Firm Raises Concerns With Application of Special Deduction to Partnerships, S Corporations

Dear Sirs:

We are writing to you on behalf of several clients to express our concerns with regard to the operation of the special deduction under section 179D(d)(4) of the Internal Revenue Code as it applies to partnerships and S corporations. The main problem posed by the application of section 179D(d)(4) to partnerships and S corporations is that these types of entities may have insufficient basis to enjoy the benefits of the deduction when the deduction is transferred from a governmental entity that is the owner of an energy efficient commercial building to the designer of the building. We suspect that this concern is widespread and affects the very essence of the operation of section 179D(d)(4). Unfortunately, this problem appears to have been overlooked by Congress in the drafting of section 179D(d)(4).

Following the issuance of Notice 2008-40, 2008-14 I.R.B. 725, we raised these concerns informally with representatives of the Service. While the Service personnel were sympathetic and are studying the problem, no immediate solution has been proposed. For that reason, we are bringing this problem to your attention.

We have given careful consideration to the problem posed by the application of section 179D(d)(4) to partnerships and S corporations and we believe that several alternative solutions to the problem may be available. In this letter we will explain the nature of the problem and the potential solutions to that problem.

To encourage the public sector to utilize these same energy efficient enhancements when a building will be owned by the federal, state, or local government, Congress included in section 179D a provision, section 179D(d)(4), that allows for the transfer of the section 179D deduction from a tax indifferent public owner of an energy efficient commercial building to the person responsible for designing the energy efficient enhancements installed in the building. According to section 179D(d)(4), the designer of the energy efficient enhancements is to be "treated as the taxpayer for purposes of [section 179D]."

The statute confers broad authority on the Treasury Department to "promulgate a regulation to allow the allocation of the deduction to the person primarily responsible for designing the property in lieu of the owner of such property." To date, the Treasury has not promulgated any regulations pursuant to section 179D. However, the Service has issued two explanatory notices -- Notice 2006-52 and Notice 2008-40 -- that provide substantial guidance as to the operation of section 179D, including the effect of the deduction transfer provision in section 179D(d)(4).

In this regard, section 3.06 of Notice 2008-40 contains two basic holdings that govern the transfer of the income tax deduction under section 179D(d)(4) from a governmental owner of a commercial building to the designer of the energy efficient enhancements to that building. First, the Notice provides that the designer to whom the deduction is transferred is not required to include any amount in gross income by reason of the transfer of the deduction under section 179D(d)(4). Second, the Notice provides that the designer to whom the deduction is transferred is not required to reduce future depreciation or other deductions by reason of the transfer of the section 179D deduction to the designer.

The first holding appears to be an attempt by the Service to avoid any negative tax consequences to the designer to whom a section 179D(d)(4) deduction is transferred. This holding is consistent with Congress' expressed intent to provide incentives for architects and engineers to market and produce energy efficient building designs for public buildings.

The second holding is also consistent with the broader purpose of the statutory provision. Language in section 179D(e) that applies to both deductions claimed by the owner of the building and by the designer of the building requires that the building owner reduce its basis in the building by the amount of the section 179D deduction. Notice 2008-40 interprets this requirement as being confined to the actual owner of the building, so that if the owner is a governmental entity and the deduction is transferred to the designer of the building, no other type of basis reduction, such as a reduction in the designer's basis in other property, would be required if the benefit of the section 179D deduction is transferred to the designer of the building.

Unfortunately, the rest of the mechanics of the deduction are not addressed in either the statute or the Service's notices. Accordingly, there is considerable uncertainty surrounding the application of the deduction transfer provision in section 179D(d)(4) to partnerships and S corporations. The problem with the application of section 179D(d)(4) to partnerships and S corporations is addressed separately below.

It is also important to recognize that actual distributions from a partnership to its partners do not affect the amount of the partnership's taxable income. Moreover, distributions of partnership assets do not affect the income of the partner receiving the distribution to the extent of the partner's basis in the partnership. Section 731(a)(1). This provision is intended to prevent double taxation of partnership income, once when the income is earned and again when the resulting income is distributed to the partners of the partnership. However, distributions in excess of a partner's adjusted basis in a partnership are taxed to the partner as capital gain.

The foregoing statutory scheme normally functions appropriately. However, when a partnership experiences an event that reduces its net income and therefore reduces its basis, without also reducing the aggregate basis of the partnership's assets, commonly referred to as a partnership's "inside basis," distortions may occur. Absent a transfer of a partner's interest to a third party,² such events are uncommon, because genuine expenditures that reduce a partnership's net income correspondingly reduce the outside and the inside basis of a partnership. In this way, parity is maintained and partnerships will rarely be placed in a position where the value of a distribution could exceed a partner's basis in the partnership.

However, the application of section 179D(d)(4) is one of those unusual situations where a partnership's inside basis and the outside basis of the partners may diverge. To understand why this may occur, the following simple examples are provided.

Example 1: ABC Partnership Owns Energy-Efficient Building

A partnership, ABC, is organized to construct and operate a commercial office building. Assume that partner G contributes $500X to the ABC partnership, which in turn plans to build a building for its own use which will cost $500X. If G's basis in the ABC partnership prior to the contribution was $0, G's basis in the ABC partnership would be increased to $500X after the $500X is contributed to the partnership.

Assume that the ABC partnership constructs the building with energy efficient features that qualifies for the section 179D deduction. Further assume that in the year the building is placed in service, the ABC partnership earns $100X of gross income and receives a $100X section 179D deduction, so that the ABC partnership's net taxable income is $0. The ABC partnership may distribute $100X to G without any additional resulting tax consequences. No tax consequences result to G by reason of the distribution because G has a basis in the ABC partnership equal to $500X prior to the distribution. After the distribution of $100X, G has a basis in the ABC partnership of $400.

Example 2: Government Owns Energy-Efficient Building, DEF Partnership is the Designer of the Building

Partner H forms a professional service partnership, DEF, which requires no capital and thus H has a $0 basis in the DEF partnership. Assume that the DEF partnership is hired by a local government agency to design an energy efficient commercial building that will be owned by the local government.

Because the DEF partnership does not own the building that it designs and therefore the DEF partnership expends none of its own funds to construct the building, assume that partner H continues to have a $0 basis in the DEF partnership. However, the local government pays the DEF partnership $500X for its design work and Partner H's share of that income is $100X. Thus, Partner H's basis in the DEF partnership would be increased to $100X.

Further assume that the owner of the building is entitled to a section 179D deduction for the energy efficient features in the building and the owner elects to assign the section 179D deduction to the DEF partnership pursuant to section 179D(d)(4). Because the DEF partnership's gross income is fully offset by the section 179D(d)(4) deduction, Partner H's share of the partnership's taxable income is $0. The basis that Partner H would otherwise have had as a result of the partnership's income is eliminated by the section 179D(d)(4) deduction. Thus, Partner H's basis in the DEF partnership is still $0.

Despite the fact that partner H's basis in the DEF partnership is $0, the DEF partnership nevertheless has sufficient assets to distribute the $100X in cash to Partner H. As a result, partner H will recognize a taxable gain on the full amount of the distribution.

The transfer of a deduction under section 179D(d)(4) to a partnership has the effect on the partners described in Example 2 because the partnership receives a deduction that reduces both partnership income and each partner's basis in the partnership by reason of the incurring of an expense that does not represent an out-of-pocket cost to the partnership. Thus, in this situation, the increase in the value of partnership assets resulting from the earning of income is not taken into account in computing the partner's basis in the partnership so as to enable the partnership to make as tax-free distribution of that income. In other words, the partner is taxed on income that is not otherwise taxable.

Though greatly simplified, Example 2 generally conforms to the structure and tax consequences for an architectural or designer partnership that receives a section 179D(d)(4) deduction. Because these professional service partnerships typically require minimal capital in order to operate, a partner in such a partnership typically has a relatively insignificant basis in the partnership. While an increase in a partner's basis will normally result from the partnership's earning of income during the year, most such firms distribute all of their net income to their partners by, or shortly after, their year end. After such distributions are taken into account, these partners will typically have a basis in their partnership close to zero.

Thus, partners in partnerships who are allocated a section 179D(d)(4) deduction would likely not receive a tax-free distribution of the tax saved by the application of section 179D(d)(4), because actual assets in the partnership prior to any distributions will exceed the partners' basis in the partnership by the amount of the Section 179D(d)(4) deduction. Accordingly, even though it was Congress' intent to provide a tax break to designers of energy efficient buildings, the actual operation of section 179D(d)(4) may result in no tax benefit to designers and architects operating though partnerships.

We submit that the foregoing results were not intended by Congress. We believe that there are several potential ways to avoid those adverse results. These alternatives are addressed in separate sections below.

1. Summary of Alternative Approaches

In order for a partnership to obtain the benefits intended by Congress in section 179D(d)(4), it is necessary for partners in that partnership to obtain a basis in their partnership that ignores the effect of the section 179D(d)(4). There are three plausible ways to accomplish that result.

One potential approach would be to treat partners in a designer partnership as having a basis in the energy efficient commercial building property in an amount equal to the section 179D(d)(4) deduction. In effect, this approach would place a designer of the building in the same position as the building's owner, but only for the purposes of the section 179D(d)(4) deduction.

Another possible approach would be to treat the designer's deduction as the equivalent of income that is exempt from taxation. Under section 705, a partner's basis in a partnership is increased by the partner's share of tax exempt income. This basis increase would offset the section 179D(d)(4) deduction and enable the partnership to make a tax free distribution of income.

A third approach would be to permit designers of energy-efficient buildings to use the alternative basis calculation method provided in section 705(b) whenever a section 179D deduction results in a partner's adjusted basis in a partnership that is lower than the partnership's basis in its own assets. The recalculated basis under this approach would track the increased basis that would result from the first two alternatives.

2. Transferring Basis from the Owner of the Property to Its Designer

As noted above, one alternative approach to eliminating the basis mismatch that might result under section 179D(d)(4) would be to treat the designer partnership to which the deduction is transferred as though the designer partnership were itself the owner of the energy efficient commercial building property for which the deduction is allowed. The authority for this treatment would be based on an expansive reading of the language in section 179D(d)(4).

Section 179D(d)(4) provides, in part, "[the designer] shall be treated as the taxpayer for purposes of this section." Although the scope of this provision is unclear, one could conclude that the provision unequivocally calls for equality in treatment of designers and non-designers for purposes of Section 179D. By transferring basis from the owner of the energy efficient commercial building to the designer of the building, the designer would be placed in the same position as the owner of the building for purposes of claiming the section 179D deduction.

While we acknowledge that the transfer of basis between the owner and the designer of the energy-efficient building under this approach treats a designer more favorably than the owner of the building because future depreciation of the building is not reduced in the case of the designer, the same result would occur if the designer of the building were an individual. While section 179D operates to recover the deduction granted by that section through reduced depreciation of the building in future years, there is no such depreciation offset for designers. Thus, the deemed transfer of basis from the owner of the building to the designer merely provides a mechanism for treating partnerships and individuals in an equivalent fashion.

3. Treating the Section 179D Deduction as the Equivalent of Tax-Exempt Income to the Partnership

A second potential approach to resolving the partnership basis mismatch created by section 179D would be to treat the amount of the section 179D(d)(4) deduction that is assigned to a partnership and allocated to its partners as being equivalent to income earned by the partnership that is exempt from tax. If the income otherwise shielded from tax by the section 179D(d)(4) deduction were in fact classified as income exempt from tax to the partnership to which the deduction is allocated, the partners of that partnership would be entitled to receive a basis increase under section 705 to the extent of the untaxed income. This treatment would then enable the partnership to distribute the accumulated income for the year to the partners without exposing them to additional tax.

As background for this alternative approach, it should be noted that section 705(a)(1)(B) provides that a partner's basis in a partnership is increased by the partner's share of tax exempt income earned by the partnership. Since section 705(a)(1)(A) increases a partner's basis by his or her share of a partnership's taxable income, this provision in section 705(a)(1)(A) is designed to prevent a partnership's nontaxable income from triggering additional tax to a partner when that nontaxable income is distributed to the partner.

In enacting section 705(a)(1)(B), Congress recognized that without this special relief, a partnership's tax exempt income might be converted into taxable gain to a partner upon the distribution of the tax exempt income by reason of the operation of the general partnership basis rules. Thus, in concept, the problem addressed by section 705(a)(1)(B) is virtually identical to that posed by section 179D(d)(4). The only difference being that section 705(a)(1)(B) focuses on the receipt of tax exempt income, whereas section 179D(d)(4) involves an artificial deduction.

Accordingly, the issue is posed whether the meaning of "income exempt from tax" that is used in section 705(a)(1)(B) is broad enough to cover income that is shielded from taxation by the deduction in section 179D(d)(4). While we could not locate any precedents involving the application of section 705(a)(1)(B) to artificial deductions, that is hardly surprising in light of the highly unusual approach adopted in section 179D(d)(4).

However, in other circumstances, the Service has broadly interpreted section 705(a)(1)(B) to effectuate the purposes of Subchapter K. A good example of the Service's broad interpretation of section 705(a)(1)(B) is presented in Rev. Rul. 96-10, 1996-1 C.B. 138. The situation addressed in Rev. Rul. 96-10 involves a partnership that sold property to another related partnership, thus creating a loss that was disallowed under the provisions of section 707(b)(1).³ The partnership purchasing the loss property then sold the property to a third party at a gain equal to the first partnership's loss. Because under section 707(b)(1) a partnership only recognizes gain in excess of previously disallowed losses by a related party seller, section 707(b)(1) provides that no gain was to be recognized by the second partnership upon the resale of the original property.

Nonetheless, without an increase in basis equal to the unrecognized gain, the partners in the second partnership could have been required to recognize the untaxed gain upon a distribution or termination of their interest in the second partnership. Accordingly, the Service ruled in Rev. Rul. 96-10 that the second partnership's unrecognized gain was to be treated as income exempt from tax for the purposes of calculating a partner's basis under section 705(a)(1)(B).

Rev. Rul. 96-10 makes it clear that the treatment of unrecognized gain as income exempt from tax is motivated by a desire to reconcile contrary Subchapter K provisions. According to the Service:

Using the foregoing analysis, the Service adopted the view that section 705(a)(1)(B) is intended to cover situations where income is not strictly speaking tax exempt, but instead is simply not recognized under any provision of the Code. This interpretation is entirely consistent with treating the income shielded by section 179D(d)(4) as income exempt from tax for purposes of section 705(a)(1)(B).

The logic underlying the holding in Rev. Rul. 96-10 is similar to that employed by Congress in dealing with a similar problem in the case of a credit and grant provision found in the section 48 of the Code. Under sections 48(a)(2) and 48(a)(5)(A), a taxpayer may claim an energy credit of 10% or 30% of the basis of certain energy property placed in service, depending on the type of property. Generally, section 50(c)(3) provides that the basis of energy property is reduced by 50% of the energy credit. In lieu of claiming the credit, however, taxpayers may elect to apply for a grant under section 1603 of the American Recovery and Reinvestment Act of 2009 (ARRA). The amount of the grant is the same as the amount of the credit. Grants are available for certain types of energy property (see ARRA Section 1603(d)) placed in service during 2009 and 2010 (or thereafter, under certain circumstances).

Partners' basis in a partnership receiving the grant would be increased by the full amount of the grant. However, section 50(c)(3) requires that the basis of the property acquired with the grant be reduced by an amount equal to half the amount of the grant. Taken together, partnership basis is increased by half the amount of the grant, giving rise to a potential tax free distribution of the amount of the grant to partners. However, if the grant were not classified as income exempt from tax for purposes of section 705(a)(1)(B), the amount of the grant could be subject to possible gain upon distribution or termination of a partner's interest in the partnership. Several commentators have addressed this issue and concluded that section 705(a)(1)(B) would be applicable in this case.⁴

The basis problem addressed in Rev. Rul. 96-10 and ARRA Section 1603 resemble the basis mismatch caused by Section 179D(d)(4). Accordingly, the Treasury and Service should interpret section 179D(d)(4) in a manner consistent with those predents and treats the deduction under section 179D(d)(4) as equivalent to the receipt by a partnership of tax exempt income.

4. Reliance on the Alternative Basis Calculation Rule of Section 705(b)

A third possible approach to addressing the partnership basis mismatch caused by section 179D(d)(4) would be to permit partners to use the alternative basis calculation rules in section 705(b). Section 705(b) instructs the Treasury to prescribe regulations that allow the adjusted basis of a partner's partnership interest to be determined with reference to the partnership's basis in its assets allocated to such partner. Absent any other reason for a mismatch between a partner's outside basis and his or her share of the partnership's inside basis in its own assets, the application of section 705(b) in this circumstance could rectify the mismatch in basis caused by the application of section 179D(d)(4).

The Treasury implemented the Congressional mandate and issued regulations under section 705(b). Treas. Reg. § 1.705-1(b) provides that the alternative basis calculation method may be used when either: (1) a partner cannot "practicably apply the general rule" or (2) "if, in the opinion of the Commissioner," it is reasonable to conclude that the result produced will not vary substantially from the result obtainable under the general rule. While the application of this regulation is generally limited to situations where the calculation of a partner's basis in a partnership is administratively complex, in our view, the provision is broad enough to support its application to the section 179D(d)(4).

The effect of the entity's debt on the calculation of the owner's basis in the entity is one area where Subchapters K and S are not treated the same. Under Subchapter K, a partner's basis in a partnership is generally increased by his or her share of a partnership's liabilities, as defined by section 752 and the regulations thereunder. Although the precise rules differentiating between liabilities that increase a partner's basis in a partnership from those that do not are complex, the general approach to determining basis is inclusive. Partnership obligations to partners, as well as to third parties, generally are considered liabilities within the meaning of section 752 and such liabilities increase a partner's basis in the partnership.

In contrast, only obligations of an S corporation to its shareholders increase a shareholder's basis in an S corporation. According to section 1366(d)(1), shareholders obtain a basis in their S corporation if direct loans are made to the S corporation. In contrast, obligations to third parties guaranteed by a shareholder do not increase a shareholder's basis in the S corporation. Leavitt Est v. Comm'r, 90 T.C. 206 (1989) aff'd, 875 F.2d 470 (4th Cir. 1989), cert. denied, 493 U.S. 958 (1989) (denying shareholders an increase in basis for a loan issued by a third party to a heavily indebted S corporation solely on the strength of the shareholders' guarantee).

As a result, it will be more difficult for a shareholder of an S corporation to have sufficient basis in the S corporation to support a distribution after claiming a section 179D(d)(4) deduction than it will be for a partner of a partnership in a similar business. Thus, shareholders in an S corporation are even more likely to face the problem of insufficient basis to claim the full tax benefit conferred by section 179D(d)(4).

The strong similarities between Subchapter S and Subchapter K argue for applying either of the first two solutions outlined above for partnerships to S corporations. These two approaches -- (1) transferring basis in the energy efficient commercial building property to the designer of the building; or (2) classifying shielded income as income exempt from tax -- would operate in exactly the same manner for S corporation shareholders as for partners of a partnership. The third approach discussed above -- applying section 705(b) -- would not be applicable to S corporation shareholders, as there is no similar provision in Subchapter S.

After you have had an opportunity to consider the alternatives presented herein, we would be pleased to meet with you to discuss the possibility of applying one of these alternatives to partnerships and S corporations.

² A partner who enters a partnership through the purchase of another partner's interest will frequently posses an outside basis that is different from its share of the inside basis. Ordinarily, no adjustment is made to address this difference. A partnership may, however, make a Section 754 election to allow the partner to adjust bases of partnership assets to match the partner's outside basis. Section 743 also requires an adjustment to the inside basis when a substantial built-in loss exists at the time a partnership interest is transferred. A substantial built-in loss exists if the partnership's adjusted basis in its property is more than $250,000 greater than the fair market value of the partnership's property.

³ Section 707(b)(1) disallows deductions for losses from sales or exchanges of property between a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest or the profit interest in the partnership or between two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests.

⁴See McKee, Nelson, and Whitmire, Federal Taxation of Partnerships & Partners, Fourth Edition (Thomson Reuters/WG&L, 2009), ¶ 6.02[3] [a]. Section 48(d)(3)(A) provides that the energy grant "shall not be includible in the gross income of the taxpayer." McKee, Nelson, and Whitmire interpret this to mean that the grant is income exempt from tax. This conclusion is shared by Neil D. Kimmelfield, Grants in Lieu of Tax Credits Under the Recovery Act -- A Square Peg in a Round Hole, Journal of Taxation, January 2010.