During the period of this update (Nov. 1, 2021, through Oct. 31, 2022), the IRS issued guidance for taxpayers regarding changes made to Subchapter K over the past few years. Also, the Service issued guidance related to foreign partners. In addition, the courts and the IRS issued various rulings that addressed partnership operations and allocations.

Economic substance

A basic principle of tax law is that taxpayers are entitled to structure their business transactions in a manner that produces the least amount of tax. However, business transactions must have economic substance. For a transaction to have economic substance, it must have a reasonable possibility of a profit, and the transaction should have a business purpose independent of reducing taxes. The IRS has been diligent in examining transactions that it considers to lack economic substance or that are shams. The IRS generally has prevailed on the issue. To help clarify the rules, Congress codified the economic substance doctrine in 2010. Several cases during the update period considered whether a partnership transaction had economic substance.

Sham partnerships

In some court cases, partnership structures were found to be abusive arrangements or shams.

In Sarma, the taxpayer participated in a tax avoidance scheme to avoid paying tax on the gain he expected on the sale of his business. This scheme required the creation of a set of three-tiered partnerships with upper, middle, and lower tiers. The partnerships were designed to generate significant artificial losses to offset legitimate taxable income, according to a district court opinion in earlier, related proceedings. An essential component of the scheme was a series of offsetting foreign currency exchange forward contracts or straddles. The IRS audited the partnerships and determined that they were an abusive tax shelter and, thus, disallowed the losses generated. The partnerships filed suit in district court, which found the scheme to be an abusive tax shelter and in a partnership-level proceeding upheld the IRS’s disallowance of the benefits of the losses. The partnership appealed to the Eleventh Circuit, which affirmed the district court’s ruling.

As a result of the partnership-level proceeding, the IRS issued a notice of deficiency to the married taxpayers in Sarma, disallowing the loss deduction they reported on their joint tax return from the husband’s participation in the scheme as a partner. The taxpayers sought review by the Tax Court. The taxpayers argued that the statute of limitation expired prior to the IRS’s issuance of the notice to them.

The resolution of this issue hinged on whether the partner’s outside basis in the partnership was an item affected by a partnership item (an “affected item”) under TEFRA’s former Sec. 6229. The Tax Court determined that it was and found the notice to be both timely and valid. In addition, the Tax Court determined that the outside basis of the partnership interest was zero because a partner cannot have any basis in a sham partnership. Thus, the taxpayers were not entitled to the passthrough loss. The taxpayers appealed on both issues to the Eleventh Circuit, which in 2022, after careful review, affirmed the Tax Court’s decision.

Partnership definition

Sec. 761 defines a partnership as an entity including any syndicate, group, pool, joint venture, or other unincorporated organization through or by which a business, financial operation, or venture is carried on and that is not by definition a corporation or a trust or estate. During 2022, the question of whether an entity was a partnership was raised in two cases. In one case, shortly after Congress expanded the refined coal tax credit, a corporation began developing coal refining technology and set out to launch a coal refining facility. To do so, it formed a new single-member LLC.

The corporation anticipated that the LLC would be able to claim the tax credit but would produce tax losses. The LLC brought in additional investors to allow the original owner to spread its own investment over a larger number of projects and to reduce its overall risk. A secondary reason to expand the ownership was that the original owner could claim only a portion of the refined coal tax credits in any given year; the rest would have to be carried forward. Because money has a time value, it made sense to have partners who could claim the credits sooner. All of the members of the LLC were actively involved in its operation and financed any operating shortfall. For the years in question, the LLC had ordinary business losses and claimed more than $25.8 million in refined coal tax credits. The LLC distributed the credits and losses proportionally among its members.

On audit, the IRS concluded that the LLC was not a partnership because it was formed to facilitate the prohibited transaction of monetizing the refined coal tax credits. Since the LLC was not a partnership, only the original owner could claim the tax credits. The taxpayer petitioned the Tax Court, which ruled that the LLC was a bona fide partnership because all three members made substantial contributions to the LLC, participated in its management, and shared in its profits and losses.

The IRS appealed the ruling to the D.C. Circuit, which agreed with the Tax Court. Factors that the appellate court held showed that the entity met the definition of a partnership included that the founder had legitimate nontax motives for forming it and for recruiting other partners, such as spreading investment risk over a larger number of projects; that there was nothing wrong with the founder’s seeking partners who could apply the tax credits immediately rather than carrying them forward to future tax years; and that all of the partners shared in the partnership’s potential for profit and risk of loss.

In another case, a partnership purchased a commercial rental property by financing the property with the proceeds of a loan. The loan document included an “additional interest agreement” that entitled the lender to additional interest of two types — “NCF [net cash flow] interest” and “appreciation interest.” The partnership made regular loan payments that included the NCF interest. Later, the partnership sold the property and, in accordance with the loan documents, paid the appreciation interest. On its tax return, the partnership claimed an interest deduction for the payment of the appreciation interest. The partnership also reported a Sec. 1231 gain on the sale of the property.

A partner in the partnership reported his distributive share of the appreciation interest and the gain on his individual return. The IRS audited his return and disallowed the deduction for the appreciation interest but did not adjust the gain on the sale of the property. The IRS argued that the lender and the partnership were a joint venture, making the appreciation interest a nondeductible return on equity. The Tax Court rejected that argument and found that, based on the facts, it was clear the partnership and the lender did not enter into a joint venture. The facts the court relied on included that there was no contribution by the lender, the parties stipulated that all funds provided to the partnership were loans, the lender did not have a “single equity interest” in its dealings with the partnership, and the records showed the partnership payments were income to the lender for the use of funds it had advanced.