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Taxpayer Wins High Stakes Partnership Income Allocation

The IRS’s revenue collection tally just went down by over $650,000 after it lost a major case involving partnership interest deductions. The issue was whether a son who received his partnership interests from his father by gift and bequest had to treat partnership loan interest in the same way as his father—as investment interest. The IRS said yes, but the Tax Court gave a resounding no, based on the purpose the debt in the son’s hands. Here’s what happened.

The Lipnick case is of special interest partly because it is a “case of first impression.” This means that the Tax Court has not ruled on the exact issue before and a new, important interpretation of the law has been formulated. The ruling stands for the proposition that the nature of an existing partnership loan can change in the hands of a taxpayer who acquires his or her partnership interest by gift and bequest, subject to the partnership’s debts. In this situation, the new owner is not bound by the treatment of the loan interest in the hands of the previous owner.

Father had Debt-Financed Distributions

In Lipnick v. Commr., the taxpayer son had acquired interests in several real estate partnerships from his father by gift and upon the father’s death in 2013. The partnership’s holdings included high-end real estate in the District of Columbia and suburban Maryland. The son took the father’s interests subject to the partnerships’ debts, including loans the partnership had previously taken out to make distributions to its partners, including the father. The father used the debt-financed distributions to buy investment assets and reported the passed-through interest expense as investment interest on Schedule A, an itemized deduction limited by net investment income.

The son, however, treated the interest from the almost $80 million in partnership loans as attributable to the acquisition of his partnership interests, reported it on Schedule E, and used it to offset his allocable share of partnership rental income in tax years 2013 and 2014. The IRS assessed the following deficiencies and penalties based on the interest deductions taken by the son on his share of the loans:

Year

Deficiency

Penalty

2013 $269,202 $53,840
2014 $286,232 $57,246

Son not Bound by Father’s Use

Under IRS temporary regulations, interest allocations are traced through and characterized based on the use of the debt proceeds. The father had used the partnership loans to make distributions and then used the distributions for investment purposes. The IRS argued that the taxpayer son stepped in the shoes of his father and had to treat the interest the same as the father–as investment interest not deductible against partnership income. The Tax Court disagreed, finding that, under the IRS’s own tracing rules in the temporary regulations, the son has used the loans for a different purpose. The son acquired his partnership interests subject to the partnerships’ debts, and thus used his allocable share of those debts to pay for his partnership interests, the Court reasoned. Those partnership interests were “actively managed operating assets”, so the interest expense that passed through to the son was not investment interest and could be used to offset partnership rental income. The Court noted that the son did not receive any portion of father’s distributions or use any partnership distributions to make any investment expenditures himself.

This new ruling has implications for anyone who becomes a new owner of a partnership interest by gift or bequest.  If you have questions about the unique tax situations that arise within partnerships please reach out to the tax team at Frazier & Deeter.

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