EXECUTIVE SUMMARY

• Several bills in Congress as of this writing would affect partners and partnerships. Sen. Ron Wyden, D-Ore., the chair of the Senate Finance Committee, has proposed changes to partnership allocations.
• Final regulations were issued under Sec. 1061 that provides guidance on the recharacterization of certain net long-term capital gains of a partner that holds one or more applicable partnership interests (carried interests) as short-term capital gains.
• Final regulations provided special rules for how partnerships apply the Sec. 163(j) business interest limitation. Concurrently issued proposed regulations provided additional guidance on the deduction limitation, including on issues with tiered partnerships and dispositions of a partnership interest.
• The IRS issued new international-related Schedule K-2, Partner’s Distributive Share Items — International, and K-3, Partner’s Share of Income, Deductions, Credits, etc. — International, along with instructions.
• Court rulings addressed sham partnerships, cancellation-of-indebtedness income, theft loss deductions, and disguised sales, among other topics.

This article reviews and analyzes recent law changes as well as rulings and decisions involving partnerships. The discussion covers developments in the determination of partners and partnerships, gain on disposal of partnership interests, partnership audits, and basis adjustments.

During the period of this update (Dec. 1, 2020, through Oct. 31, 2021), the IRS issued guidance on the law known as the Tax Cuts and Jobs Act (TCJA), which was enacted at the end of 2017, and made several changes that affect partners and partnerships. The IRS also provided guidance for taxpayers regarding other changes made to Subchapter K over the past few years. Also, the courts and the IRS issued various rulings that addressed partnership operations and allocations.

Current proposals

There are several new bills in Congress as of this writing that would impact partners and partnerships.

Build Back Better Act

At the time this is being written, the House and Senate are attempting to finalize President Joe Biden’s social safety net proposal known as the Build Back Better Act. The current version of the proposed act contains two provisions that would have an impact on partners and partnerships.

The first provision relates to taxes paid on a partner’s share of income. Under current law, general partners pay self-employment tax on the full amount of their net trade or business income, subject to certain exceptions such as rents, dividends, capital gains, and certain retired partner income. Likewise, the net investment income tax imposes a 3.8% tax on “net investment income” on individuals that have a modified adjusted gross income over defined thresholds. Other than for guaranteed payments, limited partners and some members of limited liability companies (LLC) are not subject to Self-Employment Contributions Act (SECA) taxes or net investment income tax.

The House’s version of the Build Back Better Act would expand the scope of the net investment income tax to cover “specified income” derived in the ordinary course of a trade or business for taxpayers with more than $400,000 in taxable income for single filers and $500,000 for married filing jointly returns. The net investment income tax would not be imposed on income on which Federal Insurance Contributions Act (FICA) tax is already imposed. This change would subject all earnings from pass-through entities to either the 3.8% self-employment Medicare tax or the 3.8% net investment income tax.

The second provision would change the rules related to the amount of losses a partner may deduct on a noncorporate tax return. The TCJA added Sec. 461(l), which limited the amount of business losses a noncorporate taxpayer could deduct each year. Sec. 461(l) is set to expire on Dec. 31, 2026. However, the Build Back Better Act would make this section permanent.

Wyden proposal

At the time of this writing, Sen. Ron Wyden, D-Ore., the chair of the Senate Finance Committee, has proposed some major changes that would affect how income from a partnership is calculated and taxed. Wyden’s proposal, released on Sept. 10, 2021, would eliminate or amend a number of sections in Subchapter K.

The first change would impact Sec. 704. The current versions of Secs. 704(a) and 704(b) would be repealed. New Sec. 704(a) would require a partnership to allocate income and loss items based on the partner’s interest in the partnership. A partner’s interest in the partnership would take into account the partner’s contributions to the partnership, the partner’s interests in cash flow and other non-liquidating distributions, the partner’s entitlement to distributions on liquidation, and the partnership agreement. Under a new Sec. 704(b), if two or more members of a controlled group are partners, the allocations would need to be determined using the consistent-percentage method. In addition to the changes to Secs. 704(a) and (b), the proposal would require that Sec. 704(c) allocations be made using the remedial method for property contributed after Dec. 31, 2021. A new subsection would be added to the Code for revalued property that would be similar to the current rules contained in Sec. 704(c).

In another section of Wyden’s proposal, Sec. 707(c) regarding guaranteed payments would be repealed. Instead, partners would have to report income if they had an excess share of the partnership. An excess share of a partnership would occur if the partner’s share of the partnership in liquidation exceeds his or her interest in the partnership based on his or her net contributed capital. Likewise, Sec. 736, which governs payments to retiring partners, would be repealed.

The proposal would also change basis adjustments and allocation of liabilities. In the proposal, a basis adjustment would be mandatory when a partnership interest is transferred or when property is distributed to partners under Secs. 734 and 743. The proposal would also change the allocation of debt under Sec. 752. Going forward, all debt, other than debt personally guaranteed by a partner, would be allocated based on the partners’ share of partnership profits. The proposal does give some relief for gains that would occur if liabilities are reallocated among partners. In this case, any gain that results from the reallocation of debt would be taxed to the partners over an eight-year period.

Further, Wyden’s proposal would change the tax treatment for many publicly traded partnerships (PTPs). The proposal would repeal the exceptions for the treatment of PTPs used by many oil and gas and real estate partnerships. The impact would be that all PTPs would be treated as corporations for tax purposes.

Tax Cuts and Jobs Act

On Dec. 22, 2017, President Donald Trump signed the TCJA, the first major tax reform in over 30 years. The law contained several provisions that affect partners and partnerships. These include a new limitation on the deduction for business interest and new rules for income from carried interests. In 2021, Treasury issued regulations that explain these provisions.

Limitation on business interest deductions

The TCJA added Sec. 163(j), which limits the amount of business interest an entity can deduct each year. Sec. 163(j)(4) provides special rules for applying the interest deduction limitation to partnerships, which include:

• The limitation on the deduction for business interest expense must be applied at the partnership level, and a partner’s adjusted taxable income must be increased by the partner’s share of excess taxable income, as defined in Sec. 163(j)(4)(C), but not by the partner’s distributive share of income, gain, deduction, or loss (Sec. 163(j)(4)(A)).
• The amount of partnership business interest expense limited by Sec. 163(j)(1) is carried forward at the partner level (Sec. 163(j)(4)(B)).
• Excess business interest expense allocated to a partner and carried forward is available to be deducted in a subsequent year only if the partnership allocates excess taxable income to the partner (Sec. 163(j)(4)(B)(ii)).
• Rules are provided for the adjusted basis in a partnership of a partner that is allocated excess business interest expense (Sec. 163(j)(4)(B)(iii)).

Final regulations under Sec. 163(j) issued in 2020 provided special rules for how partnerships apply the Sec. 163(j) limitation. Treasury also issued proposed regulations to accompany the final regulations to provide additional guidance on several other aspects of the deduction limitation including issues with tiered partnerships and dispositions of a partnership interest. Final regulations were issued in 2021, which adopted the proposed regulation related to partnerships. The final regulations adopt an entity approach where if excess business interest expense (EBIE) is allocated to an upper-tier partnership (UTP), the UTP’s basis in a lower-tier partnership (LTP) is reduced; however, the UTP partners’ bases in the UTP are not reduced until the UTP EBIE is treated as paid or accrued by the UTP. In order to reflect the reduction in value associated with the LTP’s business interest expense (BIE), the UTP treats any BIE paid or accrued by the LTP as a nondeductible noncapitalizable expenditure solely for purposes of Sec. 704(b). The UTP treats the UTP EBIE as a nondepreciable capital asset with a value of zero and a tax basis equal to the amount of UTP EBIE. A direct or indirect UTP partner that has a Sec. 704(b) capital account reduction because of UTP EBIE is a “specified partner,” and UTP EBIE is tracked to each “specified partner” and their transferees.

The final regulations also provide that if a partner disposes of a partnership interest, the adjusted basis of the partnership interest is increased immediately before the disposition by the entire amount of the partner’s remaining EBIE (basis addback rule). Partners also may now add back a proportionate basis on partial sales of partnership interests. Partnerships are required to create a new block of “inert” basis in the assets equal to the amount added back on the sale or distribution.

Carried interests

The TCJA added Sec. 1061 to the Internal Revenue Code. Sec. 1061 governs how to treat partnership income allocated to a partner that has a carried interest. Generally, income allocated to a carried interest will be treated as a short-term capital gain instead of a long-term capital gain.

In February 2021, Treasury released final regulations under Sec. 1061. The final regulations include general definitions, guidance, and rules specific to applicable partnership interests (APIs) and applicable trades or businesses and exceptions to the definition of an API. They also provide computational and operational rules, rules for certain related-partner transfers of an API, and reporting rules. The regulations spell out that the amount of income to be recharacterized under Sec. 1061 is determined solely by the owner taxpayer. An owner taxpayer and a passthrough taxpayer each are treated as a taxpayer for the purpose of determining the existence of an API under Sec. 1061(c).

The regulations also make clear that once a partnership interest is an API, it remains an API and never loses that character, unless one of the exceptions to the definition of an API applies. The final regulations provide that if a partnership disposes of an asset, it is the partnership’s holding period in the asset that controls. If a partner disposes of an API, generally the partner’s holding period in the API controls.

The final regulations also include a limited “lookthrough rule.” In the case of a taxable disposition of a directly held API with a holding period of more than three years, the lookthrough rule applies if the assets of the partnership in which the API is held meet a “substantially all test.” The substantially all test generally would be met if 80% or more of the assets of the partnership include assets that would produce capital gain or loss that is not excluded from the rules of Sec. 1061 and that have a holding period of three years or less. If the lookthrough rule applies, a percentage of the gain or loss on the sale is potentially subject to Sec. 1061(a) recharacterization, based on the relative gain inside the partnership on a hypothetical sale of the partnership’s assets at the aggregate fair market value (FMV).

CARES Act

Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, Sec. 168 was amended so that qualified improvement property now meets the definition of “qualified property” for bonus depreciation purposes. Thus, bonus depreciation would be available to an electing real property trade or business for property that meets the definition of “qualified property.” In response, the IRS issued Rev. Proc. 2021-29, which allows partnerships to file amended returns for 2018, 2019, and 2020 if they want to change their depreciation method for this type of property. The revenue procedure also explains how a partnership under the centralized partnership audit regime that wishes to change its recovery period under Sec. 168(g) of the Code for such property may do so without filing an administrative adjustment request.

Audit issues

Before summarizing recent developments related to partnership audits, a broad overview may be helpful. Back in 1982, the Tax Equity and Fiscal Responsibility Act (TEFRA) enacted “unified audit rules” to simplify IRS audits of large partnerships by determining partnership tax items at the partnership level. Any adjustments would then flow through to the partners, whom the IRS would assess deficiencies. Two issues that arose frequently under TEFRA concerned partnership-level items of income and the statute of limitation for the partners and the partnership.

In an effort to streamline the audit process for large partnerships, Congress enacted Section 1101 of the Bipartisan Budget Act of 2015 (BBA), which amended in its entirety Sec. 6221 et seq. The revised sections instituted new procedures for auditing partnerships, affecting issues including determining and assessing deficiencies, who pays the assessed deficiency, and how much tax must be paid. The BBA procedures replace the unified audit rules as well as the electing large partnership regime of TEFRA. In 2018, Congress enacted the Tax Technical Corrections Act (TTCA), which made a number of technical corrections to the rules under the centralized partnership audit regime. The amendments under the TTCA are effective as if included in Section 1101 of the BBA and, therefore, are subject to the effective dates in Section 1101(g) of the BBA.

Statute of limitation

In 2020, the IRS instructed its auditors on statute-of-limitation issues involving centralized audits of partnerships where a transition tax issue under Sec. 965 has been identified. Sec. 965 generally requires U.S. shareholders to pay a “transition tax” on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States. Sec. 965(k) generally provides that the statute of limitation on assessment will not expire before six years after the return for that tax year is filed. Taxpayers may elect to pay Sec. 965 tax liabilities over an eight-year period.

The IRS made clear that the deferred taxes are liabilities for the original year of inclusion, not the year of payment. Thus, the six-year statute of limitation will apply to the inclusion year but not to the payment year if the deferral was elected. Under the BBA, any adjustment to a partnership-related item must be determined at the partnership level. According to the IRS, all Sec. 965 amounts are partnership-related items.

Court decisions

Even with the adoption of the BBA audit rules, cases are still being litigated involving TEFRA issues. Most TEFRA cases revolve around either a statute-of-limitation issue or whether the income or deduction is a partnership item. This past year one case dealt with a statute-of-limitation issue, and another dealt with the partnership item issue.

In BCP Trading & Investments, LLC, the IRS issued tax adjustments to an LLC that the members of the LLC challenged. The members argued that the adjustments were untimely and that the IRS mistakenly determined that the partnership was a sham. The Tax Court originally found the adjustments timely because the three-year statute of limitation for the adjustments was extended by the partnership and its members, and those extensions, contrary to the members’ challenges, were consistent with fiduciary and contract principles. The Tax Court also agreed with the IRS that the partnership was a sham for tax purposes.

The LLC members appealed the Tax Court decision. In the appeal, the members argued that the extensions of the statute of limitation were voidable under fiduciary rules because the members relied upon advice from an accounting firm/tax shelter promoter. The appeals court disagreed and upheld the Tax Court decision, stating that the argument was misguided because the tax matters partner, not the accounting firm, was the person who signed the original consent and thus was the relevant fiduciary for these purposes. In addition, other members all also signed extensions individually. The court found that any claim that the statute-of-limitation extensions were otherwise voidable under contract principles of misrepresentation and undue influence also failed because the members could not show that any of them justifiably relied on the accounting firm’s advice, especially when considering they were all sophisticated business professionals who had additional advisers and ample reason to question the accounting firm’s advice long before the consents to extend the limitation period were signed.

A second case, ES NPA Holding, LLC, examined whether the item in question was a partnership item. In this case the IRS determined that an LLC had significant unreported income attributable to its receipt of a direct capital interest in another LLC in exchange for services the first LLC provided. The taxpayer argued that the income adjustment related to a partnership item of the second LLC, not to the first LLC. Thus, the adjustment was outside the Tax Court’s jurisdiction. The Tax Court did not accept this argument, stating that the adjustment was properly classified as a partnership item of the first LLC because the adjustment resulted when the first LLC obtained an interest in the second LLC, not from its receipt of a distributive share of the second LLC’s income. Accordingly, the taxpayer’s argument that the adjustment fell outside the court’s jurisdiction failed.

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 an independent business purpose beyond reducing taxes. The IRS has been diligent in examining transactions that it considers to lack economic substance or to be a sham transaction and generally has prevailed on the issue. To help clarify the rules, Congress codified the economic substance doctrine in the Health Care and Education Reconciliation Act of 2010. There were several cases this past year that considered whether a partnership had economic substance.

Sham partnerships

In several deficiency cases consolidated into a single proceeding, Greenberg, a taxpayer/CPA and a colleague/attorney allegedly used a purported investment partnership and other entities to effect son-of-boss/short option strategy tax shelter transactions. The Tax Court rejected the taxpayer’s loss deduction claim for one partnership’s abandonment of its purported interest in another entity. The court concluded that the taxpayer failed to show that the partnership ever owned any interest in the stated entity, or if it did, that it intended to abandon the interest and/or took steps to do so. The taxpayer appealed.

Affirming the Tax Court’s ruling, the appellate court found that the Tax Court properly upheld the IRS’s adjustments, including those disregarding certain partnerships as shams and treating the transactions that the partnership engaged in as engaged in by the taxpayer directly. The appellate court also rejected the taxpayer’s arguments that the IRS failed to make a considered determination regarding these transactions or that the Tax Court erred by not putting the burden of proof on the IRS. Further, the appellate court rejected the taxpayer’s arguments that the Tax Court erred in post-trial rulings by accepting IRS computations that contained errors or by not considering new substantive issues that the taxpayer waited to raise until after the trial.

In addition, the appellate court found that the Tax Court properly rejected the taxpayer’s deficiency notice challenge that the IRS did not issue prerequisite final partnership administrative adjustments to the partnership in accordance with TEFRA procedures. The partnership in this case was a small partnership; however, the partnership did not make a valid TEFRA election to be treated as such. The taxpayer also argued unsuccessfully that the deficiency notices were mailed after the statute of limitation expired in one year under review. With respect to another year, the taxpayer claimed that the deficiency notice was untimely because the deficiency was for “converted items.”

The Tax Court ruled that all of the deficiency notices were timely filed. The appellate court agreed and ruled that the Tax Court properly rejected the taxpayer’s arguments because the taxpayer had no proof that the IRS failed to follow “established procedures” for mailing notices for the first year, and the record showed that the assessment period was suspended for the deficiency notice related to the converted items.

Partnership reporting

Beginning in the 2020 tax year, partnerships are required to calculate and report their partners’ capital accounts using the transactional approach for the tax basis method. The instructions to the 2020 Form 1065, U.S. Return of Partnership Income, explained that if a partnership did not report its partners’ capital accounts using the tax basis method in the 2019 tax year and did not maintain its partners’ capital accounts under the tax basis method in its books and records, the partnership may determine its partners’ beginning capital accounts for the 2020 tax year using any one of the following methods: the tax basis method, the modified outside basis method, the modified previously taxed capital method, or the Sec. 704(b) method.

In Notice 2021-13, the IRS determined that a partnership that includes incorrect information in reporting its partners’ beginning capital account balances on the 2020 Schedules K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., will not be subject to a penalty under Sec. 6698 if the partnership can show that it took ordinary and prudent business care in calculating beginning basis. Sec. 6698 imposes a penalty for failing to file a return or report at the time prescribed, or for filing a return or a report that fails to show the information required under Sec. 6031.

In 2021, Treasury and the IRS released final versions of Schedules K-2, Partners’ Distributive Share Items — International, and K-3, Partner’s Share of Income, Deductions, Credits, etc. — International, for Forms 1065 for tax year 2021. The schedules are designed to help guide partners and shareholders on how to compute their U.S. income tax liability with respect to items of international tax relevance, including claiming deductions and credits. The IRS has also issued draft instructions that explain how to complete the forms.

The new forms and instructions will also provide greater clarity to partnerships, S corporations, and U.S. persons who are required to file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, with respect to controlled foreign partnerships on how to provide international tax information. The updated forms will apply to any persons required to file Form 1065; Form 1120-S, U.S. Income Tax Return for an S Corporation; or Form 8865, but only if the entity for which the form is being filed has items of international tax relevance (generally foreign activities or foreign partners).

To promote compliance with adoption of Schedules K-2 and K-3 by affected passthrough entities and their partners and shareholders, Treasury and the IRS have provided certain penalty relief for tax years that begin in 2021. If the filer establishes to the satisfaction of the IRS that it made a good-faith effort to comply with the new reporting requirements on Schedule K-2 and K-3, certain penalties will not be imposed for incorrect or incomplete reporting.

Partner’s income

Partnerships are not subject to federal income tax under Sec. 701. After items of income and expense are determined at the partnership level, each partner is required to take into account separately in the partner’s return a distributive share, whether or not distributed, of each class or item of partnership income, gain, loss, deduction, or credit under Sec. 702.

Income included on partner’s return

Sec. 702 requires partners to report income on their tax returns when the partnership earns the revenue even if the partner does not receive the proceeds. In Dodd, the taxpayer was a partner in a partnership that reported a gain on the sale of partnership property. The partner’s share was reported on her Schedule K-1, and she reported that amount on her individual tax return but did not pay the tax on the gain.

The taxpayer argued that the proceeds of the sale went to the bank to pay off several loans and that she got no benefit from these funds. The IRS disagreed, noting that partners must report income whether they receive the proceeds or not. The Tax Court sided with the IRS and held that the income was taxable even though the taxpayer did not receive any of the proceeds from the sale.

Cancellation-of-indebtedness income

In another case, Hohl, three individuals were partners in a partnership from which they reported guaranteed payments. A fourth partner regularly put money into the partnership, which the partnership and the partners generally treated as loans. The year the partnership ceased operation, the partners treated the fourth partner’s loans as contributions of capital, and the other partners were not required to repay their respective shares of the loans. The partners did not report any income related to the change from loans to capital contribution.

The IRS agent determined the change from a loan to a capital contribution created cancellation-of-indebtedness income to the partners. This determination was made because the funds originally provided by the fourth partner were loans to the partnership, which were allocated among the partners. Since none of the partners were insolvent, the cancellation of those loans resulted in income to the partners.

The Tax Court held in favor of the IRS, noting that the taxpayers’ argument that the loans were not in fact loans in the first place, but instead represented capital contributions, failed because the partnership had reported the advances as liabilities for each operating year before the year of termination. It did not matter that the partners did not include their share of the liabilities in their capital account. Alternatively, the taxpayers argued that the loans were recourse liabilities that should be allocable solely to the fourth partner. The court rejected this argument because the partnership had originally allocated the debt to all partners. This case is another instance where taxpayers were not allowed to change the substance of a transaction once they had elected a specific form.

Certain disallowed deductions

In Chief Counsel Advice (CCA) 202050015, the IRS Chief Counsel’s Office addressed the issue of whether certain insurance premiums paid by a partnership were deductible. In this situation, the partnership paid for an insurance policy to reimburse partners in the event of an adjustment upon audit to a deduction claimed for a charitable contribution. The policy would reimburse the partners for any difference between the tax benefits they claimed and the tax benefits they are entitled to receive, regardless of any trade or business activity of the partnership. The Chief Counsel’s Office determined that the cost of the insurance policy was not deductible because the premiums were not sufficiently related to the partnership’s trade or business to support a deduction under Sec. 162(a) and were not sufficiently related to the partnership’s income-producing activities under Sec. 212.

In a Tax Court case, Estate of Morgan, the taxpayer had several businesses prior to the years in question. However, the businesses had gone into receivership. Afterward, the taxpayer attempted to find a new business and deducted the expenses incurred in searching for a new business. The IRS disallowed the deductions for the expenses related to searching for a new trade or business. The Tax Court agreed with the IRS that the taxpayer was not carrying on a trade or business through his search for a new trade or business to acquire. Thus, the expenses did not qualify under Sec. 162. The court held that at most the expenses would be Sec. 195 startup expenses, but since the taxpayer never started a business, the expenses were not deductible under Sec. 195 either.

Theft loss deduction

In Vennes, taxpayers claimed passthrough theft loss deductions for losses from the husband’s S corporation and related partnership interests. The losses were sustained from a massive Ponzi scheme, which was orchestrated by a longtime acquaintance using an electronics resale company to solicit loans in exchange for fictitious notes. The husband participated in the scheme. However, he was not charged with knowledge of the underlying fraud. The taxpayers claimed theft losses from the S corporation and the related partnerships on their personal tax return when the scheme collapsed.

The IRS disallowed the losses because the taxpayers failed to properly substantiate the losses and could not show there was no reasonable prospect of recovery in the year the losses were claimed when considering overall circumstances, including assets potentially available or the possibility of obtaining legal restitution via other avenues.

The Tax Court agreed with the IRS with regard to the loss from the S corporation because the safe-harbor relief provided in Rev. Proc. 2009-20 was not available as to the S corporation, because the qualified loss and qualified investor requirements of the safe harbor were not met. However, those requirements were met with respect to the partnerships in which the husband held a partnership interest. Thus, the court allowed deductions for his allocable share of the partnership losses. These losses were allowed even though the husband’s S corporation was the original partner. The court ruled that the S corporation’s partnership interests had been redeemed and the husband had invested individually before the loss was recognized.

Disguised sale

In a case that involved the Chicago Cubs, Tribune Media Co., the Tax Court addressed whether an exception to the disguised-sale rules applied. The taxpayer formed an LLC with another member. The taxpayer contributed the baseball team, and the other member contributed cash. As part of the transaction, the LLC entered into two debt contracts, one with a commercial lender and the other with the other member. The loan from the other member was subordinate to the commercial loan. The taxpayer guaranteed both debts. The LLC then distributed cash to the taxpayer. Neither party disputed that this type of transaction is a “disguised sale,” which is taxable under Sec. 707(a)(2)(B). However, there are exceptions to the disguised-sale rules, including the debt-financed distribution rule. The debt-financed distribution rule permits a partner to receive a debt-financed distribution of property from a partnership as part of a disguised sale tax-free up to the amount of debt allocated to that partner.

Because the taxpayer guaranteed both debts and thus was ultimately responsible for the debts, the taxpayer took the position that the distribution met the debt-financed distribution exception and therefore was not taxable. The IRS argued that the debt funded by the other LLC member was not bona fide debt but rather was disguised equity. Thus, the subordinate debt should be disregarded for the debt-financed distribution rule. The IRS also argued that the likelihood of the taxpayer ever being required to satisfy the guaranty was so remote that the guaranty for the commercial debt also should be disregarded.

The court examined a number of issues that would distinguish whether the subordinate debt was debt or equity for tax purposes. Based on its examination, the court determined that the subordinate debt should be characterized as equity; thus, the portion of the distribution attributable to the subordinate debt cannot offset the taxpayer’s recognized gains from the disguised sale. The other debt guaranty was bona fide even if the probability the taxpayer would be required to make a payment is remote. Thus, the portion of the distribution attributable to the other debt guaranty is a nontaxable debt-financed distribution, the court held.

Sec. 754 election

When a partnership distributes property or a partner transfers his or her interest, the partnership can elect under Sec. 754 to adjust the basis of partnership property. A Sec. 754 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. The partnership must file the election by the due date of the return for the year the election is effective, normally with the return.

Currently, if a partnership inadvertently fails to file the election, the only way to remedy the failure is to ask for relief under Regs. Secs. 301.9100-1 and -3 either through automatic relief if the error is discovered within 12 months or through a private letter ruling. To be valid, the election must be signed by a partner.

Extensions of time

In several private letter rulings during this period, the IRS granted an extension of time to make a Sec. 754 election. In each case, the partnership was eligible to make the election but had inadvertently omitted the election when filing its return. The IRS reasoned that the partnership in each case acted reasonably and in good faith, and it granted an extension to file the election under Regs. Secs. 301.9100-1 and -3. In these rulings, each partnership had 120 days after the ruling to file the election. In some cases, the IRS granted the partnerships the extension even though they had relied on a professional tax adviser or preparer when they failed to timely make the election.

Missed elections

The Sec. 754 election is allowed when a partner dies and his or her interest is transferred. In many cases the election is inadvertently missed in this situation. Last year the IRS granted an extension of time to make the Sec. 754 election in several situations where a partner died and the partnership missed making the election.

Revoking a Sec. 754 election

A partnership that wants to revoke its Sec. 754 election should file its revocation request using newly released Form 15254, Request for Section 754 Revocation, which must be filed no later than 30 days after the close of the partnership’s tax year and must state the reason(s) for requesting a revocation. The regulations provide examples of situations that may warrant the IRS’s approval of a partnership’s revocation application. A revocation application will not be approved when the revocation’s purpose is primarily to avoid a reduction in the basis of partnership assets upon a transfer or distribution of partnership property.

This past year the IRS provided updated procedures in memorandum LB&I-04-0621-0004 (8/21/21) for its employees to follow when reviewing Form 15254. Before a Sec. 754 election is finalized, it must be reviewed and approved by a manager and the Chief Counsel’s office. This guidance applies to any partnership, whether subject to TEFRA, the BBA, or separate deficiency proceedings.

Other elections

Foreign entities formed as LLCs that want to be taxed as a partnership in the United States must make an election on Form 8832, Entity Classification Election. Without this election, this type of entity defaults to a corporation. In several instances this past year a foreign entity failed to make the election in a timely manner. In each of these instances the IRS allowed the entity 120 days after the ruling to file the election.

Partnerships that qualify as qualified opportunity funds under Sec. 1400Z must also file an election to self-certify their assets. In one instance this past year a partnership missed the deadline for the election and requested additional time to file the election. In this instance, the partnership was granted only 45 days after the ruling to file the election.