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.
Income included on partner’s return
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.
In a case decided in 2022, three single-member entities were partners in an accounting firm organized as a partnership. The partners negotiated a buyout of one of the partners in anticipation of the retirement of that partner’s principal owner. The buyout was added to a restated partnership agreement. The partnership agreement also included provisions governing allocations of income and distributions (both liquidating and non liquidating) to the partners and a qualified income offset provision. The partnership agreement anticipated that a partner could receive a distribution of clients from the partnership and provided a method for valuing such a distribution.
Shortly after finalizing the restated partnership agreement, the other two partners withdrew from the partnership and formed a new partnership. Some of the old partnership’s clients moved to the new partnership. The old partnership reported on its tax return that the two partners that withdrew received distributions in amounts equal to the value of the clients (as determined under the restated partnership agreement) that followed them to the new partnership. The partnership also decreased the withdrawing partners’ capital accounts by the value of the reported distributions, which reduced their capital accounts below zero. To restore their capital accounts to zero, the partnership allocated all of the partnership’s ordinary income to the withdrawing partners pursuant to the qualified income offset provision in the partnership agreement.
The withdrawing partners filed Forms 8082 contesting the income allocations. The IRS audited the partnership return and issued an FPAA that disregarded the distributions and redetermined the allocations of ordinary income, contending that the distributions had not been substantiated and that the corresponding allocations of income lacked substantial economic effect. The partnership petitioned the Tax Court.
The Tax Court agreed with the partnership and rejected the IRS’s determination to disregard the distributions. Instead, the court found that the distribution treatment was correct and that the partnership’s method for valuing the distributions met the definition of fair market value (FMV) under Regs. Sec. 1.704-1(b)(2)(iv)(h)(1). However, the court also found that the partnership’s special income allocations to the withdrawing partners lacked substantial economic effect because the partnership had not maintained capital accounts for the partners. Thus, the distributions did not meet the requirements under Regs. Sec. 1.704-1(b)(2)(iv) for maintaining capital accounts and had to be reallocated in accordance with the partnership interests under Sec. 704(b) and Regs. Sec. 1.704-1(b)(3). In addition, since the withdrawing partners had negative capital accounts at the end of the year and the partnership agreement included a qualified income offset provision, ordinary income had to be allocated first to those partners in the amount necessary to bring their respective capital accounts up to zero.
Character of partner’s loss
The character of a loss was at issue in a case24 in 2022 in which a taxpayer and his colleague formed a partnership that purchased lots for investment purposes. Before any lots were sold or distributed, the partnership did not make any improvements to develop the lots. Later, some of the lots were distributed to the taxpayer, and he sold them at a loss. The taxpayer reported the loss as ordinary.
The character of income reported by a partner is generally determined at the partnership level. In this situation, the IRS determined that the loss on the sale should be capital and not ordinary, as reported. It noted that the lots were purchased by the partnership for investment purposes, not for development; therefore, any losses at the partnership level would have been capital. It also indicated that, even if the lots were initially intended for development, the development plan was abandoned well before the lots were distributed and that no improvements were in fact made. Other factors that indicated the loss was capital included that the sale was an isolated transaction for the taxpayer and that the taxpayer’s regular business was a law practice, not real estate. The facts that the taxpayer hired a broker and advertised the lots for sale were not enough to counter the other facts.
The Tax Court agreed with the IRS and concluded that the lots in the taxpayer’s hands were neither his stock in trade, inventory, nor property held primarily for sale to customers in the ordinary course of business under Sec. 1221(a)(1) and thus were capital. The taxpayer alternatively argued that the lots were inventory as defined in Sec. 751(d) and that, pursuant to Sec. 735(a), they retained their inventory character from the partnership. Therefore, he argued, he was allowed an ordinary loss upon their sale within five years of the partnership’s distribution. The court also rejected this argument.