The US Tax Court recently held that a foreign corporation is not subject to US income tax on the sale of a partnership interest where the partnership conducts a US business.  In so holding, the Tax Court rejected a 26 year old Revenue Ruling (Rev Rul 91-32) that reached the opposite conclusion.  For foreign investors in US businesses (that do not own real estate), this is an important decision.

A foreign investor who owns an interest in a partnership that holds US real estate may be subject to US federal income tax on a sale of that partnership interest under the Foreign Investment in Real Property Tax Act (“FIRPTA”).  For real estate, the IRS has indicated that gain derived by a foreign investor from the disposition of an interest in a partnership is subject to US tax only to the extent it is attributable to US real property interests owned by the partnership.  Regs §1.897-7T(a); Notice 88-72.

In Rev Rul 91-32, the IRS set forth its view that taxation on the sale of a partner’s interest in a partnership can go beyond mere real estate investment and apply to a sale of an interest in a partnership if the partnership is engaged in any US trade or business and has effectively connected income (“ECI”).  In this ruling, the IRS applied the “aggregate” theory of partnership taxation to justify looking through the partnership to its underlying assets in determining the source and character of the partner’s gain.

In July, 2017, the Tax Court issued its decision in Grecian Magnesite, Mining, Industrial & Shipping Co, SA v Comm’r, 149 TC 3The court declined to follow the IRS’s long standing position under Rev Rul 91-32, and held that a non-US person’s gain from the sale of its interest in a partnership engaged in a US trade or business is generally not subject to US federal income tax.

Grecian Magnesite Mining was a privately owned corporation organized under the laws of Greece that sells magnesia and magnesite to customers around the world.  From 2001 through 2008, it was a member of a US LLC that was engaged in the business of extracting, producing, and distributing magnesite in the US.  In 2008, Grecian Mining’s interest in the LLC was completely redeemed, resulting in treating the transaction as a sale or exchange of the membership interest.

The IRS asserted that the capital gain was properly treated as ECI since Grecian Mining was engaged in a trade or business as a result of its investment in the LLC.  Grecian Mining’s position was that the assets of the LLC do not control the character of the gain from a disposition of an interest in the LLC.  The gain should not have been treated as US-source gain and generally cannot be taxed in the US as ECI under the proposition that foreign-source income cannot be ECI except in limited instances that arise from the presence of US real estate under FIRPTA, which only applied to a small part of their gain.

Foreign investors should carefully review their US tax exposure on a sale of a partnership interest before they simply pay tax on their realized gain.  Grecian Magnesite calls into question the validity of Rev Rul 91-32 (though an appeal or non-acquiescence is possible).  A foreign investor should be able to rely on this case to avoid paying tax.  Moreover, foreign investors that have already paid income tax based upon Rev Rul 91-32 may wish to file a refund claim based on this decision.

On November 2, 2015, new partnership audit rules, repealing existing TEFRA rules, were enacted in Section 1101 of the Bipartisan Budget Act (“BBA”).  On August 15, 2016, Treasury published temporary regulations (TD 9780, 81 FR 51795).  The BBA will become effective on January 1, 2018, although partnerships can elect into the new rules retroactively to November 2, 2015.

The new rules have created quite the excitement among certain tax professionals because they shift both the audit and the collection of partnership taxes to the partnership.  Since 1982, partnership audits have been governed by the Tax Equity and Fiscal Responsibility Act (“TEFRA”).  Partnerships with 10 or fewer partners (with some exceptions, such as tiered partnerships) were exempt from TEFRA rules, and were governed by the default partner-level audit regime that existed prior to TEFRA.  What that means is, such small partnership audits were of the K-1’s of the partners who owned interest in the partnership in the years under audit, and correspondingly any adjustments were paid by those “review-year” partners.  For all other partnerships, TEFRA now required that the audit be conducted at the partnership level, which means adjustments were to be made to partnership income and deductions, with amended K-1’s then issued to the review-year partners.  The regime was now partnership-level audits with partner-level assessments.  In other words, those partners whose actions caused the additional tax were the ones responsible for paying it.

In addition, under TEFRA, over-100 partner partnerships could elect to have partnership-level assessments, that is, additional tax paid not by review-year partners but by current, “audit-year” partners (under the Electing Large Partnership Audit rules that were also repealed by the BBA).  This would result in a partnership-level audit and partnership-level assessment.

Unfortunately, over the years the IRS found partner-level collection difficult, and Congress has now responded by consolidating not only the audit but also the collection of tax at the partnership level.  In other words, the collection of tax is now made from audit-year partners, or partners having interest in the partnership in the year it is being audited.  This may be fine for small static family partnerships whose partners do not change, but it is not fine for large dynamic partnerships with ever-changing ownership interests.

A partnership representative (PR), rather than TEFRA’s Tax Matters Partner (TMP), now controls the conduct of the audit at the partnership level.  Neither the IRS nor the PR is statutorily obligated to give notice or audit rights to the other partners, a response to the IRS’ desire to streamline the audit without too many administrative hurdles.

An additional change in IRS’ favor is that there is no longer an automatic exemption from the consolidated audit for under-10 partnerships.  Now the burden is on the partnership to make an annual election out of the BBA rules under Section 6221 of the Internal Revenue Code.  The election can only be made by partnerships having fewer than 100 partners and those partners have to be individuals, C corporations, S corporations, tax-exempt entities or estates of partners.  When such an election out of the BBA is made and an audit arises that year, the partnership will essentially have a pre-TEFRA audit at the partner-level (as had been the case for under-10 partnerships under TEFRA).  The catch?  If the partnership has other partnerships or trusts as partners, it cannot elect out of the BBA consolidated rules no matter its size or preference.

If a partnership cannot elect out of the BBA rules because of its size or composition of its partners, it can still elect under Section 6226 to “push-out” payments of the additional tax assessed from the audit-year to the review-year partners.  The push-out election essentially replicates the TEFRA regime of partnership-level audit and partner-level payment.

Note that the rules are not clear on whether multi-tier partnerships can push-out payment to the ultimate partners.  The IRS has indicated the push-out will not automatically reach the ultimate partners unless the partnership can provide sufficient information about the tiers of income and loss allocations.

The new rules upend the status quo, affect countless existing partnership agreements, and create additional liability for purchasers of partnership interests.  At the same time, the new rules potentially create additional leverage for controlling partners.  All these considerations need to be reviewed on a case-by-case basis to amend existing agreements and draft robust new ones for the future under the new regime.