Partners Were at Risk During Some Periods, But Not Others

2. Whether the partnership agreements can be retroactively amended in order to avoid the effects of the at risk rules?

3. Whether the at risk elements at issue constitute affected items or partnership items?

4. Whether the change in each partner's tax liability can be assessed by computational adjustment?

2. Retroactive amendment of the partnership agreements is not effective to change the taxpayers' at risk status unless fraud is proven.

3. The at risk issue in this case -- whether the related party rule of section 465(b)(3) has been violated -- is an affected item that requires a partner level proceeding.

4. The at risk issue in this case is an affected item that requires a partner level proceeding and, therefore, cannot be assessed by computational adjustment.

[5] Your office wishes to demonstrate that the taxpayer partners are not at risk because the related party provision of I.R.C. section 465(b)(3) has been violated. In addition, * * * has stated to the Appeals Officer involved in this case that he will retroactively amend all investor partnership agreements so that his profits interest in each entity is reduced to whatever level is necessary to escape the effect of the at risk rules. He has asserted that any amendments will be effective as of the date of the original partnership agreement.

[6] Section 465(b)(2) provides that a taxpayer will be considered at risk with respect to amounts borrowed for use in an activity to the extent the taxpayer is personally liable on the debt or has pledged property other than property used in the activity as security. Section 465(b)(3) operates to exclude from the amount at risk those borrowed amounts if the taxpayer owes the debt to any person who is "related" within the meaning of that section. This discussion is divided into three sections because the portion of section 465(b)(3) that defines a related party was amended during the course of the tax years at issue.

Period I: Taxable Years Beginning After December 31, 1975 Through December 31, 1983

[7] On October 4, 1976, Public Law No. 94-455 added section 465 effective for losses attributable to amounts paid or incurred in taxable years beginning after December 31, 1975. As originally enacted, section 465(b)(3) reads as follows:

Period II: Taxable Years Beginning After December 31, 1983, Through September 27, 1985

[10] Public Law No. 98-369 amended section 465(b)(3) to read as follows effective for taxable years beginning after December 31, 1983:

[13] During Period II, the inquiry under section 465(b)(3)(B) is whether the taxpayer partners have borrowed from a person who is related to a person who has an interest in the activity. Thus, in this case, the question is whether the lender * * * is "related" to * * *, a person who has an interest in the activity (due to his * * * percent ownership interest in each of the investor partnerships).

[14] With respect to section 707(b)(1)(A), covering a partnership and a partner, we conclude that this test has not been violated because * * * was not a direct partner in * * * and the constructive ownership provisions of section 267(c) do not apply to him under these circumstances. See Treas. Reg. section 1.707-1(b)(3). With respect to section 707(b)(1)(B), covering two partnerships, we conclude that this test has not been violated because the 10 percent ownership test was not met. * * * is owned by * * * family -- his wife, sister and brothers. Thus, under the constructive ownership rule of section 267(c)(2), 100 percent ownership of * * * is attributed to * * * During Period II, however, * * * only owned * * * percent of each of the investor partnerships. Thus, * * * does not own, directly or indirectly, greater than a 10 percent ownership in the two partnerships, * * * and each of the investor partnerships. With respect to the section 52 common control rules, we agree with your conclusion that this section does not apply to these facts.

[15] With respect to section 267(b), we believe an argument can be made that the related party rule has been violated. Federal tax law embraces both the entity and aggregate concepts of partnerships. See McKee, Nelson & Whitmire, Federal Taxation of partnerships and Partners paragraph 1.02 (2d ed. 1990).

[16] The Tax Court has held that the aggregate theory is more appropriate in construing section 267(b). See Casel v. Commissioner, 79 T.C. 424 (1982). Treas. Reg. section 1.267(b)-1(b) provides that:

[18] In this case, the transaction is between a partnership in which * * * (person other than the taxpayer who has an interest in the activity) is a partner and another partnership in which * * * family members are partners. Treas. Reg. section 1.267(b)-1(b) refers to the relationship between a partnership and a person other than a partner in that partnership. In this case, the partnership is the lender partnership. The "person other than a partner" is * * * We believe the fact that * * * is also a partner in the borrowing investor partnerships should not be determinative of whether a prohibited relationship exists between the lender partnership and * * * We believe the lender partnership is viewed under section 267(b) as an aggregate of its individual partners -- partners who are related to * * * a person who has an interest in the activity. To allow otherwise would circumvent the section 267(b) rules by the mere formation of two partnerships comprised of related family members. Accordingly, although we believe there are some litigation hazards in taking this position, we believe the taxpayer partners are not at risk for amounts borrowed from * * * during Period II.

Period III: Taxable Years Ending After September 27, 1985 To The Present

[19] The only important change with respect to the relevant portions of the at risk rules occurring during this period was enacted by Pub. Law No. 99-514 which substituted "a person" for "a partner" in section 707(b)(1)(A). ² Based upon this amendment, we believe that the section 707(b)(1)(A) relationship test has been violated and that the taxpayers are not at risk during Period III. This is because * * * (the person referred to in section 707(b)(1)(A)) indirectly owned (through the family attribution rules of section 267(b)) a 100 percent capital and profits interest in * * * (the partnership referred to section 707(b)(1)(A)). In other words, * * * is considered a partner in * * * under the family attribution rules and, therefore, possesses greater than a 10 percent ownership interest in * * * Accordingly, the taxpayer partners are not at risk for amounts borrowed from * * * during Period III.

RETROACTIVE PARTNERSHIP AGREEMENT AMENDMENTS

[20] You have asked us to determine whether * * * retroactive amendment of the partnership agreements will be effective to alter each partner's at risk status. Section 465(a)(1) provides that any loss from an activity to which section 465 applies for a taxable year shall be allowed to the extent a taxpayer is at risk at the close of that taxable year. While a retroactive amendment may be effective for state law purposes, it cannot retroactively increase a taxpayer's amount at risk. Moreover, even if * * * were to argue that the amendments, rather than the original partnership agreements, more accurately reflect the facts in existence during the tax years at issue, he would have to prove fraud. The Ninth Circuit applies a "proof of fraud" rule in cases involving the tax consequences of agreements made by taxpayers. See Baxter v. Commissioner, 433 F.2d 757, 759 (9th Cir. 1970) (in the absence of a claim of fraud, a taxpayer cannot challenge the tax consequences of an agreement which he voluntarily and knowingly made); Rogers v. United States, 240 F.2d 501 (9th Cir. 1961) (third parties may question the resolutions of parties to a contract, but in the absence of fraud, it is not usually open to the bargainees to do so). See also Palo Alto Town & Country Village, Inc. v. Commissioner, 565 F.2d 1388, 1390 (9th Cir. 1977).

PARTNERSHIP ITEMS, AFFECTED ITEMS AND COMPUTATIONAL ADJUSTMENTS

[21] You asked us to consider whether the at risk determination in this case is a partnership or affected item. A "partnership item" is defined in I.R.C. section 6231(a)(3) as any item required to be taken into account for the partnership's taxable year under any provision of subtitle A to the extent regulations prescribed by the Secretary provide that such item is more appropriately determined at the partnership level than at the partner level. An "affected item" is defined in I.R.C. section 6231(a)(5) as any item to the extent such item is affected by a partnership item.

[22] The regulations take the position that, to the extent determinable at the partnership level, at risk is a partnership item; otherwise, it is an affected item. Under Treas. Reg. section 301.6231(a)(3)-1(a)(1)(vi)(C), amounts determinable at the partnership level with respect to partnership assets, investments, transactions, and operations necessary to enable the partnership to determine amounts at risk in any activity to which section 465 applies are partnership items. However, Temp. Treas. Reg. section 301.6231(a)(5)-1T(c) provides that the application of the at risk limitation under section 465 to a partner with respect to a loss flowing from a partnership is an affected item to the extent that it is not a partnership item.

[23] In Roberts v. Commissioner, 94 T.C. 853 (1990), the Tax Court held that the determination of the petitioners' amount at risk under section 465 depended upon the operation of certain third party side agreements, which was an issue more appropriately determinable at the partner level. In reaching this conclusion, the court relied on three factors: (1) determination of the section 465 issue would have no impact on either the returns of the other partner or the books and records of the partnership; (2) the partnership was not required to account for the side agreements entered into by the petitioners with third parties; and (3) the partnership was not a party to the side agreements. Therefore, the petitioners' amount at risk was held to be an affected item as described in Temp. Treas. Reg. section 301.6231(a)(5)-1T(a), and not a partnership item as described in Temp. Treas. Reg. section 301.6231(a)(3)-1. See also Dial, USA. Inc. v. Commissioner, 95 T.C. 1 (1990).

[24] Based upon the court's opinions in Roberts and Dial it appears that the hallmark of a partnership item is that the partnership is required to take the item into account for the partnership's taxable year under any provision of subtitle A. I.R.C. section 6231(a)(3). Thus, because the taxpayer's amount at risk based on the side agreements in Roberts was not required to be taken into account at the partnership level under any provision of subtitle A, the court concluded that the taxpayer's amount at risk was more appropriately classified as an affected items.

[25] In addition to finding that the taxpayer's amount at risk was an affected item, the court, in footnote five of Roberts, expressed doubt as to whether at risk could ever be a partnership item because the loss limitation imposed by section 465 applies only to individuals and to certain C corporations. Although the court declined to rule on the issue, the emphasis placed on the phrase "required to be taken into account under any provision of subtitle A" indicates that the court may take the position that because section 465 is not applicable at the partnership level there will never be an instance in which a section 465 item is required to be determined at the partnership level.

[26] In the wake of Roberts and Dial, we believe that it is not appropriate to treat a taxpayer's amount at risk as a partnership item. Nevertheless, the nature of the relevant inquiries regarding the at risk determination indicate that some legal and factual determinations that underlie the determination of partnership items (which are themselves partnership items) will contribute to the determination regarding at risk. Therefore, to the extent the components of at risk are partnership items, those items must be raised and disposed of in a TEFRA proceeding. An example of a component of at risk that may be a partnership item is a determination that a partnership borrowing is nonrecourse. Cf. Gemini Twin Fund III v. Commissioner, T.C. Memo. 1991-315 (where court held that partner's basis in notes to the partnership is not a partnership item, but the amount and character of the notes may be determined at the partnership level).

[27] In this case, the at risk determination is based upon whether there is a prohibited relationship under section 465(b)(3)(B). Because this subsection was amended during the course of the tax years at issue, each version must be analyzed separately.

[28] During Period I, the relationship under scrutiny is that between the taxpayer partner and the lender. I.R.C. sections 465(b)(3)(B); 267(b). We believe this determination is analogous to the third party side agreements in Roberts. The facts necessary to determine whether such a relationship exists is unique to each taxpayer and is not a determination common to all partners. Most importantly, it is not an item for which the partnership is required to account for under subtitle A. However, since we concluded that the taxpayers are at risk during period I, it is not necessary to raise at risk as an affected item level proceeding.

[29] During Periods II and III, the relationship under scrutiny is that between the lender and a person or partner (other than the taxpayer) who has an interest in the activity. Again, we believe such a determination is an affected item that requires a partner level proceeding. Whether a relationship exists between the lender and a third party who had an interest in the activity is not an item that the partnership must account for under subtitle A. In contrast, determinations such as whether the debt is genuine or whether it is recourse are made at the partnership level because the partnership should reflect such information in its books and records. Although the related party determination must be made separately at each partner level proceeding and will not be unique to each partner, we believe that, as a practical matter, once the issue is determined in favor of the government, it can be used as a basis for resolving the remaining partners' cases.

[30] Finally, you have asked us to consider whether each investor partner's tax liability may be determined by computational adjustment if the at risk issue is resolved at the partnership level in the government's favor. A computational adjustment is defined as the change in tax liability of a partner that properly reflects the treatment of a partnership item under subchapter C of chapter 63. I.R.C. section 6231(a)(6). Assessment of tax pursuant to a computational adjustment is specifically excluded from the deficiency procedures of subchapter B of chapter 63 by section 6230(a)(1). Thus, a computational adjustment is only appropriate where the effect of the partnership item on the partner's tax liability can be computed mathematically without further determinations at the partner level.

[31] In this case, we have concluded that Periods II and III are the periods in which the taxpayers' at risk status may be challenged. Whether the related part rule of section 465(b)(3)(B) has been violated is an affected item that requires a further partner level proceeding. Accordingly, assessment by computational adjustment is not appropriate.

[32] This document may include confidential information subject to the attorney-client and deliberative process privileges, and may also have been prepared in anticipation of litigation. This document should not be disclosed to anyone outside the IRS, including the taxpayer(s) involved, and its use within the IRS should be limited to those with a need to review the document in relation to the subject matter or case discussed herein.

[33] If there are any questions concerning this matter, please contact * * * at FTS 202-566-* * *

² Pub. Law No. 99-514 also incorporated by reference the section 168(e)(4)(D) relationship test into section 465(b)(3)(c) for property placed in service in tax years ending after September 27, 1985.