Monday, September 30, 2013
Last week, a letter was published by “a group of people in our 20s and 30s with inherited wealth and class privilege” advocating tax reforms for the benefit of the Philadelphia schools. Yes, they did write, “Tax us more!,” pointing out that “Wealthy individuals and corporations are not paying our fair share of taxes.” Whether the vast majority of their peers agree with them remains to be seen.
This group, however, also offered an very interesting argument against the claim that the additional funds available to the wealthy on account of tax cuts can be used for philanthropic purposes to accomplish what governments cannot do on account of revenue shortfalls. They explain that there is a huge difference between education and similar public endeavors being financed with tax money and those same activities being financed with private philanthropic funding. Funding financed with tax dollars is subject to public scrutiny, control, and input, whereas privately-funded alternatives, the existence of which is another cause of the public school system financial distress, contributes to the “root causes of inequality.” As they point out, “It weakens the democratic process.”
Those who signed the letter suggest that when the wealthy give away money, they feel they are making a difference, but by retaining the power to decide what gets funded, they “perpetuate the injustice we think we’re addressing.” Indeed, one of the great risks of the ever-increasing inequality that afflicts this country is that democracy is in danger of being replaced by oligarchy.
Another suggestion from this group deserves deep consideration. “Make policies that require businesses to respect people over profit. Until wealthy people’s means of making money are just, no amount of charitable philanthropy will cancel out the exploitation that initially created the wealth.”
One of their sentences caught my eye. I like it. “Require us to opt in to the public sphere, not choose to pay to set our lives apart.” The days of nobles in castles and peasants on the land, of plantation owners on porches and slaves in the field, of wealthy in gated communities and poor in slums need to be part of history taught as reminders of why democracy matters and how fragile it is. Those days ought not be present-day conditions of society.
Friday, September 27, 2013
The taxpayer attempted to prove that he was not a partner in the partnership by showing that he did not sign the partnership’s amended and revised operating agreement. The Tax Court explained that determining whether a partnership exists and whether a person is a partner in a partnership are questions of fact, resolving the issue of whether “the parties intended to join together in good faith with a valid business purpose in the present conduct of an enterprise.” To answer the question, the court noted the importance of the agreement between the parties, the conduct of the parties, the parties’ statements, testimony from disinterested persons, the relationship of the parties, the abilities and capital contributions of the parties, the actual control of income, and the purposes for which the income is used.
The Court focused on a variety of facts. The taxpayer and the partnership acted as though he was a partner. The taxpayer testified that he contacted the other partners because he wanted to pool his resources and develop business jointly with them. The taxpayer entered into a memorandum of agreement and a revenue sharing agreement with the partnership, and both agreements set forth a mechanism for letting the taxpayer share in the profits. Both agreements also provided that the partnership would issue a Form 1099-MISC or a Schedule K-1 to the taxpayer with respect to any money paid to the taxpayer, and there was nothing in the record indicating that the taxpayer objected to receiving a Schedule K-1 on the grounds he was not a partner. In addition, the revenue sharing agreement referred to the taxpayer and the other partners as “producers,” thus putting the taxpayer on the same footing as the other partners with respect to revenue sharing. One of the other partners testified that they intended for the taxpayer to be a partner in the business. After the taxpayer joined the partnership, it changed its name so that the taxpayer could tell clients that the name of the partnership included the first letter of his surname, and there was nothing in the record indicating that the taxpayer objected to this change of partnership name to include a reference to him.
Though it can be considered clever to argue that one is not a partner because one has not signed a revised partnership agreement, the law makes it clear that there is much more to determining whether someone is a partner than the mere appearance of the words of the person’s name in signature form on an agreement. Actions, not surprisingly, speak much louder than do words. If a person acts like a partner, is held out to the world as a partner, and is treated as a partner without objection, that person ought not claim that he is not a partner.
Wednesday, September 25, 2013
Readers of MauledAgain know that I am very critical of the decision of the Delaware River Port Authority to use toll revenues for purposes other than the building, maintenance, repair, and operation of the bridges and other port facilities under its management. As I pointed out in posts such as Soccer Franchise Socks it to Bridge Users, Bridge Motorists Easy Mark for Inflated User Fees, Don’t They Ever Learn? They’re At It Again, A Failed Case for Bridge Toll Diversions, and DRPA Reform Bandwagon: Finally Gathering Momentum, the DRPA has a long history of using toll revenues for projects such as a private sector major league sports team, private restaurants, a medical school, and other endeavors generating income for the private sector, including those who insist on reducing or eliminating taxes while feeding on tolls paid by motorists coping with inadequate bridges and other public facilities.
Recently, the Government Accounting Office issued a report, INTERSTATE COMPACTS: Transparency and Oversight of Bi-State Tolling Authorities Could Be Enhanced, and presented it to the Chair of the United States Senate’s Committee on Commerce, Science and Transportation. The report concluded, not surprisingly, that multi-state toll agencies have not been sufficiently accountable to those paying the tolls, and are not complying with a federal law that requires the tolls to be “just and reasonable.” The reason for the non-compliance is that the federal government is not enforcing the requirement. The lack of enforcement stems from the fact that Congress repealed the authority of federal agencies to enforce the requirement. It doesn’t take a degree in political science, or the brain of a rocket scientist, to figure out that if funding and authority for enforcement of a requirement is eliminated, the requirement has no meaning. Is it any wonder that the DRPA has gone on a spending spree with tolls, and has raised those tolls on several occasions to finance the spending that is not related to the facilities under its care? Relying on the states to correct the problem has proven to be impractical, as entrenched private sector interests have blocked attempts at reform. The situation is a classic example of why federal intervention is necessary in order to advance justice.
The motorists who object to repeated toll increases used to enrich private sector enterprises, rather than being used to care for the tolled facilities, might consider how they have ended up in the objectionable situation in which they find themselves. Is it possible that they would have been spared these financial burdens had federal oversight of multi-state toll facility agencies been left in place? Is it possible that cries for deregulation, translated as letting the private sector run roughshod over the public, were not the pathways to individual freedom for all as touted, but were devices to assist in the financial oppression of the middle class and the enrichment of the well-connected financial elite? Those who claim that “the federal government is not your friend” fail to point out that “the state governments and the multi-state agencies under their supervision are our friends, not yours.” If states continue to fail in their fiduciary responsibilities, it’s time to restore federal agency authority, and funding, to rectify the injustices being done to motorists.
Monday, September 23, 2013
When I taught the basic federal income tax course, one of the concepts in the group of principles that a student needed to master in order to earn a passing grade was the difference between a deduction and a credit. For the curious, others included the difference between an exclusion and a deduction, the difference between a personal exemption and a dependency exemption, the status of the standard deduction as an alternative to, rather than supplement to, itemized deductions, the difference between income and gross income, the difference between gross income and adjusted gross income, and some other similar concepts.
Thanks to a sharp-eyed reader who brought the IRS page to my attention. When even the agency charged with administering the tax law is confused, that’s a clear signal to the Congress that it ought to turn its attention to constructive endeavors, such as repairing the tax law. But I suspect that’s asking just a bit too much of our legislators.
Friday, September 20, 2013
The first aspect of the case that caught my eye was the attempt of a tax return preparer to deduct a vacation as a business expense. She explained that she operated her tax return business from her home, and explained that “living in her neighborhood was stressful and that she felt harassed by her clients who would call her home at any hour.” Accordingly, she concluded that she needed to travel “just to get rest so that . . . [she] could function.” The Court, not surprisingly, denied the deduction, characterizing the cost of the vacation as a personal expense. The decision is consistent with the holdings that the cost of food cannot be made deductible by arguing the lack of food prevents a person from engaging in any activities, including income-producing activities.
The second aspect of the case that caught my eye was the outcome with respect to the taxpayer’s home office deduction. The taxpayer claimed a home-office deduction based on one-half of her residence expenses, explaining that she operated her tax return business on the entire first floor of her two-story residence. The Court upheld the IRS disallowance of the deduction on the ground that the taxpayer had not proven that one-half was the appropriate fraction. Two years ago, in Linzy v. Comr., T.C. Memo 2011-264, in a case involving the same taxpayer – though with the name Joyce Ann Linzy rather than Joyce A. Linzy as in the recent decision – the taxpayer was permitted to deduct one-third of the expenses for the building in which she lived. Though the facts are unclear, it appears that the building used in the earlier case was a different building, because it is described as having a basement in addition to two floors and as having an apartment on each of those two floors. It appears, though this is an educated guess, that the IRS and the taxpayer stipulated as to the usage of the building in the earlier case, whereas in the recent case no such stipulation appears. Presumably, in the earlier case, the taxpayer provided sufficient evidence to the IRS to obtain its agreement to the stipulation, and thus the question is why, knowing how to generate a stipulation, the taxpayer did not provide equivalent evidence in the more recent case. The question is particularly interesting because the taxpayer is a tax return preparer.
The taxpayer’s argument with respect to the first point, though unsuccessful, reveals some degree of cleverness. Why that cleverness did not carry over to the procuring of a stipulation with respect to the home office deduction remains a mystery.
Wednesday, September 18, 2013
This time, Vos Savant took on a question about selling an encumbered residence. The questioner described a situation in which two people owned a home, presumably equally. The home is worth $200,000 “with $10,000 in equity.” Owner #1 will retain title to the house, and offers Owner #2 $5,000. Owner #2 wants $100,000. The questioner asked, “What’s the fairest thing to do?”
It is unclear from the question whether Owner #2 will remain liable on the mortgage loan, or whether Owner #1 will assume responsibility for repaying the loan. Vos Savant did not take that factor into account. Instead, she pointed out that a “key factor” to consider was the amount remaining on the loan. She suggested that, “Maybe the house was bought when it was worth half as much. Or twice as much!” She then presented two examples. In the first, she hypothecates that the house was purchased for $150,000, with $140,000 “left on the loan.” Thus, she concludes that the co-owners “would gain $60,000” if they sold the house for $200,000, requiring Owner #1 to pay $30,000 to Owner #2. In the second example, she hypothecates that the house was purchased for $250,000, with $240,000 remaining on the loan. She concludes that the co-owners would lose $40,000 if they sold the house for $200,000, requiring Owner #2 to pay $20,000 to Owner #1.
Here’s the problem. The facts presented by the questioner make it clear that the balance on the loan – whether the unpaid portion of the loan taken out at the time of the purchase or a subsequent loan, or a combination – is $190,000. The house is worth $200,000, the equity is $10,000, and thus the loan balance is $190,000. The loan balance is not $140,000, and the loan balance is not $240,000. Thus, the examples Vos Savant provides don’t answer the question. They answer questions not asked about situations not confronting the questioner.
Here is the answer that I would have provided. If Owner #1, with the consent of the lender, assumes full responsibility for the loan, Owner #2 should be paid $5,000 by Owner #1. That is the value of Owner #2’s interest in the residence. If, on the other hand, Owner #2 is required by the creditor to remain liable on the loan, then Owner #1 should pay $5,000 to Owner #2, plus any amounts paid by Owner #2 to the lender should be reimbursed by Owner #1 because Owner #1 is taking full ownership of the residence.
To demonstrate why this is correct, consider several possibilities of how the owners ended up in this situation. Assume that they purchased the residence for $200,000, each paying $5,000 in cash, and together borrowing the $190,000. Assume further that the residence did not change in value. Owner #2 invested $5,000, and would be getting that $5,000 from Owner #1, and thus is whole. Or suppose that they purchased the residence for $100,000, each paying $5,000 in cash, and together borrowing $90,000. Assume further that the residence increased in value to $200,000, and that the owners jointly borrowed another $100,000 and split the proceeds. Economically, the owners together have a gain of $100,000, the residence having been purchased for $100,000 and having increased in value to $200,000, and thus each owner should emerge from the transaction with their $55,000, the sum of the $5,000 that was originally invested plus $50,000, one-half of the gain. If Owner #1 pays $5,000 to Owner #2, Owner #2 ends up with $55,000, with $50,000 coming from the proceeds of the second mortgage loan and $5,000 coming from Owner #1.
No matter how one slices it or how many factual variations are constructed – of course, without changing the original facts that at the present time the equity is $10,000 and the loan balance is $190,000 – Owner #2 would incur a windfall if paid $100,000 by Owner #1. There are no factual variations – putting aside gifts from Owner #1 to Owner #2, something beyond the scope of the question – that justifies Owner #2 walking away with $100,000, or $30,000, or that justifies Owner #2 paying anything to Owner #1.
I concluded Getting Smart About Tax Questions with this comment, “Though how smart a person Marilyn vos Savant is continues to be debated, one thing is certain. When it comes to income taxation, she has more to learn.” I conclude this post with “Though how smart a person Marilyn vos Savant is continues to be debated, one thing is certain. When it comes to residential financing, she has more to learn.”
Monday, September 16, 2013
About a year ago, in When Privatization Fails: Yet Another Example, I explored the adverse consequences of putting a public bridge into private hands in Michigan. Earlier this year, in How Privatization Works: It Fails the Taxpayers and Benefits the Private Sector, I examined a similar failure, though with parking garages and not highways or bridges. Two months ago, in More Proof of How Privatization Harms Taxpayers, I explained how privatization of the tax refund process in Virginia did more harm than good.
Last month, I had the opportunity to see privatization, United Kingdom style, and privatization, France style. The difference in terms of highway conditions was notable, and as I drove I thought about the difference. In the United Kingdom, motorways for the most part are congested, even at times one would expect that not to be the case. During my ten days of driving, I often encountered stopped or crawling traffic in remote areas. Service areas exist, though in some places they are few and far between. Residents with whom I discussed the motorway situation complained that they expected to get more for their road tax dollars than they were getting. In contrast, motorways in France are congested for the most part only at the times and places one would expect. They are in such good condition that the speed limit is roughly 10 miles per hour higher than in the United Kingdom. Rest areas exist every ten kilometers or so, and service areas every 40 kilometers. Given the choice of which system I would want to use for a road trip, setting aside issues of destination and weather, I would select France.
I noticed two differences. First, in the United Kingdom, only a very small fraction of the motorway system is in the hands of the private sector. Second, the tolls in France, though high by American standards, are lower per-mile than the tolls charged on the few miles of United Kingdom motorways. An peek at what happened in the United Kingdom opens the door to understanding the differences. Because of severe congestion on one motorway, the United Kingdom government decided that a bypass needed to be constructed. Rather than building it with road tax funds, the government granted the construction rights to a private company that was permitted to charge tolls. What happened? The road was built, but the motorists didn’t show up. Motorists continued to use the severely congested motorway. Because of the insufficient revenue, the private company increased the tolls several times, and consequently road usage declined even more. I drove the toll road, out of curiosity and because my routing sent me that way. For a one-time use, I wasn’t very concerned about the toll. There was very little traffic on the toll road, and when it reconnected with the motorway it bypassed, traffic slowed to a crawl.
If privatization is going to work, it needs to be structured so that the public, through government representation, has overall control of the system. Tolls need to be imposed so that the alternatives, such as French regional roads, are sufficiently less attractive in comparison that most motorists will use the motorways. Toll revenue needs to be plowed back into the highways and not diverted to other uses such as has happened in Pennsylvania and other states. The bottom line is that the notion of driving on highways without paying tolls or any sort of sufficient fuels tax is a recipe for the deficiencies afflicting American interstate highways. Because the problem isn’t limited to interstates, but afflicts all sorts of roads, the solution is the mileage-based user fee, an approach that I have discussed extensively, in posts such as Tax Meets Technology on the Road, Mileage-Based Road Fees, Again, Mileage-Based Road Fees, Yet Again, Change, Tax, Mileage-Based Road Fees, and Secrecy, Pennsylvania State Gasoline Tax Increase: The Last Hurrah?, Making Progress with Mileage-Based Road Fees, Mileage-Based Road Fees Gain More Traction, Looking More Closely at Mileage-Based Road Fees, The Mileage-Based Road Fee Lives On, Is the Mileage-Based Road Fee So Terrible?, Defending the Mileage-Based Road Fee, and Liquid Fuels Tax Increases on the Table.
Though some Americans perceive France as the antithesis of the capitalistic ideal, its experience with motorways suggests that there are ways to rescue America from the highway infrastructure deterioration that threatens its economy and security, without selling out to the private sector. The history of highway privatization failures in the United States and in the United Kingdom suggests that there are some lessons to be learned in those nations.
Friday, September 13, 2013
Wednesday, September 11, 2013
Monday, September 09, 2013
Friday, September 06, 2013
Considering the extensive explanations provided by advocates of repealing section 736, there is no need to duplicate those efforts. Suffice it to say that section 736 is a maze of exceptions, exceptions to exceptions, and exceptions to exceptions to exceptions, is a trap for the unwary who do not realize there are opportunities to affect the outcomes by putting goodwill provisions into the partnership agreement, and adds layers of unnecessary complexity to the taxation of partnerships.
Wednesday, September 04, 2013
In contrast, if the partnership or partner transfers the property to another person under circumstances that cause the other person to obtain a transferred basis in the property, sections 724 and 735(a) do not apply. In other words, if a partner, for example, transfers distributed inventory by gift to a another person, the other person holds the property as an investment and subsequently disposes of the property within the five-year property, section 735(a)(2) does not apply. The other person’s gain would be capital gain, not ordinary income. For sections 724 and 735(a) to be fully effective, they need to apply not only to substituted basis property but also to transferees with transferred basis in the property.
Monday, September 02, 2013
Friday, August 30, 2013
Section 724(a) provides that unrealized receivables contributed by a partner to a partnership generate ordinary income when the partnership sells them, even if held by the partnership as an investment, no matter when the sale takes place. Section 724(b) provides that inventory contributed by a partner to a partnership generates ordinary income when the partnership sells it, even if held by the partnership as an investment, if sold within five years of the distribution. Section 724(c) provides that a capital asset contributed by a partner to a partnership that has an adjusted basis exceeding fair market value generates capital loss to the extent of the inherent loss when the partnership sells it, even if held by the partnership as inventory, if sold within five years of the distribution.
It is easy to see the lack of symmetry. There is no section 724(c) equivalent in section 724(a). The reason probably is explained by the fact that section 724 was enacted decades after section 735 was enacted and nothing was done to bring section 735 up to date. There needs to be a section 724(a)(3), to provide that a capital asset distributed by a partnership to a partner that has an adjusted basis exceeding fair market value generates capital loss to the extent of the inherent loss when the partner sells it, even if held by the partner as inventory, if sold within five years of the distribution.
Wednesday, August 28, 2013
The basis adjustments under sections 734(b) and 743(b) resolve problems that exist because of the manner in which subchapter K applies both entity and aggregate approaches to different provisions. Those problems affect all partnerships. Now that pencil and paper calculations have been replaced by computer software, there is no good reason to make those adjustments optional. If making them mandatory in certain situations is acceptable, making them mandatory across the board is no less justifiable. If the adjustments are mandatory, the need for section 732 disappears and it can be repealed.
Monday, August 26, 2013
Until 1997, inventory items were classified as ordinary income items, for purposes of both sale and distribution transactions, only if they were substantially appreciated. In 1997, the definition of ordinary income items was amended so that inventory items are treated as ordinary income items for sale transactions but are not treated as ordinary income items for distribution purposes unless they are substantially appreciated.
Finding a sensible reason for the change, and for the different treatment, is difficult if not impossible. I tell students that Congress has created a trap for the unwary. I also tell students that Congress has also created an examination question that indicates the extent to which students are paying attention, being precise, and recognizing the twists and turns of tax law. Making matters worse, unrealized receivables are treated as inventory items, the practical effect of which is that because they already are ordinary income items, they play a role in determining whether inventory is substantially appreciated. It works both ways. For example, inventory with an adjusted basis of $100 and a value of $105 is not substantially appreciated standing alone, but if the partnership also has unrealized receivables with an adjusted basis of zero and a value of $50, the inventory is substantially appreciated because the total adjusted basis is $100 and the total value is $155. As another example, inventory with an adjusted basis of $100 and a value of $130 is substantially appreciated standing alone, but if the partnership also has realized receivables with an adjusted basis and a value of $100, the inventory is not substantially appreciated because the total adjusted basis is $200 and the total value is $230.
This complexity is unwarranted and unnecessary. Inventory is an ordinary income asset, period. Whether or not it is substantially appreciated is irrelevant to its nature as an ordinary income asset. Congress should repeal the substantial appreciation test and treat all inventory as ordinary income assets for purposes of section 751, whether the transaction is a sale of a partnership interest or a distribution.
Friday, August 23, 2013
A partner must include a guaranteed payment in gross income in the taxable year for which the partnership properly claims the deduction or makes the required increase in the basis of an asset. Thus, if the partnership uses the accrual method and the partner uses the cash method, the partner includes the guaranteed payment in gross income even if it has not been paid. A mechanism is required to prevent the partner from including the guaranteed payment in gross income when it is eventually paid. This mechanism is basis.
The question is whether the basis acquired by reason of including the guaranteed payment in gross income is a stand-alone basis in the guaranteed payment or is added to the partner’s adjusted basis in the partnership interest. Though one might expect something to be found in section 705 or even section 707(c), or the regulations interpreting those sections, there is no answer there or in revenue rulings, notices, or court opinions. There is dictum in one case suggesting that the partner increases adjusted basis in the partnership interest, but there are inferences in the regulations that the partner does not increase adjusted basis in the partnership interest, though the reasoning is quite attenuated.
An example illustrates why the question matters. Assume that at the beginning of year 5, A’s adjusted basis in the partnership interest is $100. During year 5, the partnership accrues a $400 guaranteed payment to A but does not pay it. After deducting the guaranteed payment, the partnership breaks even, so there are no partnership items to allocate among the partners. During year 6, the partnership again breaks even, but there is no guaranteed payment. During year 6, the partnership sells a capital asset in which its adjusted basis is $1,000. It sells the asset for $1,000, and distributes $200 to each partner, including A. During year 7, the partnership again breaks even, and again there is no guaranteed payment, but the partnership pays to A the $400 guaranteed payment accrued during year 5.
If the inclusion of the guaranteed payment in gross income for year 5 increases A’s adjusted basis in the partnership interest, the results are as follows. The basis of A’s partnership interest at the end of year 5 is $500 ($100 plus $400). The sale of the asset during year 6 has no effect on A’s adjusted basis in the partnership interest. The distribution of $200 reduces A’s adjusted basis in the partnership interest to $300 ($500 minus $200). The payment of the guaranteed payment of $400 in year 7 reduces A’s adjusted basis in the partnership interest to zero, and generates gain of $100 under section 731(a)(1) ($400 minus $100).
If the inclusion of the guaranteed payment in gross income for year 5 creates a stand-alone basis in an item that could be called, for ease of reference, guaranteed payment receivable, the results are as follows. The basis of A’s partnership interest at the end of year 5 remains $100, and A also has a basis of $400 in the guaranteed payment receivable. The sale of the asset during year 6 has no effect on A’s adjusted basis in the partnership interest. The distribution of $200 reduces A’s adjusted basis in the partnership interest to zero, and generates gain of $100 under section 731(a)(1) ($200 minus $100). The payment of the guaranteed payment of $400 in year 7 reduces A’s adjusted basis in the guaranteed payment receivable to zero, but does not generate any gain.
The difference, therefore, essentially is one of timing. Either way, A must report ordinary income of $400 in year one, and gain of $100. If the inclusion of the guaranteed payment in gross income for year 5 increases A’s adjusted basis in the partnership interest, the gain is reported in year 7. If the inclusion of the guaranteed payment in gross income for year 5 creates a stand-alone basis in a guaranteed payment receivable, the gain is reported in year 6. Put another way, the issue is whether the basis obtained from including the guaranteed payment in gross income can be used to offset distributions and not just payment of the guaranteed payment.
However the question is resolved, clarifying amendments to the Internal Revenue Code or the regulations are necessary. Even if the situation arises only for partners with zero or relatively low adjusted basis in their partnership interests, taxpayers deserve an answer.
Wednesday, August 21, 2013
There are better ways to accomplish what section 704(e)(2) is designed to accomplish. In addition, the principles of section 704(e)(2) ought to apply across the board, and not merely in the limited circumstances to which it applies. Unlike sections 704(c) and 737, which also deal with assignment of income concerns but do not have subchapter S equivalents, section 704(e)(2) has a subchapter S equivalent, so this aspect of assignment of income apparently is of greater concern to the Congress.
With section 704(b) having been amended and regulations issued under section 704(b) in the years after section 704(e)(2) was enacted, it makes more sense to incorporate the concerns of section 704(e)(2) in section 704(b). In determining a partner’s interest in a partnership, including a partner’s interest in the income, gain, loss, deduction, and credit items of a partnership, the extent to which a partner’s services or capital generates the partnership’s income is a factor that needs to be taken into account. The repeal of section 704(e)(2), and its accompanying section 704(e)(3), needs to be done in tandem with the enactment of language in section 704(b) that states, “In determining a partner’s interest in a partnership, including a partner’s interest in the income, gain, loss, deduction, and credit items of a partnership, the extent to which a partner’s services or capital generates the partnership’s income is a factor that must be taken into account.”
Monday, August 19, 2013
Section 704(e)(1) provides that “a person shall be recognized as a partner . . . if he owns a capital interest in a partnership in which capital is a material income-producing factor. . .” Section 704(e)(1) was enacted in response to the Supreme Court’s decision in Culbertson, which essentially tagged the question of whether a person is a partner as a factual question. To the extent section 704(e)(1) was intended to reduce the amount of factual analysis necessary to answer the question, it has failed. First, it only applies to certain partnerships, and is of no value for partnerships in which capital is not a material income-producing factor. Second, section 704(e)(1) takes one factual question, namely, does the person in question intend to be a partner, and turns it into two questions, namely, when is capital a material income-producing factor in a partnership and what does it mean to own a capital interest.
The process of determining whether a partnership exists should also determine who the partners are. This is true even if two persons are identified as partners and the status of a third person is in question. The reason is that the technical question is whether a partnership exists among all three persons, not whether the third person is a member of a partnership between the first two persons.
In any event, no matter how the issue of whether a person is a partner is resolved, section 704(e)(1) is of no help whatsoever. Its repeal not only would remove useless language from the Internal Revenue Code, it would eliminate the need to answer the two questions of when is capital a material income-producing factor in a partnership and what does it mean to own a capital interest.
Friday, August 16, 2013
If an S corporation shareholder contributes appreciated or depreciated property to the S corporation, the gain or loss recognized by the corporation, which includes the gain or loss inherent in the property when contributed, is allocated among all the shareholders. Thus, the inherent gain or loss is shifted to other shareholders. Why is there no section 704(c) and section 737 equivalents in subchapter S? Apparently, preventing the shifting of the gain or loss isn’t as terribly important as one might have guessed. The practical explanation probably is that enacting section 704(c) and section 737 equivalents in subchapter S would make subchapter S “too complicated.” So why is it acceptable to have a “too complicated” subchapter K when it comes to contributed property?
Until and unless subchapter S is graced with section 704(c) and section 737 equivalents, subchapter K ought to be relieved of a computational and interpretational complexity that does not afflict subchapter S. Surely the shifting of income and loss either is good or bad, but whatever it is, it ought to be the same whether it is being done by partners or by subchapter S shareholders.