James F. McDonough
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Partner’s Interest May Be More Difficult To Determine
Author: James F. McDonough
Date: January 13, 2015
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Determining A Partner’s Interest In a Partnership
One might think that determining a partner’s interest in a partnership is easy and that strict rules provide absolute certainty. This is not the case.
The rights conferred by states under partnership, limited partnership or limited liability company law do not define a partner’s interest for federal tax purposes. State law is interested in governing the relationship among partners and transactions between the partnership and non-partners. State law, though helpful in the federal tax analysis, does not control federal tax treatment. Federal tax law is more concerned with the economic arrangement among the partners. IRS of concern to IRS are the assignment of income to lower bracketed taxpayers, the shifting of deductions and losses and gift and estate tax.
Federal tax law relies upon a facts and circumstances test that is designed to adapt to imaginative tax planning that cannot be anticipated.
A partnership capital interest is very different from a partnership profits interest. A profits interest is given to a partner who must perform services and receives his or her reward from the profits of the venture. If a partnership is liquidated shortly after capital contributions are made, but prior to the partnership generating revenue or expense, a service partner holding only a profits interest will not receive any distribution. The partners holding capital interests would receive a return of their contributions. Any shift of capital to a service partner holding only a profits interest results in compensation. If undertaken in a family setting, an assignment of income or a disguised gift is a possible unwelcome outcome.
During 2014, we were presented with two matters where the business terms were not clear at the outset of discussions. In one transaction, the service partner insisted upon receiving a credit to his capital account that would be immediately deducted from the capital account of the partner contributing property. This shift would result in immediate taxation to the service partner because the credit was not subject to a substantial risk of forfeiture. The second matter was a service partnership which allocated income in a subjective manner considering originations, services and account revenue increases. This raises the prospect of shifting or transitory allocations that the IRS may not respect.
A partner’s interest in a partnership is applicable to other areas aside from allocations of income and the distribution of cash.
The allocation of interest deductions directly allocable to a partner under IRC §861 relies upon the determination of a partner’s interest in a partnership. Corporations owning 10% or more of a partnership must apply a special rule under that code section. Allocations of non-recourse debt are made in accordance with a partner’s interest in profits of the partnership. In a complex or tiered distribution arrangement, the answer may not be readily apparent. Attribution of corporate ownership through constructive ownership under §318 requires one to measure the partner’s interest in the partnership where applicable.
Perhaps the only point that is clear is that the Service will continue to be able to second guess taxpayers under a facts and circumstances test.
No Aspect of the advertisement has been approved by the Supreme Court. Results may vary depending on your particular facts and legal circumstances.
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Partner’s Interest May Be More Difficult To Determine
Author: James F. McDonough
Determining A Partner’s Interest In a Partnership
One might think that determining a partner’s interest in a partnership is easy and that strict rules provide absolute certainty. This is not the case.
The rights conferred by states under partnership, limited partnership or limited liability company law do not define a partner’s interest for federal tax purposes. State law is interested in governing the relationship among partners and transactions between the partnership and non-partners. State law, though helpful in the federal tax analysis, does not control federal tax treatment. Federal tax law is more concerned with the economic arrangement among the partners. IRS of concern to IRS are the assignment of income to lower bracketed taxpayers, the shifting of deductions and losses and gift and estate tax.
Federal tax law relies upon a facts and circumstances test that is designed to adapt to imaginative tax planning that cannot be anticipated.
A partnership capital interest is very different from a partnership profits interest. A profits interest is given to a partner who must perform services and receives his or her reward from the profits of the venture. If a partnership is liquidated shortly after capital contributions are made, but prior to the partnership generating revenue or expense, a service partner holding only a profits interest will not receive any distribution. The partners holding capital interests would receive a return of their contributions. Any shift of capital to a service partner holding only a profits interest results in compensation. If undertaken in a family setting, an assignment of income or a disguised gift is a possible unwelcome outcome.
During 2014, we were presented with two matters where the business terms were not clear at the outset of discussions. In one transaction, the service partner insisted upon receiving a credit to his capital account that would be immediately deducted from the capital account of the partner contributing property. This shift would result in immediate taxation to the service partner because the credit was not subject to a substantial risk of forfeiture. The second matter was a service partnership which allocated income in a subjective manner considering originations, services and account revenue increases. This raises the prospect of shifting or transitory allocations that the IRS may not respect.
A partner’s interest in a partnership is applicable to other areas aside from allocations of income and the distribution of cash.
The allocation of interest deductions directly allocable to a partner under IRC §861 relies upon the determination of a partner’s interest in a partnership. Corporations owning 10% or more of a partnership must apply a special rule under that code section. Allocations of non-recourse debt are made in accordance with a partner’s interest in profits of the partnership. In a complex or tiered distribution arrangement, the answer may not be readily apparent. Attribution of corporate ownership through constructive ownership under §318 requires one to measure the partner’s interest in the partnership where applicable.
Perhaps the only point that is clear is that the Service will continue to be able to second guess taxpayers under a facts and circumstances test.