Partnership Tax Ponderings – Flow-Through and Basis

Overview

For medium-sized and larger farming operations that grow crops covered by federal farm programs, a general partnership is often the entity of choice for the operational part of the business because it can aid in maximizing federal farm program benefits for the farming operation.  I have discussed this issue in prior posts – how to maximize farm program benefits in light of the overall planning goals and objectives of the family farming operation.

Partnerships, however, can present rather unique and complex tax issues.  The “flow-through” feature of partnership taxation and tax basis of a partnership interest – these are the topics of today’s post.   

Partner's income

Partnerships are not subject to federal income tax.  I.R.C. §701. The partnership’s income and expense is determined at the entity (partnership) level.  Then, each partner takes into account separately on the partner’s individual return the partner’s distributive share, whether or not distributed, of each class or item of partnership income, gain, loss, deduction, or credit.  I.R.C. §702.  This sounds simple enough, but the facts of a particular situation can make the application of the rule something other than straightforward. 

For example, in Lipnick v. Comr., 153 T.C. No. 1 (2019), the petitioner’s father owned interests in partnerships that owned and operated rental real estate.  In 2009, the partnerships borrowed money (in the millions of dollars) and distributed the proceeds to the partners.  The loans had a 5.88 percent interest rate and a note secured by the partnership’s assets, but no partner was personally liable on the notes.  The father deposited the proceeds of the distributions in his personal account, and he later invested the funds in money market and other investment assets which he also held in his personal accounts until his death in late 2013.  The partnerships incurred interest expense on the loans from 2009-2011, and the father treated his distributive share of the interest on the loans that the partnerships paid that passed through to him as “investment interest” on Schedule A of his individual return.  By doing so, he deducted the investment interest to the extent of his net investment income.  See I.R.C. §163(d)(1).

In mid-2011, the father transferred his partnership interests to the petitioner with the petitioner agreeing to be bound by the operating agreement of each partnership.  However, the petitioner did not become personally liable on any of the partnership loans.  The gifts relieved the father of his shares of the partnership liabilities and he reported substantial taxable capital gain as a result. 

The father also owned minority interests in another partnership that owned and operated rental real estate.  In early 2012, this partnership borrowed $20 million at a 4.19 percent interest rate and distributed the proceeds to the partners.  Partnership assets secured the associated note, but no partner was personally liable on the note.  Again, the father deposited the funds in his personal account and then invested the money in money market funds and other investment assets that he held in his personal accounts until death.  Under the terms of his will, he bequeathed his partnership interest to the petitioner. 

The loans remained outstanding during 2013 and 2014, and the partnerships continued to pay interest on them with a proportionate part passed through to the petitioner.  The petitioner treated the debts as allocable to the partnerships’ real estate assets and reported the interest expense on his 2013 and 2014 individual returns (Schedule E) as regular business interest that offset the passed-through real estate income from the partnerships.  On Schedule E, the interest expense was netted against the income from each partnership with the resulting net income reported on Forms 1040, line 17.  The IRS disagreed, construing the interest as investment interest (“once investment interest, always investment interest”) reportable on Schedule A with the effect of denying any deduction because the petitioner didn’t have any investment income.

The Tax Court disagreed with the IRS position.  The Tax Court noted that the partnership debt was a bona fide obligation of the partnership and the petitioner’s partnership interest was encumbered at the time it was gifted to him.  The Tax Court also pointed out that the petitioner did not receive any distributions of loan proceeds to him and he didn’t use any partnership distributions to make investment-related expenditures.  The Tax Court determined that the proper treatment of the petitioner was that he made a debt-financed acquisition of the partnership interests that he acquired from his father.  Under I.R.C. §163(d) the debt proceeds were to be allocated among all of the partnerships’ real estate assets using a reasonable method, and the interest was to be allocated in the same fashion.  Treas. Reg. §1.163-8T(c)(1). 

Under the tracing rule of the regulation, debt is allocated by tracing disbursements of the debt proceeds to specific expenditures.  While the tracing rule is silent concerning its application to partnerships and their partners, the IRS has provided guidance.  Notice 89-35, 1989-1 C.B. 675.  In that guidance, the IRS provided that if a partner uses the proceeds of a debt-financed distribution to acquire property held for investment, the corresponding interest expense that the partnership incurs and is passed on to the partner will be treated as investment interest.  But, the Tax Court held that the petitioner was not bound to treat the interest expense passed through to him in the same manner as his father.  The Tax Court noted that the petitioner, instead of receiving debt-financed distributions, was properly treated as having made a debt-financed acquisition of his partnership interests for purposes of I.R.C. §163(d).  He also made no investment expenditures from distributions that he received.  See Treas. Reg. §1.163-8T(a)(4)(i)(C).  Furthermore, because the partnerships’ real estate assets were actively managed in the operation of the partnerships, they didn’t constitute investment property.  The Tax Court also held as irrelevant the fact that the petitioner was not personally liable on the debts.  That fact did not mean that his partnership interest was not “subject to a debt” for purposes of Subchapter K.  It was enough that he had acquired his partnership interests subject to the partnership debts. 

Basis

A taxpayer’s income tax basis in an asset is important to know.  Basis is necessary to compute gain on sale, transfer or other disposition of the asset.  The starting point for computing basis is tied to how the taxpayer acquired the asset.  In general, for purchased assets, the purchase price establishes the taxpayer’s basis.  If the property is received by gift, the donor’s basis becomes the donee’s basis.  For property that is acquired by inheritance, the value of the inherited property as of the date of the decedent’s death pegs the basis of the asset in the recipient’s hands.  The same general rules apply with respect to a partnership interest when establishing the starting point for computing basis.  But, as with other assets, the basis in a partnership interest adjusts over the time of the taxpayer’s ownership of the interest.  For example, the basis in a partnership interest is increased by contributions to the partnership as well as taxable and tax-exempt income.  It is decreased by distributions, nondeductible expenses and deductible losses.  I.R.C. §705.  But, the deductibility of a partner’s distributive share of losses is limited to the extent that the partner has insufficient basis in the partner’s partnership interest.  I.R.C. §704(d). 

Sec. 754 election

When a partnership distributes property or transfers the partner’s partnership interest (such as when a partner dies), the partnership can elect under I.R.C. §754 to adjust the basis of partnership property.  See, e.g., Priv. Ltr. Ruls. 201909004 (Dec. 3, 2018); 201919009 (Aug. 9, 2018); and 201934002 (May 16, 2019). This election allows a step-up or step-down in basis under either I.R.C. §734(b) or I.R.C. §743(b) to reflect the FMV at the time of the exchange. This election has the advantage of not taxing the new partner on gains or losses already reflected in the purchase price of his or her partnership interest. The partnership must file the election by the due date of the return for the year the election is effective, normally with the return.  In late 2017, the IRS proposed to amend Treas. Reg. §1.754-1(b)(1) to eliminate the requirement that an I.R.C. §754 election be signed by a partner of the electing partnership.  REG-116256-17, 82 Fed. Reg. 47408 (Oct. 12, 2017).    

I.R.C. §743 requires a partnership with an I.R.C. §754 election in place or with a substantial built-in loss to adjust the basis of its property when a partnership interest is transferred.  I.R.C. §743(d).  A partnership has a substantial built-in loss if the partnership's basis in its property exceeds the fair market value by more than $250,000.  Id.  But, do contingent liabilities count as “property” for purposes of I.R.C. §743?  The answer is not clear.  Treas. Reg. §1.752-7 treats contingent liabilities as I.R.C. §704(c) property, but the I.R.C. §743 regulations do not come right out and say that contingent liabilities are “property” for purposes of I.R.C. §743. 

The IRS addressed the lack of clarity in 2019.  In Tech. Adv. Memo. 201929019 (Apr. 4, 2019), two partnerships with the same majority owner merged.  The merging partnership was deemed to have contributed all of its assets and liabilities in exchange for an interest in the resulting partnership.  Then the interest in the resulting partnership was distributed to the partners in complete liquidation.  The resulting partnership had a substantial built-in loss – the result when either the adjusted basis in the partnership property exceeds its fair market value by more than $250,000 or the transferee partner is allocated a loss of more than $250,000 if the partnership sells its assets for fair market value immediately after the merger. 

I.R.C. §743(b) requires a mandatory downward inside-basis adjustment in this situation, but the question presented was whether it applies to a deemed distribution of an interest.  The IRS determined that it did, taking the position that a deemed distribution of an interest of the resulting partnership was to be treated as a sale or exchange of the interest of the resulting partnership.  See I.R.C. §§761(e) and 743.   

As for the adjusted basis computation in the transferred partnership interest for the transferee partner, the IRS said that the resulting partnership’s liabilities (including contingent ones) must be included in the transferee partner’s basis in the partnership interest.  They are also to be included in the transferee partner’s basis in the transferred partnership interest.  Likewise, they are to be included in the transferee partner’s share of the resulting partnership’s liabilities to the extent of the amount of the I.R.C. §731(a) gain that the transferee partner would recognize absent the netting rule of Treas. Reg. §1.752-1(f).  But, deferred cancellation-of-debt income (under I.R.C. §108(i)) is not to be included in calculating the transferee partner's share of previously taxed capital because this type of income is not taxable gain for purposes of I.R.C. §743.

Conclusion

General partnerships can be a very useful entity for the operational entity of a farm.  Liability protection can be achieved by holding the partnership interests in some form of entity that limits liability – such as a limited liability company.  But, with partnerships comes tax complexity.  When a partnership interest is transferred (by sale, gift or upon death) the tax consequences can become complicated quickly.  The same is true when partnerships are merged.  Understanding how the flow-through nature of a partnership works, and how basis is computed and adjusted in a partnership is important when such events occur.