The stated legislative purpose behind this statute permitting taxpayers to be awarded litigation costs was two-fold:  To “deter abusive actions and overreaching by the Internal Revenue Service and “to enable individual taxpayers to vindicate their rights regardless of their economic circumstances.”

Not all “prevailing parties” are eligible to receive fees under the statute, however.  To qualify for a fee award, the taxpayer must be (i) an individual whose net worth did not exceed $2,000,000 at the time the civil action was filed, or (ii) any owner of an unincorporated business, or any partnership, corporation, association, unit of local government, or organization, the net worth of which did not exceed $7,000,000 at the time the civil action was filed, and which did not have more than 500 employees at the time the civil action was filed.

In addition, the prevailing taxpayer must have “exhausted the administrative remedies available to [him] within the Internal Revenue Service,” and cannot have “unreasonably protracted” the proceedings that generated the attorneys’ fees.

Although subject to significant limitations, the statute permitting taxpayers to be awarded litigation costs can be effectively used to recoup expenses incurred in fighting unreasonable positions taken by the Internal Revenue Service, and as added leverage in settlement negotiations with the Internal Revenue Service.

One of the primary reasons why computation of a partner’s interest in a partnership and its assets often confuses partners and their advisers alike is that two different, contemporaneously operating measurements exist to value the interest.

Specifically, a partner in a partnership (or a member of a limited liability company treated as a partnership for tax purpose) has both (1) an “outside basis,” measuring the adjusted basis of the partnership interest he holds, and (2) a “capital account,” reflecting his equity investment in the partnership.[1]

A partner’s capital account is substantially different from his outside basis in the partnership interest, and the two concepts should not be confused.  The following chart summarizes the principal similarities and differences between a partner’s outside basis and capital account:

In handling civil and criminal tax cases, I am often asked whether, and to what extent, an accountant-client confidentiality or work-product privilege exists.  The applicability of such a privilege is often of pivotal importance.  It can determine whether an accountant may lawfully be subpoenaed to testify in court against his client, or whether the accountant’s memoranda, e-mail or work papers can be used by the state or federal government against the client.

In 1998, Congress enacted certain accountant-client confidentiality protections, now codified under Section 7525 of the Internal Revenue Code.  Under Section 7525, the attorney-client privilege was made to extend to communication between a taxpayer and any federally authorized tax practitioner with respect to tax advice, to the extent the communication would be privileged if it were between a taxpayer and an attorney.

Superficially, the accountant confidentiality privilege of Section 7525 appears to provide sweeping protection to discussions between taxpayers and their accountants.  The privilege’s limits and exceptions, however, tend to render the privilege inapplicable just when it matters.

It should first be noted that the privilege generally applies to an accountant only if the accountant is a certified public accountant or registered as an enrolled agent with the Internal Revenue Service.

The privilege may only be asserted in a non-criminal tax matter before the Internal Revenue Service or in a non-criminal tax proceeding in federal court brought by or against the United States.  The privilege may not be asserted to prevent the disclosure of information to any regulatory body other than the Internal Revenue Service (such as the Securities and Exchange Commission), including in an administrative or court proceeding.  Thus, the privilege exists only for civil tax disputes with the Internal Revenue Service or the United States.  It arguably does not apply in a criminal tax matter or non-tax proceeding even if the subject communication originated in the context of a tax-related civil matter or proceeding.

Additionally, the privilege does not apply to any written communications in connection with the promotion of a tax shelter.

“The privilege’s limits and exceptions . . . tend to render the privilege inapplicable just when it matters.”

Perhaps most importantly, the privilege only applies to communications regarding tax advice.  “Tax advice” may include backup research or memoranda reflecting mental impressions of the accountant.  Yet no actual work-product privilege exists for accountants, so work papers, memoranda and the like will generally not be protected.

Furthermore, communications regarding return preparation are not considered to constitute tax advice.  An accountant arguably is able to make both privileged and non-privileged communications to a client.  In practice, however, the Internal Revenue Service and Department of Justice generally take the litigation position that no communications between an accountant and client are privileged if the communications relate to a tax year for which the accountant prepared a return.

Also, it is very important to note that unlike the attorney-client privilege, the accountant-client privilege can never be used to prevent disclosure of the underlying facts of which the accountant is aware.

Due to the numerous ways in which the applicability of accountant-client privilege under Section 7525 can be challenged, non-tax return-related documents (such as memos and work papers) should continue to be prepared by accountants only under the protection of a “Kovel” letter.  A Kovel letter (named after a Second Circuit Court of Appeals case by such name) is a letter by which an attorney may extend the protection of the attorney-client privilege to an accountant’s work, provided that the accountant is retained to assist in providing legal services to the attorney’s client. In order to extend the attorney-client privilege to a non-testifying accountant, the accountant’s services must be necessary for the attorney’s rendering of legal advice.

If you have any questions about whether your accountant’s work or work-product is privileged or exempt from disclosure, or needs to be, please feel free to call us.

It is not an uncommon occurrence for taxpayers, even those well-experienced with federal tax audits, to become discomposed upon receipt of an Internal Revenue Service summons.  Understandably, a summons by the IRS tends to cause taxpayers to fear the worst – usually, a criminal tax investigation.

In reality, summonses are used by the IRS for a variety of reasons, and they are not always employed as part of a criminal tax investigation.

Types of Summonses

The Internal Revenue Code provides statutory authority for the IRS to issue summonses in order to ascertain the correctness of any tax return, make a substitute return where none has been filed, or determine the liability of any person for any internal revenue tax.  Section 7602 of the Internal Revenue Code specifically authorizes the IRS to issue three types of summonses: (1) a summons for books, records and other documentary data; (2) a summons for the testimony of the person concerned; and (3) a summons for the testimony of third parties.[1] A summons to a third party recordkeeper can be served by certified or registered mail. Service of a summons on any other third party, or on the taxpayer himself, must be done by hand or by leaving the summons at the taxpayer’s home or business (depending on the nature of the tax issue).

Enforcement of Summons

There are two significant popular misconceptions about IRS summonses.  In the first place, the IRS is not required to have probable cause in order to issue a summons.

Second, IRS summonses are not actually self-enforcing.  In other words, for the IRS to enforce a summons, it must first seek an order from a Federal District Court of competent jurisdiction.

To secure judicial enforcement of a summons, the U.S. Supreme Court requires the IRS to establish that (1) the investigation will be conducted pursuant to a legitimate purpose; (2) the inquiry may be relevant to that purpose; (3) the information sought is not already in the IRS’ possession; and (4) the administrative steps required under the Internal Revenue Code have been followed.

Before issuing an enforcement order, a District Court will then generally order the taxpayer to appear and show cause as to why compliance should not be ordered.  Failure to comply with an order to show cause will usually result in a contempt order.  If the District Court does order the summons enforced, the taxpayer will have the right to appeal such decision to the appropriate Circuit Court of Appeals.

Complying with a Summons

Although an attorney can and should accompany the summoned person, the attorney is not permitted to appear instead of the person.  If the taxpayer desires to claim a privilege (such as attorney-client privilege, or the privilege against self-incrimination), he or she must still appear but can claim the privilege in response to each question or request for production of documents.

Fortunately, no summons can be issued by the IRS with respect to any person if there is any “Justice Department referral” in effect with respect to such person.  A “Justice Department referral” means any recommendation by the IRS to the Attorney General of a grand jury investigation of, or the criminal prosecution of, such person for any offense connected with the administration or enforcement of federal tax law.  It also includes most situations involving a request by the Justice Department to the IRS for the disclosure of any tax return or return information relating to such person.

Additionally, while the IRS can request that a summoned taxpayer bring records, the IRS does not have the authority to require a taxpayer to create documents or prepare returns not in existence on the date that the summons was issued.

Contesting the Issuance or Enforcement of a Summons

A summons can be contested on substantive grounds, technical or procedural grounds, or on Constitutional or other privilege grounds.  Substantive defenses typically include arguments over whether a particular matter is part of a legitimate investigation, or whether the persons or documents summoned are relevant to an IRS investigation.

Technical or procedural defenses usually are not worth litigating because the IRS can simply issue another summons (that has been corrected for its technical or procedural errors) by the time that the defense is argued in an enforcement proceeding in Federal District Court.

A taxpayer who has received a summons may also be able to assert privileges under the Fourth and Fifth Amendments to prevent the summons from being enforced.  These rights and privileges are asserted where the information sought is incriminating and protected from disclosure under the Fifth Amendment to the Constitution, or where the summons itself is so broad that it constitutes an unreasonable search under the Fourth Amendment to the Constitution.

In most cases, however, if a taxpayer does have grounds to contest the issuance or enforcement of a summons, a compromise can be reached with the IRS.  Such compromises are beneficial to the extent that they eliminate the need for costly litigation or hearings in Federal District Court.

Going Forward

It should be noted that a number of other defenses and challenges to IRS summons not set forth above are possible. It is extremely important to consult with a tax attorney immediately upon receipt of an IRS summons in order to protect one’s rights, privileges and defenses to the summons.  Failure to respond to a summons can waive otherwise valid defenses to the issuance and enforcement of the summons.

A Minimum Gain Chargeback provision is required as a matter of law to be included in partnership agreements in order for non-recourse deductions to be allocated to the partners in any manner other than strictly according to the partners’ overall percentage capital interests in the partnership.

In brief, Minimum Gain is created as a partnership claims deductions (typically depreciation) that decrease the partnership’s book basis in the property below the balance of the non-recourse debt on the property.

Minimum Gain Chargeback is an allocation of gain, for tax purposes only, to partners or members who have received the benefit of prior non-recourse deductions or who have received distributions of partnership proceeds attributable to non-recourse borrowing.

These deductions or distributions are “charged back” to such partners or members upon either (a) a disposition of the underlying property(ies) subject to the non-recourse debt, or (b) a change in the character of the non-recourse debt (most commonly by a conversion to recourse debt, or by forgiveness of the debt).

A partnership’s minimum gain is generally equal to the excess of a partnership’s non-recourse liabilities over the adjusted tax basis of the property securing the debt. For example, if a partnership purchased a property for $100,000, took $50,000 in depreciation deductions, and then refinanced the property with $150,000 of non-recourse debt because the fair market value of the property was now $200,000, the Minimum Gain would be $100,000 ($150,000 minus the property’s adjusted basis (purchase price minus depreciation)).

Several important exceptions to the mandatory minimum gain chargeback do exist. In particular, a partner is not subject to a Minimum Gain chargeback to the extent that his share of the net decrease in partnership Minimum Gain is attributable to the conversion of a non-recourse liability to a recourse liability (e.g., as a result of a guarantee or refinancing). Likewise, a partner is not subject to the chargeback to the extent that he contributes capital to the partnership to repay a non-recourse liability. And a partnership may also request a waiver of the chargeback requirement if it would lead to certain unintended economic distortions.

Minimum Gain Chargeback provisions are by necessity complex, because of the need to anticipate a variety of situations in which the amount of phantom gain can change or the partners’ shares of the gain can change.

If you have questions regarding the operation or allocation of recourse or non-recourse deductions from a partnership or limited liability company, please feel free to call our office.

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¹ For tax purposes, a partnership liability is deemed non-recourse to the extent that no partner bears the economic risk of loss for that liability, even though the partnership itself is liable.

² Where differences exist between book value and basis for contributed property, minimum gain is calculated by reference to the book value of an asset, rather than to its tax basis.

However, not all tax assessments are subject to the deficiency procedures. Deficiency procedures apply only to those assessments that fit within the relatively narrow, technical definition of a “deficiency.”

The term “deficiency” is defined as the excess of the correct tax over the amount shown as due on the return, whether for income, estate, or gift tax, as well as certain excise taxes on transactions involving foundations and pension plans. The amount a taxpayer shows as due on its return is not considered a deficiency, so an assessment of the amount does not require a notice of deficiency.

Even if a tax adjustment would ordinarily be subject to the deficiency procedures, the IRS is not always required to deliver a statutory notice of deficiency to a taxpayer, such as where:

(1) A mathematical or clerical error appears on the return and is the basis for adjustment;

(2) A tentative carryback adjustment was refunded in excess of the proper assessment attributable to the carryback year;

(3) There is a jeopardy assessment (imposed when the IRS believes that the assessment or collection of a deficiency be jeopardized by delay); or

(4) The taxpayer has voluntarily waived its right to receive the statutory notice of deficiency by executing a written waiver (IRS Form 870).

The Internal Revenue Service has issued proposed Treasury Regulations that would provide guidance for determining how a partner’s distributive share of partnership items should take into account the varying interests of the partners in any year in which there is a change in a partner’s interest in the partnership.

In general, a partner separately takes into account his distributive share of partnership items of income, gain, loss, deduction, or credit. Each partner reports his distributive share of the partnership income, deductions and other items (including guaranteed salary and interest payments) for a partnership tax year on his return for his tax year within or with which the partnership tax year ends.

Under Section 706(d) of the Internal Revenue Code (the “Code”), generally speaking, if there is a change in a partner’s interest in the partnership during the partnership’s tax year, each partner’s distributive share of any partnership item of income, gain, loss, deduction or credit for such tax year is determined by using any method prescribed by Treasury Regulations which takes into account the varying interests of the partners in the partnership during the year. This is referred to as the “varying interests rule.”

Proposed Treasury Regulations Section 1.706-4 would contain numerous rules including the following:

1. If a partner’s interest changes during the partnership’s tax year, the partnership would have to determine the partner’s distributive share using the interim closing method. However, the partnership by agreement of the partners could use the proration method.

2. A partnership generally would have to take into account any variation in the partners’ interests in the partnership during the tax year by determining the distributive share of partnership items under Section 702(a) of the Code for each segment of that tax year using an interim closing of the books method and by allocating those items among the partners in accordance with their respective partnership interests during that segment.

3. For each partner whose interest changes in the tax year, the partnership would have to maintain segments to account for such changes. The partnership would have to determine the items for each segment of the tax year created by the variation event for a partner in accordance with the partnership’s method of accounting used for its entire tax year. For purposes of the Proposed Treasury Regulations’ interim closing and proration methods, a special accounting rule would have to be used to account for certain items.

4. A partnership using the proration method would have to allocate extraordinary items (as defined in the Proposed Treasury Regulations) among the partners in proportion to their interests at the beginning of the day on which they are taken into account.

5. A partnership using the interim closing method could use either a calendar day convention or a semi-monthly convention. A partnership using the proration method could use only the calendar day convention.

6. The varying interests rule would not preclude changes in the allocations among contemporaneous partners resulting from amendments to the partnership agreement made no later than the due date of the partnership return for the tax year (excluding extensions).

7. Service partnerships could allocate items relating to the provision of services among the partners whose interests vary during the year using any reasonable method to account for such changes.

8. A deemed disposition of the partner’s interest under Treasury Regulations Section 1.1502-76(b)(2)(vi) (relating to corporate partners that become or cease to be members of a consolidated group), Treasury Regulations Section 1.1502-76(b)(2)(vi) (relating to the termination of the S election of an S corporation partner), or Treasury Regulations Section 1.1502-76(b)(2)(vi) (regarding an election to terminate the tax year of an S corporation partner), would be treated as a disposition of the partner’s entire interest in the partnership.

If you have any questions regarding the foregoing, please feel free to call our office.

If you are expecting a loss for the tax year from your interest in a partnership, but do not currently have enough basis in your partnership interest to allow a full deduction, several solutions exist.

In general, a partner cannot take a loss on his or her individual tax return greater than his or her basis in the partnership interest as of the last day of the partnership’s tax year.

A partner’s basis in the partnership interest is generally equal to the amount of cash contributed to the partnership by the partner, plus the partner’s basis in any property contributed to the partnership, plus the partner’s share of partnership debt. (Contributed property that is subject to debt involves more complex rules beyond the scope of this article.) Basis is then increased by the partner’s share of any partnership income or gains and any subsequent contributions made to the partnership. Basis is generally decreased (a) by cash distributions received by the partner from the partnership, (b) by the basis of property distributed to the partner, and (c) by the partner’s share of deductible losses.

Accordingly, if you anticipate that you will be allocated losses from the partnership that will be non-deductible because they exceed your basis, four basic approaches can be considered to increase your basis before the end of the partnership’s tax year:

1. Accelerate planned contributions to the partnership;

2. Defer distributions from the partnership until your basis is increased in the following year by your allocable share of income or gains;

3. Have the partnership increase its debt load; or

4. Increase the proportion of partnership debt that is allocable to you for tax purposes, without increasing your recourse liability.

It should be noted that if the passive loss rules apply to you, or you have amounts that are not considered to be at-risk in the partnership, different solutions will be required.

If you have any questions about how the foregoing strategies can be applied to your situation, please feel free to call us at (239) 354-4300.

The disclosure to be required by the Service will have to include a description of each uncertain tax position in sufficient detail so that the Service can determine the nature of the issue. To be sufficient, the description will have to include disclosure of:

1. The section(s) of the Internal Revenue Code potentially implicated by the position;

2. The tax year or years to which the position relates;

3. Whether the position involves an item of income, gain, loss, deduction or credit against tax;

4. Whether the position involves a permanent inclusion or exclusion of any item, the timing of that item, or both;

5. Whether the position involves a determination of the value of any property or right; and

6. Whether the position involves a computation of basis.

In addition, the IRS will require a taxpayer to specify for each uncertain tax position the entire amount of U.S. federal income tax that would be due if the position were disallowed in its entirety on audit.

The Service is currently in the process of finalizing its requirements for disclosure, so the ultimate contours of the requirement remain unclear. Due to the sweeping nature of their application, the new requirements, once finalized, will likely be codified in the form of Temporary Treasury Regulations.

Currently unclear are several matters that will affect how wide-ranging an effect these new requirements will have. In particular, it is unclear how, under the new requirements, assets will have to be valued for purposes of the requirements’ application. Also, it is unclear how an “uncertain tax position” is to be defined, and what the penalties will be for failure to make disclosure.

There is little doubt, however, that the new requirements will increase scrutiny of small businesses, including family partnerships formed for estate planning purposes.

In general, a claim for credit or refund of a tax paid by a tax return must be filed within the later of (a) three years from the date that the return was timely or untimely filed (or the due date if filed earlier), or (b) two years from the date the tax was paid. If the required tax return was not filed, the claim for refund must be filed within two years from when the tax was paid. Certain exceptions do exist. For example, the claim period is seven years for an overpayment resulting from a bad debt or from worthless securities. And for an overpayment resulting from the payment or accrual of foreign taxes for which a foreign tax credit is allowed, the claim period is ten years.

Surprising to many taxpayers is the fact that there exists no provision in the Internal Revenue Code or Treasury Regulations requiring the Internal Revenue Service to accept an amended return in place of a previously filed original return. There accordingly is no deadline for the filing of an amended return.

The Service will generally recognize amended returns filed after the return due date for the purpose of correcting clear errors or plain mistakes in original returns. But the acceptance or rejection of an amended return is in fact a matter that is within the Service’s administrative discretion, and the Service’s refusal to accept an amended return may be reviewed by a court only for abuse of discretion.

From the taxpayer’s perspective, there is more than a tincture of unfairness to the fact that the Service is not required by law to accept an amended return. On the other hand, a broad requirement for the Service to accept amended returns could be disruptive of tax administration because a taxpayer could disregard his original tax return and automatically change an assessment by filing an amended return in his favor after the expiration of time for filing the original return.

If you have questions about the filing of a refund claim or amendment to a return, please feel free to call our office.

An interest in a partnership is considered a capital asset. Loss upon sale of a partnership interest is therefore generally treated as a capital loss.

But can the sale of a partnership interest be restructured to permit ordinary losses? With inventive planning, it can – particularly for real estate and other “asset-rich” partnerships.

Rather than a having a partner sell his interest in the partnership to a third party, the partnership can make an “in-kind” liquidating distribution to the departing partner of an undivided interest in partnership property (such as real estate) commensurate with the value of that partner’s partnership interest.

The departing partner then is able to sell the undivided interest in the partnership property to the third party. Assuming that the partnership property (such as real estate) is considered a Section 1231 asset (property used in a trade or business), the capital loss can then effectively be converted into an ordinary loss.

An established, more sophisticated (and generally more practical) variation of this method entails having the partnership itself sell an interest in the partnership property to the purchaser equal in value to the departing partner’s interest. Rather than the departing partner selling the partnership interest to a third party, the partnership may sell an equivalent undivided interest in its assets (such as real estate) to the third party, taking a leaseback of the undivided interest.

Proceeds of the partnership’s sale are then distributed to the departing partner in liquidation of his interest, and the partnership’s ordinary loss on the sale can be directly allocated to the selling partner.

To secure ordinary loss treatment, certain precautionary structural measures are crucial to prevent application of the judicially-articulated anti-abuse “step transaction” and “substance over form” doctrines (also addressed under Section 707(a)(2)(B)), which could otherwise fuse or re-cast the transactions. Additionally, any special allocations of the ordinary loss must be made in a manner that complies with the requirements for “substantial economic effect” under Section 1.704-1(b)(2) of the Treasury Regulations.

“Salary or wages,” for these purposes, generally includes compensation for services paid in the form of fees, commissions, bonuses and similar items. The levy is deemed to attach to both salary or wages earned but not yet paid at the time of levy, advances on salary or wages made subsequent to the date of the levy, and salary or wages earned and becoming payable subsequent to the date of levy, until the levy is released.

Similarly, whenever any property or rights to property upon which a levy has been made are not sufficient to satisfy the federal tax lien for which the levy is made, the Internal Revenue Service is authorized to thereafter, as often as it may deem necessary, proceed to levy on any other property or rights to property that is subject to levy.

Dispute often arises as to whether a particular form of compensation is subject to continuing levy, and as to whether a particular type of property or property right is subject to successive seizure.

If you are subject to a continuing levy or successive seizure order and have questions about its validity or enforceability, please feel free to call our office.

By way of background, Section 6501(a) of the Internal Revenue Code generally provides that a valid assessment of income tax liability may not be made more than 3 years after the later of the date that the tax return was filed or the due date of the tax return. However, this 3-year period is extended to a period of 6 years when a taxpayer “omits” from gross income an amount in excess of 25% of the amount of gross income stated on the tax return.

Several courts, including the Ninth Circuit Court of Appeals and the United States Tax Court, recently held that an “omission” does not occur by an overstatement of basis, and thus that the longer period for the statute of limitations cannot apply. The U.S. Tax Court in particular relied on a United States Supreme Court decision that interpreted the predecessor of Section 6501 of the Code. In that case, the Supreme Court held that the plain meaning of the term “omits” (as used in the applicable subsection of the Internal Revenue Code) is that something has been “left out” and not that something has been put in and overstated.

The new Treasury Regulations, however, now clarify what constitutes an “omission from gross income” under the Internal Revenue Code. By formally altering the definition of a term contained in the Internal Revenue Code, the Internal Revenue Service expects that its new Treasury Regulation will be entitled to deference by the courts – even though the Regulation’s interpretation of the Internal Revenue Code runs contrary to that made by courts in several jurisdictions.

Until such time as this issue is fully resolved by the courts, taxpayers who are challenged by the Internal Revenue Service should generally (depending on their jurisdiction) continue to dispute the applicable statute of limitations on assessment when it hinges on an expansive definition of the term “omission.” It should also be noted that for purposes of the applicable statute of limitations, the amount omitted from gross income does not include any amount disclosed on the return, or in a statement attached to the return, in a manner adequate to apprise the Internal Revenue Service of the nature and amount of the item. This disclosure exception applies to omissions from gross income resulting from basis overstatements, so taxpayers who adequately disclosure the nature and amount of the omissions from gross income will generally not be subject to the extended 6-year statue of limitations in the first place.

If you have any questions about applicable statutes of limitation on assessment or collection, or about basis overstatements, please feel free to call our office.

In many cases, structuring a partner’s withdrawal as a liquidation will provide more favorable tax treatment than if it is structured as a sale to the remaining partners. This is particularly the case for partners who derive no significant benefit from having their gains classified as capital gains.

The underlying reason for this disparity is that sale or liquidation payments are taxed according to the types of partnership property to which they are attributable.

Consider the taxation of payments for unrealized receivables. In a liquidation, these payments will be taxed as ordinary income to the distributee (departing partner) under Section 736(a) of the Code, and the remaining partners will receive ordinary deductions. However, if the transaction is instead structured as a sale, the departing partner will still have ordinary income under Section 751(a), but the remaining partners will receive no deduction. (If a Section 754 election is in effect, the remaining partners will of course obtain a basis step-up, which will reduce their ultimate taxes.)

If any of the payments to the departing partner are attributable to inventory, it would also generally be preferable to structure the transaction as a liquidation rather than as a sale. If the partnership’s inventory is appreciated, that partner will have ordinary income on a sale but not upon liquidation. (In the case of “substantially appreciated” partnership inventory, the departing partner will have ordinary income regardless of whether the transaction is a sale or liquidation.) Furthermore, whereas the remaining partners will receive a cost basis for the departing partner’s share of the inventory if the transaction is a liquidation, the remaining partners in the case of a transaction structured as a sale will be able to increase their basis only if a Section 754 election is in effect.

In a liquidation, moreover, payments for unstated goodwill will generate ordinary income to the departing partner and ordinary deductions for the remaining partners. In a sale, by contrast, any payment received upon a purchase of a partnership interest that is attributable to partnership goodwill is generally treated as capital gain and is not deductible by the remaining partners.

The collateral consequences of a liquidation also often tend to be more favorable than the collateral consequences of a sale. Under Section 708(b)(1)(B), a sale will terminate a partnership’s existence if the departing partner holds a 50-percent or greater interest in the partnership. The termination of a partnership not only creates administrative hassles, but will also give rise to certain constructive transactions that may have undesirable tax results. By contrast, a liquidation of a partner’s interest in the partnership will not cause such a termination, even if the partner has a 50-percent or greater interest in the partnership.

It should be noted that several seemingly ancillary tax factors can alter the analysis in choosing between sale and liquidation treatment. Additionally, careful planning and draftsmanship are crucial to distinguish a transaction as a liquidation or sale because a partnership’s mere choice of form for the transaction.

If the target is (i) a member of a consolidated group, (ii) a non-consolidated selling affiliate, or (iii) an S corporation, and the purchaser acquires a minimum percentage of the target’s stock by vote and value (after excluding any non-voting, non-convertible preferred stock) within a defined acquisition period, the buyer and seller may jointly elect under Section 338(h)(10) of the Internal Revenue Code to treat the stock sale as a sale of assets for tax purposes.

From a technical standpoint, the 338(h)(10) election causes the target to be deemed to have sold its assets in a taxable transaction and then distributed the proceeds in a constructive liquidation while still a member of the selling consolidated group or while still owned by the selling affiliate or S corporation shareholders. The sale of the target’s stock will accordingly be ignored, and the distribution of the proceeds from sale will be treated as a complete liquidation under Sections 336 and 337 of the Code. The parties then allocate the purchase price for the stock (grossed up to 100 percent if less than 100 percent is sold) and liabilities of the target amongst the target’s assets (including goodwill) in the same manner as an asset sale.

A purchaser benefits from a 338(h)(10) election if the stock purchase price is greater than target’s basis in its assets (the “Inside Basis”). In such cases, the purchaser is able to step up the Inside Basis to equal the purchase price, and thereby claim higher depreciation deductions from the increased Inside Basis.

Additionally, if the target was a member of a consolidated group, the deemed asset sale will be considered to have occurred while the target was still a member of the selling consolidated group. This makes it possible to shelter the gain on the deemed asset sale with operating losses of the selling group.

However, in situations where the Inside Basis is lower than the seller’s basis in its target corporation stock (the “Outside Basis”), a 338(h)(10) election will tend to disadvantage the seller, who may incur additional taxes due to the disparity between Inside and Outside Bases. In such situations, it is often advantageous for the purchaser to pay some or all of any additional tax incurred by the seller. Because any additional payment by the purchaser for the increased taxes is itself taxable, the entire indemnification amount must be “grossed up” by the highest applicable tax rate.

A Section 338(h)(10) election often provides parties to stock sale with the best of all worlds. However, due to the existence of certain complexities in the tax law, the election should be made only in certain circumstances and only after careful evaluation, particularly in the case of S corporations.

1. Failing to Plan for Service Partner’s Tax Bite.

A partner who receives an interest in partnership capital as compensation for his future services to the partnership is taxed on the value of that interest. He is taxed either immediately or when the right to a share of partnership capital becomes “substantially vested.”

Corporate and real estate attorneys may mistakenly believe that because (for example) the par value of the limited liability company units is set to a low dollar amount, the service partner who receives an interest (and takes such interest with a zero basis) will pay nominal, if any, taxes. For tax purposes, however, the stated value of a partner’s units is irrelevant; it is the true value of his interest in the partnership that is dispositive.

In order for a service partner to avoid the negative tax result of having to pay tax upon receipt of his interest, two options exist. The first option is to simply delay income recognition by delaying the time at which the service partner’s right to partnership capital becomes substantially vested. This requires the inclusion of certain technical tax provisions in the partnership or operating agreement.

The second option is for the service partner to make an election under Section 83(b) of the Code. Under Section 83(b), the service partner may elect to include the value of non-vested property in income at the time of receipt. Once making the Section 83(b) election, the service partner will not recognize any additional compensation income when the property becomes substantially vested.

Whether or not the service partner should make a Section 83(b) election depends upon a number of factors, including the likelihood of the partnership interest being forfeited prior to becoming substantially vested, and the length of time that the service partner intends to retain his interest subsequent to vesting.

2. Failing to Properly Segregate “Investment” Property from “Dealer” Property.

Property that is deemed held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business is considered “dealer” property subject to ordinary income treatment, rather than “investment” property subject to capital gain treatment.

In order to avoid losing the preferential capital gain tax treatment on properties earmarked as investments, it is important for brokers and developers threatened with dealer status to properly segregate their investment and dealer properties. Segregation into separate entities is not conclusive, as the surrounding circumstances are examined for substantiation, but proper segregation is an important structural step in avoiding dealer classification and the loss of capital gain treatment.

3. Failing to Plan for Income Imputation from Original Issue Discount or Unstated Interest.

In general, if a debt instrument of any kind (including bonds, debentures, notes, certificates of deposit, or loans) is acquired from an issuer for an amount (the “issue price”) less than its face value (its “stated redemption price at maturity”), the difference is Original Issue Discount (“OID”). Regardless of the holder’s method of accounting, he must generally (and subject to certain de minimis rules) report part of the OID amount as interest income in each tax year that the debt instrument is held, even through the OID will not be paid until maturity.

In real estate transactions, OID may arise not only when a debt instrument provides for a below-market interest rate, but also where a debt instrument’s at-market interest rate is actually payable at a lower rate, such as with balloon or lump-sum payments at maturity.

Similarly, whenever there is an issuance of a debt instrument with deferred payments or installment sales in conjunction with a sale or exchange of property, certain sections of the Internal Revenue Code require that adequate interest be charged and paid on the obligation. If adequate interest is not charged and currently paid, part of the payments received will be treated as unstated interest taxable to the seller, regardless of the parties’ intentions.

4. Failing to Price Tenant’s Tax Costs in Lease Sales and Subleases.

From an economic standpoint, it is often irrelevant to a landlord whether his lease agreement provides for a lease sale or a sublease.

For tax purposes, however, the distinction between a lease sale and a sublease is very important. While a tenant’s sale of its leasehold interest generally results in capital gain, a sublease creates ordinary rental income to the tenant. Not only is the difference in tax cost significant to the tenant who must actually pay the tax; sophisticated landlords can demand price premiums for agreeing to help tenants avoid the tax costs associated with a sublease by restructuring the sublease as a lease sale.

It is not always easy for tax purposes to distinguish between a sale of a lease from a sublease. In general, if a tenant is divested of its entire interest in the lease, the transaction will be classified as a sale for tax purposes. However, certain rights, options, existing subleases, and types of payment structuring can inadvertently cause the transaction to be re-characterized as a sublease for tax purposes. With proper provision and tax drafting, both landlord and tenant frequently can benefit from structuring a sublease as a lease sale.

5. Failing to Understand Who Gets the Depreciation.

When partners enter into real estate ventures, they often mistakenly assume that, as “partners,” they are equally entitled to depreciation deductions according to their proportionate interests in the partnership.

In reality, partners’ shares of partnership liabilities and corresponding allocations of depreciation depend upon whether liabilities are “recourse” or “nonrecourse.” Those active in the real estate business are certainly familiar with these terms. But for tax purposes, definitions of the terms “recourse” and nonrecourse” are more technical and restrictive than might otherwise be expected.

Recourse liabilities are allocated in accordance with the partners’ economic risk of loss, so liabilities are recourse to the extent that a partner bears the economic risk of loss if the liability is not satisfied by the partnership. A partner generally bears such economic risk of loss to the extent that he is required to make a contribution to the partnership (including the obligation to restore a deficit capital account) or pay creditors in a theoretical liquidation of the partnership. In effect, a partner’s economic risk of loss is measured by his ultimate responsibility to pay a partnership creditor or to contribute additional funds to the partnership.

A partner is not considered to bear the economic risk of loss if he is entitled to reimbursement from other partners or from the partnership, such as through an indemnification agreement or a state law right to subrogation. Moreover, limited partners cannot be allocated recourse liabilities in excess of their respective capital contributions (and future contribution obligations) unless they have properly agreed to restore capital account deficits or to indemnify other partners for their debts with respect to a liability. It should also be noted that separate rules apply in the case of nonrecourse debts of the partnership where a partner is the lender or has guaranteed repayment of the debt.

By contrast, a nonrecourse liability is a liability for which none of the partners bears the economic risk of loss, and none of the partners has issued a personal obligation to repay the loan on the part of any of the owners. A partner’s share of nonrecourse liabilities equals the sum of: (1) the partner’s share of partnership “minimum gain,” (2) the partner’s share of taxable gain upon constructive liquidation, and (3) the partner’s share of excess nonrecourse liabilities.

Mechanical rules do limit how, and to what extent, partners may share items of depreciation, but partners can maximize their depreciation deductions with proper planning and careful drafting.

There are three primary methods of dividing a corporation tax-free: (1) spin-off, (2) split-off, and (3) split-up. A spin-off is a pro rata distribution of a controlled corporation’s stock to the distributing corporation’s shareholders without requiring the shareholders to surrender any of their stock in the distributing corporation.

A split-off is a pro rata or non-pro rata distribution of a controlled corporation’s stock to one (or more) of the distributing corporation’s shareholders in exchange for stock held in the distributing corporation. (A split-off is identical to a spin-off, except that the shareholders of the distributing parent corporation surrender part of their stock in the parent in exchange for the stock of the subsidiary.)

In a split-up, there is a transfer of all the businesses of a distributing corporation to controlled corporations, followed by a distribution of the stock of the controlled corporations to the distributing corporation’s shareholders and the liquidation of the distributing corporation. The distribution of the controlled corporations’ stock to the distributing corporation’s shareholders can be either pro rata or non pro rata. In the case of a non-pro rata division, the overall effect of the split-up is to completely separate corporations, whereas in the case of a pro rata division, the split-up’s overall effect is to create a “brother-sister” relationship between subsidiaries.

In order for a distribution of stock of a controlled corporation to qualify as tax-free under Section 355 of the Internal Revenue Code, certain basic requirements must be met: (i) The distributing corporation must control the corporation whose stock or securities it distributes (“controlled corporation”) immediately before the distribution; (ii) The distributing corporation must distribute all of the stock or securities held by it in the controlled corporation immediately before the distribution; (iii) The transaction must not be used principally as a device for distributing the earnings and profits of either the distributing corporation or the controlled corporation; (iv) Immediately after the distribution both the distributing and the controlled corporations, or, in the case of a split-up, each of the controlled corporations must be engaged in the active conduct of a trade or business; (v) There must be a corporate business purpose for the distribution; and (vi) With certain exceptions, the distributing corporation must distribute only stock or securities of the controlled corporation to a shareholder with respect to his stock or to a security holder in exchange for his securities.

If a company fails to meet these requirements, its divisive transaction will not qualify as tax-free under Section 355 of the Code, and the result can be quite expensive. In the case of a failed spin-off, the distribution will be taxable as a dividend to the extent of the distributing parent’s earnings and profits. In the case of a failed split-off, the transaction will be taxed as either a sale or exchange of stock or a dividend under the redemption rules of Section 302 of the Code. In the case of a failed split-up, the corporation will be treated as having been liquidated or as having been liquidated and then re-incorporated.

However, it is all too often that statutes of limitation on the Internal Revenue Service’s federal income tax collection create as many surprises as they prevent.

Assessment of any federal tax (including any interest, additions, and penalties imposed thereon) generally must be made by the IRS within a 3-year period beginning with the date that a return is filed.

A number of important but little-known exceptions to this general three-year statute of limitations, however, often catch both taxpayers and their attorneys by surprise.

For example, in the case of pass-through entities (such as partnerships and S corporations), the three-year statute of limitations period runs from the date that the entity’s shareholder, member, or beneficial owner files its return, not from the date that the pass-through entity files its return.

Another often-overlooked exception applies where there has been a failure to notify the IRS of certain transfers abroad. Failure to notify the IRS of certain foreign transfers extends the assessment period to three years after the date that the IRS is notified. The same rule applies to a taxpayer’s failure to notify the IRS of certain distributions in connection with a tax-free corporate division.

One of the other most important exceptions to the general statute of limitations rule is that the assessment period is extended to 6 years for income tax returns that omit from gross income more than 25% of the gross income that is reported. The same rule applies for estate, gift, and excise tax returns.

An even more serious exception to the general statute of limitations period arises in “false, fraudulent, and no return” situations. No statute of limitations whatsoever applies if a taxpayer files a false return, willfully attempts to evade tax, or fails to file a return in the first place. Most problematic is the fact that even innocent miscalculations of tax can result in a “false” return that will cause the assessment period to remain open indefinitely.

Additionally, “willful evasion” of tax (which voids any statute of limitation) is often extremely difficult to distinguish from “willful avoidance” of tax – except that the former is illegal and the latter is legal. Just as civil litigators tend to allege fraud in all plaintiff contract claims in order to qualify for an award of punitive damages, the IRS tends to allege fraud in as many serious collection actions as possible in order to avoid application of the statute of limitations.

Taxpayers with IRS disputes or questionable items on their returns would be well advised to avoid surprises by determining which type of statute

However, certain real estate professionals may be able to treat rental real estate activities as non-passive. There are two requirements that must be met in order to qualify. First, more than one-half of the person services performed by you in trades or businesses during the tax year must involve real property trades or businesses in which you (or your spouse) materially participate. Second, you must perform more than 750 hours of service during the tax year in real property trades or businesses in which you (or your spouse) materially participate.

These rules are applied as if each of your interests in rental real estate were a separate activity, although qualifying taxpayers can elect (by filing a specified statement) to treat all interests in rental real estate as one activity.

It should be noted that personal services performed as an employee are not taken into account for purposes of the two-part test unless you own more than a 5 percent interest in the employer. Closely-held corporations can qualify as real estate professionals if more than 50 percent of their annual gross receipts for the tax year are derived from real property trades or businesses in which they materially participate.

Qualifying taxpayers who materially participate in a rental real estate activity may avoid automatic passive activity characterization, and accordingly can use losses or credits generated by the activity to offset non-passive income.

Other important exceptions and rules do apply to passive activities. If you believe that some of your income or loss might be tainted by “passive activity,” it is important that you seek experienced counsel for analysis and planning specific to your situation.

But can the sale of a partnership interest be restructured to permit ordinary losses? With inventive planning, it can – particularly for real estate and other “asset-rich” partnerships.

Rather than a having a partner sell his interest in the partnership to a third party, the partnership can make an “in-kind” liquidating distribution to the departing partner of an undivided interest in partnership property (such as real estate) commensurate with the value of that partner’s partnership interest.

The departing partner then is able to sell the undivided interest in the partnership property to the third party. Assuming that the partnership property (such as real estate) is considered a Section 1231 asset (property used in a trade or business), the capital loss can then effectively be converted into an ordinary loss.

An established, more sophisticated (and generally more practical) variation of this method entails having the partnership itself sell an interest in the partnership property to the purchaser equal in value to the departing partner’s interest. Rather than the departing partner selling the partnership interest to a third party, the partnership may sell an equivalent undivided interest in its assets (such as real estate) to the third party, taking a leaseback of the undivided interest.

Proceeds of the partnership’s sale are then distributed to the departing partner in liquidation of his interest, and the partnership’s ordinary loss on the sale can be directly allocated to the selling partner.

To secure ordinary loss treatment, certain precautionary structural measures are crucial to prevent application of the judicially-articulated anti-abuse “step transaction” and “substance over form” doctrines (also addressed under Section 707(a)(2)(B)), which could otherwise fuse or re-cast the transactions. Additionally, any special allocations of the ordinary loss must be made in a manner that complies with the requirements for “substantial economic effect” under Section 1.704-1(b)(2) of the Treasury Regulations.