Abusing Partnerships?
I am certain that most of you have encountered at least one unscrupulous “advisor” who tried to convince you or your client to take advantage of what they described as a perfectly legal “loophole” in the Code that could generate significant tax savings.[i]
Over the years, many of these aggressive tax “planning” strategies have utilized the partnership form of business entity[ii] to claim the “as advertised” tax benefits but without demonstrating any independent business or investment purpose for the partnership.
Subchapter K
As you know, the partnership provisions of the Code[iii] (including the regulations issued thereunder, the “Rules”) were enacted to permit taxpayers to conduct joint business or investment activities for economic profit through a flexible arrangement – a state law partnership or limited liability company – that accurately reflects the partners’ economic agreement without incurring an entity-level tax.
The Rules are not intended to permit taxpayers to structure transactions using partnerships to achieve tax results that are inconsistent with either the underlying economic arrangements of the parties or the substance of the transactions. Similarly, the existence of a partnership should not be used to avoid the purposes of other provisions of the Code.[iv]
Provided the Rules are applied in a manner consistent with their intent, the IRS will not interfere with bona fide joint business arrangements that involve the use of partnerships.
Anti-Abuse Rules
However, the IRS is authorized to recast those transactions in which taxpayers try to exploit and misuse the Rules to avoid tax.[v] If a partnership is formed or availed of in connection with a transaction with a principal purpose of substantially reducing the partners’ aggregate federal tax liability in a manner that is inconsistent with the intent of the Rules, the IRS can disregard the form of the transaction.
In such a case, even if the partnership and the partners comply with the literal language[vi] of the Rules, the IRS can recast the transaction for federal tax purposes.
For example, where appropriate, the IRS may determine that: (1) the purported partnership should be disregarded in determining the tax effects of the transaction; (2) one or more of the purported partners of the partnership should not be treated as such; or (3) the allocations of the partnership’s items of income, gain, loss, deduction, or credit should be disregarded and reallocated.[vii]
Implicit in the intent of the Rules are three requirements:
- First, the partnership must be bona fide, and each partnership transaction must be entered into for a substantial business purpose;
- Second, the form of each partnership transaction must be respected under substance over form principles; and
- Third, the tax consequences arising under the Rules for each partner as a result of partnership operations (and of transactions between the partner and the partnership) must accurately reflect the partners’ economic agreement and clearly reflect each partner’s income.
Indicia of Intent
Whether a partnership was formed or availed of with a principal purpose to reduce substantially the partners’ aggregate federal tax liability in a manner that is inconsistent with the intent of the Rules is determined based on all of the facts and circumstances, including a comparison of the purported business purpose for a transaction and the claimed tax benefits resulting from the transaction.
The factors set forth below may be indicative, but do not necessarily establish, that a partnership was used in a manner that is contrary to the Rules. These factors are illustrative, and may not be the only factors to consider. Moreover, the weight given to any factor will depend on all the facts and circumstances. The presence or absence of any factor does not create a presumption that a partnership was (or was not) used in such a manner. The factors of interest to today’s post include:
- (1) The partners’ aggregate federal tax liability is substantially less than had the partners owned the partnership’s assets and conducted its activities directly;
- (2) The partners’ aggregate federal tax liability is substantially less than would be the case if purportedly separate transactions that are designed to achieve a particular end result are, instead, integrated and treated as steps in a single transaction;[viii]
- (3) One or more partners who are necessary to achieve the claimed tax results either have a nominal interest in the partnership, are substantially protected from any risk of loss from the partnership’s activities, or have little or no participation in the profits from the partnership’s activities;[ix]
- (4) Substantially all of the partners are related to one another;
- (5) Partnership items are allocated in compliance with the literal language, but inconsistent with the purpose, of the Rules.[x] or
- (6) The benefits and burdens of ownership of property nominally contributed to the partnership are in substantial part retained by the contributing partner.
Taxpayers’ “Strategy”
The IRS Office of Chief Counsel recently issued Field Attorney Advice[xi] in a matter that involved the use of a partnership to generate a charitable contribution deduction for, and to shift income away from, its controlling members (“Taxpayers”).[xii]
The Strategy
Advisor devised the Strategy pursuant to which Taxpayers could earn investment income in what was described as “a tax-free environment” and claim a charitable contribution deduction.
The steps in the Strategy were as follows:
- 1. In Year-1, Advisor organized Charity, which was recognized by the IRS as an exempt charitable organization[xiii] and classified as a public charity[xiv] as of its date of formation.
- 2. In Year-2, Taxpayer-Husband organized LLC with himself as the only member, and adopted an operating agreement prepared by Advisor. On the same day, Taxpayer-Husband transferred the nonvoting interest in LLC to Charity to fund a purported donor advised fund.
- 2. In Year-2, Taxpayers opened a brokerage account for LLC. They opened the account in their names, as members of LLC, giving them signatory authority to manage the investment and business activities of LLC. Taxpayer-Husband transferred assets, including marketable securities, to the LLC account.
- 3. During Year-3, Taxpayer-Husband made additional deposits into LLC’s brokerage account.
- 4. Pursuant to the terms of the operating agreement, Taxpayer-Husband, as Manager of LLC and as the owner of all its voting interests, allocated Percentage-1 of LLC’s partnership items to Charity-1 and Percentage-2 (99% and 1%, respectively – see the endnote) of LLC’s partnership items to Taxpayers.[xv]
- 5. In Year-3, Taxpayers claimed a charitable deduction for the donation of the LLC units to Charity.[xvi]
- 6. Appraiser determined the fair market value of the Percentage-1 non-voting membership interest Taxpayer-Husband transferred to Charity-1 as a charitable contribution in Year-3.
- 7. On its Year-3 Form 990, Charity reported a grant to another charitable organization.[xvii]
- 8. According to the terms of the operating agreement, Charity should have received an economic interest in LLC.
In Year-3, Taxpayers reported their Percentage-2 distributive share of LLC’s investment loss. In Year-4, Taxpayers reported their distributive share of LLC’s investment income.
As a tax-exempt organization, Charity’s distributive share of LLC’s investment income escaped taxation in Year-3 and Year-4.
Operation/Management of LLC
As Manager of LLC, Taxpayer-Husband was authorized to make all decisions concerning any matter affecting, or arising out of, LLC’s activities.
However, he was also required to distribute a specified amount of LLC’s total assets annually, yet he never authorized a distribution to Charity, and Charity had no independent right to receive any of LLC’s investment income without Taxpayer-Husband’s consent.
Moreover, Charity had no right to participate in LLC’s management, and its ability to transfer its nonvoting interest in LLC without Manager’s consent was severely limited.
Thus, for all intents and purposes, Charity had no control over its interest in LLC.
The Field Attorney Advice
Against this background, the issue that IRS Field Counsel (“FC”) was asked to consider – and from which all the other issues arose – was whether Taxpayer-Husband’s transfer of nonvoting interests in LLC to Charity, pursuant to the Strategy, should be respected for federal income tax purposes.[xviii]
FC’s Conclusions
FC determined that Taxpayers’ transfer of LLC’s nonvoting interests to Charity lacked economic substance and had to be disregarded.[xix]
Consequently, Charity was not a member of LLC, and all income or gains of LLC should have been allocated to Taxpayers.
FC explained that pursuant to the Strategy, Taxpayers controlled the LLC assets and the related investment income, tried to report and pay tax on only Percentage-2 (1%) of the investment income, and tried to shift “liability” for tax on the remaining Percentage-1 (99%) to tax-exempt Charity.
FC’s Analysis of Economic Substance
Interestingly, FC’s analysis of the Strategy did not reference the partnership anti-abuse rules discussed earlier, though it certainly could have; ultimately, it came back to other parts of the Rules to support its conclusion.[xx]
Instead, its discussion focused upon the economic substance doctrine, as codified in the Code.[xxi]
The Code defines the “economic substance doctrine” as the common-law doctrine that disallows tax benefits under the federal income tax[xxii] if the transaction that produces those benefits lacks economic substance or a business purpose.
A transaction has economic substance if: (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position; and (2) the taxpayer has a substantial purpose – some intent apart from federal income tax effects – for entering into such transaction.
However, a transaction is disregarded for federal tax purposes if the taxpayer did not enter into the transaction for a valid business purpose but, rather, sought to claim certain tax benefits not contemplated by a reasonable application of the language and purpose of the Code or its regulations.
Although the doctrine recognizes a taxpayer’s right to minimize taxes through legal means, it also states that “the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended.”
Application to Taxpayers
According to FC, the measures implemented by Taxpayers pursuant to the Strategy lacked economic substance and were undertaken for no purpose other than tax savings.[xxiii]
By transferring most of LLC’s membership interests[xxiv] to tax-exempt Charity, Taxpayers avoided income tax during the life of LLC with respect to the distributive share of LLC income and gain allocated to such gifted interests. At the same time, they maintained complete control over, and use of, LLC’s underlying assets, which Taxpayers had earlier contributed to LLC’s capital.[xxv]
For instance, Taxpayer-Husband made withdrawals from LLC (later characterized as loans)[xxvi] which, according to FC, evidenced Taxpayer-Husband’s ability to drain value out of LLC at any time. This afforded Taxpayers the immediate benefit of LLC’s largely untaxed investment income.
Moreover, Taxpayer-Husband did not follow LLC’s operating agreement. Significantly, he disregarded the requirement for mandatory annual distributions of a specified percentage of the assets; no such distributions were made to Charity, and no member could force a distribution.[xxvii]
Indeed, few of the significant provisions in the operating agreement were followed. For instance, the agreement required the approval of Charity for all “financial decisions,” but neither member attempted to follow this provision; indeed, there was no evidence that Charity was ever contacted regarding what would constitute “financial matters.”
For the same reason, the nonvoting LLC interests had little to no value. Any potential distribution paid to the nonvoting interest holder was within the discretion of Taxpayer-Husband.
Charity was also unable to realize any value from the transfer or sale of the nonvoting LLC units. Charity could not sell the interests to obtain value, because the interests had no value and the ability to sell any interests was limited and subject to Taxpayer-Husband’s consent.[xxviii]
When questioned regarding their motives, Taxpayer-Husband indicated that one purpose of this arrangement was for their assets to grow in a “tax free environment.”[xxix] They understood that by participating in the Strategy their investments would grow without taxation.[xxx]
Taxpayer-Husband engaged in the Strategy with the help of Advisor in order to shield their investment income and accumulate wealth in a “tax free environment.” According to FC, the transactions were structured so Taxpayers could avoid paying income tax by transferring Percentage-1 of their investment income (on paper) to Charity while retaining the assets under their control for their unfettered use and taking charitable deductions; therefore, they lacked economic substance.
Reasonable Investor
Next, FC considered whether a “reasonable investor” would have entered into the transactions, which required examination of the “overall structure” of the transactions and their “practical” economic effects.
In particular, FC considered whether there was “realistic potential for profit” so that, “the hypothetical reasonable businessman would make the investment.”
Again, FC determined that the transaction also did not satisfy this inquiry because (a) LLC was not organized for a nontax business purpose, and (b) the parties’ respective economic positions did not change as a result of the transaction.
Taxpayers treated the assets held by LLC (i.e., the brokerage account) as if they were the Taxpayer’s personal assets. After the purported transfer of the nonvoting units to Charity, Taxpayer-Husband remained in control of all assets held by LLC. Economically, Taxpayer-Husband was in the same position as to the assets after the purported charitable contribution to Charity, as he was before. Further, Charity was in the same position as to the assets before and after the purported contribution to Charity, as it held no enforceable right to those assets. It did not participate in any of the upside or downside from LLC.[xxxi]
The transactions lacked economic substance, both subjectively and objectively; they did not meaningfully change Taxpayers’ economic position aside from tax consequences; Taxpayers did not have a substantial purpose in participating in the transactions aside from tax consequences.
The Rules
Having already decided that the transactions had to be disregarded for federal income tax purposes under an economic substance analysis, FC next turned next to the Rules – but not expressly to the partnership anti-abuse regulations – to further support its findings that LLC was not a bona fide partnership under the Code.
FC began by stating that the key inquiry in considering whether a partnership interest in form should be respected as a partnership interest in substance was whether the purported partner had a meaningful stake in the success or failure of the enterprise.[xxxii]
According to FC, Charity was a partner in name only, as established by the totality of the circumstances. It was created by Advisor to allow individuals, such as the Taxpayers, to accumulate wealth “tax free.”
Not surprisingly, FC then launched into the same analysis, for all intents and purposes, that it had applied in its economic substance analysis, and recited the same “helpful” facts described earlier, while also adding some “new” observations; for example, Charity did not pay for its membership interest in LLC and was not obligated to make any cash outlays to fund LLC; although it was allowed to share in the losses per the operating agreement, it never had any interest in LLC to lose; it did not perform any due diligence prior to accepting the nonvoting interests, did not inquire into the type of assets being put into LLC, the type of income it would generate, the timing of any potential distributions, the possible expenses, etc.[xxxiii]
FC stated that LLC did not engage in any business or investment activity beyond purportedly holding the cash in the brokerage account, the income from which Taxpayers controlled.
LLC was also used as a vehicle to avoid paying income tax on the appreciation in that account and to obtain a tax deduction.
FC explained that, with respect to partnerships in which capital was a material income-producing factor – for example, an investment partnership – the Code generally provides that a person shall be recognized as a partner for income tax purposes if he owns a capital interest in such a partnership whether or not such interest is derived by purchase or gift from any other person.[xxxiv]
Whether an alleged partner who is a donee of a capital interest in a partnership is the real owner of such capital interest, and whether the donee has dominion and control over such interest, must be ascertained from all the facts and circumstances of the particular case. The reality of the transfer and of the donee’s ownership of the property attributed to the donee are to be ascertained from the conduct of the parties with respect to the alleged gift and not by any mechanical or formal test.[xxxv]
If the donor has retained control of the partnership interest that he has purported to transfer to the donee, then the donor should be treated as remaining the substantial owner of the interest.[xxxvi] Among the “controls of significance” enumerated by FC were the following: (1) the donor’s retention of (a) control over distributions, (b) control of assets essential to the business (for example, through retention of assets leased to the alleged partnership), (c) management powers inconsistent with normal relationships among partners, and (2) limitation of the right of the donee to liquidate or sell their interest in the partnership at the donor’s discretion.
If controls retained by the donor are exercised indirectly (such as through a separate business organization, trust, or partnership), then the reality of the donee’s interest will be determined as if such controls were exercisable directly.[xxxvii]
On the other hand, FC continued, substantial participation in the control and management of the business (including participation in major policy decisions affecting the business) is strong evidence of a donee-partner’s exercise of dominion and control over their interest.[xxxviii]
In addition, actual distribution to a donee-partner of the entire amount or a major portion of their distributive share of the business income is evidence of the reality of the donee’s interest.[xxxix]
In determining if a donee’s ownership interest exists, consideration will be taken into whether the donee-partner is included in the operation of the partnership business.[xl]
A donee-partner may be a limited partner who does not participate in the management of the partnership if the donee-partner’s right to transfer his interest is not subject to substantial restriction.[xli]
According to FC, while Taxpayer-Husband, as LLC’s Manager and the voting interest holder, retained all control of LLC, because the nonvoting interests could be seen as akin to limited partnership interests, Charity’s lack of voting rights or control of LLC1 would not be dispositive of the issue in this case. Rather, it was important to note that aside from the lack of voting interests, Charity also had no ability to realize the value allegedly associated with the nonvoting interests (because Taxpayer-Husband’s consent was required to approve all transfers), that Taxpayer-Husband was able to (and did) drain value from the assets that were to provide the value allegedly donated to Charity, and that Charity could only receive distributions when Taxpayer-Husband decided that he wanted Charity to receive any (never).[xlii]
Because Charity had no interest in LLC, Charity was not a partner of LLC, which means all income, loss, deductions, capital accounts, and credits from LLC reported on LLC’s tax return should have been allocated to Taxpayer-Husband.
In order for a valid transfer of property to occur, there must be a significant change in the economic relationship of the taxpayer to the property.
As previously analyzed, Taxpayer-Husband never parted with dominion and control over the assets of LLC. There was no change in the economic relationship of Taxpayer-Husband and the property of LLC. Taxpayers created the illusion that they parted with an interest in LLC, but in reality, Taxpayers only assigned the income for purposes of the Form 1065, as Charity had no right to this income or any distributions from the partnership. The nonvoting interests in LLC had no value and were created in form to give the illusion that Taxpayer-Husband had parted with an interest in the securities that represent the value of LLC. Thus, the income from the assets of LLC should be treated as 100% taxable to Taxpayers, pursuant to the assignment of income doctrine.
Taxpayer-Husband’s transfer of nonvoting interests in LLC to Charity was to be disregarded for federal income tax purposes because it lacked economic substance; Charity did not have sufficient economic or membership interests in LLC to be treated as a bona fide partner. Thus, the partnership income allocated to the nonvoting interests in LLC transferred to Charity should have been taxed to Taxpayers, instead.[xliii]
What’s the Point?
Why so much attention and analysis for what was clearly an abuse of a partnership entity, undertaken only to attain a tax benefit, and without any business or investment purpose? (Sounds ripe for application of the partnership anti-abuse rules.)
Probably because many so-called advisors continue to conjure up and peddle purportedly Code-compliant tax-saving schemes that tax-averse taxpayers are willing, even eager, to accept lock, stock, and barrel – and for which such advisors are paid – without first consulting with an experienced tax advisor.[xliv]
A couple of years back, a colleague told me about a situation in which an S corporation “contributed” its business to a partnership in exchange for which it received a “partnership interest” that entitled it to a zero percent interest in partnership profits/losses and a zero percent interest in partnership capital. Its shareholders received bona fide partnership interests, having contributed to the partnership money distributed to them by the corporation. The S corporation received a Schedule K-1 that reflected these percentages but that also showed a “capital account” in an amount equal to the value of the alleged contribution. Over time, upon the retirement of partners who were also shareholders, the partnership would be obligated to transfer money to the S corporation (a “return of capital”), which would then redeem the stock held by the retiring shareholder.
In response to his question as to why this arrangement was not treated as a sale by the S corporation to the partnership in exchange for deferred payments,[xlv] my colleague was told that no promissory note had been issued by the partnership.[xlvi] In response to his question as to how the S corporation could be treated as a partner under the circumstances described, my colleague was directed to its capital account. Oh well.
Yes, taxpayers have to be made aware that partnerships are not a panacea. I suppose that includes some education regarding the arguments the IRS may apply to put the kibosh on ostensibly, and seemingly compliant (at least superficially), business-oriented arrangements, as demonstrated in the FAA described above.
More importantly, tax advisers have to be respectful of the policies underlying the tax law, and they need to be firm with clients who insist upon disregarding what is hopefully sound advice.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i]Fortuna audaces iuvat. Or, instead, should I say, “Fools rush in where angels fear to tread”?
[ii] This includes limited liability companies that are treated as partnerships for tax purposes. Reg. Sec. 301.7701-3.
[iii] Subchapter K.
[iv] S. Rep. No. 1622, 83d Cong., 2d Sess. 89 (1954); H.R. Rep. No. 1337, 83d Cong., 2d Sess. 65 (1954).
[v] Reg. Sec. 1.701-2.
[vi] The above-referenced “loophole.” I detest the word.
[vii] Alternatively, the IRS may determine that: (1) the partnership and its partners should be respected but the partners should be treated as owning their respective shares of partnership assets directly; (2) the methods of accounting used by the partnership or a partner should be revised to more clearly reflect the partnership’s or the partner’s income; or (3) the intended tax treatment should otherwise be precluded.
[viii] For example, where it was contemplated that the interest of a partner whose presence was necessary to achieve the intended tax results for the remaining partners would then be liquidated or disposed of.
[ix] Other than, perhaps, a preferred return that is in the nature of a payment for the use of capital.
[x] In this regard, particular scrutiny will be paid to partnerships in which income or gain is specially allocated to one or more partners that may be legally or effectively exempt from federal taxation (for example, a foreign person, an exempt organization, an insolvent taxpayer, or a taxpayer with unused federal tax attributes such as net operating losses, capital losses, or tax credits).
[xi] IRS Field Attorney Advice (FAA) 20260401F. Chief Counsel is the legal advisor to the Commissioner of Internal Revenue and the Service’s officers and employees on all matters pertaining to the interpretation, administration, and enforcement of the internal revenue laws and related statutes. Chief Counsel attorneys provide legal advice in a number of contexts to the IRS and other Counsel offices. Many requests for legal advice may be received informally, and in cases where the subject matter concerns relatively routine and simple concepts, an informal response will be sufficient. Where the question posed is more complex, an inquiry may be more appropriately handled with a formal written response. Field Counsel renders advice directly to revenue agents, revenue officers, appeals officers, IRS Campuses, and the Taxpayer Advocate Service, without consultation with the Associate offices with respect to matters where the advice consists of issues that can be resolved with a high degree of certainty by the application of settled principles of law or law consistent with the IRS’s position to the facts. With respect to matters where the law or the IRS’s position is unclear, or when the law is being applied in a setting that is significantly different from the context in which it was developed, Field Counsel must coordinate with the Associate Chief Counsel having subject matter jurisdiction over the issue before rendering the requested legal advice. See IRM 33.1.1.
[xii] A married couple.
[xiii] Described in IRC Sec. 501(c)(3).
At some point, the IRS proposed the revocation of Charity’s tax-exempt status for failure to operate exclusively in furtherance of its exempt purpose. Specifically, the Service determined that more than an insubstantial part of Charity’s activities were not in furtherance of an exempt purpose. These activities included participating in a tax shelter scheme, and operating as a vehicle to assist the promoter of the scheme (Advisor) in carrying out the scheme, including Charity’s participation in the Strategy with Taxpayers and LLC.
[xiv] Described in IRC Sec. 509(a)(1) and Sec. 170(b)(1)(A)(vi).
[xv] LLC-1 reflected this allocation on its Year-3 partnership tax return, on Form 1065, Schedule K-1.
In its recital of the facts, the FAA refers to Taxpayers’ holding a Percent-2 Interest in LLC, while Charity holds a Percent-1 interest.
However, the FAA seems to have dropped its guard in its discussion of Taxpayers’ lack of charitable intent, where the FAA states that, “Taxpayers had signatory authority over the brokerage accounts and chose LLC’s investment strategy thereby earning investment income on investments of their choosing on which they paid only 1% of the tax, escaping tax on the rest.”
[xvi] An officer of Charity signed the Donee Acknowledgment, Part V of the Form 8283, on Date-1. However, Taxpayers did not attach a qualified appraisal for the value of the property transferred, nor a Contemporaneous Written Acknowledgment of the contribution, to their Year-3 return. Reg. Sec. 1.170A-13. So many reasons for the IRS to deny a deduction.
[xvii] Window-dressing anyone?
[xviii] The same question, from the perspective of Charity was whether Charity had sufficient economic or membership interests in LLC to be treated as a bona fide partner.
The next issue was whether the partnership income allocated to the nonvoting interests in LLC purportedly transferred to Charity was taxable to Taxpayers.
Relatedly, and finally, FC was asked to consider whether Taxpayers could claim a charitable contribution deduction for the transfer of nonvoting interests in LLC to Charity – of course they weren’t.
[xix] Under the economic substance doctrine as codified by IRC Sec. 7701(o).
[xx] See https://www.taxnotes.com/research/federal/other-documents/other-court-documents/irs-says-loper-bright-doesnt-apply-antiabuse-rule-validity/7kgmq, in which the IRS stated that it did not rely on the overruled Chevron decision “to establish the validity of the partnership anti-abuse rule.”
[xxi] IRC Sec. 7701(o), which was added to the Code by Sec. 1409 of the Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152.
[xxii] Subtitle A of the Code.
[xxiii] In fact, Taxpayers’ stated purpose for engaging in the Strategy was to grow the investments in LLC “in a tax-free environment,” ostensibly to maximize their charitable giving.
[xxiv] Representing 99% of LLC’s equity.
[xxv] Taxpayer-Husband was LLC’s manager and held all the membership voting power.
[xxvi] By having LLC authorize and enter into a loan agreement signed by Taxpayer-Husband as Manager of LLC, as the lender, and signed by Taxpayers in their individual capacity as the borrowers. Although LLC’s loans were subsequently papered to be limited to “qualified borrowers” and were to be secured by collateral, “qualified borrower” is not defined and there was no evidence that the Taxpayers’ loans were secured in any way.
[xxvii] Although the agreement required yearly distributions to Charity, Taxpayer-Husband retained the sole discretion to dissolve LLC at any time or to exhaust LLC’s investments, and Charity had no right to demand any distributions.
[xxviii] Charity was not able to realize any value through the sale of its interest. The Operating Agreements set out the process of selling membership interests. It provided for a right of first refusal to purchase an interest if a member found a willing third-party buyer. It was highly unlikely that Charity would be able to find a buyer for its nonvoting interests because Charity exercised no control of LLC, LLC did not conduct an operating business, and LLC only held assets tied to the managing partner. Furthermore, because the nonvoting member has no upside potential and any transfer of interests has to be approved by Taxpayer-Husband, it was unlikely that an outside buyer would have had any interest in purchasing the nonvoting units.
An amendment to the agreement required the vote of voting members of which Taxpayer-Husband was the only voting member.
[xxix] Remember, Charity held a 99% interest.
[xxx] They further stated that they were guaranteed the investments would grow tax free.
[xxxi] Charity could not, and did not expect to share in the upside potential of LLC. Under the Strategy, Charity would not have any upside potential in the assets, or investment income, of LLC. Also, it seemed evident that Charity never expected to have any upside potential, as it never expressed any concern about not receiving a distribution, despite the terms of the agreements.
[xxxii] It required a consideration of all the facts, including “the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent – the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.”
[xxxiii] Not the behavior of a true member or partner.
[xxxiv] IRC Sec. 704(e)(1); Reg. Sec. 1.704-1(e)(1)(ii).
[xxxv] Reg. Sec. 1.704-1(e)(2).
[xxxvi] Reg. Sec. 1.704-1(e)(2)(ii).
[xxxvii] Reg. Sec. 1.704-1(e)(2)(iii).
[xxxviii] Reg. Sec. 1.704-1(e)(2)(iv).
It should be noted that, according to FC, if the reality of the transfer of interest is satisfactorily established, the motives are generally immaterial, but the presence of a tax avoidance motive is still one factor to consider in determining the reality of the ownership of a donee’s partnership interest. Reg. Sec. 1.704-1(e)(2)(x).
[xxxix] Reg. Sec. 1.704-1(e)(2)(v).
[xl] Reg. Sec. 1.704-1(e)(2)(vi). Whether or not the donee has been held out publicly as a partner in the conduct of the business, in relations with customers, or with creditors or other sources of financing, is of primary significance. The regulations list other significant factors.
[xli] Reg. Sec. 1.704-1(e)(2)(ix).
[xlii] For those of you familiar with family limited partnerships or LLCs, these and other factors mentioned in today’s post are also considered in gift tax and estate tax audits involving the transfer of business interests to family members.
[xliii] The FAA relied on a misstatement of the assignment of income doctrine. I don’t understand why it would rely on the doctrine, as properly applied, in any case. The transfer to Charity was disregarded as though it had never occurred for tax purposes. The assignment of income doctrine assumes a bona fide transfer of property or of the right to the proceeds from the sale of such property. It then directs the income to the transferor, as the appropriate owner of the income notwithstanding the transfer of the property.
[xliv] Hook, line, and sinker, if you prefer.
[xlv] Which would have triggered the recognition of ordinary income under IRC Sec. 751 for the year of the alleged contribution.
[xlvi] Forget the application of IRC Sec. 707(b)(2) if the S corporation held a true capital interest, or preferred interest.