Partnership Tax Allocation May Do More Harm than Good
Bruce M Bird, Mark A Segal, Marcia Sakai. The CPA Journal. New York: Dec 2008. Vol. 78, Iss. 12; pg. 10, 2 pgs
Taxpayers invest in partnerships for a variety of reasons. Partnerships can be structured to attract certain types of investors. This can be accomplished through the partnership agreement itself or through the use of multi-tiered partnerships. Sometimes, an arrangement involving a partnership allocation is structured in such a way that it attracts IRS scrutiny. The utilization of state tax credits is the first part of a two-part strategy to reduce a taxpayer's total federal tax liability. The second part of this strategy involves the sale of the investor's interest in the partnership, at a fraction of its basis, to one of the partnership's promoters in order to generate a capital loss. In one sense, the strategy described in CCA 200704028 is arguably a testament to the creative tax planning abilities of real estate promoters. In another, it is arguably an example of "too clever by half" tax planning.
axpayers invest in partnerships for a variety of reasons. Partnerships can be structured to attract certain types of investors. This can be accomplished through the partnership agreement itself or through the use of multi-tiered partnerships. Partnership agreements, for example, commonly provide for special allocations of certain partnership items. Special allocations that have a substantial economic effect are typically respected for tax purposes.
Sometimes, an arrangement involving a partnership allocation is structured in such a way that it attracts 1RS scrutiny. In Chief Counsel Advice (CCA) Memorandum 200704028, the 1RS examined one such partnership involving a partnership's allocation of state historic rehabilitation tax credits to its investors. Prior to a change in the law of a given state, a partnership was allowed to make a one-time transfer of its state rehabilitation credits to its investors. After the change in the law, the state rehabilitation credits could no longer be transferred by the partnership. The state did, however, allow for the allocation of the credits by partnerships and S corporations to its investors. Under the new law, the state rehabilitation credit had to be identified and used for the year earned, with any unused credit carried forward to future years.
For projects implemented after the change in state law, the promoters in CCA 200704028 formed a new partnership, Pl, which joined the developers' existing partnerships, and contributed cash-fixed on a per-dollar-of-credit basis-in exchange for the allocation of the state rehabilitation credits earned by the developers' partnerships. In tum, Pl allocated all of the rehabilitation credit it had been allocated to a group of individual investor partners in Pl and several other partnerships (P2 and P3). These other partnerships then allocated their distributive shares of the credits to their individual investors.
It should be noted that the individual investor partners in Pl had a combined interest of approximately 1%. In addition, the individual investor partners in P2 and P3 had a combined interest of approximately 1% in each respective partnership.
The individual investors executed subscription agreements with Pl, P2, or P3, providing that the given partnership anticipated receipt of the credit and agreed to allocate a fixed number of the credits to the investors. Upon the execution of the subscription agreements and cash contributions, these partnerships transferred credits simultaneously. (Future allocations of credits, if any, did not occur simultaneously but typically within a given time frame.)
Each of the Pl, P2, and P3 partnership agreements in CCA 200704028 contained an interesting feature. The individual investors executed option agreements granting each partnership the right to repurchase the investors' partnership interests for a one-year period at fair market value. In fact, most of the individual partners resold their interests to one of the key promoters of the partnerships after a number of months and at a small fraction of their basis in the partnership. Accordingly, the investors claimed large capital losses on their federal income tax returns.
According to the marketing materials, the taxpayers would not receive any material distributions of cash flow or net proceeds from the sale of the partnerships Pl, P2, or P3. Furthermore, the investors would not be allocated material amounts of federal income tax credits or partnership items of income, gain, loss, or deduction. The marketing materials also provided that the investors' return in Pl, P2, or P3 is dependent entirely upon the allocation of state tax credits and the capital loss for federal tax purposes generated upon the sale of the investors' interests in Pl , P? or P3.
A Tax Strategy
At first glance, the notion of investing in a partnership primarily to "harvest" state tax credits does not appear to be particularly appealing. Some partnerships, however, are primarily marketed to individual taxpayers already subject to the alternative minimum tax (AMT). The utilization of state tax credits is the first part of a twopart strategy to reduce a taxpayer's total federal tax liability (regular plus AMT).
For purposes of computing regular federal tax liability, a taxpayer can deduct state income taxes where total allowable itemized deductions (on Schedule A) exceed the applicable standard deduction amount. State income taxes, however, are not deductible for purposes of computing an individual's AMT liability. As a result, the state tax credits will reduce the taxpayer's state tax liability. This will then increase the taxpayer's regular federal tax liability (usually by the reduction in state tax liability multiplied by the taxpayer's marginal tax rate). For purposes of computing AMT, however, a state tax credit typically does not benefit a taxpayer already subject to the AMT.
The second part of this strategy involves the sale of the investor's interest in the partnership, at a fraction of its basis, to one of the partnership's promoters in order to generate a capital loss. (It should also be noted that, for purposes of computing a partner's basis in a partnership interest, a state tax credit is not a "partnership item" affecting basis.) In many cases, the partnership interest will be purchased and sold by the investor in the same tax year. Accordingly, the capital loss will be short-term in nature.
For a taxpayer already subject to the AMT, this strategy would appear to convert state income taxes that cannot be used for AMT purposes into capital losses that can. In addition, it would appear that, given the structure of the partnership arrangement, an investor subject to the AMT could receive tax savings far in excess of the amount invested in the partnership.
In CCA 200704028, the IRS indicated it did not care for this partnership arrangement. Based upon the materials submitted and representations made, the IRS concluded that 1) the investors receiving the allocation of state tax credits should not be treated as partners in the partnerships under the "substance over form" doctrine; 2) the transactions should be recharacterized as disguised sales of partnership property under IRC Section 707(aX2)(B); and 3) the transactions should be recast under the partnership anti-abuse rules of Treasury Regulations section 1.701-2.
The critical inquiry in the substanceover-form doctrine is taxpayer intent. In a partnership, the intent of the parties is to join together in conducting a business activity and sharing the profits.
The LRS noted that the transactions were promoted "as ones in which the investors would receive no material cash distribution, no net proceeds from a sale of the projects or operating partnerships, no allocations of federal income tax credits, and no partnership items of income, gain, loss, or deduction." Stated alternatively, the investors knew that me only benefits of entering partnerships Pl, P2, or P3 were the distributions of state tax credits and federal income tax losses to be claimed upon the termination of the investor's interests. Thus, the investors were not partners in the partnerships.
Disguised Sale of Property
IRC section 707(a)(2)(B) provides that if 1) there is a direct or indirect transfer of money or other property by a partner to a partnership; 2) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or to another partner); and 3) the above transfers, when viewed together, are properly characterized as a sale or exchange of property, then such transfers shall be treated either as occurring between the partner and one who is not a partner, or as a transaction between two or more partners acting other than in their capacity as members of the partnership.
Whether a nonmoney transfer of property by a partner to a partnership and a transfer of money or other consideration by the partnership to that partner is to be treated as a sale of property-in whole or in part-by the partner to the partnership is a facts-and-circurnstances issue covered by Treasury Regulations section 1.707(3Xb). This regulation generally provides mat two conditions must be satisfied for the transfer to be considered a sale of property (in whole or in part):
(i) The transfer of money or other consideration would not have been made but for the transfer of property; and
(ii) In cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.
In addition, if these transfers occur within a two-year period, the presumption is that they will be treated as a sale of the property to the partnership unless the facts and circumstances clearly establish otherwise.
Similar rules are contained in Treasury Regulations section 1.707-6(a) for the purposes of determining whether a transfer of property by a partnership to a partner and one or more transfers of money or other consideration by that partner to the partnership are treated as a sale of property-in whole or in part-to the partner.
Partnership Anti-Abuse Rule
Treasury Regulations section 1.701-2 contains a partnership anti-abuse rule. There are three implicit requirements in subchapter K:
* The partnership must be bona fide, and each partnership transaction or series of related transactions must be entered into for a substantial business purpose;
* The form of each partnership transaction must be respected under substanceover-form principles; and
* In general, the tax consequences under subchapter K to each partner of partnership operations and of transactions between the partner and the partnership must accurately reflect the partners' economic agreement and clearly reflect the partner's income.
If a partnership is formed or availed of in connection with a transaction-a principal purpose of which is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter Kthe IRS can recast the transaction to achieve tax results more consistent with the intent of subchapter K.
The IRS concluded mat partnerships Pl, P2, and P3 in CCA 200704028 were used for the specific purpose of allocating the state tax credits to the investors, resulting in substantial federal tax reduction. Thus, the transactions should be recast as ones in which the partnership promoters purchased the credits from the project developers at a specific amount per dollar of credit and, then, sold them to the individual investors at a specific amount per dollar of credit The 1RS further concluded that partnerships Pl, P2, and P3 should be disregarded for federal tax purposes, and disallowed the losses claimed by the individual investors for the sale of their purported partnership interests.
CCA 200704030 involved another partnership arrangement that attracted IRS scrutiny. Unlike CCA 200704028-which involved a partnership's allocation of non-transferable state tax credits - this advice dealt with an arrangement in which the state tax credits were transferable. Using a similar analysis, the 1RS also indicated its disapproval of the taxpayer's two-part strategy to reduce the total federal tax liability (regular plus AMT).
In 2007, the LRS issued generic legal advice indicating its disapproval of the taxpayer strategies used in CCAs 200704028 and 200704030. Later that year, the LRS gave its agents "blanket authority" to apply the partnership anti-abuse rules in certain areas, one of which involves a partnership's sale or allocation of state tax credits.
The IRS has also indicated that both CCAs are not intended to question the validity of state tax credits, state tax credit "deals," or the use of partnerships in structuring state tax credit "deals." Rather, these CCAs are intended to thwart a specific abuse involving the improper use of state tax credits by a taxpayer subject to the AMT by disallowing the taxpayer from claiming a loss when selling back his interest in the partnership, at a fraction of its basis, to the promoter.
In one sense, the strategy described in CCA 200704028 is arguably a testament to the creative tax planning abilities of real estate promoters. In another, it is arguably an example of "too clever by half' tax planning.
CCAs 200704028 and 200704030 stand for the proposition that the 1RS will closely scrutinize certain partnership arrangements. In essence, the LRS concluded that, based upon the facts and circumstances, the investors were not "partners." Individual investors subject to the AMT would be well advised to avoid such transactions.
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Partnership Tax Allocation May Do More Harm than Good