The IRS published taxpayer-favorable proposed regulations to help minimize unnecessary tax under the Section 751(b) “hot asset” rules when a partnership makes a disproportionate distribution. The hot asset rules are designed to prevent a shifting of higher-tax ordinary income gain assets between partners. Thus if a partnership has a mix of capital gain and ordinary income assets, the rules prevent the partnership from distributing tax-free all of the ordinary income assets to one partner and capital gain assets to another. However, these rules had an intrinsic flaw in that they tracked the hot assets based on the gross value of the assets and not the net gain inherent in the assets. This disconnect resulted in the potential application of a deemed taxable hot asset exchange in many instances where it was not warranted.
The proposed regulations follow the general construct the IRS suggested in Notice 2006-14, Specifically, the proposed regulations adopt the hypothetical sale approach as the method by which the partners must measure their respective interests in Section 751 property for the purpose of determining whether a distribution reduces a partner’s interest in the partnership’s Section 751 property. Because this approach relies on Section 704(c) locking in a partner’s share of hot asset gain, the proposed regulations make so-called “bookups” mandatory under Reg. §1.704-1(b)(2)(iv)(f) in a distribution that would implicate the Section 751(b) hot asset rules. The proposed regulations also contain a special revaluation rule for distributing partnerships that own an interest in a lower-tier partnership and describe how basis adjustments under Sections 734(b) and 743(b) affect the computation of partners’ interests in Section 751 property.
The regulations are proposed to apply to distributions occurring in any taxable period ending on or after the date of publication of the regulations as final.
In consolidated cases known as Kenna Trading LLC, the Tax Court shut down an attempt to contribute foreign currency losses into a US partnership and syndicate the losses to investors by selling partnership interests followed soon by the partnership selling the loss assets. According to the court, the persons contributing loss assets did not qualify as partners under the traditional “Culbertson” test. The transaction also failed under the disguised sale rules as well as lacked economic substance.
The Tax Court found the transaction subject to significant penalties including the high “listed transaction” penalty for one of the years at issue based on it being substantially similar to the distressed asset trust shelter. Further the case was analogized to the recent IRS victory in Superior Trading. Note that 2004 legislation has since changed the law to more clearly prevent the syndication of losses imported into a partnership. The taxpayer tried to use state-law trusts in 2005 to avoid this law change. The Tax Court analyzed that such state-law trusts did not meet the tax definition of trusts, nor did they meet the tax definition of partnership, and regardless they lacked economic substance and were shams.
Notice 2014-58 adds some clarity to when the IRS will assert the strict-liability economic substance penalties and how they will determine the “transaction” that is disregarded under the Section 7701(o) economic substance doctrine. The new guidance amplifies Notice 2010-62 and also formalizes some of the unofficial guidance in the 2011 IRS LB&I field directive.
IRS reserves the ability to aggregate or disaggregate transaction steps when defining “transaction”, depending on the facts
The question of what is the “transaction” is critical to the economic substance analysis, particularly when testing the overall motivations for a broader business transaction with certain tax-motivated steps. The Notice clarifies that the term “transaction” generally includes all the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement; and any or all of the steps that are carried out as part of a plan. However, the IRS will apply a facts and circumstances approach and may include only the tax-motivated steps that are not necessary to accomplish the non-tax goals — a disaggregation approach.
IRS provides some clarity on when other tax doctrines are subject to strict liability economic substance penalties under “similar rule of law” rule
The economic substance doctrine “strict liability” penalties under section 6662(b)(6) apply to underpayments attributable to any disallowance of a claimed tax benefit under the section 7701(o) economic substance doctrine “or if the transaction fails to meet the requirements under any “similar rule of law”. The Notice clarified that “similar rule of law” means a rule or doctrine that applies the same factors and analysis that is required under section 7701(o), even if a different term or terms are used to describe the rule or doctrine. The IRS referred to the sham transaction doctrine as one such example. On the helpful side, the IRS stated that it will not apply the section 6662(b)(6) penalty unless it also raises section 7701(o) to support the underlying adjustments. Further, the IRS stated that if tax benefits are denied under Code sections and regulations other than section 7701(o), they are not similar rules of law for purposes of the section 6662(b)(6) penalty.
Earlier this week, the Treasury Department and the IRS announced that they would issue regulations that substantially limit the U.S. tax benefits of corporate inversions (and certain post-inversion transactions). The regulations described in Notice 2014-52 and in the IRS “Fact Sheet” will make it more difficult for U.S. corporations to satisfy the ownership thresholds necessary to avoid subjecting the inverted company to continued U.S. taxation, and will also significantly impact a new foreign parent’s ability to access offshore earnings free of U.S. tax after an inversion (including through tax-free decontrol of CFCs). Specifically, the regulations will:
- Restrict inversions with foreign corporations that have substantial passive assets (including cash and marketable securities).
- Restrict the U.S. company’s ability to satisfy the applicable ownership tests by making “skinny-down” distributions (i.e., pre-inversion “extraordinary” dividends).
- Restrict the U.S. company’s ability to engage in so-called “spinversions” under the internal group restructuring exception to the inversion rules.
- Prevent inverted companies from accessing earnings of existing CFCs using “hopscotch” loans, stock sales, or de-controlling transactions (such as tax-free transfers of stock of a CFC to the new foreign parent).
While new restrictions announced in Notice 2014-52 strike a substantial blow to U.S. companies hoping to gain U.S. tax benefits from inverting, there is still more to come. Treasury has indicated that future guidance will impose further limitations on the benefits of post-inversion tax avoidance transactions as well as inversion transactions that are contrary to the purposes of Section 7874. Earnings-stripping structures (which were not targeted by Notice 2014-52) are also under consideration by Treasury and may be the subject of future guidance. Further, there are also separate legislative proposals by Sen. Schumer and Sen. Levin that target earnings-stripping structures as well as more general proposed legislation to prevent corporate inversions.
Notice 2014-52 is generally applicable to transactions completed on or after September 22, 2014. There is no grandfathering provision for signed but not yet completed transactions.
In new Rev. Proc. 2014-54, the IRS modified the procedures to obtain the IRS consent to a change in method of accounting for dispositions of tangible depreciable property. This relates to the ”repair regulations“ finalized last year. The new guidance includes procedures to (i) obtain automatic IRS consent in certain contexts, (ii) to allow a late partial disposition election under Reg. § 1.168(i)-8 to be treated as a change in method of accounting for a limited period of time, and (iii) to modify the Appendix of Rev. Proc. 2011-14 regarding a change to the method of accounting described in Rev. Proc. 2014-16, for amounts paid to acquire, produce, or improve tangible property.
75% of a REIT’s assets must be real estate. When a REIT owns a debt secured by both real estate and non-real estate, the regulations create an apportionment formula that, although typically favorable, creates an inappropriate bias against real estate classification for distressed debt. The IRS previously published Rev. Proc. 2011-16 to provide taxpayers with an “Asset Test Safe Harbor” to avoid inappropriately classifying distressed debt as a non-real estate asset. However, the IRS has become aware of “anomalous results” with this safe harbor if the underlying asset begins to regain its value after the REIT originates or acquires the loan. Therefore in new Rev. Proc. 2014-51 the IRS modified the safe harbor test and related examples to avoid this anomaly. In a particularly helpful fashion, the new guidance is effective for all calendar quarters and all taxable years.
In CCA 201436049 the IRS concluded that owners of an investment fund management company LLC were not eligible for the limited partner exception to Section 1402 self-employment taxes. Ultimately the IRS found that the income earned by the partnership directly related to the services from such partners and was not of an investment nature that should be eligible for the exception.
In the CCA, the taxpayers were partner-owners of an LLC that served as the management company for a family of investment partnerships. The LLC treated partners that were active in day-to-day fund management as qualifying for the “limited partner” exception to the 3.8% self-employment tax otherwise imposed on a partner’s share of partnership ordinary income. The taxpayer asserted that limited partner status was appropriate as the partners paid more than a nominal sum for their equity interest and were paid “wage” amounts representing “reasonable compensation” for each partner.
The IRS acknowledged that the term “limited partner” is not defined. However, the IRS cited legislative history for the proposition that the limited partner exclusion was to exclude earnings that were basically of an investment nature. The IRS further cited the 2011 Renkemeyer case where a law firm LLP partner was similarly denied the limited partner exception and the 2012 Riether case denying the exception for an LLC owner. The IRS concluded that the LLC members were earning their share of LLC fee income in their capacity as service partners and the exception was intended to apply only to income which was basically of an investment nature. Interestingly, the CCA contained substantial redacted material under the title “case development, hazards, and other considerations.” Note also that the IRS never finalized the 1997 proposed regulations to add a definition of limited partner and their analysis in the CCA was not based on the proposed regulations.
In McElroy v. Commissioner, the Tax Court concluded that the taxpayer failed the requisite profit motive to receive a tax deduction from an investment in a charitable syndication partnership. The case involves an attempted syndication of charitable deductions by placing real estate into a partnership, soliciting investors with promised charitable deductions well in excess of their investment, and then donating the real estate one year later and reporting large charitable deductions to the partners. The taxpayer in the case invested into one of these partnerships. The IRS said that the taxpayer could not even deduct their original contribution as a Section 165 loss, let alone the reported charitable deductions. The court denied the taxpayer’s deduction because Section 165 required that the investment be made with the intent to make a pre-tax profit. The taxpayer lost its argument that its requisite profit was the net benefit of the extra charitable deductions it received over the cash it contributed to the partnership. The case also addressed TEFRA partnership procedural issues regarding the ability of the tax matters partner to extend the statute of limitations while under criminal investigation.
The IRS and Treasury announced taxpayer-favorable guidance regarding the grandfathering of pre-2014 projects for the purposes of the renewable electricity production tax credit (PTC) or the energy investment tax credit (ITC). As noted in our 2013 blog, a “qualified facility” is eligible to receive either a renewable electricity production tax credit or energy investment tax credit, if construction of such facility begins before January 1, 2014. Notice 2013-29 provided guidelines and a safe harbor to determine when construction has begun on such a facility under the Physical Work Test or the Safe Harbor. According to the Treasury press release, new Notice 2014-46 does the following:
- Clarifies that the Physical Work Test relates to the nature of the work, not the amount or cost. (Work of a significant nature includes, for example, any of the following activities: beginning of the excavation for the foundation, the setting of anchor bolts into the ground, or the pouring of the concrete pads of the foundation).
- Clarifies that a fully or partially developed facility may be transferred without losing its qualification under the Physical Work Test or the Safe Harbor for purposes of the PTC or the ITC. The only exception to this provision is transfers consisting solely of tangible personal property between unrelated parties.
- Provides that the Safe Harbor may be used by taxpayers that have paid or incurred less than five percent, but at least three percent, of the total cost of a facility before January 1, 2014. These taxpayers may claim a reduced credit proportional to the amount paid or incurred before January 1, 2014.
Today the IRS finalized regulations that penalize tax advisors who do not properly notify the IRS on Form 8918 with respect to so-called “listed” or “reportable” transactions. These rules, applicable to so-called “material advisors”, are a back door way for the IRS to track transactions that have a higher probability of being tax shelters. However, the transactions covered can in some cases be quite innocent, such as when a non-corporate taxpayer reports certain non-exempted transaction losses in excess of $2 million. Form 8918 is due the last day of the month that follows the end of the calendar quarter in which the advisor became a material advisor with respect to the reportable transaction.
The final regulations make a series of changes from the original proposed regulations published in December 2008. For example, the final regulations clarify that if a transaction is both a listed and reportable transaction, only the higher listed transaction penalty will apply. Further, if the material advisor fails to comply with its obligations on more than one reportable or listed transaction, a separate penalty will apply for each transaction. Perhaps most important is additional guidance on how the IRS will apply its authority to rescind the penalty when a taxpayer files, but files late. The final regulations note that if a material advisor unintentionally failed to file a Form 8918, but then files a properly completed form with the IRS, that filing will be a factor that weighs in favor of rescission of the section 6707 penalty if the facts suggest that the material advisor did not delay filing the form until after the IRS had taken steps to identify that person as a material advisor with respect to that particular transaction. The final regulations further provide that the late filing will not weigh in favor of rescission if the facts and circumstances suggest that the material advisor delayed filing the Form 8918 until after the material advisor’s client filed its Form 8886 (or successor form) identifying the material advisor with respect to the reportable transaction in question.