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Partnership Related Party Loss Disallowance | Tax Lawyer & Attorney

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In a series of articles concerning Internal Revenue Code (“IRC”) §267, I discussed various rules concerning related party loss disallowance. In this article, I would like to focus on special rules concerning partnership related party loss disallowance.

Partnership Related Party Loss Disallowance: Main IRC Provisions

Three IRC sections are most relevant to special rules of partnership related party loss disallowance. §707(b)(1) governs the disallowance of losses with respect to transactions between a partnership and its members as well as certain transactions between partnerships with common partners. §267(a)(1) contains the main rule concerning losses on sales or exchanges between a partnership and any person other than a member of the partnership (a third party), including another partnership. Finally, there are special provisions under §267(a)(2) which are applicable to partnerships. Let’s discuss each of these provisions in more detail.

Partnership Related Party Loss Disallowance: §707(b)(1)

§707(b)(1) disallows a loss from a direct or indirect sale or exchange of property (other than a partnership interest) when such sale or exchange occurs between: “(A) a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership, or (B) two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests.”

It is important to note that the ownership the capital or profits interest in a partnership by a partner may be direct or indirect. For example, in TAM 201737011, the IRS disallowed the losses of a hedge fund upon its transfer of securities to trading accounts owned by taxpayer who held greater than 50% interest in capital or profits of hedge fund.

Furthermore, it should be noted that §707(b)(1) incorporates §267(d) in order to mitigate the impact of loss disallowance. This means that the transferee may offset future gain on a sale or exchange of the affected property by the disallowed loss.

Partnership Related Party Loss Disallowance: Expansion of §707(b)(1) to Related Persons

Prior to 1985, §707(b)(1) applied strictly to partners. In September of 1985, the IRS dramatically expanded the application of §707(b)(1) to certain persons related to partners by incorporating the constructive ownership rules of §267(c)(1), §267(c)(2), §267(c)(4) and §267(c)(5). “Under these rules, ownership of a capital or profits interest in a partnership may be attributed to a person who is not a partner as defined in section 761(b) in order that another partner may be considered the constructive owner of such interest under section 267(c).” Treas. Reg. §1.707-1(b)(3). Note, however, that §707(b)(1)(A) does not apply to a constructive owner of a partnership interest since he is not a partner as defined in §761(b). Id.

Treas. Reg. §1.707-1(b)(3) provides an illustration of this expansion of §707(b)(1):

“For example, where trust T is a partner in the partnership ABT, and AW, A’s wife, is the sole beneficiary of the trust, the ownership of a capital and profits interest in the partnership by T will be attributed to AW only for the purpose of further attributing the ownership of such interest to A. See section 267(c) (1) and (5). If A, B, and T are equal partners, then A will be considered as owning more than 50 percent of the capital and profits interest in the partnership, and losses on transactions between him and the partnership will be disallowed by section 707(b)(1)(A). However, a loss sustained by AW on a sale or exchange of property with the partnership would not be disallowed by section 707, but will be disallowed to the extent provided in paragraph (b) of § 1.267(b)-1.”

In this context, it should be noted that the validity of Treas. Reg. §1.267(b)-1(b)(1) is currently in question. There is definitely an unsettled conflict between these regulations and the expanded version of §707(b)(1).

Partnership Related Party Loss Disallowance: Transactions Between Partnerships and Third Parties

As it was mentioned above, the IRC §267(a)(1) contains a special rule concerning losses which occur between between a partnership and a third party (i.e. someone other than a partner). Under this rule, the transaction is treated as if it happened between the third party and individual members of the partnership; this is a type of a look-through rule.

The disallowance rules of §267 govern as long as the third party and a partner are considered to be related parties under any of the relationships described in §267(b). In other words, if 267(b) applies in this context, then no deductions will be allowed with respect to transactions between the third party and the partnership “ (i) To the related partner to the extent of his distributive share of partnership deductions for losses or unpaid expenses or interest resulting from such transactions, and (ii) To the other person to the extent the related partner acquires an interest in any property sold to or exchanged with the partnership by such other person at a loss, or to the extent of the related partner’s distributive share of the unpaid expenses or interest payable to the partnership by the other person as a result of such transaction.” Treas. Reg. §1.267(b)-1(b)(1).

Partnership Related Party Loss Disallowance: Transactions Between Certain Partnerships

As a result of the Tax Reform Act of 1984, §267(a)(1) rules were expanded to disallow loss realized on transactions between certain partnerships. “Certain partnerships” include two types of partnerships.

First, partnerships that have one or more common partners. A “common partner” is a partner who owns directly, indirectly, or constructively any capital or profits interest in each of the partnerships. Treas. Reg. §1.267(a)-2T(c) Q&A-2.

Second, a situation where a partner in one partnership and one or more partners in another partnership are related parties within the meaning of §267(b). Id.

The amount of the disallowed loss is generally the greater of: (1) either the amount that would have been disallowed if the transaction had occurred between the “selling partnership and the separate partners of the purchasing partnership (in proportion to their respective interests in the purchasing partnership)”; or (2) the amount that would have been disallowed if the transaction had occurred between “the separate partners of the selling partnership (in proportion to their respective interests in the selling partnership) and the purchasing partnership.” Id. There is an exception: there will be no disallowance of loss if the disallowed amount is less than 5% of the total loss from the sale or exchange. Id.

It should be noted that §267(a)(1) also applies to S-corporations. §267(a)(1) disallows losses realized in transactions between an S corporation and its shareholder holding more than 50%-in-value of the stock.

Partnership Related Party Loss Disallowance: Deferral of a Deductible Payment Under §267(a)(2)

The Tax Reform Act of 1984 affected not only §267(a)(1), but also expanded the deferral of an otherwise deductible payment between certain partnerships under §267(a)(2). These “certain partnerships” are the same as those described in the expanded rules of §267(a)(1): (i) partnerships that have one or more common partners and (ii) a partner in one partnership and one or more partners in another partnership are related parties within the meaning of §267(b) (without §267(e) modification). See Treas. Reg. §1.267(a)-2T(c) Q&A-3.

The amount of deferred deduction is the greater of: (1) the amount that would have been deferred if the transaction that gave rise to the otherwise allowable deduction had occurred “between the payor partnership and the separate partners of the payee partnership (in proportion to their respective interests in the payee partnership)”, or (2) the amount that would have been deferred if such transaction had occurred “between the separate partners of the payor partnership (in proportion to their respective interests in the payor partnership) and the payee partnership.” Id. Similarly to 267(a)(1), there is an exception: no deferral shall occur if the amount that would be deferred is less than 5% of the otherwise allowable deduction. Id.

It should be noted that the status of some provision of the expanded §267(a)(2) is unclear at this point, because §707(b)(1) was amended in 1986 specifically in reference to §267(a)(2) income-deduction matching rules. As amended, §707(b)(1) state that partnerships in which the same persons own more than 50% of the capital interest or profits interests are treated as related under §267(b). It appears that, with respect to such partnerships, §707(b)(1) overrides the rules described in Reg. §1.267(a)-2T(c) Q&A-3.

Partnership Related Party Loss Disallowance: Additional Deferrals Under §267(a)(2)

With respect to the §267(a)(2) limitations on deductions for payment to related persons, a partnership and its members are treated as related persons under §267(e). As already described above, §707(b)(1) (last sentence) extended this rule to transactions between commonly owned partnerships.

Additionally, under §§267(e)(1)(C) and §267(e)(1)(D), a partnership and a person owning any profits or capital interest in a partnership in which the partnership also holds such an interest (and any persons related to these parties within the meaning of §707(b)(1) or §267(b)) are also related persons.

Finally, §267(a)(2) also applies to S-corporations in an almost identical way as it applies to regular partnerships: the deduction for a payment to a related person is delayed until the recipient includes the payment in his gross income. As a result of the Tax Reform Act of 1984, §267(e) treats an S-corporation and any of its shareholders (regardless of amount of stock owned) as related persons.

§§267(e)(1)(C) and §267(e)(1)(D) further expand the definition of related persons to situations where a transaction occurs between an S-corporation and a person owning any profits or capital interest in a partnership in which the S-corporation also holds such an interest (and any persons related to these parties within the meaning of §707(b)(1) or §267(b)).

Contact Sherayzen Law Office for Professional Help With US Tax Law Concerning Partnerships and S-Corporations

US tax law concerning partnerships and S-corporations is incredibly complex. The rules concerning the partnership related party loss disallowance is just one example of this complexity.

This is why you need the professional help of the experienced tax law firm of Sherayzen Law Office. We have helped clients throughout the United States and the world with US tax laws concerning partnerships (domestic and foreign) and S-corporations. We can help you!

Contact Us Today to Schedule Your Confidential Consultation!

International Business Transactions | Business Tax Lawyer Minneapolis

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Despite their apparent diversity and complexity, international business transactions can be grouped into three categories: export of goods and services, licensing and technology transfer and foreign investment transactions.

International Business Transactions: Export of Goods and Services

The first category of international business transactions consists of exports involving a sale of a commodity, manufactured goods or services to a purchaser in a foreign country. Such exports may be done pursuant to a single or series of contracts (first type of export of goods and services) or under a more permanent arrangement (second type of export of goods and services), such as: branch office, sales subsidiary, designated foreign representative, distributor, et cetera.

The first type of exports of goods and services are usually “arms length transactions” whereas the second type often involves related-party transactions. The latter sub-type may often draw the attention of the IRS due to high potential of abuse through tax avoidance measures as well as transfer pricing.

In addition to import tax considerations, exporting goods and services also entails a number of legal considerations and documents, such as the sales contract, insurance, transportation documents (e.g. bill of lading), payment mechanisms (e.g. letters of credit), export and import licenses, et cetera. Even the very establishment of a permanent export structure (franchise, subsidiary, et cetera) may raise an avalanche of legal issues that must be resolved in order for the business structure to work.

International Business Transactions: Licensing and Technology Transfers

The second category of international business transactions involves licensing of intellectual property rights and technology transfers. In reality, the technically-correct classification of international business transactions would place licensing and technology transactions as a variation on the export transactions. However, there are important distinctions between the first and the second categories of international business transactions that justify the classification of licensing and technology transfers as a separate category of international business transactions.

The basic idea behind the licensing and technology transfer transactions is not complex: instead of manufacturing a particular product in its home country and then exporting it to foreign countries, the company that owns the intellectual property rights licenses the actual science and the know-how behind the manufacturing process to a foreign firm so that it can manufacture the goods in the foreign country. In return, the company that owns the IP rights receives either a specified payment or a certain percentage based on annual gross sales or production volume.

The advantage of this type of export transaction is the relative ease with which the owner of IP rights can increase earnings without the need to set up a foreign distribution and services network. Moreover, the costs and risks of such a sales distribution network shift to licensee instead of the owner of the IP rights.

The technology transfer and IP licensing, however, carry significant risks of their own. First of all, there is a significant danger that the foreign licensee will master the new technology to directly compete with the IP owner. We have recently seen such an example with many “clean energy” Chinese companies. Second, there is a risk that the transferred technology may be simply stolen in a country where the IP rights are not property protected. Here, the problem is not only the appearance of an eventual competitor, but also of lost license fees. Finally, the licensee may improperly use the technology and create substandard goods, thereby damaging the reputation of the IP owner.

While these risks may be mitigated with proper business planning, one must be very careful about technology transfers and IP licensing, especially in the industries where technologies and know-how change at a slower pace.

International Business Transactions: Foreign Investment Transactions

The final major type of international business transactions consists of foreign investment transactions. This category, in turn, consists of two sub-categories: direct foreign investments and portfolio foreign investments.

Direct foreign investment usually implies an establishment or acquisition of a production capacity or a permanent enterprise, such as a factory or hotel, in the United States. In the United States, any equity investment of ten percent or more is classified as direct foreign investment. Usually, the foreign investor would directly participate in the management of this enterprise. Of course, the direct foreign investment can be done by a US investor investing directly in a foreign country and a foreign investor investing directly in the United States.

There are two types portfolio foreign investments. The first type consists of investments in debt instructions, such as bonds and debentures. The second type consists of an equity investment in which an investor does not have any management role.

There are many advantages to engaging in foreign investment transactions; I will just point out four such advantages here. First, an investor is investing directly into a foreign enterprise which is considered to be a “local” company, thereby avoiding the complications of exporting goods and services. Second, an acquisition of an already established company with its business network, established workforce and reputation, may facilitate a rapid growth in the sales of the produced goods or services. Third, unlike the first category of international business transactions, the host country may be very interested in a direct foreign investment, because it creates jobs and helps the local economy. Hence, an investor may benefit from government incentives, especially free economic zones which levy low to no tax. Finally, in the case of a portfolio investment, investors have limited exposure due to a diversified portfolio and limited equity stake in a single enterprise.

There may be, however, serious disadvantages to foreign investment transactions; I will mention here only three potential problems. First, a direct foreign investment exposes an investor to potential political and economic changes in the host country. For example, expropriation is a significant risk in South American countries. Second, a direct foreign investment implies an international corporate structure that may be very complex, expensive and require extensive tax and business planning. Finally, a portfolio investor without a management role is at the mercy of the company’s management, which may significantly affect the value of his investment.

International Business Transactions: Hybrid Investments

The classification of international business transactions that I provided above is an ideal one. In reality, hybrid investments (i.e. investments that have the features of more than one category of international business transactions) are widespread. One can easily find examples of portfolio investors who control an enterprise through a management agreement.