In DJB Holding Corp. the 9th Circuit concluded that a purported related-party partnership was not a bona fide partnership for tax purposes and taxable income was redirected to the taxable C corporation performing the underlying profitable services. The ultimate taxable services were performed by the C corporation but a partnership agreement between that C corporation and an upper-tier pass-through entity directed 70% of the income to the upper-tier pass-through entity for the stated consideration that the pass-through entity (and its owners) provided a needed financial guarantee as shown in this simplified diagram. The 9th Circuit affirmed the Tax Court conclusion that this was not a bona fide partnership under the historical Culbertson and Luna authorities.
The underlying Tax Court decision essentially disregarded the upper-tier guarantor’s nominal ownership in the partnership, noting that the totality of the circumstances did not support partner status. First, as an factual matter, the partners did not respect their own documentation and the actual income sharing between the partners was substantially different than the documented sharing and the accountant did not file partnership tax returns. Second, the court did not find the guarantee to be of significant value and noted that the other related parties that joined in the guarantee did not also receive partnership interest. Third, the court noted that the unilateral control exercised by the taxable C corporation supported the lack of partnership status. The primary issue on appeal was whether the guarantee had any significant value. The 9th circuit court found that the record supported that there were no value to such guarantee, asserting that the 100% owned taxable C corporation would have been entitled to the guarantees of the ultimate individual owners through their existing obligations to the C corporation.
In new Notice 2015-66 the IRS said it plans to amend FATCA regulations to reduce certain collateral restrictions on grandfathered obligations and extend the following transition rules:
(1) the date for when withholding on gross proceeds and foreign passthrough payments will begin;
(2) the use of limited branches and limited foreign financial institutions (limited FFIs); and
(3) the deadline for a sponsoring entity to register its sponsored entities and redocument such entities with withholding agents.
According to the IRS, the Notice provides additional time for withholding agents and FFIs to address the phase-out of the transitional rules. The Notice also provides information on the exchange of information by Model 1 IGA jurisdictions with respect to 2014.
The flurry of Opco-Propco REIT conversions has hit a stumbling block this week when the IRS issued a Revenue Procedure announcing a “no rule” policy for a key corporate tax issue for many REIT spin offs. Basically to do a tax-free REIT spin off, the existing single corporation must be able to qualify the REIT entity as having a 5-year history as an “active trade or business”. Traditionally companies ask the IRS’s blessing that the new REIT’s assets met this very factual inquiry. However, the IRS now says it will “not ordinarily” issue those Section 355 rulings if the transaction is part of a plan to separate a REIT (or RIC) from a taxable C corporation. The “no rule” also applies to cases where the “active” business of either the historical or the spun off corporation is small (less than 5%) when compared to the value of the assets of that corporation. The latter issue is often described as whether a “mere peppercorn” of a business is sufficient for a spin off. The revenue procedure applies to all ruling requests that are postmarked or, if not mailed, received on or after September 14, 2015, and relate to distributions that occur after such date.
Today the IRS issued proposed regulations that eliminate the “foreign goodwill exception” under the Section 367(d) regulations and also limit the scope of property that is eligible for the so-called “active trade or business” exception generally to certain tangible property and financial assets. Thus, upon an outbound transfer of foreign goodwill or going concern value, a U.S. transferor will be subject to either current gain recognition under section 367(a)(1) or the tax treatment provided under section 367(d). The regulation preamble explains that this taxpayer-adverse change is in response to certain taxpayers attempting to avoid recognizing gain or income attributable to high-value intangible property by asserting that an inappropriately large share of the value of the property transferred is currently subject to the favorable treatment for foreign goodwill or going concern value. The proposed regulations also eliminate the rule that limits the useful life of intangible property to 20 years and provide that the useful life of intangible property is the entire period during which the exploitation of the intangible property is reasonably anticipated to occur, as of the time of transfer.
The text of the proposed regulations are incorporated into new TD 9738 (clarifying of the coordination of the transfer pricing rules with other Code provisions). The proposed regulations are proposed to apply to transfers occurring on or after September 16, 2015, and to transfers occurring before September 16, 2015, resulting from entity classification elections made under regulation section 301.7701-3 that are filed on or after September 16, 2015.
In CCA 201537022, the IRS allowed a real estate developer to capitalize its required “advance” to the city for common infrastructure improvement costs, subject to later year adjustment to the extent the city repaid the funds. In form, the developer initially financed the capital improvements with an advance, but the city’s obligation to repay the funds was contingent on bond financing based on revenues derived from ad valorem property taxes. Thus, the ruling concluded that the entire risk of development rested with the developer with only a contingent repayment and therefore the taxpayer’s disregard of the form of the transaction and treatment in accord with its substance “appears to have been proper”. However, the IRS denied the taxpayer’s inconsistent treatment where it followed the form in part and treated some of the repayment of the advance as tax-free municipal bond interest under Code § 103. Instead, the IRS required that later repayments to the developer reduce the tax basis for real estate lots not yet sold by that time and be reported as ordinary income if the lots have already been sold.
Yesterday the IRS published two sets of regulations addressing when a US owner of a Controlled Foreign Corporation (CFC) has a deemed repatriation through the use of a CFC-owned foreign partnership. The regulations are based on Section 956, which in essence deems a repatriation to the extent a CFC invests in “U.S. property” – which includes loans by the CFC to its owners and certain pledges by the U.S. owners of the CFC stock or assets. The new temporary and final regulations attack situations where a CFC, instead of doing a prohibited direct loan to its U.S. owner, forms a controlled partnership that instead makes the loan to the U.S. owner. In addition, the regulations provide that the Section 956 anti-abuse rule is not limited to entities that are funded with capital contributions or debt, and clarify that any tax attributes associated with an inclusion under Section 956 will be taken into account in applying the anti-abuse rule. The new proposed regulations go farther with respect to foreign partnerships owned by CFCs, and generally treat an obligation of a foreign partnership as an obligation of its partners to the extent of each partner’s share of the obligation, as determined in accordance with the partner’s interest in partnership profits. The proposed regulations also address a number of aggregate-entity partnership questions under Section 956, including extending certain current pledge and guarantee rules to pledges and guarantees made by partnerships. The regulations are generally effective on September 1, 2015 and apply to property acquired, or pledges or guarantees entered into, on or after September 1, 2015
The IRS issued Notice 2015-54 stating that it plans to issue regulations under Section 721(c) to ensure that U.S. taxpayers do not use partnerships to shift built-in gains to non-U.S. affiliates. In 1997 Congress authorized the IRS to issue regulations to turn off the normal tax-free rules for partnership contributions if there could be a shifting of built-in gain to non-U.S. persons. In response to a concern of U.S. taxpayers using partnerships to shift gain to non-U.S. affiliates, Notice 2015-54 provides that new regulations will mandate using the “Remedial” method under Section 704(c), plus several other restrictions, if a U.S. person contributes built-in gain property to a domestic or foreign partnership when (i) a related foreign person is a direct or indirect partner, and (ii) the U.S. transferor (or a related person) owns more than 50% of the partnership. The new guidance will generally apply to transfers occurring on or after August 6, 2015 (or earlier deemed contributions from check-the-box elections made on or after this date).
In T.D. 9728 the IRS finalized the 2009 proposed § 706(d) regulations relating to how partnerships should allocate tax items to take into account a variance in a partner’s interest during a year. A typical example is when a partner makes a disproportionate contribution or received a disproportionate distribution during the year. The IRS also issued new proposed regulations to address the special interaction with tiered partnerships and so-called “allocable cash basis items” such as interest, taxes and service payments that are required to be prorated among the days to which they relate. In general these rules effect the legislative requirement that one cannot generally make a large capital contribution to a partnership at the very end of the year and receive a disproportionate loss allocation that relates to losses incurred earlier in the year.
The final regulations are quite lengthy and show the great attention to detail by the IRS as they tried to incorporate many practical taxpayer comments to make the process of allocating items among the partners more administrable. Helpful changes made in the final regulations include (1) expanding the exception for service partnerships to no longer be limited to specific types of services but instead include any partnership where capital is not a material income producing factor; (2) allowing a partnership to use different methods for different ownership changes, such as closing the books for one change and pro-rations for another change, provided that the overall combination of methods is reasonable based on the overall facts and circumstances; (3) permitting partnerships to perform regular monthly or semi-monthly interim closings, and to prorate items within each month or semi-month, as applicable, and (4) expanding the list of extraordinary items that may not be prorated to allow a partnership to add additional non-enumerated items for a taxable year if, for that taxable year, there is an agreement of the partners to consistently treat such items as extraordinary items and no substantial distortion of income results.
The Senate today voted 91-4 to extend the highway trust fund authorization through October 29th from its current expiration date of July 31st, 2015 and it is now headed to the President for signature. The bill – H.R. 3236 – contains numerous revenue raising provisions (intended to raise approximately $8 billion in revenue to offset the cost of continued highway spending). Among the other revenue-related provisions, the bill (approved by the House of Representatives on July 29th) would accelerate the deadline for filing partnership tax returns to March 15 for calendar year taxpayers (or two and a half months after the close of the tax year for fiscal year taxpayers). At present, partnerships have until April 15 (or three and a half months after the close of the tax year) to file returns. The proposed effective date is for returns for taxable years beginning after December 31, 2015. If passed, partnerships will need to accelerate when they prepare K-1s and file tax returns before the new, accelerated deadline, and ultimately may need to request extensions of time to file. The maximum extension for partnership Form 1065 is proposed to be a 6-month period ending on September 15 for calendar year taxpayers.
The IRS issued the much anticipated proposed regulations that severely curtail the practice of a fund manager waiving management fees in exchange for a share of future partnership profits. In essence the regulations tighten the necessary “entrepreneurial risk” required of the future profits interest plus list five other negative factors for recasting the profits interest back into a fee. The IRS also noted that Rev. Proc. 93-27, which treats a qualifying profits interest as having a zero value, will be amended to provide an additional exception for profits interests given in exchange for a partner forgoing a substantially fixed right to payment for services. This latter change would mean that even if the fee waiver has the requisite entrepreneurial risk, there would still be a material risk that the IRS will treat the present value of the profits interest as compensation income. This one-two punch has the distinct possibility of knocking out fee waivers altogether plus extending uncertainty beyond fee waivers to other targeted issuances of profits interests. The regulations are to be effective for all arrangements entered into or modified after the regulations are published as final.
The proposed regulations also address other related topics. First, the examples in the proposed regulations that find sufficient entrepreneurial risk involved partnerships that liquidated with positive capital accounts, despite the prevalence of partnerships liquidating instead with a cash waterfall and using “targeted” tax allocations. The Preamble specifically states that there is no inference whether such targeted capital accounts could satisfy the allocation safe harbors and requests comments if taxpayers want more guidance. Second, the proposed regulations modify an important “guaranteed payment” example that currently treats an allocation of profits over a fixed floor amount as always getting the benefit of profits interest treatment to the extent the profit share exceeds the floor amount. The example now always treats the fixed floor amount as a guaranteed payment even if the profits exceed the minimum floor amount. Finally, the Preamble appears to confirm the IRS position in Rev. Rul. 69-184, that a guaranteed payment to a partner cannot be treated as an employee payment (i.e., no W-2).