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.

Other charitable contributions

Beyond conservation easements, other types of charitable contribution deductions have led to disputes as well. In Keefer, for instance, the taxpayers purported to assign a partial interest in a partnership that held hotel property to a foundation, the purpose of which was to establish a donor-advised fund. At the time of the assignment, the sale of the hotel was pending. The taxpayers took a charitable contribution deduction on their personal tax return for the assignment. On audit, the IRS disallowed the deduction because the taxpayers did not have a contemporaneous written acknowledgment from the charitable organization showing that the donor-advised fund had exclusive legal control over the assets contributed and the appraisal did not include the appraiser’s identifying number.

The district court agreed with the IRS because the donation was an anticipatory assignment of income. The court noted that it was not the pending sale of the hotel itself that created the assignment of income. Rather, the assignment of income arose because the assignment agreement carved out a portion of the partnership interest before it was donated. In addition, the taxpayers’ deduction failed under Sec. 170(f) because the taxpayers did not obtain a contemporaneous written acknowledgment of the contribution. Although they subsequently obtained a letter properly acknowledging the donation, the letter did not state that the foundation had exclusive legal control of the contributed assets, as is required in Sec. 170(f)(18)(B).

Losses allowed

Other recent litigation has concerned deductions for losses, including whether a partner had adequate basis in the partnership interest to take the loss. Sec. 704(d) allows a taxpayer to deduct losses from a partnership interest as long as the taxpayer has basis in the interest. Any losses in excess of basis are disallowed and carried forward until the partner’s basis is restored.

In a case where the taxpayers deducted losses from both the husband’s and the wife’s partnership interests, the IRS disallowed the losses for the wife’s interest because she could not document either a loan or capital contribution she supposedly made to the partnership. The couple claimed that the wife had loaned $200,000 to the partnership. The partnership included the loan on its balance sheet, but the liability was not allocated to any of the partners on the Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc. The only documentation the couple produced to substantiate the loan was a promissory note bearing someone else’s name. The capital contribution documentation also indicated that the contribution came from a different source than the wife. Thus, the court ruled that the wife did not have adequate basis to deduct the loss.

However, it was not a total win for the IRS. The IRS tried to disallow a loss for an additional year by raising as an issue for the first time at trial of the partnership’s opening tax-basis capital account balances that were reported for that year. The court rejected the Service’s attempt to raise the issue as untimely and outside the jurisdiction of the case. The court also noted that even if the issue had been raised timely, the IRS’s argument failed on the merits, as it was predicated on the apparent conflation of a partner’s tax-basis capital account with a partner’s outside basis in a partnership.

Likewise, in Kohout, married taxpayers engaged in medical funding and real estate business ventures through the husband’s wholly owned S corporation. The S corporation in turn owned 99% of another medical funding business operated as a partnership. The partnership generated losses that were allocated to the S corporation and then to the taxpayer. The taxpayers deducted the losses on their personal tax return. The IRS disallowed the loss deduction because the taxpayers could not document that either the S corporation or the husband, who owned the other 1% of the partnership individually, had sufficient basis in their partnership interest to deduct their pro rata share of the partnership’s loss.

The Tax Court agreed with the IRS. It found that while the S corporation had made contributions to the partnership, based on the record, they were less than the amount claimed by the taxpayers and less than the distributions the partnership made to the S corporation. In addition, no credible evidence in the record showed that the husband had made any contributions to the partnership.

Sec. 754 elections

There have been some recent IRS rulings on elections under Sec. 754 to adjust the basis of partnership property. When a partnership distributes property or a partner transfers his or her interest, the partnership can make a Sec. 754 election. The election allows a step-up or step-down in basis under either Sec. 734(b) or Sec. 743(b) to reflect the FMV at the time of the exchange. This election has the advantage of not taxing the new partner on gains or losses already reflected in the purchase price of his or her partnership interest.

In Chief Counsel Advice (CCA) 202240017, the taxpayer made intercompany transfers of interests in tiered partnerships among members of the taxpayer’s consolidated group and did not report any gain on the transactions. As a result of these intercompany transfers, the partnerships adjusted the basis in their respective assets allocable to the transferred interests under Sec. 743(b). The adjustments allowed the taxpayer group to claim increased depreciation and amortization deductions, which significantly reduced its taxable income. In the CCA, the IRS focused on how the Regs. Sec. 1.1502-13 rules applied to the increased deductions the group took on its consolidated tax return.

In this situation, the IRS concluded that Regs. Sec. 1.1502-13 redetermines the taxpayer’s increased deductions to be noncapital, nondeductible amounts. This redetermination is required by the fundamental purpose of Regs. Sec. 1.1502-13: “to clearly reflect the income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (or consolidated tax liability).” Thus, the partnerships could not claim increased deductions for depreciation and amortization attributable to the Sec. 743(b) adjustments.