March 2007 Identifying Partners' Interests In Profi Ts And Capital .

Identifying Partners’ Interests in Profits and Capitalof long-outstanding regulations contain illustrationsin which the Treasury and the IRS acknowledge a difference in percent in the partners’ respective capitaland profits interests.18 In today’s sophisticated world,taxpayers continue to design (i.e., “slice and dice”19)their cash flow, profits and loss arrangements so asto meet their respective business and investmentobjectives, and the partnership with “straight up”ownership interests (e.g., 60 percent to Partner A and40 percent to Partner B of all items of capital, profitsand losses) is the rare exception, not the rule.We are unaware of a comprehensive analysis of “relatedness” in identifying PIPP and PIPC. We also areunaware of a thorough discussion as to whether the measurement of a partner’s profits and/or capital interest is thebest way to identify ownership in the partnership context.Indeed, we were unaware of many matters involvingPIPP and PIPC prior to this undertaking, and havingbegun the journey we remain unaware of explanations,answers and solutions to most of those matters.OverviewPart I of this paper contains a survey of operative Codeprovisions and regulations involving PIPP and/orPIPC. Part I illustrates the importance of measuringprofits and capital interests in areas both inside andoutside of Subchapter K.Parts II and III of this paper identify definitional andmeasurement issues arising from a partner’s “profits interest” and “capital interest,” respectively. A thoughtfulset of proposals to measure PIPP was prepared by theAmerican Law Institute (ALI) some 25 years ago,20 butthey apparently did not gain traction with Congress orthe Treasury. Through use of several discussion models,we analyze in Part II a variety of methods (each havingsome merit) that can be utilized in measuring PIPP.Part II also identifies additional issues in defining PIPPwith respect to the inclusion or exclusion of items suchas guaranteed payments, built-in gains under CodeSec. 704(c), mandatory minimum gain and partnerminimum gain chargebacks, qualified income offsets,curative allocations of income and gain, and other“mechanical” gain or income allocations mandatedby the complex Regulations under Code Sec. 704.21Should any of these items be included in determiningPIPP? If so, which, when, how, and to what extent?Other definitional issues are also identified.Part III attempts to measure PIPC for purposes ofthe numerous operative Code provisions, regulationsand rulings that utilize that concept as a measuring200stick for purposes of identifying “relatedness.” TheALI Project also attempted to define PIPC and madea recommendation which, like its PIPP proposals, hasnot been accepted by Congress or the Treasury.Part IV deals with practical and administrativeaspects of identifying PIPP and PIPC. How do validretroactive allocations of profits affect the measurement of PIPP and PIPC during the year? If methodsused to determine PIPP result in different profits interests among the partners during the year or in differentyears, what are the operative tax consequences ofchanges or shifts in profits interests? If the partnership owns more than one property and the partnersshare profits and losses (or have capital contributionobligations) differently for each property, are PIPPand PIPC determined on a property-by-property basisor a unitary (or “overall”) basis? More basically, canthe partnership and its partners validly take differentpositions as to the measurement of PIPP and PIPC?Part V identifies planning opportunities (and traps forthe unwary) in dealing with various operative Code provisions, with respect to the meaning of PIPP and PIPC.Part VI identifies and explores conceptual issues,having relevance both inside and outside of Subchapter K, with respect to “relatedness.” Some of therelevant conceptual issues include the following:Should there be uniform definitions of PIPP andPIPC, respectively, for all purposes of the Code, orshould they evolve on an operative Code section–by–Code section basis? If a uniform definition isappropriate, is it within the domain of Congress,the Treasury or the IRS to provide same?Why is the line of percentage demarcation drawnin various operative Code sections and Treasuryregulations where it is? Why is “50 percent” usedin some places, while zero, one, two, five, 10, 20,25, 30, 35, 70, 80, 90 percent or something elseis used in others?22 If the underlying theme is toidentify when a partnership is “related” or “unrelated” to one or more of its partners, why are thereany—much less so many—differing standards?Should the percentage be made uniform?From an administrative viewpoint, how does thesystem currently deal with this problem? In draftingstatutes and regulations, it appears that Congress,the Treasury and the IRS typically “punt” on theissue, making no attempt to define the standardagainst that the operative Code provision is to bemeasured. Have the drafters of statutory and regulatory provisions concluded it is preferable for the IRSand taxpayers to resolve the issues as they arise on

March 2007a case-by-case basis (i.e., upon request for privateruling, during an audit, or in litigation), rather thanattempt to establish bright-line rules?23 How can ordoes the IRS administer the system?In the absence of guidance, are tax practitionersrequired to follow the “lowest common denominator” approach, i.e., certainty exists only if any and allinterpretations of what constitutes the measurementof partnership profits or capital are met (or failed)? Isthe “lowest common denominator” approach whatCongress, the Treasury and the IRS have in mindwhen they use the undefined terms? How are thecourts likely to respond?In defining PIPP and PIPC, should anything turnon the partner’s interest in partnership losses? Is“relatedness” only relevant based on one’s shareof partnership profits or capital?24The concept of “ownership of the partnership”recently arose in the Instructions to Schedule M3. Is this a new, different method of determining“relatedness,” or is it merely shorthand for identifying the partner’s interest in partnership profitsand/or capital?In Part VII, we analyze whether the concepts of“relatedness” contained in the Code with respect to corporate stock ownership provide any useful analysis orbenchmarks in thinking about this topic. Are the methodologies or the measuring sticks used in determiningcorporate “relatedness” (in comparison to those used forPIPP and PIPC) different but good, different but bad, orjust plain “different”? A discussion model, involving astate law LLC that is initially taxed as a partnership butin a later year simply elects to be taxable as a corporation (with no change in ownership) could illustrate thedifferent regime that applies to the same owners of thesame state law unincorporated entity in determiningwhether “relatedness” exists for tax purposes.Part VIII considers alternative approaches to “relatedness” for partnerships and partners. If PIPP and PIPCwere not the measuring rod for most “relatedness” purposes, what alternative or supplemental approachescan be provided that are viable and administratable?Is the presence or absence of voting power relevantfor determining relatedness? Should the value of eachpartner’s interest be the sole arbiter of whether relatedness exists in the partner/partnership context? Are thereother approaches? Stated succinctly, should there be auniform alternative approach, which takes the place ofPIPP and PIPC throughout the Code, regulations andother governmental guidance? What are the advantages and disadvantages of each alternative?TAXES—THE TAX MAGAZINEFinally, in Part IX your author provides certain observations, conclusions and remaining concerns asto the concept of “relatedness.”Before we begin our analysis, a few words as to whatis not covered herein. This article does not addressother concepts of partnership ownership that appearin the Code or regulations. Thus, there is no extensivediscussion of the measuring of a “partner’s interest in thepartnership,” which appears, inter alia, in Reg. §1.7041(b). (A thoughtful analysis and proposed definitionof that amorphous concept were presented at this TaxConference by our esteemed colleagues Howard Kraneand Jeffrey Sheffield almost 25 years ago.25) Nor do wedeal directly with the meaning or measurement of “theownership interest in the entity,” which is of significancefor certain purposes under the check-the-box regulations.26 This article does not delve into the meaning ormeasurement of each partner’s “proportionate share” ofownership of the partnership, which is of significancein applying the partnership-to-partner attribution rulein Code Sec. 318(a)(2)(A).27 This article also does notcover the meaning and measurement of a “proportionalinterest in a partnership,” which is relevant for purposesof determining whether a U.S. person is required tofile a tax return with respect to his or her interest in aforeign partnership.28 Although “attribution” and “relatedness” (the latter being the linchpin of this article)are somewhat related and sometimes confused witheach other, this paper does not plunge into the broaderquestions of the scope, meaning and inconsistenciesof the Code’s attribution rules.29One further prelude to the analysis. I wish to expressmy gratitude to my fellow author and co-commentator,Philip Postlewaite, for both his assistance in shapingmy thinking on this topic and in going beyond the callof duty to prepare a thoughtful and far-reaching papermany degrees past that of a mere Monday morningquarterback commenting on my Sunday shenanigans.As a practitioner who wrestles with the vagaries of PIPPand PIPC in practice, I am inclined to get caught in thethicket of a dense forest of a topic where no sunshinehas been seen for at least 52 years (i.e., since the 1954Code) on such questions as, “what is the meaning andmeasurement of PIPP and PIPC, with respect to thesemyriad references throughout the Code and Regs, andhow do I apply it to the unlimited permutations ofpartnership arrangements that my clients generate?”It is easy to get lost in those trees.In contrast, Phillip, bringing the academic’s viewpoint to the jungle, need not be greatly botheredby the practical; he swings lithely and blithely,201

Identifying Partners’ Interests in Profits and Capitalfrom tree to tree, from his high perch, able to seethe entire forest (swooping down on occasion totouch ground, machete in sheath) and focusing onthe higher questions of “what should the measurement of PIPP and PIPC be, and which governmentalinstitution has proper standing to bring sense to thesenseless?” A comparison of our papers (mine, thequantity; his, the quality) shows the checks andbalances that the University of Chicago Tax Conference format forces us to adopt. Stated simply, inthe pending case of Forest v. Trees, Phillip sees theforest, whilst I wander through the trees.Inclusion of Phillip in this panel was not withoutsome modest concerns. Having an inkling that themeasurement of PIPP and PIPC could ultimatelybe a potential morass, did I want to make Phillip afirst-hand witness of still another perceived failingof Subchapter K? After all, this is the man who hadthe chutzpah to write an article (not that long ago)entitled, I Come to Bury Subchapter K, Not to PraiseIt.30 Why add fuel to the fire?Nonetheless, I do not in the slightest rue ourinvitation to him to participate and contribute substantially to this topic.Phillip is unique in many senses of the word; hisstrong interest in Subchapter K and his willingnessto swing his imaginary machete through the denseunderbrush of PIPP and PIPC truly marks him as“The Hemingway of Subchapter K.” (A nickname thatrhymes!) One must read his introductory discussionabout “The Hemingway Play” and its profound effects on the four phases of Phil’s fabulous career toappreciate both the moniker hereby bestowed onhim as well as the schizophrenic dilemma Phillipgraciously faced in taking on, with his typical goodnature, a self-examination of his own thinking andpositions on PIPP and PIPC published 20 yearsearlier!31 I continue to enjoy the stimulating discussions we have had in editorially commenting oneach other’s papers, just as was the case two yearsago,32 and this time around we shared the joy andwonderment of two grizzled veterans of Sub K—having about 60 years’ combined experience traipsingin Code Secs. 701 et seq.—who have discoveredthat many of our presumptions, predilections andpremonitions about PIPP and PIPC were unfounded,inappropriate and/or straight out wrong! I commendPhil’s paper to all readers on this topic, and tip myFrench beret to him as the only human being to seriously tackle this topic twice—and exhibiting evengreater perception the second time around.202I. Survey of Operative ProvisionsInvolving PIPP and/or PIPCAs reflected in Appendices I and II, there are over 250provisions in the Code and Treasury regulations thatwe have identified as potentially having significant taxconsequences depending upon whether a partner ownsa specified percentage of partnership profits and/orcapital. A fair number of these provisions (almost 100)listed in Appendix I expressly establish the requisiteownership in the partnership; far more (in excess of160, at last count, listed in Appendix II) incorporate the“relatedness” tests found in Code provisions such asCode Secs. 267(b) and 707(b)(1) to determine whethercertain transactions among a partner and another person have desirable or undesirable tax consequences.The listings in Appendices I and II identify the operative tax consequences arising from the measurementof PIPP or PIPC. As one might expect, some provisions involving PIPP and/or PIPC have substantialimpact as to transactions governed by Subchapter K,including termination of the partnership’s tax year33;disallowance of losses on sales involving a partnerand his partnership (or two partnerships);34 electionsout of Subchapter K,35 determining the tax year of thepartnership,36 and determining whether the broadscope of information on the new Schedule M-3 to theU.S. Form 1065 partnership tax return is required.37However, the references to PIPP and PIPC found inSubchapter K (and regulations thereunder) are shockingly few, i.e., we have identified less than 25.The measurement of PIPP and/or PIPC can havesubstantial impact outside of Subchapter K. Indeed,the vast majority of provisions that incorporate PIPP orPIPC measurement tests are found outside of Subchapter K—well over 200 at last count. Matters as diverse asconstructive ownership under the consolidated returnrules,38 REIT qualification,39 prohibited transactions,40taxes on excess business holdings of private foundations,41 qualified retirement plan matters involvingowner-employees,42 a partner’s apportionment of hisor his partner’s interest expense43 and computation ofthe percentage depletion allowance,43a to name a few,can be affected by PIPP and PIPC standards.44Perusal of Appendices I and II evidences how PIPP andPIPC measurement tests have become embedded in allcrevices of the Code. Your author and those commenting on this manuscript have uniformly been amazed tolearn of statutes and regulations that rarely if ever arisein one’s tax practice but which have implemented PIPPor PIPC standards, either explicitly or indirectly through

March 2007references to Code Secs. 267(b) and 707(b), which themselves incorporate PIPP and PIPC measurement rules.PIPP and PIPC measurement issues are not uniqueto federal income tax matters; they cut across manystates’ tax rules, which piggy back off the computationsof taxable income and loss under the Internal RevenueCode (with adjustments). In addition, tax matters notdirectly based on the Code, such as aggregation ofmultiple LLCs formed to avoid state fees45 and multistate apportionment of income, can raise issues of PIPPand PIPC at the state and local level. For example,draft amendments relating to regulations involving thetaxation of corporate partners under New York Tax LawArticle 9-A provide that under the aggregate methoda corporate partner’s proportionate part of partnershipassets and liabilities “generally is based on the partner’scapital interest in the partnership.” In commenting onthis, the New York State Bar Association Tax Sectionnoted that “ascertaining a partner’s overall capitalinterest in a partnership” (i.e., PIPC) is “not always aclear-cut exercise, as a partner’s capital interest percentage may change during the course of the tax yearfor any number of reasons,” and identified this as anarea that will likely require further study.46II. Partner’s Interest in PartnershipProfits: Measurement IssuesAs Part I and Appendices II and III illustrate, thereare numerous operative provisions that turn uponthe presence or absence of a specified percentageinterest of ownership of a partnership’s profits and/orcapital. In a situation involving partners who havethe identical proportionate interest in all items ofpartnership income, gain, loss and capital, this testis relatively straightforward. Example 1 provides thebenchmark (a “proportionate” or “straight-up” ownership of partnership interests in profits and capital)for purposes of launching our analysis.Before we can contemplate and calibrate the measurement of partners’ interests in “profits” and “capital,” wemust first come up with working definitions of thoseterms. Neither term is defined in the Code; if they were,some of the “fun to come” might never be encountered.The Code’s failure to define what constitutes either a capital or a profits interest in a partnership has been identifiedas being in part “a result of the elusive nature of the taxpartnership and the unusual accounting that often attendsthe partnership’s variable form and procedure.”47In absence of guidance in the Code, might referenceto state law applicable to partnerships provide usefulTAXES—THE TAX MAGAZINEguidance as to the meaning of the terms “profits interest” and “capital interest?”48 The states are not uniformin their partnership acts, but if Illinois statutes aretypical, state statutes are not particularly illuminating.The prior version of the Illinois Uniform PartnershipAct (relating to general partnerships) provided simplythat the property rights of a partner are (1) his rightsin specific partnership property; (2) his interest in thepartnership; and (3) his right to participate in the management.49 In turn, the old Act defined the “partner’sinterest in t

Identifying Partners' Interests in Profi ts and Capital: Uncertainties, Opportunities and Traps By Sheldon I. Banoff* 2007 S.I. Banoff Sheldon I. Banoff, P.C. is a Partner in the Chicago offi ce of Katten Muchin Rosenman LLP. The Problem 198 Overview 200 I. Survey of Operative Provisions Involving PIPP and/or PIPC 202 II.