If you’ve already read Monte Jackel’s articles on partnership taxation, such as “Is it (Finally) Time? Reforming Subchapter K,” you are already aware that the tax treatment of partnerships can be complicated. Then consider this: what happens when you are ready to sell your partnership interest or buy someone else’s? You will learn from one of our expert M&A tax professionals, Mr. Jackel, that the tax treatment of the sale of a partnership interest will vary on a case-by-case basis. It will also depend on whether the IRS decides to tax the partnership as an aggregate of its partners or as an entity separate from its partners. Treating a partnership as a separate entity is unique to M&A transactions. As you may already be aware, partnerships are “pass-through” entities, meaning that the individual partners file tax returns, but the partnership itself does not. This is just one of the many ways in which the tax treatment of sales of a partnership interest departs from the standard tax treatment of partnerships. Therefore, before approaching an M&A transaction that involves the sale of a partnership interest, you’ll want to consider the tax strategies that will enable your business to further your business goals while maximizing the efficiency of your tax structuring. For example, partnerships owning real property are still subject to FIRPTA for foreign partners, will want to address any of the FIRPTA issues presented in the M&A transaction. To ensure that your M&A transaction’s tax strategies are as effective as possible, consider conducting tax due diligence early on in order to best position yourself for any eventualities such as the ones discussed in this article.
Note that this outline is reprinted from the outline first published in Tax Notes, Tax Analysts, Fairfax, VA, on July 26th, 2017. See 2017 TNT 142-21. The outline has not been updated since that publication. Note that certain laws have changed since the initial posting (for example, the introduction of Section 864(c)(8) and the DC Circuit Court opinion affirming the Grecian Magnesite case), and the analysis provided herein has not been updated for such changes.
1. General Principle of Law
The general principle of law underlying aggregate or entity treatment of a partnership is set forth in the 1954 Conference Report on Section 707: H.R. Conf. Rep. No. 2543, 83d Cong., 2d Sess. 59 (1954), which states the general proposition that aggregate or entity principles are applied as appropriate under the circumstances:
“Both the House provisions and the Senate amendment provide for the use of the “entity” approach in the treatment of the transactions between a partner and a partnership which are described above. No inference is intended, however, that a partnership is to be considered as a separate entity for the purpose of applying other provisions of the internal revenue laws if the concept of the partnership as a collection of individuals is more appropriate for such provisions. An illustration of such a provision is section 543(a)(6), which treats income from the rental of property to shareholders as personal holding company income under certain conditions.”
2. Some Congressional (And IRS) Applications Of The General Principle
Congress and the IRS have set forth several examples of the application of this general principle of law.
1. 1954 House and Senate Reports on sections 741 and 751.
House Report, H.R. Rep. No. 1337, 2d Sess., pp 70-71 (March 9, 1954).
“Under present decisions the sale of a partnership interest is generally considered to be a sale of a capital asset, and any gain or loss realized is treated as capital gain or loss. It is not clear whether the sale of an interest whose value is attributable to uncollected rights to income gives rise to capital gain or ordinary income. There is also doubt under present law whether the basis of the assets of the partnership may be adjusted, or is required to be adjusted, to reflect the purchase price paid by a new partner for his interest.
“Because of the confusion in this area, basic rules have been set forth in order to clarify the tax treatment and at the same time to prevent the use of the sale of an interest in a partnership as a device for converting rights to income into capital gain.
“The general rule that the sale of an interest in a partnership is to be treated as the sale of a capital asset is retained.
“In order to prevent the conversion of potential ordinary income into capital gain by virtue of transfers of partnership interests, certain rules have been adopted by your committee which will apply to all dispositions of partnership interests. The bill provides that, if in connection with the transfer of a partnership interest, the partner receives any amount attributable to his share of (1) the unrealized receivables and fees of the partnership, or (2) substantially appreciated or depreciated inventory or stock in trade, such amounts are to be treated as ordinary gain or loss. In effect, the partner is treated as though he disposed of such items independently of the rest of his partnership interest H. Rept. No. 1337 (1954).” (emphasis added).
1. Senate Report, S. Rep. No. 1622, 83d Cong., 2d Sess., U.S. Cong. & Adm. News, 54-296, at pp 4731-5733 (1954).
“In order to prevent the conversion of potential ordinary income into capital gain by virtue of transfers of partnership interests or by distributions of property, certain rules have been adopted by the House and your committee which will apply to all dispositions of partnership interests. The bill provides that, if in connection with the transfer of a partnership interest, the partner receives any amount attributable to his share of (1) the unrealized receivables of the partnership, or (2) substantially appreciated inventory or stock in trade, such amount is to be treated as ordinary gain or loss. In effect, the partner is treated as though he disposed of such items independently of the rest of his partnership interest. (Emphasis added).
“Except for technical amendments, this section corresponds to the House provision. It provides that the sale or exchange by a partner of his interest in the partnership shall be treated generally as the sale or exchange of a capital asset. Any gain or loss shall be treated as capital gain or loss unless the partnership has unrealized receivables, or inventory items which have substantially appreciated in value, as defined in section 751. If section 751 is applicable, a portion of the gain or loss shall be treated as ordinary income or loss. S. Rept. No.1622 (1954).”
- 1984 Blue Book Relating to section 453(i) And Depreciation Recapture and section 751(f) Tiered Partnerships, General Explanation Of The Deficit Reduction Act Of 1984, JCS-41-84 (December 31, 1984) (pp 241-242 on section 751, and pp 333-335 on section 453).
- Section 453(i).
“The taxpayer may own a partnership interest which, if sold by the taxpayer for cash, would generate some depreciation recapture income to the taxpayer under section 751. If the taxpayer sold his interest on the installment basis, the provisions of the Act would apply. This is because depreciation recapture, like some other items, is a severable part of the taxpayer’s partnership interest. (See the discussion relating to section 76 of the Act.).”
- Section 751(f) (Section 76 of the 1984 Act).
“Under the Act, in determining whether partnership property is an unrealized receivable or an inventory item under section 751, the partnership is to be treated as owning its proportionate share of the property of any other partnership in which it is a partner. Thus, the ordinary income rules of section 751 are applied by regarding income rights (as section 751 was intended to under prior law) as severable from the partnership interest, and a partner is treated as disposing of such items independently of the rest of his partnership interest. This rule applies regardless of how many tiers of partnerships exist between the transferring or distributee partner and the ordinary income assets.” (Emphasis added).
- Reg. secs. 1.701-2(e)(l) and 1.701-2(f), examples 1 (section 163(e)(5)) and 2 (section 1059) state that the IRS can treat a partnership as an aggregate of its partners as appropriate to carry out the purpose of the code or regulation provision at issue, unless that other provision of the code or regulations clearly prescribes entity treatment.
- H.R. Rep. No.1167, 96th Cong., 2d Sess. 511 (1980) (legislative history to section 897(g)), where it is stated as follows:
“In order to impose a tax on gains from the sales of U.S. real estate, it is also necessary to impose a similar tax on gain from the disposition of interests in entities that hold substantial U.S. real property. Otherwise, a foreign investor could, as under present law,avoid tax on the gain by holding real estate through a corporation, partnership or trust and disposing of his interest in that entity rather than having the entity itself sell the real estate.” (emphasis added).
Section 1248 Regulations
(1) T.D. 9345; 72 F.R. 41442-41450:
“Under § 1.1248-1(a)(4) of the proposed regulations, the partners in a foreign partnership shall be treated as selling or exchanging their proportionate share of stock of a corporation sold or exchanged by the foreign partnership. The proposed regulations also apply section 1248(a) in cases where the stock in a corporation that is sold or exchanged is held through tiers of foreign partnerships. This treatment is necessary to reflect properly each partner’s share of the corporation’s earnings and profits as a dividend.
“A commentator noted that § 1.1248-1(a)(4) of the proposed regulations could be read to apply to the sale by a partner of its interest in a partnership holding the stock of a corporation. The Treasury Department and the IRS did not intend that interpretation because it would be contrary to section 1248(g)(2)(B). An amount that is received by a partner in exchange for all or part of its partnership interest is treated as ordinary income under section 751(a) and (c) to the extent attributable to stock in a foreign corporation as described in section 1248. Section 1248(g)(2)(B) provides that section 1248 will not apply if any other provision of the Code treats an amount as ordinary income. Accordingly, § 1.1248-1(a)(4) in the final regulations is revised to clarify that a foreign partnership is treated as an aggregate for this purpose only when a foreign partnership sells or exchanges stock of a corporation. Finally, a commentator requested that the final regulations allow a taxpayer to elect to apply the rule in § 1.1248-1(a)(4) to taxable years ending before the effective date of the final regulations. The Treasury Department and the IRS regard this rule as a clarification of existing law, but recognize that some practitioners have expressed the view that prior law was not entirely clear. Accordingly, the final regulations allow taxpayers to apply the rule in § 1.1248-1(a)(4) to open years provided that the taxpayer consistently applies the rule in all such years. A partner makes this election by treating its distributive share of gain attributable to a sale of shares in a controlled foreign corporation as gain recognized on a sale or exchange of stock in a foreign corporation within the meaning of section 1248(a).”
(2) REG-135866-02, June 2, 2006:
“Sale or Exchange of Stock by a Foreign Partnership
“A domestic partnership is treated as a United States person for purposes of section 1248. See section 7701(a)(30)(B) and § 1.1248-1(a)(1). Accordingly, the sale by a domestic partnership of the stock of a foreign corporation is subject to section 1248(a). Section 1248 and the existing regulations do not, however, address specifically sales or exchanges of stock by foreign partnerships with United States persons as partners.
“The legislative history of subchapter K of the Code provides that, for purposes of interpreting Code provisions outside of that subchapter, a partnership may be treated as either an entity separate from its partners or an aggregate of its partners, depending on which characterization is more appropriate to carry out the purpose of the particular Code section under consideration. H.R. Conf. Rep. No. 2543, 83rd Cong. 2d. Sess. 59 (1954). The purpose of section 1248 is to ensure that earnings and profits of controlled foreign corporations (or former controlled foreign corporations) are taxed as a dividend when certain United States persons recognize gain on the sale or exchange of stock in such corporations. In cases in which the United States person is a partner in a foreign partnership and recognizes income on the sale of stock of a foreign corporation by such foreign partnership, the purpose of section 1248 is fulfilled only if the partnership is treated as an aggregate for section 1248 purposes. Treatment of a foreign partnership as an entity, in contrast, could result in partners in the partnership inappropriately receiving capital gain treatment on the sale by the partnership of stock of the foreign corporation.
“Thus, under proposed § 1.1248-1(a)(4), a foreign partnership is treated as an aggregate of its partners for purposes of section 1248(a). Under the proposed regulations, for example, the partners in a foreign partnership shall be treated as selling or exchanging their proportionate share of stock held by the foreign partnership. The proposed regulations also apply section 1248(a) in cases where the stock in a corporation that is sold or exchanged is held through tiers of foreign partnerships. This treatment of the foreign partnership as an aggregate, rather than as an entity, for purposes of applying section 1248 is necessary to reflect properly the attributable earnings and profits as a dividend.”
Section 751 Proposed Regulations
The section 751(a) and (b) proposed regulations apply both aggregate and entity principles at the same time in the case of a sale of a partnership interest where the partnership holds both hot and cold assets and both assets have declined in value at the time of the sale of the partnership interest by the partner. The proposed regulation does this by ignoring changes in the value of cold assets and also, at the same time, applying the remedial allocation method under reg. section 1.704-3(d) to hot assets-if that section 704(c) method has been adopted by the partnership for the contribution of a hot asset by a partner to the partnership-in testing for the amount of ordinary income realized by the partner on the sale of his partnership interest.1If the partnership has adopted the remedial allocation method under the section 704(c) regulations for the contributed hot asset, the selling partner will be treated, in effect, as if the hot asset had not declined in value and that partner will also be treated as if the cold asset were not held by the partnership in testing for the amount of ordinary income realized by the partner. This approach combines both aggregate and entity principles at the same time2
The proposed regulation preamble3 justifies its approach this way:
“Whether section 751(b) applies depends on the partner’s interest in the partnership’s section 751(b) property before and after a distribution. The statute does not define a partner’s interest in a partnership’s section 751 property, but the legislative history indicates that Congress believed a partner’s interest in a partnership’s section 751 property equals the partner’s rights to income from the partnership’s section 751 property: ‘The provisions relating to unrealized receivables and appreciated inventory items are necessary to prevent the use of the partnership as a device for obtaining capital-gain treatment on fees or other rights to income and on appreciated inventory. Amounts attributable to such rights would be treated as ordinary income if realized in normal course by the partnership. The sale of a partnership interest or distributions to partners should not be permitted to change the character of this income. The statutory treatment proposed, in general, regards the income rights as severable from the partnership interest and as subject to the same tax consequences which would be accorded an individual entrepreneur. (citing to S. Rep. No. 1622 at 99 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 4732. (Emphasis added.)’”
Entity IRS Rulings
The IRS has issued a series of revenue rulings holding that entity treatment of a partnership was most appropriate in the fact patterns examined.
A.Revenue Ruling 75-62, 1975-1 C.B. 188. The IRS applied entity theory of partnerships for purposes of section 805(b)(4), whereby an interest in a partnership that held real property was treated as personal property and not real property. Under the applicable law, real property was valued based upon actual fair market value, whereas personal property was generally valued at adjusted basis. The IRS stated that in the absence of tax avoidance and due to the lack of legislative history stating that aggregate principles were most appropriate, entity principles should apply, thereby enabling the taxpayer to use adjusted basis rather than fair market value. In so holding, the IRS stated that “there exists no exclusive rule as to when a partnership will be viewed as an entity or an aggregate. The resolution is generally dependent upon the question to be resolved.”
- Revenue Ruling 87-51, 1987-1 C.B. 158. The sale of upper-tier interest in a partnership is not treated as a sale of the lower-tier partnership interest for purposes of section 708(b)(1)(B) unless the upper-tier partnership is technically terminated on the sale. The entity theory of partnerships was applied because the IRS believed, without citation to any authority, that section 708(b)(1)(B) is an entity oriented provision:
“Under the provisions of subchapter K of the Code, a partnership is considered for various purposes to be either an aggregate of its partners or an entity, transactionally independent of its partners. Generally, subchapter K adopts an entity approach with respect to transactions involving partnership interests. See Rev. Rul. 75-62, 1975-1 C.B. 188. Whether an aggregate or entity theory of partnerships should be applied to a particular Code section depends upon which theory is more appropriate to such section. See S. Rep. No. 1622, 83d Cong., 2d Sess. 89. (1954), and H.R. Rep. No.2543, 83d Cong., 2d Sess. 59 (1954); Casel v. Commissioner, 79 T.C. 424 (1982). The termination of a partnership under section 708(b)(1)(B) depends on whether there was a sale or exchange of a partnership interest and on whether there was a transfer of at least 50 percent of the total interest in partnership capital and profits. Because section 708(b)(1)(B) is an entity-oriented provision, an entity approach is more appropriate for that section.” (Emphasis added).
Aggregate IRS Rulings
The IRS, in a series of revenue rulings, has held that aggregate treatment of the partnership was most appropriate in the fact patterns examined.
A. Revenue Ruling 72-172, 1972-1 C.B. 265 (sale of all partnership interests to a controlled entity in effect treated as a sale of the underlying assets of the partnership in applying section 1239).
- Revenue Ruling 89-108,1989-2 C.B. 100. The sale of a partnership interest holding substantially appreciated inventory under section 751 not eligible for installment sale treatment under section 453. The IRS relied on section 751 for its holding and did not discuss aggregate-entity issues:
“Gain recognized under section 741 of the Code on the sale of a partnership interest is reportable under the installment method. See Rev. Rul. 76-483, 1976-2 C.B. 131. However, because section 751 effectively treats a partner as if the partner had sold an interest in the section 751 property of the partnership, the portion of the gain that is attributable to section 751 property is reportable under the installment method only to the extent that income realized on a direct sale of the section 751 property would be reportable under such method. Because the installment method of reporting income would not be available on a sole proprietor’s sale of the inventory, the installment method is not available for reporting income realized on the sale of a partnership interest to the extent attributable to the substantially appreciated inventory which constitutes inventory within the meaning of section 453(b)(2)(B).”
- Revenue Ruling 89-85, 1989-2 C.B. 218. This ruling is now incorporated in reg. sec. 1.1502-13(c)(7)(ii), example 9. The IRS relied on section 743(b) reflecting an aggregate approach and to prevent a distortion of the deferred intercompany transaction (“DIT”) rules to hold that as the section 743(b) adjustment was depreciated by the purchasing group member of the partnership interest, the DIT was restored to income by the selling group member of the partnership interest:
“Subchapter K of the Code is a blend of the “aggregate” and “entity” treatment for partners and partnerships. Compare section 751 of the Code with section 741. Moreover, for purposes of interpreting provisions of the Code not contained in Subchapter K, a partnership also may be treated either as an aggregate of its partners or as an entity distinct from its partners . . . The treatment of partnerships in each context must be determined on the basis of countervailing factors applicable to such context . . .
“Section 754 of the Code and the related adjustments provided in section 743(b) reflect an aggregate approach to partnership taxation . . . Upon the sale by P to X of its interest in PS, the adjusted bases of the partnership assets are increased with respect to X as a consequence of the section 743(b) adjustment. There is no express statement in the deferred intercompany transaction rules as to how adjustments under section 743(b) factor into the restoration to income of deferred gain. The application of the deferred intercompany transaction rules without taking into account the adjustments under section 743(b), however, would permit a group to avoid the intended application of the deferred intercompany transaction rules (i.e., to prevent the group from obtaining a double benefit by claiming increased cost recovery deductions resulting from a positive section 743(b) adjustment without taking into account any of the deferred gain to which that additional basis is attributable).”
- Revenue Ruling 90-112,1990-2 C.B. 186. This ruling treated a partnership interest that is not itself U.S. property under section 956 as U.S. property to the extent that the partnership held U.S. property. The IRS applied the aggregate theory because the IRS believed that it would not be appropriate to frustrate the purpose of section 956 by treating the partnership as an entity. However, the IRS never explains in the ruling why it is appropriate to apply section 956 by using the aggregate theory:
“Section 956 of the Code, and the regulations thereunder, do not specifically address the treatment of a CFC’s investment in United States property through a partnership. Whether a CFC partner is treated as holding, on the last day of its taxable year, a portion of the United States property owned by the partnership depends upon whether the partnership is viewed as an “entity” separate from its partners or as an “aggregate” of its partners for purposes of section 956. There is no exclusive rule as to when a partnership will be treated as an entity or as an aggregate for purposes outside of subchapter K. FIRPTA The resolution depends upon which approach is more appropriate to the specific Code section involved. See. e.g., Rev. Rul. 89-72, 1989-1 C.B. 257 (a CFC’s distributive share of income from a non-controlled partnership is treated as foreign base company sales income, if it would have been treated as such had it been realized directly by the CFC). See also Rev. Rul. 89-85, 1989-2 C.B. 218, and the authorities cited therein.
“For purposes of section 956 of the Code, a CFC is considered to hold United States property if it holds the property directly or indirectly. See section 956(a)(1). This rule is a specific application of the general principle that section 956 is concerned with the substance of a transaction and not merely its form. See Rev. Rul 89-73, 1989-1 C.B. 258. The House Report on the Revenue Act of 1962, which adopted section 956, stated that an objective of that section was “to prevent the repatriation of income to the United States in a manner which does not subject it to U.S. taxation.” H.R. Rep. No.1447, 87th Cong., 2d Sess. 58 (1962). While taxpayers with excess foreign tax credits may desire to trigger a section 956 inclusion, it is still appropriate to construe section 956 in a manner consistent with this statement under these facts.
“The purpose of section 956 of the Code would be frustrated if it were construed not to reach the United States property held by a CFC through a partnership. Thus, in the context of section 956, it is appropriate to apply the aggregate view of a partnership so that the United States property of the CFC includes United States property held by the CFC through a partnership. This result applies section 956 according to the substance of the arrangement, without regard to whether the form of the ownership is direct or indirect.”
- Revenue Ruling 91-32, 1991-1 C.B. 107. The IRS applied the aggregate theory on the sale by a nonresident alien of a partnership interest not involving U.S. real property (and, thus, not subject to aggregate treatment under section 897(g)). It is not clear from the text of the ruling exactly what authority the IRS relied on to reach this “appropriate” answer:
“Subchapter K of the Code is a blend of aggregate and entity treatment for partners and partnerships. Compare section 751 of the Code with section 741. For purposes of applying provisions of the Code not included in subchapter K, a partnership may be treated as an aggregate of its partners or as an entity distinct from its partners, depending on the purpose and scope of such provisions. Rev. Rul. 89-85, 1989-2 C.B. 218, 219; see Casel v. Commissioner, 79 T.C. 424 (1982). The treatment of amounts received by a foreign partner from a disposition of a partnership interest must therefore be considered in connection with the general purpose and scope of section 864(c) and section 865(e). Pursuant to section 865(e)(3) the principles of section 864(c)(5) are applied to determine whether gain or loss from a sale is attributable to an office or fixed place of business for purposes of section 865(e)(1) and (2), so the same analysis applies to both sections 864(c) and 865(e)”.
- Revenue Ruling 99-574, 1999-2 C.B. 678. (section 1032 and aggregate principles relating to section 704(c) gain allocable to a corporate partner):
“Partnership taxation is a mixture of provisions that treat the partnership as an aggregate of its members or as a separate entity. Under the aggregate approach, each partner is treated as the owner of an undivided interest in partnership assets and operations. Under the entity approach, the partnership is treated as a separate entity in which partners have no direct interest in partnership assets and operations. In enacting subchapter K, Congress indicated that aggregate, rather than entity, concepts should be applied if the concepts are more appropriate in applying other provisions of the Code. S. Rep. No.1622, 83d Cong., 2d Sess. 89 (1954) and H.R. Conf. Rep. No.2543, 83d Cong., 2d Sess. 59 (1954); See also Treas. Reg. § 1.701-2(e) (1994).
“Section 1032 is intended to prevent a corporation from recognizing gain or loss when dealing in its own stock. Under § 704(b) and 704(c), a corporate partner contributing its own stock generally will be allocated an amount of gain attributable to its stock FIRPTA that corresponds to its economic interest in the stock held by the partnership. Accordingly, use of the aggregate theory of partnerships is appropriate in determining the application of § 1032 with respect to gain allocated to a corporate partner.”
- PLR 9651001(June 27, 1996). The IRS held in this technical advice memorandum that the sale of a partnership interest by a tax-exempt entity, where the partnership held section 514 debt-financed property, should be treated as unrelated business taxable income, applying the aggregate theory of partnership taxation.
- Revenue Ruling 60-352, 1960-2 C.B. 208. In this ruling, the IRS held that the charitable transfer of a partnership interest where the partnership held section 453 installment obligations should be treated as a disposition of the underlying partnership assets in applying then section 453(d) (now section 453B):
“Thus, while the partnership interest generally may be regarded as constituting a partner’s interest in the profits and surplus of the partnership, the fundamental principles of Federal income taxation require that an interest in income earned by the partnership which FIRPTA has not been realized, or has not yet been subjected to taxation, be treated as distinct from any “partnership interest” which is recognized as a capital asset for income tax purposes. Therefore, unrealized or untaxed rights to partnership income may be transferred with, but not as a part of, the partnership interest which constitutes a capital asset. . . .
“Based on the foregoing, it is held that a transfer of a limited partner’s interest in a partnership appurtenant to which is a right to share in unrealized partnership income reflected in installment obligations receivable by the partnership constitutes a transfer of a capital asset coupled with a disposition of such installment obligations subject to the provisions of section 453(d) of the Code. To the extent that the transaction constitutes a disposition of installment obligations receivable, the gain is taxable to the transferor as ordinary income.”
- Revenue Ruling 85-60, 1985-1 C.B. 187 (relying on section 702(b) (character of distributive share determined at the partnership level) to attribute a permanent establishment to a partner.
- FSA 200026009(June 30, 2000). The IRS held in this field service advice that a partnership with corporate partners should be treated as an aggregate for purposes of determining the fraction a foreign sales corporation wholly owned by the partnership should use in calculating the exempt portion of its foreign trade income under the FSC administrative pricing rules of section 925.
- See also TAM 200811019 (March 14, 2008)(aggregate treatment used in applying section 864(c)).
Entity Case Law
The courts, in a series of cases, have held that entity treatment of the partnership was most appropriate under the fact patterns examined in those cases.
- Clinton Pollack v. Comm’r, 69 T.C. 142 (1977). The Tax Court held that the sale of a partnership interest should be accorded capital loss treatment under section 741 despite potential application of the then viable Corn Productsdoctrine, based on legislative history to section 741:
“Section 741 was enacted by Congress as part of subchapter K of the Internal Revenue Code of 1954. Subchapter K was enacted to resolve the chaos which permeated the partnership area under the 1939 Code.”
The Tax Court then continued with its analysis:
“A prime example of such confusion under the 1939 Code was the treatment of gain or loss from the sale or exchange of a partnership interest. Prior to 1950 the Government took the position, under the so-called aggregate theory of partnership, that the selling partner actually sold his undivided interest in each of the partnership’s assets, and the character and amounts resulting from the disposition of those assets should be considered individually. See Commissioner v. Lehman, 165 F.2d 383 (2d Cir. 1948), aff’g 7 T.C. 1088 (1946), cert, denied 334 U.S. 819 (1948). . . . This position, however, found no acceptance in the courts, which consistently held a partnership interest to be a capital asset in its entirety regardless of the nature of the underlying partnership assets. See Swiren v. Commissioner, 183 F.2d 656 (7th Cir. 1950), rev ‘g a Memorandum Opinion of this Court dated October 11, 1949, cert, denied 340 U.S. 912 (1951). Faced with this situation, Congress, in the 1954 Code, sought to eliminate the confusion on this point by codifying the Government’s concession in G.C.M. 26379 and, at the same time, reduce the availability of the collapsible partnership as a tax avoidance device. See H. Rept. No.1337, to accompany H.R. 8300 (Pub. L. No.591), 83d Cong., 2d Sess. 71 (1954). Congress accomplished its dual purpose by enactment of section 741, which treated the sale of a partnership interest as the sale of a capital asset, and section 751, which specifically excluded from capital gain or loss treatment, that portion of the partnership interest representing income from unrealized receivables and substantially appreciated inventory items. See S. Rept. No.1622 to accompany H.R. 8300 (Pub. L. No.591) 83d Cong., 2d Sess. 96 (1954). [Citations omitted.]
“In view of the foregoing legislative record and the plain language of the statute itself, we conclude that Congress intended section 741, if applicable, to provide capital gain or loss treatment on the sale or exchange of a partnership interest by a partner without regard to section 1221. Indeed, Congressional use of the phrase “shall be considered as” in section 741 is unambiguous and mandatory on its face. See Helvering v. Flaccus Leather Co., 313 U.S. 247 (1941). Furthermore, the singular meaning of such phrase is demonstrated by its consistent interpretation in sections 731,735, 736 and 751. See sections 1.731-1(a)(3), 1.735-l(a), 1.736-1(a)(4), and 1.751-l(a)(l), Income Tax Regs. In fact, where Congress has intended section 1221 to apply despite similar statutory specificity, it has generally either expressly or impliedly said so. See e.g., sections 302, 331, 1232, 1233; compare section 1235.”
- PDB Sports, Ltd. v. Comm’r. 109 T.C. 423(1997). The Tax Court held that the sale of a partnership interest where the partnership held section 1056 player contracts should be treated as a sale of a separate capital asset and not as a sale of the underlying player contracts. Nevertheless, the Tax Court did reject a universal application of the entity theory under section 741, stating:
“Petitioner contends that section 1056 is unambiguous, makes no reference to partnership transactions, and applies only to transactions directly involving sports franchises not including the sale of a partnership interest. Finally, petitioner argues that the legislative history is inconclusive and, in any event, irrelevant because the statute is unambiguous. Because partnerships can be and have been treated as an aggregate or entity, we must disagree with petitioner’s contention that section 1056 is unambiguous. Petitioner is of the view that the entity approach is to be applied to Internal Revenue Code provisions that are outside of subchapter K unless Congress provides otherwise. No such presumption favoring the entity approach exists.”
- Petroleum Corporation of Texas, Inc. v. U.S., 939 F.2d 1165 (5th Cir. 1991) (no statutory basis to use aggregate theory of partnerships in applying section 336; Holiday Villagedistinguished as a tax avoidance case.)
- Coggin Automotive Corp., 292 F.3d 1326 (11th Cir. 2002). The Eleventh Circuit, reversing the Tax Court, 115 T.C. 349 (October 18, 2000)(see summary of the Tax Court case below), held that a holding company, on making an S corporation election, isn’t required to include a share of partnerships’ inventories in gross income as its share of the LIFO recapture amount because it had no LIFO inventory. The court first determined whether there was a bona fide purpose for the formation of the partnership and the transfer of LIFO inventory to the partnership. Having thus determined that the formation FIRPTA of the partnerships served valid business purposes, the Eleventh Circuit applied the plain meaning rule. The court looked to the literal words of section 1363(d) and determined that since the taxpayer corporation never directly owned the LIFO inventory, the partnerships did, the court refused to look to the legislative history of sections 1374 and 1363(d), as the Tax Court did, and held for the taxpayer. The Eleventh Circuit cited the U.S. Supreme Court’s opinion in Gitlitzfor the proposition that if there was an inequity in section 1363(d) in this case because the statute on its face does not refer to partnerships holding LIFO inventory where the converting C corporation is a partner, that is a problem for Congress to fix; it was not the province of the courts to fix the statute by applying the aggregate theory of partnerships on an ad hoc basis. The court cited Treasury regulation section 1.701-2(e), the partnership abuse of entity rule, but did not discuss either the validity or potential effect of the regulation since the years before the court predated the effective date of the regulation.
- Grecian Magnesite
In Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, 149 T.C. No. 3 (July 13, 2017), Judge David Gustafson sided with the taxpayer, Grecian Magnesite Mining, in rejecting the aggregate approach set out in Revenue Ruling 91-32 for taxing foreign partners’ gains on the redemption of U.S. partnership interests.
The facts of the Grecian Magnesite case are fairly straightforward. The taxpayer was a foreign corporation that invested in a US LLC (taxed as a partnership for US income tax purposes) that was engaged in a trade or business in the United States. From 2001 through the 2008 taxable year, the taxpayer received allocations of income from the partnership that the taxpayer reported on its form 1120F as effectively connected income under sections 864, 865 and 882. In the 2008 taxable year, the taxpayer exercised an option to put (sell) its interest back to the partnership. The taxpayer was redeemed out of the partnership with two payments, the last of which was agreed to be deemed received on the last day of 2008.
The taxpayer was subsequently audited. The IRS, applying Revenue Ruling 91-32, argued that the partnership should be treated as an aggregate and that the taxpayer should be treated as selling its share of the partnership’ assets. Under that theory, the taxpayer would be treated as selling assets used in its trade or business and as having US source effectively connected business income. The taxpayer, on the other hand, argued that the it should be treated as selling a single indivisible capital asset, the partnership interest, under sections 731(a) and 741. Under that theory, the taxpayer would be treated as realizing foreign source non-effectively connected income and, thus, the gain would not be taxable.
The Tax Court, through Judge Gustafson, rejected the IRS argument and its reliance on Revenue Ruling 91-32, finding that the ruling was poorly reasoned and not entitled to deference. The court found that the ruling’s reliance on the Congressional statement from the 1954 code that a partnership can be treated as an aggregate of its partners “as appropriate” for the code provision at issue was too general a statement to override the clear wording of sections 731(a) and 741 that a single indivisible capital asset was sold in the transaction. The court found that only when Congress has provided an express exception, such as under section 897(g) (or section 751), can a sale or exchange of a partnership interest be treated as a sale of the partnership’s underlying assets.
The Court stated:
The parties agree that the transaction between GMM and Premier was a redemption. The payments GMM received in the liquidation of its partnership interest were, in the words of section 736(b)(1), “made in exchange for the interest of such partner [i.e., GMM] in partnership property”, and therefore they are to “be considered as a distribution by the partnership”. (Emphasis added.) The effect of such a “distribution” is governed by section 731(a), which provides: “In the case of a distribution by a partnership to a partner — * * * [a]ny gain or loss recognized under this subsection shall be considered as gain or loss from the sale or exchange of the partnership interest of the distributee partner.” (Emphasis added.) That is, when a partner liquidates its partnership interest and is paid for its interest in the partnership’s property, then under section 736(b)(1) the payment is “considered as a distribution”; and under section 731(a) the gain is considered to arise from “the sale or exchange of the partnership interest”, i.e., not from the sale or exchange of the partner’s portion of individual items of partnership property.13
GMM acknowledges that, for purposes of section 731, it recognized gain as a result of the distributions by Premier, and it points to section 741 to demonstrate that such gain on liquidation is capital, just as if GMM had sold the partnership interest. Section 741 provides:
SEC. 741. RECOGNITION AND CHARACTER OF GAIN OR LOSS ON SALE OR EXCHANGE.
In the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items).
GMM cites our decision in Pollack v. Commissioner, 69 T.C. 142 (1977), and argues that in this case, as in Pollack, we must apply the “entity theory”, which generally gives independent tax effect to transactions between a partner and a partnership, or to transactions involving a partnership interest. In Pollack it was the taxpayer who asserted the “aggregation theory”, because losses (not gains) of the partnership’s business were at issue, and the taxpayer wanted to claim not capital losses but ordinary losses, as if he himself had been engaged in the business. “Respondent, on the other hand, contends that except for specific exceptions not relevant herein, section 741 mandates the loss be characterized as a capital loss.” Id. at 145. We held for the Commissioner and explained:
[B]oth the legislative history of section 741 and its language indicate that Congress intended it to operate independently of section 1221 so as to be dispositive of the character of petitioner’s loss.
Section 741 was enacted by Congress as part of subchapter K of the Internal Revenue Code of 1954. * * *
* * * * * *Prior to 1950 the Government took the position, under the so-called aggregate theory of partnership, that the selling partner actually sold his undivided interest in each of the partnership’s assets, and the character and amounts resulting from the disposition of those assets should be considered individually. * *
* * * * * *This position, however, found no acceptance in the courts, which consistently held a partnership interest to be a capital asset in its entirety regardless of the nature of the underlying partnership assets. In response, the Government in 1950 reversed its position in G.C.M. 26379, 14 1950-1 C.B. 58 * * *
* * * * * *Congress, in the 1954 Code, sought to eliminate the confusion on this point by codifying the Government’s concession in G.C.M. 26379 and, at the same time, reduce the availability of the collapsible partnership as a tax avoidance advice. Congress accomplished its dual purpose by enactment of section 741, which treated the sale of a partnership interest as the sale of a capital asset, and section 751, which specifically excluded from capital gain or loss treatment that portion of the partnership interest representing income from unrealized receivables and substantially appreciated inventory items.
In view of the foregoing legislative record and the plain language of the statute itself, we conclude that Congress intended section 741, if applicable, to provide capital gain or loss treatment on the sale or exchange of a partnership interest by a partner without regard to section 1221. Indeed, congressional use of the phrase “shall be considered as” in section 741 is unambiguous and mandatory on its fact* * *Id. at 145-147 (citations and fn. refs. omitted).
GMM argues that “the sale of a partnership interest is respected as the sale of an indivisible item of intangible personal property, and may not be recharacterized * * * as the sale of separate interests in each asset owned by the partnership.” That is, GMM argues that the general principle of section 741, effecting the “entity theory”, should apply here.
The Commissioner acknowledges the general principle but argues15 that in this context we should nonetheless employ the “aggregate theory”, that is, that we should treat the partner’s sale of a partnership interest as the partner’s sale of separate interests in each asset owned by the partnership. As for section 741, the Commissioner argues that the statute cannot be interpreted to require that the sale (or liquidation) of a partnership interest be treated as the sale of an indivisible asset irrespective of the context, because then section 897(g) — whose operation is conceded here, see supra part III.A — would be inoperable. The Commissioner states:
The sale of a partnership interest cannot simultaneously be both (a) a sale of an indivisible asset, as petitioner argues is required by section 741, and (b) a sale of U.S. real property interests and a sale of a partnership interest, as required by section 897(g).
The Commissioner posits that the only way to reconcile the two provisions is to interpret section 741 as applicable only to the character of the gain recognized — i.e., as capital rather than ordinary. That is, the Commissioner maintains that while section 741 expressly requires that the gain “shall be considered as gain or loss from the sale or exchange of a capital asset”, the statute does not preclude treating the (capital) gain as arising not from the sale of the partnership interest per se (which the entity theory would yield) but from the partnership’s underlying assets that give value to the partnership interest (which the aggregation theory would yield).
It is true that, in providing that the gain “shall be considered as gain * * * from the sale or exchange of a capital asset”, section 741 does not specify which asset. However, there are four flaws in the Commissioner’s approach that cause us to reject it. First, he exaggerates the conflict between an “entity theory” construction of section 741 and the existence of an exception in section 897(g). In its own terms, section 741 acknowledges one exception (“except as otherwise provided in section 751”), 16 so section 741 is only a general rule, not a rule of absolute and universal application. Congress is always free, having enacted a general rule, to enact exceptions.
Second, the Commissioner’s reading of section 741 gives insufficient effect to one word in the statute. Section 741 provides that income realized on the sale of a partnership interest “shall be considered as gain * * * from the sale or exchange of a capital asset”. (Emphasis added.) Congress used the singular “asset”, rather than the plural “assets”. This singular wording is more consistent with the treatment of the sale of a partnership interest according to the entity theory, under which the selling partner is deemed to have sold only one asset (its partnership interest) rather than being deemed to have sold its interest in the multiple underlying assets of the partnership. See also P.B.D. Sports, Ltd. v. Commissioner, 109 T.C. 423, 438 (1997) (“Generally, subchapter K employs the entity approach in treatin[g] transfers of partnership interests. The sale of a partnership interest is treated as the sale of a single capital asset rather than as a transfer of the individual assets of the partnership. See secs. 741 and 742.”); Unger v. Commissioner, T.C. Memo. 1990-15 (listing section 741 as an example of the entity theory in the Internal Revenue Code), aff’d, 936 F.2d 1316 (D.C. Cir. 1991). And absent some overriding mandate, section 731 directs that gain or loss on a distribution (such as the one at issue) “shall be considered as gain or loss from the sale or exchange of the partnership interest of the distributee partner” (that is, as directed by section 741).
Third, Congress has explicitly carved out a few exceptions to section 741 that, when they apply, do require that we look through the partnership to the underlying assets and deem such a sale as the sale of separate interests in each asset owned by the partnership. If Congress had intended section 741 to be interpreted as a look-through provision, these exceptions in sections 751 and 897(g) would be superfluous. See TRW Inc. v. Andrews, 534 U.S. 19, 31 (2001).
Accordingly, the enactment of section 897(g) actually reinforces our conclusion that the entity theory is the general rule for the sale or exchange of an interest in a partnership. Without such a general rule, there would be no need to carve out an exception to prevent U.S. real property interests from being swept into the indivisible capital asset treatment that section 741 otherwise prescribes.
Fourth, section 731(a) — brought into this analysis by the express wording of section 736(b)(1) — makes explicit that the “entity theory” generally applies to a partner’s gain from a distribution:
Any gain or loss recognized under this subsection shall be considered as gain or loss from the sale or exchange of the partnership interest of the distributee partner.
Sec. 731(a) (emphasis added). This wording could hardly be clearer. The partnership provisions in subchapter K of the Code provide a general rule that the “entity theory” applies to sales and liquidating distributions of partnership interests — i.e., that such sales are treated not as sales of underlying assets but as sales of the partnership interest. Of course, Congress may enact exceptions or different rules, such as for foreign partners, and we consider that possibility below; but we begin our analysis with this generality from subchapter K.
The Commissioner’s interpretation of the Code acknowledges the same sequence we have followed — i.e., that section 736(b)(1) leads to section 731, which in turn leads to section 741, but he evidently thinks such an analysis stops short.
The Commissioner apparently maintains that, after applying those sections in that order, one must still return to section 736(b)(1) — so that, while section 741 mandates the capital character of the income, in the end the distribution is still characterized as “payments * * * made in exchange for the interest of such partner in partnership property”. Sec. 736(b)(1) (emphasis added). The emphasized phrase certainly does appear in section 736(b)(1), and the analysis in this case begins there precisely because GMM did indeed receive payments that, given the nature of a partnership, can be said to have been made ultimately in exchange for GMM’s interest in the partnership’s various items of property. However, sections 736(b)(1), 731(a), and 741 tell us what to do with such payments for tax purposes; and as we have shown, they direct us to a conclusion: “gain or loss from the sale or exchange of the partnership interest”, sec. 731(a), which is “a [singular] capital asset”, sec. 741. We see no reason to abandon that conclusion, return to section 736(b)(1), and halt at the phrase that most nearly coincides with the Commissioner’s position.17
The Commissioner also argues that section 741 should not be applied to characterize the income at issue because applying it in that manner would contradict “Congress’ intent in enacting section 865”, the sourcing rule we discuss below in part IV.B. The Commissioner argues that, when addressing a partnership question under subchapter K of the Code (which deals primarily with partners and partnerships) and applying a Code section (such as section 865) that is outside of subchapter K, one must look to “the nature of the partnership interest involved, together with the intent and purpose of the non-subchapter K section being applied.” Using this rule, the Commissioner explains that not section 741 but rather section 736(b)(1) more appropriately characterizes the type of income here — i.e., as a payment for GMM’s interest in the “partnership property”. We see no basis for the Commissioner’s selection of this particular phrase from section 736(b)(1) as the guiding star for navigating the intersection of partnership taxation and the taxation of international transactions, and we have already explained why this phrase is at the beginning and not the end of the analysis. More important, the Commissioner cites no authority for his posited rule, which seems (at least as he uses it here) to shortcut or distort the subchapter K analysis by invoking a purpose (not explicitly enacted) that he discerns in subchapter N. The Commissioner has not convinced us to reconsider the argument that we rejected 38 years ago when it was advanced by the taxpayer in Pollack. Addressing ourselves to the statutory text, we conclude that subchapter K mandates treating the disputed gain as capital gain from the disposition of a single asset, and in part IV.B below we apply the provisions of section 865 accordingly.
In sum, section 736(b)(1) provides that payments such as those giving rise to the disputed gain “shall * * * be considered as a distribution by the partnership”; section 731(a) provides that such gain “shall be considered as gain ** * from the sale or exchange of the partnership interest of the distributee partner”; and section 741 provides that such gain “shall be considered as gain ** * from the sale or exchange of a capital asset”. (Emphasis added.) Accordingly, GMM’s gain from the redemption of its partnership interest is gain from the sale or exchange of an indivisible capital asset — i.e., GMM’s interest in the partnership.
. . . .
Rev. Rul. 91-32 is not simply an interpretation of the IRS’s own ambiguous regulations, and we find that it lacks the power to persuade. Its treatment of the partnership provisions discussed above in part II.B is cursory in the extreme, not even citing section 731 (which, as we set out, yields a conclusion of “gain or loss from the sale or exchange of the partnership interest” (emphasis added)). The ruling’s subchapter K analysis essentially begins and ends with the observation that “[s]ubchapter K of the Code is a blend of aggregate and entity treatment for partners and partnerships.” We criticize the ruling’s treatment of the subchapter N issues in notes 22 and 24 below. We decline to defer to the ruling. We will instead follow the Code and the regulations to determine whether the disputed gain is effectively connected income.
Aggregate Case Law
The courts, in a series of cases, has held that aggregate treatment of the partnership was most appropriate under the fact patterns at issue in those cases.
- Casel v. Comm’r, 79 T.C. 424 (1982). The Tax Court applied aggregate principles to invoke section 267 where a partnership accrued, but did not pay, management fees to a corporation controlled by one of the partners. The Court held that the related partner could not take a distributive share of the loss for this accrual even though section 267 did not, at that time, technically defer losses between a partnership and a corporation related to a partner of the partnership:
“When the 1954 Code was adopted by Congress, the conference report, discussed and excerpted in part above, clearly stated that whether an aggregate or entity theory of partnerships should be applied to a particular Code section depends upon which theory is more appropriate to such section. Section 267(a)(2) serves to foreclose a loophole to the tax laws that would otherwise permit a deduction for a payment never made to a related party that may never seek enforcement of its contractual rights. If we were to apply an entity theory of partnerships to such section, then that loophole would continue to exist whenever an individual partner interposed his partnership between himself and his related corporation in transactions encompassed by section 267(a). Under the 1939 Code, the courts rejected such an approach and applied an aggregate theory of partnerships to section 24(b) and (c), the predecessor of section 267. Section 267, insofar as pertinent to the issue before us, embodies essentially the same language and policies as section 24(b) and (c) of the 1939 Code. When the Secretary issued section 1.267(b)-1(b)(1) and (2), Income Tax Regs, he simply followed the long-standing position taken by the courts with respect to section 24(b)(1)(B), 1939 Code, a position followed by the Court of Claims in Liflans Corp. v. United States, supra, which arose under the 1954 Code. Since section 267 embodies essentially the same language and policies as section 24(b) and (c) of the 1939 Code, and since the conference report to the 1954 Code recognizes, when appropriate, the concept of a partnership as a collection of individuals (i.e., the aggregate theory), we are unable to say that section 1.267(b)-l(b)(1) and (2), Income Tax Regs., is inconsistent with, or an unreasonable interpretation of, section 267. Consequently, we hold that it is a valid regulation. See Commissioner v. South Texas Lumber Co., 333 U. S. 496 (1948).”
- George Edward Quick Trust,54 T.C. 1336 (1970), aff’d per curiam, 444 F.2d 90 (8th Cir. 1971); and Woodhall v. Comm’r, 28 T.C.M. 1438 (1969), aff’d, 454 F.2d 226 (9th Cir. 1972) (applies aggregate principles to treat accounts receivable held by a partnership where an individual died holding a partnership interest as income in respect of a decedent under section 691; aggregate approach applied to reach the “appropriate” answer).
- Holiday Village Shopping Center v. U.S., 773 F.2d 276 (Fed. Cir. 1985) (99 percent limited partnership interest distributed in corporate liquidation treated as the distribution of the underlying corporate property to apply the then recapture exception to section 336).
- Tennyson v. United States,76-1 USTC 83,573 (1976) (limited partner’s purported gift of two-thirds of his partnership interest was merely a statement of intention. The gift was not actually completed until a later year when the installment sale of partnership assets had taken place. The Court held, without analysis or explanation, that the gift of the partnership interest was to be treated as a disposition of the underlying installment note):
“The gift contemplated by Mr. Tennyson in his letter agreement of June 10, 1962, was completed in September of 1964. At that time, Mr. Tennyson’s contingent inter vivos gift to his children vested and he disposed of his interest in two-thirds of the remaining proceeds attributable to his interest in the installment sales obligation held by Olds, Ltd. Therefore, the recognition of the gain attributable to such disposition is accelerated under the provisions of Section 453(d) of the Code to the year of the disposition, i.e., 1964.”
- Coggin Automotive Corp., 115 T.C. 349 (October 18, 2000) (reversed by the appellate court as noted above). The rule of section 1363(d) was applied to a C corporation that held a partnership interest (where the partnership held inventory accounted for under the LIFO method) by applying the aggregate theory, stating as follows:
“For tax purposes, a partnership may be viewed either (1) as an aggregation of its partners, each of whom directly owns an interest in the partnership’s assets and operations, or (2) as a separate entity, in which separate interests are owned by each of the partners. Subchapter K of the Internal Revenue Code (Partners and Partnerships) blends both approaches. In certain areas, the aggregate approach predominates. See sec. 701 (Partners, Not Partnership, Subject to Tax), sec. 702 (Income and Credits of Partner). In other areas, the entity approach predominates. See sec. 742 (Basis of Transferee Partner’s Interest), sec. 743 (Optional Adjustment to Basis of Partnership Property). Outside of subchapter K, whether the aggregate or the entity approach is to be applied depends upon which approach more appropriately serves the Code provision at issue. See Holiday Village Shopping Ctr. v. United States, 773 F.2d 276, 279 (Fed. Cir. 1985); Casel v. Commissioner, 79 T.C. 424, 433 (1982); Conf. Rept. 2543, 83d Cong., 2d Sess. 59(1954).
“Respondent argues that the legislative intent underlying the enactment of section 1363(d) requires the application of the aggregate theory. Respondent asserts that Congress enacted section 1363(d) in order to ensure that the corporate level of taxation be preserved on built-in gain assets (such as LIFO reserves) that fall outside the ambit of section 1374. In this regard, respondent contends that failure to apply the aggregate theory to section 1363(d) would allow the gain deferred under the LIFO method to completely escape the corporate level of taxation upon a C corporation’s election of S corporation status and would eviscerate Congress’ supersession of General Utils. & Operating Co. v. Helvering, 296 U.S. 200 (1935).
“Petitioner maintains that although there are no cases that apply the aggregate or entity approach to inventory items, the focus with respect to accounting for inventory is done at the partnership level. In essence, petitioner asserts that the LIFO recapture amount under section 1363(d) is a component of a partnership’s taxable income that must be computed at the partnership level. Petitioner posits that it would be incongruent to treat the calculation of the LIFO recapture amount as an item of income under the entity approach while applying the aggregate approach to attribute the ownership of inventory to the partners. Moreover, petitioner argues that section 1363(d)(4)(D) operates to prevent the inventory of one member of an affiliated group from being attributed to another member. . . .
“After considering the legislative histories of sections 1374 and 1363(d), we conclude that the application of the aggregate approach (as opposed to the entity approach) of partnerships in this case better serves Congress’ intent. By enacting sections 1374 and 1363(d), Congress evinced an intent to prevent corporations from avoiding a second level of taxation on built-in gain assets by converting to S corporations. Application of the aggregate approach to section 1363(d) is consistent with Congress’ rationale for enacting this section and operates to prevent a corporate taxpayer from using the LIFO method of accounting to permanently avoid gain recognition on appreciated assets. In contrast, applying the entity approach to section 1363(d) would potentially allow a corporate partner to permanently avoid paying a second level of tax on appreciated property by encouraging transfers of inventory between related entities. This result clearly would be inconsistent with the legislative history of sections 1363(d) and 1374 and the supersession of the General Utilities doctrine.
“Courts have, in some instances, used the aggregate approach for purposes of applying nonsubchapter K provisions. For instance, in Casel v. Commissioner, 79 T.C. at 433, we upheld the Commissioner’s use of the aggregate approach for purposes of applying section 267 (disallowance of losses between related parties). In Holiday Village Shopping Ctr. v. United States, 773 F.2d at 279, the Court of Appeals for the Federal Circuit applied the aggregate approach for purposes of determining the extent of depreciation recapture to each shareholder. Similarly, the Court of Appeals in Unger v. Commissioner, 936 F.2d 1316 (D.C. Cir. 1991), affg. T.C. Memo. 1990-15, used the aggregate approach in determining a taxpayer’s permanent establishment. In each of these instances, the court analyzed the relevant legislative history and statutory scheme in determining whether the aggregate or entity approach was more appropriate. Moreover, we are mindful that the aggregate approach is generally applied to various subchapter K provisions dealing with inventory and other built-in gain assets (i.e., receivables). See, e.g., secs. 704(c), 731, 734(b), 743(b), 751.
“We recognize that in several instances courts have found the entity approach better than the aggregate approach. For example, in P.D.B. Sports, Ltd. v. Commissioner, 109 T.C. 423 (1997), this Court used the entity approach for purposes of applying section 1056. Similarly, in Madison Gas & Elec. Co. v. Commissioner, 72 T.C. 521,564 (1979), affd. 633 F.2d 512 (7th Cir. 1980), this Court and the Court of Appeals for the Seventh Circuit applied the entity approach in determining whether expenses were ordinary and necessary under section 162. Likewise, in Brown Group, Inc. & Subs. v. Commissioner, 77 F.3d 217 (8th Cir. 1996), revg. 104 T.C. 105 (1995), the Court of Appeals for the Eighth Circuit concluded that the entity approach, rather than the aggregate approach, should be used in characterizing income (subpart F income) earned by the partnership. We do not believe the holdings in those cases to be dispositive here. The outcomes in those cases were based upon the specific legislative histories and statutory schemes of the respective Code provisions at issue. Each court viewed the respective statute in the context in which it was enacted and concluded that the entity approach was more appropriate than the aggregate approach to carry out Congress’ intent. Here, as stated, both the legislative history and the statutory scheme of section 1363(d) mandate the application of the aggregate approach.”
- Unger v. Comm’r, 936 F.2d 1316 (D.C. Cir. 1991) (limited partner treated as having the permanent establishment of his partnership), where the court states the following:
“The question, then, turns on the nature of a limited partnership. If Mr. Unger’s interest as a limited partner in the Company gives him an interest in its offices, he has a permanent establishment in Boston that makes his share of the Company’s profits taxable by the United States. If he has no permanent establishment here, this income is exempt.
“Two views have long competed regarding the basic nature of a partnership. The “aggregate theory” considers a partnership to be no more than an aggregation of individual partners. Under this theory, each partner has an interest in the property of the partnership; thus, Mr. Unger would be deemed to have a permanent establishment in the United States. The “entity theory” characterizes a partnership as a separate entity; under this view, the offices would be attributable to the partnership but not the partners, and Mr. Unger would not be deemed to have a permanent establishment in this country. Courts remain ambivalent in their treatment of partnerships, dealing with them as aggregates for certain purposes and as entities for others. See generally 1 A. Bromberg & L. Ribstein, Partnership § 1.03(1988).
“The Internal Revenue Code also treats partnerships as aggregates for some purposes and as separate entities for others. A partnership must calculate income as a discrete entity. See 26 U.S.C. § 703 (1988). The obligation to pay taxes, however, passes through the partnership to the individual partners. Id. §§ 701,702; United States v. Basye, 410 U.S. 441, 448 (1973) (characterizing partnership as a “conduit” through which taxpaying obligation passes). The conflict between the aggregate and the entity views, then, carries over to the realm of federal taxation. See Pusey, The Partnership as an “Entity”: Implications of Basye, 54 Taxes 143, 158 (1976) (“The entity-aggregate conflict has been, and will continue to be, one of the most controversial areas of partnership taxation.”).
“Mr. Unger argues that whatever the merits of the aggregate theory where ordinary partnerships are concerned, it should not be applied to limited partnerships. He maintains that a limited partner should be likened to (and taxed the same way as) a corporate shareholder, as both risk only the capital they have chosen to put at stake. In contrast, a general partner has full personal liability for partnership debts. See Mass. Gen. Laws Ann. ch. 109, §§ 19(a), 24. Moreover, like a shareholder, a limited partner may not participate in the active management of the enterprise; indeed, if he should, he will lose his protected status and become fully liable as a general partner. See id. § 19(a); see also id. § 19(d). Mr. Unger also points out that the distinctions between general and limited partnerships can be dispositive. Courts have chosen, for example, to protect partnership assets from execution by judgment creditors of a limited partner, see Evans v. Galardi, 546 P.2d 313 (Cal. 1976) (en banc), and to ignore the citizenship of limited partners, but not that of general partners, in determining diversity jurisdiction, see Wroblewski v. Brucher, 550 F. Supp. 742, 751 (W.D. Okla. 1982).
“Mr. Unger makes a number of valid observations about the intricacies and inconsistencies that exist in the law of partnership as it has evolved in various jurisdictions, but he fails to provide any persuasive reason, based on either Massachusetts partnership law or the facts of this case, for us to disregard what has come to be viewed as settled law under the Tax Convention.
“In 1962, in Donroy, Ltd. V. U.S. (301 F.2d 200 (9th Cir. 1962)), the Ninth Circuit was called upon to deal with an almost identical case. It involved Canadian corporations that were limited partners of two California partnerships whose principal offices were located in San Francisco. The court examined the relevant California partnership law and concluded that the aggregate theory was to be applied in determining whether the Canadian partners had a permanent establishment in the United States. It concluded that “the office or permanent establishment of the partnership is in law, the office of each of the partners — whether general or limited.” 301 F.2d at 207. The court also noted that “the United States and Canada look, not to the partnership as such, but to the distributive income of the individual partners for income tax purposes.” Id. (citing section 701 of the Internal Revenue Code, 26 U.S.C. § 701, and section 6 of the Canadian Income Tax Act). Thus the application of the aggregate theory in Donroy was consistent with the manner in which partnership income was actually taxed by both parties to the Convention.
“For many years, Donroy and the principles it expresses have guided the Internal Revenue Service. See, e.g., Rev. Rul 91-32, 1991-1 C.B. 107; Rev. Rul. 90-80, 1990-2 C.B. 170; Rev. Rul. 85-60, 1985-1 C.B. 187; Gen. Couns. Mem. 38201 (Dec, 14, 1979); Priv. Ltr. Rul. 5412105720A (Dec. 10, 1954); see also W. McKee, W. Nelson & R. Whitmire, 1 Federal Taxation of Partnerships and Partners para. 9.03[a] (2d ed. 1990). Moreover, Canadian tax authorities have placed a similar interpretation on the Convention as it applies to the taxation in Canada of an American investor’s interest in a Canadian partnership. See, e.g., No.630 v. Minister of National Revenue, 13 D.T.C. 300,302 (Can. Tax App. Bd. 1959).
“Thus, a generation of investors on each side of the border has been on notice of the tax consequences of an investment in a limited partnership that is organized and has a permanent office in the other country. Given the desideratum of a uniform administration of federal tax laws, courts should be reluctant to disturb such long-established expectations without good cause. See, e.g., Keasler v. United States, 766 F.2d 1227, 1233 (8th Cir. 1985)(”Uniformity of decision among the circuits is vitally important on issues concerning the administration of tax laws. Thus, the tax decisions of other circuits should be followed unless they are demonstrably erroneous or there appear cogent reasons for rejecting them.” (citations and internal quotes omitted)).”
Sale of Partnership Interest Holding Hot Assets
In Mingo v. Comm’r5, the Fifth Circuit affirmed the holding of the Tax Court that the installment sale method was not available for the sale of a partnership interest to the extent attributable to unrealized receivables of the partnership. In other words, the court applied pure aggregate principles.
The case involved a former partner of a major accounting firm where the firm had decided to divest itself of a business unit of which the former partner was a member. The firm had unrealized receivables for services performed by it. In an apparent plan to obtain deferral for its selling partners of the gain on sale using the installment method of section 4536, the firm formed a new entity (taxed as a partnership) and distributed interests in this new partnership to the partners of the business unit to be sold. Shortly thereafter, the partners of that business unit sold their interests to IBM.
In the Tax Court7, Judge Paris, in a memorandum opinion, held that on the sale of a partnership interest for a convertible promissory note issued by IBM, the taxpayer could not avail herself of the installment method of reporting under section 453 because, based on the 1954 legislative history to section 751, the taxpayer should be treated as if the taxpayer had sold her share of the underlying partnership property-a pure aggregate method8
The opinions of both the Tax Court and the Fifth Circuit are poorly reasoned and in my view come to the wrong result. Without any discussion of the extensive literature and commentary on the subject9, the Tax Court (in language adopted by the Fifth Circuit) states:
“In the case of a sale or exchange of a partnership interest, gain or loss recognized to the transferor is considered gain or loss from the sale or exchange of a capital asset, except as otherwise provided by section 751. Sec. 741. Section 751(a) provides that the amount received by a transferor partner in exchange for all or part of a partnership interest shall be considered as an amount realized from the sale or exchange of property other than a capital asset, to the extent such amount is attributable to unrealized receivables or inventory items of the partnership. The term “unrealized receivables” includes, to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for services rendered or to be rendered. Sec. 751(c)(2). . . . The purpose of section 751 is to prevent the conversion of potential ordinary income into capital gain when a partnership interest is sold or exchanged. See Madorin v. Commissioner, 84 T.C. 667, 682 (1985). The effect of section 751 is to sever certain income items to effectuate this purpose. For the amount of a partnership interest attributable to inventory or unrealized receivables described in section 751, the tax consequences to the transferring partner are “the same tax consequences which would be accorded an individual entrepreneur.” H.R. Rept. No. 83-1337, at 70-71 (1954), 1954 U.S.C.C.A.N. 4017, 4098; S. Rept. No. 83-1622, at 99 (1954), 1954 U.S.C.C.A.N. 4621, 4732. Essentially, the transferring partner is treated as disposing of section 751 property “independently of the rest of his partnership interest.” H.R. Rept. No. 83-1337, supra at 70, 1954 U.S.C.C.A.N. at 4097; S. Rept. No. 83-1622, supra at 98, 99, 1954 U.S.C.C.A.N. at 4731, 4732. It follows that the portion of gain attributable to section 751 property in the sale or exchange of a partnership may only be reported under the installment method to the extent that income realized on a direct sale of such property would be reportable under the installment method.”
One of the situations that our tax professional, Mr. Jackel, identified as an area in which the tax treatment of the sale of the partnership interest will vary was the participation of an international individual or entity in the M&A transaction. This is a relatively easy tax trap to fall into. As Mr. Jackel mentioned, if one of the partners owns an interest in a foreign business entity, the tax treatment will be affected. As a result, you will want to consider a number of cross-border tax strategies available to you in order to maximize your international tax structuring. Depending on the situation, you may run into any number of FIRPTA issues, such as FIRPTA withholding taxes. You may also have to deal with business interest expense limitations, where you will be restricted in your ability to make deductions. However, this doesn’t mean that your M&A transaction will be inefficient from a tax standpoint. Our experienced M&A tax advisers at Leo Berwick are able to guide you through any M&A tax issues relating to your M&A transaction.
1 The proposed regulation uses a hypothetical sale approach in measuring hot asset gain on the sale of a partnership interest, looking to the gain or loss that would be allocated to the partner if the partnership had sold all of its assets. In applying this test, the regulation specifically incorporates notional items created by the remedial allocation method under reg. sec. 1.704-3(d), if that method has been adopted by the partnership for a hot asset then held by the partnership.
2 The aggregate treatment is ignoring the decline in value of the cold asset and the entity treatment is the application of the remedial method.
3 REG-151416-06, 2014-47 I.R.B. 870, 79 F.R. 65151-65174 (Nov. 3, 2014). In this regard, see, particularly, prop. reg. secs. 1.751-1(a)(2), setting forth the hypothetical sale approach, and reg. sec. 1.751-1(g), example 1, which sets forth the only example of a sale of a partnership interest. This example only illustrates the decline in value of the cold asst. However, the regulation text itself makes clear that the remedial method could apply at the same time to the hot asset at issue in the example.
4 See, also, LTR 9822002 (Oct. 23, 1997) (aggregate principles applied to the application of section 1032 on disguised sale of property to a partnership in exchange for cash and stock of another partner in the partnership.)
5 No. 13-60801, 5Th Circuit, December 9, 2014.
6 The tax planning was not discussed in the opinions by either the Tax Court or the Fifth Circuit.
7 T.C. Memo 2013-149 (June 12, 2013).
8 The note issued by IBM was not treated as “payment” under reg. sec.15a.453-1(e)(1) because the convertibility feature of the note was not exercisable for a one-year period and under reg. sec.15a.453-1(e)(5), that one-year wait is considered a “substantial discount” thereby making the note not readily convertible into the publicly traded stock of IBM.
9 See, for example, Monte A. Jackel, Aggregate and Entity in the Partnership World, Tax Notes Today, 2012 TNT 146-7 (July 30, 2012). This prior article, at note 1, cites a representative sampling of the extensive scholarship on the subject. It is, by no means, all inclusive.