contributing partner (i.e.,
Brayden). Proposed Reg. §1.704-3(f)(3) contains the general operational rules that apply to the section 704(c)
(1)(C) basis adjustment, including Proposed Reg. §1.704-3(f)(3)(ii)(C), which adjusts gain or loss allocated to a
section 704(c)(1)(C) partner from the disposition of section 704(c)(1)(C) property by the amount of his section
704(c)(1)(C) basis adjustment. Based on the above rules, the sale of the property should produce the following
result:
Property sale gain
Sec. 704(c)(1)(C) adj.
Net
BRAYDEN DYLAN
TOTAL
$400,000 $400,000 $800,000 (1,300,000)
0
(1,300,000)
$(900,000) $400,000 $(500,000)
Effectively, the rules of Code Sec. 704(c)(1)(C) create the equivalent of Code Sec. 704(c) remedial allocations
with respect to built-in loss property that was contributed to a partnership. Note, however, that the Proposed
Regulations create a fair market value tax basis for the contributed “loss” property, at least with respect to the
non-contributing partner. Consequently, the issue that arises is whether this means that the property starts a new
holding period. If such is the case, the $800,000 gain would be short-term capital gain.
The traditional tacked-on holding period concepts of Code Sec. 1223(2) arguably are not met, because the
contributed property is required to have “the same basis in whole or in part…as it would have in the hands of the
[transferor].” This issue is not addressed in the Code Sec. 704(c)(1)(C) Proposed Regulations. However, it would
appear that the intent of Code Sec. 704(c)(1)(C) is not to create a new holding period for the contributed assets,
but, as discussed above, merely to use a remedial allocation type of approach to the tax items emanating from
the contributed Code Sec. 704(c)(1)(C) property.
In this regard, it may be useful to look at the authority under the remedial method of making Code Sec. 704(c)
allocations. While the holding period concept is not specifically addressed in the remedial allocation regulations,
note that Reg. §1.704-3(d)(3) provides that remedial allocations “have the same tax attributes as the tax item
limited by the ceiling rule.” In addition, the Preamble to the remedial allocation method provided that “[t]hese
allocations would be subject to all the rules normally applicable to capital gains and losses, as if the amounts had
actually been realized by the partnership.” T.D. 8501 (Dec. 22, 1993). These statements do not show an intent
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to create a new holding period requirement with respect to any gain or loss generated by remedial allocations.
While it is likely that most tax professionals would report the gain in the above example as long-term, additional
guidance would be helpful.
TAX PLANNING INSIGHTS
Improvements Needed to Address Partnership Noncompliance
Since 1980, partnerships' and S corporations' share of business receipts increased greatly. These entities
generally do not pay income taxes. Instead, income or losses (hundreds of billions of dollars annually) flow
through to partners and shareholders to include on their income tax returns. GAO has previously reported that
the misreporting of income by partners and shareholders poses a tax compliance risk.
Background. GAO was asked to assess IRS's efforts to ensure compliance by partnerships and S corporations.
This report
(1)
(2)
(3)
Describes what is known about misreporting of flow-through income;
Assesses how much misreporting IRS identifies; and
Analyzes possible improvements in IRS's use of data to better identify partnerships and S corporations
to consider examining.
Comparing partnership, S corporation, and other entities' examination results, GAO analyzed 2003-2012 IRS
data and evaluated possible improvement ideas stemming, in part, from prior GAO work, for how IRS identifies
examination workload.
IRS Needs to Improve Information to Address Tax Noncompliance. The full extent of partnership and S
corporation income misreporting is unknown. The IRS's last study of S corporations, using 2003-2004 data,
estimated that these entities annually misreported about 15 percent (an average of $55 billion for 2003 and
2004) of their income. IRS does not have a similar study for partnerships. Using IRS data and the study results,
GAO derived a rough-order-of-magnitude estimate of $91 billion per year of partnership and S corporation
income being misreported by individuals for 2006 through 2009.
IRS examinations and automated document matching have not been effective at finding most of the estimated
misreported income. For example, IRS reported that examinations identified about $16 billion per year of
misreporting in 2011 and 2012, the bulk of which related to partnerships. However, such information about
compliance results is not reliable. IRS estimated that 3 to 22 percent of the misreporting by partnerships was
double counted due to some partnership income being allocated to other partnerships or related parties. Further,
IRS does not know how income misreporting by partnerships affects taxes paid by partners. IRS does not have
a strategy to improve the information. As a result, IRS does not have reliable information about its compliance
results to fully inform decisions about allocating examination resources across different types of businesses.
IRS's processes for selecting returns to examine could be improved. Not all partnership and S corporation
line items from paper returns are digitized, and IRS officials said that having more return information available
electronically might improve examination selection. In 2011, about 65 percent of partnerships and S corporations
electronically filed (e-filed). Certain large partnerships and S corporations are required by statute to e-file.
Expanding the mandate would increase digitized data available for examination selection. Further, in 1995
GAO found that IRS's computer scoring system for selecting partnership returns to examine used outdated
information. IRS does not have a strategy to update and use this information to select partnerships for
examination. Relatively few partnerships are examined compared to other business entities, and many
examinations result in no change in taxes owed. Improved examination selection based on more current
information could generate more revenue and reduce IRS examinations of compliant taxpayers.
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Conclusions. Partnerships and S corporations account for billions of dollars of unpaid taxes and their share
of business activity is growing. This underscores the importance of understanding the effectiveness of IRS's
partnership and S corporation tax law enforcement efforts.
Currently, IRS examines a small fraction of partnership and S corporation tax returns. Other forms of businesses,
such as C corporations and sole proprietorships, are examined at rates that are several times higher. IRS cannot
make fully informed decisions about whether this allocation of enforcement resources is justified because it
has limited information about the extent and nature of income misreporting by partnerships and S corporations
as well as about the effectiveness of its examinations at detecting such misreporting. This also leaves IRS
unable to make a fully informed, data-based decision about whether or not to update one of its major partnership
examination selection tools, the DIF formula.
The Report identified two additional opportunities to better use data to improve compliance by flow-through
entities. First, enabling greater digitization of tax return information would help IRS identify which partnership and
S corporation tax returns would be most productive to examine. In the absence of funding for transcription, one
way to increase digitization is a statutory mandate requiring increased e-filing of partnership and S corporation
tax returns. Improving IRS's selection of partnership and S corporation returns to examine would also benefit
compliant taxpayers whose returns may otherwise be selected for examination. Further, expanded e-filing would
reduce IRS's tax return processing costs.
Second, IRS may be able to take advantage of its ongoing efforts to improve the quality of K-1 data to test
whether compliance processes could be improved. Issues with the accuracy and timely availability of K-1 data
have been a concern to IRS. Planning now for how to use the improved data would leave IRS well positioned to
analyze options for improving its partnership and S corporation compliance programs.
Partnerships and S Corporations—IRS Needs to Improve Information to Address Tax Noncompliance
(GAO-14-453)
IRS Finalizes Material Advisor Penalty Regs
The IRS has finalized regulations on the penalties to be imposed on material advisors who fail to file a true
and complete return. The final regulations make several substantive changes to the proposals in NPRM
REG-160872-04.
A new paragraph has been added under Reg. §301.6707-1(a)(1)(B) regarding the penalty in the case of listed
transactions. The new paragraph clarifies that only one Code Sec. 6707 penalty will apply in the case of a
transaction that is both a listed transaction and a reportable transaction, and that the penalty that applies in these
cases is the higher penalty for listed transactions under Reg. §301.6707-1(a)(1)(B).
The final regulations also clarify that, if there is a failure with respect to more than one reportable or listed
transaction, a material advisor will be subject to a separate penalty for each transaction. In addition, Reg.
§301.6707-1(a)(2) has been clarified to provide that only fees from a listed transaction for which the advisor is a
material advisor are taken into account for purposes of computing the penalty. A new example has been added
to illustrate this clarification.
Finally, Proposed Reg. §301.6707-1(e) has been modified to provide additional guidance on rescission of the
Code Sec. 6707 penalty. Under Rev. Proc. 2007-21, 2007-1 CB 613, and Proposed Reg. §301.6707-1(e)(3)(i),
filing Form 8918, Material Advisor Disclosure Statement, after the due date will be a factor weighing strongly in
favor of rescission unless the form is filed after the taxpayer files Form 8886, Reportable Transaction Disclosure
Statement, identifying the material advisor as an advisor with respect to the transaction or after the IRS contacts
the material advisor concerning the reportable transaction.
The final regulations modify this rule to also consider whether circumstances indicate that the material advisor
delayed filing the Form 8918, recognizing that the mere filing of a Form 8886 before filing a Form 8918, is not
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indicative of whether rescission is appropriate. Accordingly, the final regulations provide that, if a material advisor
unintentionally failed to file a Form 8918, but then files a properly completed form with the IRS, that filing will be
a factor that weighs in favor of rescission of the penalty if the facts suggest that the material advisor did not delay
filing the form until after the IRS had taken steps to identify that person as a material advisor with respect to that
particular transaction.
The final regulations further provide that the late filing will not weigh in favor of rescission if the facts and
circumstances suggest that the material advisor delayed filing the Form 8918 until after the material advisor’s
client filed its Form 8886 (or successor form) disclosing the client’s participation in the particular reportable
transaction. In addition, the final regulations clarify the language of the proposed regulations in a few other ways
not intended to be substantive, including clarification of examples.
The final regulations remove Temporary Reg. §301.6707-1T, which implemented Code Sec. 6707 as enacted in
1984. Amendments to Code Sec. 6707 made by section 816 of American Jobs Creation Act rendered Temporary
Reg. §301.6707-1T obsolete.
Sections 4.04, 4.05, and 4.06 of Rev. Proc. 2007-21, relating to the factors for rescission of the Code Sec. 6707
penalty, are superseded as of July 31, 2014.
TD 9686, ¶15,385
Insight into Proposed REIT Real Property Regulations Provided
During a June 18 program hosted by the D.C. Bar, practitioners commented favorably on the proposed
regulations issued in May relating to the definition of "real property" for purposes of the real estate investment
trust (REIT) rules in Code Secs. 856 through 859 (NPRM REG-150760-13, I.R.B. 2014-23, 1078). "It is
extremely helpful to have regulations out as opposed to having the law set by private letter rulings [LTRs] that
were fairly dusty," said Charles Temkin, director, National Tax Office, Deloitte Tax LLP, Washington, D.C.
Temkin, along with Dianne Umberger, National Tax REIT leader, Ernst & Young LLP, McLean, Va., posed
several questions relating to hypothetical situations to the four IRS attendees, whose answers yielded additional
insight into how the IRS plans to review REIT real property questions in the future.
PLR Process. The new proposed regulations should not affect the IRS’s process for issuing private letter rulings,
said Andrea Hoffenson, assistant to branch chief, Branch 1, IRS Associate Chief Counsel, Financial Institutions
& Products. "We are still issuing private letter rulings. The [issuance of proposed regulations] wasn’t intended
to stop the process. It is intended to help the process. We’re hoping less may come in," she said. Hoffenson
stated that, after the regulations are finalized, requestors will be expected to address the factors listed in the
regulations. Furthermore, the IRS will be unlikely to entertain "comfort ruling" requests relating to assets that
were listed on the safe harbor list of items that are considered real property. "But, even going forward now, if you
are coming in with [a PLR] request before the regulations are finalized, it is helpful to have facts in the request
that address the factors as well, even though they are not final," she indicated.
Umberger asked whether the IRS would entertain letter rulings from taxpayers asking for clarification on certain
questions relating to income from rents. Umberger explained that many taxpayers found the rental income
question to be a gray area. For example, "Is it a payment to use the space, or is the tenant paying to use a
service, which presumably would not generate rents from real property?" she asked. David Silber, IRS branch
II chief, IRS Financial Institutions and Products Group, stated that the IRS is aware that taxpayers have many
questions regarding income. "We know there are a lot of income issues out there, and we are thinking about
those issues…and in the meantime we are going to entertain [PLRs] on them," he said.
Hypothetical Scenarios. Umberger asked how the IRS would determine which of a company’s assets meet the
definition of "real property" in the following scenario: A company holds various leasehold interests in land with
terms of 25 years. There are easements on the land from an unrelated landowner. Company A plans to develop
and install a wind farm, which following completion will be master leased to an unrelated lessee-operator. The
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assets, Umberger said, are designed and constructed to remain in place for their entire economic useful life.
In addition to its interests in land, Company A’s assets will include leasehold interests in land improvements,
including things such as access roads, fences, small buildings that house monitoring equipment, substations,
transformers, and concrete turbine sites. Company A will install several hundred wind turbines which consist of
towers or poles attached to which are turbines that have long blades, which turn as the wind blows. The actual
towers and poles are embedded into concrete pads that are permanently attached to the ground. The turbines, in
turn, are attached to a collection system where generators produce electricity.
Julanne Allen, attorney, IRS Financial Institutions and Products Group, said that the IRS will require more facts
than Umberger listed before it would begin to apply the regulations. However, the Service would likely begin by
asking if any of the assets were listed among the safe harbors for real property. "As to the other things…you
would break them down into distinct assets, and then you would test each distinct asset," she explained. The
examples cited in the regulations would be helpful as well. "I think that the solar example really would reflect how
we would think of things and how we would apply the factors," Allen added. Umberger then asked whether the
IRS would consider temporary manufactured homes to be real property if they were constructed by an existing
REIT for the benefit of individual residents displaced by a tornado disaster. She explained that the REIT in this
scenario is engaged in the business of developing manufactured home communities throughout the Midwest
and that, in this instance, the homes intended for the disaster victims would be identical to those it already
owns "in terms of their inherently permanent structure." However, these manufactured homes set up for the
tornado victims are unlikely to remain in place indefinitely. They would, however, remain in place for their useful
economic life, after which they would either be replaced or sold.
Jonathan Silver, attorney, IRS Office of the Associate Chief Counsel, Financial Institutions & Products, stated
that the facts in Rev. Rul. 71-220, 1971-1 CB 210, are similar to the facts in this hypothetical. "Nothing about
these regulations has changed the underlying holdings of any of the existing guidance. To the extent that this
is consistent with that revenue ruling, then I think the answer would be [that the homes would be considered
real property]." Silver qualified his statement by saying that the facts of the scenario are not totally consistent
with those from Rev. Rul. 71-220. Therefore, the IRS would perform a facts and circumstances analysis since
manufactured homes are not included in the safe harbor list. "First, we have to determine, is it permanently
affixed? If so, we look at the method and manner of that affixation. The question of whether it remains in place
indefinitely is maybe a plus, maybe a minus. It’s something we can’t really answer without knowing what the
useful economic life is," said Silver. He stated that, if the REIT installed manufactured homes near the end of
their useful economic life, that would be more likely to indicate the homes are not real property. "If they’re brand
new, and they’re going to be there for a long economic life…that would probably work in their favor." Finally,
Silver stated the IRS would ask when exactly the REIT intended to sell the homes. "In this case, there is no
answer based upon the facts here. We would have to get more facts," he said.
Upcoming Guidance. Silber fielded several questions from Matthew Stevens, Ernst & Young LLP, regarding
upcoming guidance. Silber was unable to provide any definite timeframes, but did indicate that the IRS is actively
working on a guidance project relating to distressed debt. The IRS is also working on finalizing regulations
under Code Sec. 871(m), Silber stated, but he could not venture a guess on when exactly final regulations
would appear. Finally, he stated that the IRS has also placed a guidance project on prepaid forward contracts
on its current business plan. "It is very much related to the NPC project," Silber said. He added that numerous
guidance projects are related to an in-progress notional principal contract (NPC) guidance project under Code
Sec. 1256and, should the IRS make progress with that, these related projects would likely move forward, as well.
Arizona: LLC Members Not Entitled to Deduct Expenses Paid on Behalf of LLC
Taxpayers who were members in an LLC that was taxed as a partnership were not entitled to deduct on their
Arizona personal income tax return expenses paid on behalf of the LLC. Partnership expenses are deductible
only by the partnership and not the partners, unless there is an agreement among the partners that partnership
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expenses will be borne by particular partners out of their own funds. Here, the LLC’s operating agreement
provided that any operating loss not exceeding $50,000 in one fiscal year was to be paid in full by the holders
of the Class B membership interest (the taxpayers) and that the LLC manager could request cash contributions
from holders of the Class A membership interest to reimburse the LLC for losses over $50,000. However, the
operating agreement did not require the taxpayers to pay LLC expenses, as losses and expenses are two
different concepts.
Sommer v. Arizona Department of Revenue, Arizona State Board of Tax Appeals, No. 2015-12-I
California: Filing and Payment Requirements for Business Entity Members of
Multiple-Member LLCs Addressed
The California Franchise Tax Board has issued a legal ruling addressing when a business entity with a
membership interest in a multiple-member LLC that is classified as a partnership for tax purposes is required
to file a California return and pay all applicable taxes and fees that are imposed on the basis of doing business
in the state. If an LLC that is classified as a partnership for tax purposes is "doing business" in California, then
the members of the LLC are themselves doing business in California and have California return filing and tax
payment obligations. The distinction between manager-managed LLCs and member-managed LLCs is not
relevant for purposes of determining whether the members of the LLC are doing business in the state. If an
LLC is only registered to do business in California or organized in California, but has no activities or factor
presence in California sufficient to constitute doing business in the state, then the LLC will have a California
return filing requirement and be subject to the LLC tax and fee, but the LLC’s members will not have a California
return filing requirement or be subject to California tax as a result of their membership interests in the LLC. If a
member’s distributive share of the California sales of an LLC exceed the statutory threshold for doing business
in California, then the member will be doing business in the state on that basis, as well as on the basis of its
membership interest in the LLC.
Legal Ruling 2014-01, California Franchise Tax Board
Pennsylvania: Nonresident Partners Liable for Tax on Debt Discharged Because
of Foreclosure
The Pennsylvania Supreme Court affirmed the commonwealth court’s holding that a partnership was subject to
personal income tax commensurate with the total debt discharged as a result of a foreclosure, and, therefore, the
nonresident limited partners were liable for personal income tax in an amount proportionate with their shares in
the partnership. The nonresidents had invested as limited partners in a Connecticut limited partnership, which
existed for the sole purpose of owning and operating a skyscraper in the city of Pittsburgh, which went into
foreclosure in 2005. Following the property’s foreclosure, but prior to the partnership’s liquidation, the partnership
reported a gain as a result of the foreclosure on its federal and state tax filings that consisted of the unpaid
balance of the partnership’s principal and the accrued, compounded interest, totaling $2,628,491,551. The
partnership reported each individual limited partner’s respective share of that gain. Therefore, and despite their
individual investment losses, the Department of Revenue levied income tax against the taxpayers, plus interest
and penalties, related to the foreclosure on the property for tax year 2005. The amount taxed was each limited
partner’s distributive share of the gain associated with the foreclosure. The nonresident taxpayers’ challenges to
the assessments were denied by the commonwealth court.
Commerce and Due Process Clauses. The taxpayers argued that the lower court’s finding that they waived
Commerce Clause challenges was incorrect because their arguments addressed simultaneously both
Commerce Clause and Due Process Clause concepts. However, the rules of appellate procedure were
explicit that the argument contained within a brief must contain "such discussion and citation of authorities as
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are deemed pertinent." Accordingly, the lower court did not err in finding the taxpayers’ Commerce Clause
contentions waived for underdevelopment. Regarding the Due Process Clause challenge, the taxpayers had
the necessary "minimum contacts" with Pennsylvania. The taxpayers’ argument, that they were out-of-state
residents involved in a foreign, limited partnership and nothing more, simply was not accurate. Instead, the
department’s contention that the primary purpose of the partnership was to own, operate, and gain income from
a Pennsylvania office tower provided the proof of necessary "minimum contacts."
Foreclosure on a Nonrecourse Debt. The taxpayers argued that the plain language of Pennsylvania regulations
precluded the department’s taxation of the discharge of the obligation to pay the debt associated with the
property because the nonrecourse foreclosure upon the property never resulted in the conversion of the property
"into cash or other property." The taxpayers argued that the department had never before taken the position that
nonrecourse foreclosures were subject to income tax, and to the extent that the department made that assertion,
it was inconsistent with the code and regulations.
In the department’s view, the partnership, and therefore the taxpayers through their status as limited partners,
received a gain from the disposition of the property, which was situated in Pennsylvania, in the form of the
release of the nonrecourse debt. The department argued that the rule set forth by the United States Supreme
Court in Commissioner v. Tufts, 461 U.S. 300, 103 S. Ct. 1826 (1983), that for tax purposes the amount realized
by a partnership when a lender forecloses on property secured by a non recourse loan is the full amount of the
nonrecourse obligation, applied under Pennsylvania law §7303(a)(3) and regulation 103.13. The Tufts rule was
encompassed within the plain meaning of "disposition of real property," as contemplated by Pennsylvania law
and regulation 103.13; thus, the assessment of income tax was proper. The foreclosure of the property could not
be described as anything other than the "disposition of real property," which is included as a class of income in
Pennsylvania.
Further, the taxpayers contended that they were being assessed a tax by the department for income they never
received. The taxpayers argued that their taxable income must be linked to the actual income they received from
their ventures in the partnership and, because they received no net income, they could not be assessed income
tax. The department argued that under the Tufts rule, the taxpayers still had a net gain of income in the form of
the discharge of their indebtedness. The department was correct that, despite the taxpayers’ ultimate loss of
their investment, the Tufts rule controlled and permitted the assessment of income tax.
Calculation of Income Realized. The court stated that the issue of whether to include accrued interest as
taxable income was a question of first impression. The court noted that the lower court employed Allan v.
Commissioner, 56 F.2d 1169, 1173 (8th Cir. 1988), with some hesitancy, as support to include the accrued
interest. In the court’s view, upon accepting Tufts as the controlling law of the case, Allan flowed staunchly from
it, and directed that the accrued interest constituted income for purposes of state income tax. Further, the terms
of the partnership’s note contemplated the postponement of the normal interest payments on the nonrecourse
mortgage should the partnership operate at a loss for any given month, with the acknowledgment that such
payment would defer and compound on an annual basis. This constituted nothing more than an increase in the
principal amount of the nonrecourse loan, which, pursuant to Pennsylvania law and regulation, as well as Tufts,
was subject to the assessment of income tax as income associated with the disposition of real property.
Wirth v. Commonwealth of Pennsylvania, Pennsylvania Supreme Court
Footnotes
* Charles R. Levun, JD, CPA, is a Partner in the Chicago-area law firm of Levun, Goodman & Cohen,
Adjunct Professor of Law for the IIT Chicago-Kent Graduate Tax Program, Consultant to CCH’s
PARTNERSHIP TAX PLANNING AND PRACTICE GUIDE and Editor-in-Chief of the Journal of Passthrough Entities.
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