Transfer of partnership interest recast under substance-over-form doctrine

Tax Hot TopicsTax Hot Topics
In a chief counsel advice memorandum (CCA 201507018), the IRS concluded that a transaction involving a partner’s transfer of his partnership interest to a corporation through an organization seeking tax-exempt status should be recast under the substance-over-form doctrine as a direct transfer of the partnership interest by the partner to the corporation. The IRS explained that the tax-exempt organization was never a bona-fide partner because it was entitled only to distributions related to the transferred units in the partnership, while the transferor partner retained all other rights to the units in the partnership.

The partnership was formed as a limited liability company and treated as a partnership for U.S. federal income tax purposes. The partner was one of the founding members of the partnership and also served as its manager and tax matters partner. The interest in the partnership held by the partner had a high fair market value and a nominal basis.  

The partner formed a trust that was intended to be a qualified medical research organization described in Section 170(b)(1)(A)(iii). The partner claimed the trust owned all the shares of the corporation that were used to execute the transaction. However, the IRS found there had been “no meaningful change” in the partner’s control over the assets of the trust, and, thus, the trust should not be respected as a separate taxable entity. Therefore, the partner was treated as owning the assets of the trust, including all of the shares of the corporation.

The partner entered an agreement to assign some of his units in the partnership to the tax-exempt organization. On the following day, the partner executed another agreement in which the corporation purchased the interests in the partnership from the tax-exempt organization in exchange for a 20-year promissory note with some additional earn-out potential. The latter agreement also provided that the partnership “shall make a section 754 election with respect to both the original purchase of the interest as well as for any additional amounts paid by [the corporation]” under an earn-out.

In reporting this transaction, the partner claimed a charitable deduction under Section 170 on his individual tax return. The partnership increased the transferee-corporation’s share of the inside basis of the partnership’s assets under Section 743(b), allowing the corporation to take an amortization deduction. Additionally, the corporation claimed an interest deduction related to the promissory note it had issued in connection with the transaction. No party to the transaction reported any gain upon the transfers of the interest in the partnership.

The IRS said the substance of the transaction is that the tax-exempt organization never received an interest in partnership, because it never held any rights in the partnership other than the mere distribution rights for the one day it held the partnership interest. Thus, the partner wasn’t entitled to claim the charitable deduction under Section 170 and was treated as transferring the interest directly or indirectly through the trust to the corporation.  

Additionally, because the tax-exempt organization never held an interest or share of the partnership property, it never entered into a sale of the interest to the corporation that would entitle the partnership to adjust its basis under Section 743(b). Therefore, the corporation wasn’t entitled to the amortization deductions it had claimed on its tax return.

Grace Kim
+1 202 521 1590

Jose Carrasco
+1 202 521 1552

Tax professional standards statement
This document supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document, we encourage you to contact us or an independent tax professional to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this document is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.