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:: Partnership - Audit Technique Guide - Chapter 1 - Initial Year Return Issues (12-2002)
Chapter
1 - Table of Contents
In the initial year of a
partnership, several Code
sections limit or preclude a
current deduction for costs
incurred prior to the actual
operation of a business.
This
chapter deals with three
specific types of expenses:
-
Organizational Expenses
-
Syndication Expenses
-
Start
Up Expenses.
Other
issues covered in this
chapter include the tax
implications of payments
made to partners:
-
IRC
section 707(a) ─ Partner
or Non-Partner
-
Receipt
of a Capital or Profits
Interest
-
Payments Capitalized,
Deducted, or
Distributed?
-
Guaranteed Payments
ISSUE:
INITIAL YEAR EXPENSES
Under prior
law, organization,
syndication, and start up
costs were not deductible.
Through a series of
litigation, it became firmly
established that these were
capital costs and were
recovered as a part of the
partner's basis on disposal
of the partnership
interest. Subsequently,
Congress enacted IRC section
709 and IRC section 195,
which provide guidance for
these expenses.
Section
709 ─ Organization and
Syndication Expenses
Applicable
after 1975, IRC section 709
provides for the tax
treatment of the costs of
organizing a partnership and
promoting the sale of a
partnership interest.
Under IRC
section 709(a) a current
deduction is not allowed for
the cost of organizing a
partnership and promoting
the sale of partnership
interests.
Subsequently, IRC section
709(b) provides that
organization expenses may be
amortized over a period of
not less than 60 months.
The partnership must
capitalize these costs and
timely elect the 60 month
rule. The partnership is
not allowed to elect
amortization treatment after
the return has been filed,
such as during the audit
process.
Syndication expenses are not
included in IRC section
709(b). They cannot be
deducted or amortized.
Syndication Costs
These are
the costs of syndicating a
partnership and its related
investment units.
Syndication costs are
normally items incurred for
the packaging of the
investment unit (the
partnership unit), and the
promotion of it. These
include marketing costs as
well as the production of
any offering memorandums or
promotional materials.
Included is the training of
any brokers/dealers who will
sell the partnership units,
plus the actual sales
commissions paid to the
sellers of the partnership
(whether they are unrelated
third parties or the
individuals who promoted the
investment). Other costs
normally incurred as a part
of syndication could include
legal costs associated with
the offering, tax opinions,
due diligence, costs of
transferring assets to the
partnership, printing and
preparation of
offerings/prospectus, etc.
Organization Costs
Organization costs include
the legal and accounting
costs necessary to organize
the partnership, facilitate
the filings of the necessary
legal documents, and other
regulatory paperwork
required at the state and
national levels.
There is a
fine line which exists
between syndication costs
and organization costs.
Generally, syndication
represents those costs
associated with the sale of
the actual investment units,
while organization costs are
those costs necessary to
legally create the
partnership.
Election to Amortize
Organization Expenses
The
election to amortize
organization expenses is
made on the return for the
year in which business
commenced. It is made by
completing Part VI of Form
4562, Depreciation and
Amortization. A separate
statement must be attached
to the return containing the
following information:
-
A
description of each cost
-
The
amount of each cost
(costs of less than $10
may be aggregated)
-
The
month the active
business began, (or the
month the business was
acquired)
-
The
number of months in the
amortization period (not
less than 60).
An amended
return cannot be filed to
subsequently elect
amortization of organization
expenses. However, an
amended return can be filed,
including additional
organization expenses, when
a timely election has
previously been made.
IRC
section 195 Start-Up
Expenditures
IRC section
195(a), added in 1980,
denies a deduction for
start-up costs.
IRC section
195(b) however, specifically
allows the taxpayer to elect
to treat these costs as
deferred expenses and
amortize them over a period
of not less than 60 months.
IRC section
195(c) provides the
definition of the terms
"start-up costs" and
"beginning of trade or
business".
Start-up
costs are costs for creating
an active trade or business
or investigating the
creation or acquisition of
an active trade or
business. Start-up costs
include any amounts paid or
incurred in connection with
any activity engaged in for
profit or for the production
of income before the trade
or business begins, in
anticipation of the activity
becoming an active trade or
business. The expenditures
must be of such a nature
that they would be
deductible if they had been
incurred in the operation of
an existing business.
When an
active trade or business is
purchased, start-up costs
include only costs incurred
in the course of the general
search for or preliminary
investigation of the
business. Costs incurred in
the attempt to actually
purchase a specific business
are capital expenses and are
not amortizable under IRC
section 195.
Investigatory expenses are
those incurred in the review
of a prospective business
before a decision to acquire
the business has been made.
See Revenue Ruling 99-23 for
a definition of allowable
investigatory expenses.
Start-up
expenses and pre-opening
expenses include costs
incurred after a decision
has been made to acquire or
enter into a business.
These would include salaries
and wages for training
employees, travel for
obtaining prospective
distributors, suppliers, or
customers. Generally this
term is given to expenses
that would be deductible
currently if they had been
incurred after actual
business operations had
begun.
Expenses
specifically not included in
start-up costs are those
costs allowable under IRC
section 163(a), interest
expense; IRC section 164,
taxes; or IRC section 174,
research and experimental
costs.
Election to Amortize Start
Up Expenses
The
election to amortize start
up expenses must be made no
later than the due date of
the return (including
extensions). It is made by
completing Part VI of Form
4562. A separate statement
must be attached to the
return containing the
following information:
-
A
description of the
business to which the
start-up costs relate
-
A
description of each
start-up cost incurred
-
The
month the active
business began, (or the
month the business was
acquired)
-
The
number of months in the
amortization period (not
less than 60).
If a
revised statement is
required, it cannot include
any costs treated on a
return as other than a start
up cost. Accordingly, the
only costs that can be added
to the original statement
are costs incurred in a
subsequent year that are
added to the total start up
costs to be amortized. An
amended return cannot be
filed to reclassify costs to
start up costs.
Cash Basis Taxpayers and
Start Up Costs
A
partnership using the cash
basis cannot take an
amortization deduction until
the organization or start-up
cost has been paid. If paid
in a year after the business
has begun, they can deduct
an amount equal to the
number of months beginning
with the effective date of
the IRC section 709(b)
election. This will catch
up the amount of
amortization on items paid
in subsequent years with the
amortization on costs paid
in the initial election
year.
Dispositions before the End
of the Amortization Period
If a
business is completely
disposed of before the end
of the amortization period,
the remaining unamortized
balance of properly elected
organization and start-up
expense is deductible as an
ordinary loss under IRC
section 165. Syndication
expenses paid outside the
partnership by the partner,
must be added to the
partner's basis and will
affect gain/loss on
disposition or increase the
basis in distributed assets
on liquidation.
GAAP versus Tax Accounting
Start Up and Organization
Costs
Under
generally accepted
accounting principles,
organization costs and start
up costs are expensed as
incurred.
Specifically, the AICPA, in
Statement of Position (SOP)
98-5 defines in broad terms
what are start up costs and
requires that such costs be
expensed. This broad
definition would include
most of the expenditures
that are required to be
capitalized for tax
purposes. Therefore, GAAP
versus tax differences
generally exist and should
be reflected on the
partnership Schedule M-1.
Payments To A Partner: IRC
section 707(A) ─ Partner Or
Non-Partner
IRC
sections 702 and 704 provide
that a partner includes in
income his or her
"distributive share" of
partnership income or loss,
and the amount of that
distributive share is
usually determined by the
partnership agreement. IRC
section 731 provides that no
gain is to be recognized as
a result of distributions by
the partnership so long as
those distributions do not
exceed the partner's basis
in his or her partnership
interest. While these
provisions represent logical
and equitable approaches to
the taxation of businesses
operated in partnership
form, they have been used by
some taxpayers to circumvent
capitalization requirements
and to avoid reporting
income.
By treating
various payments to a
partner as a deduction or a
distribution of profits, a
partnership may attempt to
change the nature of a
payment. Examples of these
recharacterizations would
include transforming capital
items to deductible expense
and fee income into
portfolio income.
IRC section
707 (a) was enacted to
prevent such potential
abuses.
IRC section 707(a)
IRC section
707(a) was originally
intended to prevent misuse
of IRC sections 702, 704 and
731. It requires that
transactions between a
partnership and a partner,
who is not acting in his or
her capacity as a member of
the partnership, to be
considered as occurring
between the partnership and
one who is not a partner.
That is, an outsider or
unrelated party. IRC
section 707(a)(1) can
encompass loans, leases,
sales, and employment
relationships.
The wording
of IRC section 707(a)(1) is
very brief, and the
regulations for this
subsection provide very
little explanation except to
state in the last sentence
of Treas. Reg. section
1.707-1(a): "In all cases,
the substance of the
transaction will govern
rather than its form." In
general, services involving
a partner's particular
technical expertise are
considered "non-partner."
Apparently
the law and regulations were
not specific enough to
accomplish the desired
effect, so, as part of the
Tax Reform Act of 1984, a
second paragraph was added
to IRC section 707(a) which
is reflected as IRC section
707(a)(2).
The law
specifically provides that
payments to a partner for
either services or property
will be treated as a
transaction between the
partnership and an outsider
so long as he is acting
other than in his or her
capacity as a member of the
partnership. This forces
the partnership to treat the
payment as if it were paid
to an unrelated third party
and removes any option to
treat the payment as a
partner's distributive share
as shown in the Examples 1
through 4 in this chapter.
Payments To A Partner: Receipt
of a Capital or Profits Interest
During the
course of partnership
formation, it is not
uncommon for the partner who
is to manage the
partnership’s affairs to
receive an interest in
partnership profits in
exchange for the performance
of past or future services.
Since it is the combination
of labor and capital that
creates a business, this is
to be expected. Over the
years, taxpayers, the
Service, and the courts have
struggled with the tax
consequences of the many
variations of these
partnership agreements.
A
“Bare” Profits Interest
─ An interest in
partnership profits with no
interest in partnership
capital is a “bare” profits
interest. Generally, the
receipt of a partnership
interest in exchange for
services is taxable under
IRC section 61(a)(1) and
Treas. Reg. section
1.61-2(d)(1) as property
received for services.
However,
Treas. Reg. section
1.61-2(d)(6) provides an
exception in the case of
property subject to a
restriction that has a
significant effect on its
fair market value under IRC
section 83.
A capital
interest in a partnership is
generally not subject to a
substantial risk of
forfeiture under IRC section
83 and will not meet the
exception. Therefore, it
will be included in the
income of the recipient at
its fair market value
(Treas. Reg. section
1.721-1(b)(1)).
Since the
value of a profits interest
is contingent on the
realization of profits in
the future, it is difficult
to value and is generally
considered to be IRC section
83 property. Under IRC
section 83, at the time the
profit is determined and
added to the service
partner’s capital account,
it is taxable to the partner
and deductible by the
partnership.
To provide
further guidance, the
Service announced in Rev.
Proc. 93-27 that they would
not attempt to tax the
receipt of a profits
interest except where the
income is fairly certain,
the interest is disposed of
within 2 years of receipt,
or it is publicly traded.
When is a
Partner not a Partner? ─
Rev. Proc. 93-27 did not put
an end to all of the
controversy regarding
receipt of a profits
interest. The receipt of a
profits interest does not
automatically make one a
partner. A similar
agreement could be made with
an independent contractor.
Someone who receives a
“guaranteed payment” of so
much a month plus a
percentage of the profits
may in fact be an employee
with profit -sharing.
Pursuant to
Rev. Proc. 93-27, the
receipt of a profits
interest in exchange for
future services should
generally be accepted.
However, if the partnership
appears to be designed
primarily to provide tax
benefits to one or both
parties, careful analysis
should be applied to ensure
that partner status for tax
purposes is warranted.
Regulations
regarding performance of
services have not yet been
issued, but the Section 707
Committee Reports contain
significant guidance. The
Committee was concerned with
transactions that avoid
capitalization
requirements. Other
concerns were situations
where a service partner
received a portion of
partnership capital gains in
lieu of a fee, the effect of
which converted ordinary
income into capital gain.
The Committee was not
concerned with non-abusive
allocations that reflect the
various economic
contributions of the
partners. The rules apply
both to one- time
transactions and continuing
arrangements that utilize
purported partnership
allocations and
distributions in place of
direct payments.
The
Committee believed that the
following factors should be
considered in determining if
the purported allocation is
received by the partner in
his or her capacity as a
partner.
Generally,
the most important factor is
whether the payment is
subject to an appreciable
risk as to amount. An
allocation and distribution
provided for a service
partner which subjects the
partner to significant
entrepreneurial risk as to
both amount and payment
generally would be
recognized. Other factors
indicating that the payment
may be a fee include:
-
Transitory (temporary or
short-term) partner
status
-
The
payment is made close in
time to the performance
of the services
-
Whether, under all the
facts and circumstances,
it appears that the
recipient became a
partner primarily to
obtain tax benefits for
himself or the
partnership which would
not have been available
had the services been
rendered in a third
party capacity. The
fact that a partner has
significant non-tax
motives is of no
particular significance
-
The
recipient's interest in
continuing partnership
profits is small in
relation to the
allocation
In applying
these factors, one should be
careful not to be misled by
self-serving assertions in
the partnership agreement,
but should look to the
substance of the
transaction.
In cases
where allocations are only
partly related to the
performance of services, the
above provisions will apply
to the portion related to
services. Even where the
service partner has
contributed some capital,
the “profits interest” may
still be carved out and
treated as compensation.
In Smith
Est. et. al. (63-1 U.S.T.C.
9268), the Eighth Circuit
Court of Appeals held that a
common fund, from which the
manager received a
percentage of the profits
from trading commodities
futures, was a partnership
but that the manager's share
of the profits was
compensation, not capital
gain. To the extent that
partners of the manager
invested cash in the common
fund, they were entitled to
treat the income from their
investment as capital gains
and losses.
Payments to Partners ─ Payments
Capitalized, Deducted, or
Distributed?
Capital Item Shown as a
Deduction or Distribution
In the
early years of a
partnership, it is common to
see payments or
reimbursements to partners
that are properly capital in
nature.
Examples
are payments to partners for
the following:
-
Organization Expenses,
IRC section 709
-
Syndication Expenses,
IRC section 709
-
Start-up costs, IRC
section 195
-
Capital
Assets, IRC section 263
-
Uniform
Capitalization Rules,
IRC section 263A
Example
1-1
Assume
that a broker is a 25
percent interest owner
in a partnership that
plans to construct a
building. She provides
services including
packaging and promotion
of the investment units,
resulting in the sale of
all the planned
partnership units. For
her services she is paid
a fee of $40,000.
Assume that partnership
income for the year of
payment amounted to
$100,000 before
considering the $40,000
payment to broker
partner. Proper
treatment of this
$40,000 expenditure
would be to capitalize
it as a nondeductible
syndication expense,
with no direct effect on
the partnership's total
income of $100,000. Of
course, the broker
partner would also
include the $40,000 fee
in her income, probably
on a Schedule C. The
total effect on the
partners' returns would
be as follows:
This is
the proper treatment of
this item. It has been
shown as a payment to a
person who is not a
partner. This is
correct under Section
707(a).
If the partnership had
improperly deducted this
capital expenditure,
taxable income would
have been reported as
follows:
By deducting an
otherwise capital
expense, the partnership
has effectively reduced
its net ordinary taxable
income by $40,000.
Since we would disallow
this deduction because
it is a non-deductible
syndication expense, the
partnership may try to
achieve the same result
by treating the broker's
fee as part of the
broker's distributive
share.
By
treating the $ 40,000
fee as a part of the
broker's distributive
share, the partnership
has managed to deduct an
expenditure that any
other taxpayer would be
required to capitalize.
Section 707(a) would
require treatment as a
payment to a person not
a partner in the
partnership, changing
the reporting to the
$140,000 result shown in
Example 1-1.
Conversion of Fee
Income into a Capital Gain
Another abuse that IRC
section 707(a) was intended
to prevent relates to the
shifting of the nature of
income. An example of this
is the shifting of fee
income to a distributive
share of a partnership's
capital gain, portfolio
income, etc. as shown in the
following example.
Example 1-4
Mr. A
is a financial advisor.
He has a contract with
Investor B to manage $20
million of Investor B's
assets. The contract
requires Investor B to
pay 20 percent of
profits annually to Mr.
A as a fee for managing
the assets.
In Year
1, the $20 million is
invested and earns a
total of $4 million in
capital gain, dividend,
and interest income.
Accordingly, Mr. A earns
a fee of $800,000 (20
percent of the $4
million). Mr. A reports
this as income subject
to employment tax. On
his Form 1040, Investor
B includes the $4
million in income and
deducts the $800,000 fee
as a miscellaneous
itemized deduction
subject to alternative
minimum tax.
In Year
2, Mr. A and Investor B
form Partnership AB.
Investor B contributes
his $20 million in
assets. Mr. A
contributes no capital
and receives a 20
percent profits interest
in exchange for managing
the assets.
Assume
the earnings in Year 2
are equal to Year 1
earnings.
Mr. A
now receives the
$800,000 of income as a
distributive share of
partnership capital gain
and portfolio income,
not subject to
self-employment tax.
Investor B now includes
$3.2 million into income
($4 million @ 80
percent).
Although the economic
relationship between Mr.
A and Investor B has not
changed, the tax
treatment of their
activity has changed
significantly.
In general, the provisions
of IRC section 707(a) would
require the payment to Mr. A
to be treated as paid to a
non-partner. This would
require the tax treatment to
be reported as it was in
Year 1.
Guidance on the issue of
payments to service
providers who receive a
profits interest in a
partnership is set forth in
Luna, 42 T.C. 1067 (1964)
and includes:
-
The
intent of the
parties to create a
partnership
-
The
ability of the
service provider to
control the income
or capital
-
Whether the parties
share a mutual
proprietary interest
in the net profits
of the venture
-
Whether the service
provider has an
obligation to share
in losses
-
Whether the venture
was conducted in the
joint names of the
parties
-
Whether the partners
filed a partnership
return
-
Whether the parties
held themselves out
as joint venturers
-
Whether separate
books were
maintained for the
partnership
-
Whether the parties
exercised mutual
control over and
assumed mutual
responsibilities for
the business of the
partnership.
Of all of the factors
enumerated in Luna, the most
important is entrepreneurial
risk. Does the partner have
the risk of loss if the
venture is unsuccessful? In
the example above, Mr. A has
no risk of loss since he has
no capital at-risk. All
losses will be allocated to
Investor B.
Guaranteed Payments ─
IRC section 707(c)
A
guaranteed payment is
deducted in the computation
of partnership income.
Accordingly, it is
considered a payment made to
one who is not a member of
the partnership and is
deducted in full, just as if
it were an ordinary expense
under IRC section 162. A
guaranteed payment is an
amount paid to a partner
that is determined without
regard to the partnership
income and is made to a
partner acting in his or her
capacity as a partner.
Additionally, the amount
paid must be deductible
under IRC section 162 as an
ordinary business expense.
Thus, illegal payments or
payments that are
capitalizable are not
deductible under IRC section
707(c).
Prior to 1976 many taxpayers
interpreted the law as
providing that guaranteed
payments were automatically
deductible. In 1976 IRC
section 707(c) was amended
to specifically hold that if
the payment is a capital
expense under IRC section
263 it must be considered as
made to one who is not a
member of the partnership.
Accordingly, it must be
capitalized and is not
automatically deductible.
At the same time, IRC
section 709 was added and it
became evident that a
taxpayer cannot convert
organization and syndication
expenses into a current
deduction by casting the
payment as a guaranteed
payment.
It is sometimes difficult to
distinguish between payments
to partners which fall under
IRC section 707(a)(partner
not acting in capacity as
partner), and those which
are governed by IRC section
707(c) (guaranteed
payments).
-
The
determining factor
is whether the
partner is acting
other than in his or
her capacity as a
member of the
partnership.
-
Generally, if the
partner performs a
service for the
partnership that
he/she also performs
for others (such as
an attorney,
architect,
stockbroker, etc.),
payments will be
deducted or
capitalized by the
partnership under
IRC section 707(a).
-
However, if he or
she works
exclusively or
primarily for the
partnership,
payments are more
likely to be treated
as guaranteed
payments per IRC
section 707(c) (if
not based on
partnership income)
or as his or her
distributive share
under IRC section
702(a) (if based on
partnership income).
Whether the payment is under
IRC section 707(a) (payment
to a partner not acting in
his or her capacity as a
partner), or under IRC
section 707(c) (guaranteed
payment), it cannot be
treated as a distribution of
partnership profits. Also,
if it is paid for any
capital item, it cannot be
expensed.
So why even make the
distinction between IRC
section 707(a) and IRC
section 707(c)? One of the
most important reasons is
the timing of receipt of
income by the partner.
Guaranteed payments are
always includable in the
partner's taxable income as
of the end of the tax year
in which the partnership
deducts or capitalizes the
payment. On the other hand,
payments made under IRC
section 707(a), and
considered paid to a
non-partner, retain their
character and timing based
on the nature of the payment
and the accounting method of
the partner as previously
shown in Example 1-4.
Examination Techniques
Start up costs, organization
costs, and syndication
expenses of partnerships may
not have been properly
classified. Areas to
consider during examination
are:
-
Did
any partners claim
an itemized
deduction for a
legal fee, tax
advice fee, surety
fee, etc., incurred
in connection with
the partnership? If
no organization or
syndication costs
are apparent from
the records of the
partnership, it may
be necessary to
examine the general
partner or other
entity that
established the
partnership to
determine what costs
were incurred. IRC
section 709 states
that such costs are
not deductible by a
partner.
-
Is
there a first year
management fee, or a
guarantee of a set
amount of profit,
for the organizing
partner in the early
years of the
partnership that is
designed to
compensate him/her
for organization
costs?
-
A
detailed examination
of the organizing
partner's records
will be required if
you see any
indication that
syndication fees
have been amortized
under the guise of
organization costs.
-
Partnerships often
attempt to deduct
large syndication
payments in the year
of organization that
are either paid to
the general partner
or to outsiders and
are actually capital
in nature. Sales
commissions, a
proper IRC section
263 capital item,
may be labeled as
management fees,
interest, or another
classification that
would make it appear
to be a deductible
expense. When the
commission is
substantial, it is
often fractionalized
into any number of
classifications and
amounts and spread
out to appear
deductible.
-
Other payments to
partners may require
capitalization.
Examples would
include certain
legal, accounting,
and architectural
fees.
-
Partnerships with a
large number of
partners should have
significant
syndication costs on
the balance sheet
and a large amount
of organizational
expense being
amortized.
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You
should note that the
classification given
to a payment is
often misleading.
Thus, a strict
analysis is needed.
Since the payments
may require a
different tax
treatment, Rev. Rul.
75 214, Rev. Rul. 85
32, as well as IRC
sections 195, 248
and 709 should be
consulted for
guidance.
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Secure written
description of
duties performed by
the
promoter/partner.
Determine what
portion of
promoter/partner
fees is related to
syndication costs,
organizational
costs, start-up
costs, and asset
acquisition. Ask
the promoter/partner
for contemporaneous
records to verify
the amount of time
spent on initial
activities. In
instances where the
taxpayer refuses to
provide records, the
agent should
consider disallowing
the entire developer
fee. (Carp
& Zuckerman v.
Commissioner,
T.C. Memo. 1991
436).
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If
any partner receives
an interest in the
entity in exchange
for services
rendered, the facts
must be considered
to insure proper
treatment. At the
partnership level,
this will include
the determination of
when and how the
partnership reflects
the allocation of
profits and/or
capital. At the
partner level, it
will be a
determination as to
the proper timing
and nature of the
inclusion of income
by the partner
receiving the
interest.
Issue Identification
In the initial years of a
partnership the Schedule M-1
should have entries for
start-up and syndication
expenses which were deducted
per book and have been
treated differently for tax
purposes. The lack of
entries here will be an
initial indication that
start-up and syndication
expenses may have been
deducted.
Additionally, inspection of
the partners' returns may
indicate a deduction by the
partner for these items.
Sometimes these costs are
paid by the partner and
deducted as a miscellaneous
itemized deduction, etc.
Therefore, review the
partners' returns.
Any changes to the capital
accounts may reflect items
that could be subject to
capitalization.
Inspection of Schedules K-1
may reflect changes to
partnership interests.
Analysis should reflect if
any interests were provided
for services rendered to the
partnership.
Documents to Request
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Partnership
agreement and all
amendments
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Articles of
Organization (LLC's)
and all amendments
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Private Placement
Memorandum,
prospectus, or any
similar documents
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Any
agreements with
brokers or sales
agents
Interview
Questions
Interview questions will
vary based on the
information presented and
will be contingent on how
clear a picture is
presented, specifically:
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Who
organized the entity
and how was he/she
compensated?
-
Were brokers or
agents used to sell
partnership
interests?
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When did the
business begin?
-
What expenses were
incurred prior to
the opening?
Supporting Law
IRC section 709
IRC section 707
IRC section 195
IRC section 263
IRC section 263A
IRC section 61
IRC section 83
Rev Rul 99-23, 1999-20 C.B.
3, provides guidance on the
type of expenditures that
will qualify as
investigatory costs that are
eligible for amortization as
start-up expenditures under
Section 195 when a taxpayer
acquires the assets of an
active trade or business.
Rev. Rul. 88-4, 1988-1 C.B.
264, states that the fee
paid by a syndicated limited
partnership for the tax
opinion used in the
partnership prospectus is a
syndication expense
chargeable by the
partnership to a capital
account and cannot be
amortized.
Rev. Rul. 85-32, 1985-1 C.B.
186, states the following:
Syndication costs incurred
in connection with the sale
of limited partnership
interests are chargeable by
the partnership to a capital
account and cannot be
amortized.
Rev. Rul. 81-153, 1981-1
C.B. 387, states the
following: An investor in a
limited partnership may not
deduct that part of the
purchase price that is paid,
through a rebate or discount
arrangement, by the investor
to a tax advisor on behalf
of the partnership for
services related to the sale
of the partnership
interest. The partnership
may not amortize this amount
under IRC section 709(b).
The investor's basis in the
partnership is the amount of
cash contributed.
In Carp & Zuckerman
v. Commissioner, 62
T.C.M. (CCH) 658, T.C. Memo.
1991-436, the court allowed
no part of a purported
development fee as the
taxpayer failed to establish
the purpose and nature of
the expenditure.
In Diamond v.
Commissioner, 92
T.C. 423 (1989), guaranteed
payments were made to
partners which they
contended were for
management services. The
court required the payments
to be capitalized. The
taxpayer did not provide a
basis for estimating what
portion was for management
services under Cohan v.
Commissioner, 39 F.2d 540
(2d Cir. 1930).
In Collins v.
Commissioner, 53
T.C.M. (CCH) 873, T.C.
Memo. 1987-259, it was
found that management and
consulting fees paid shortly
after the formation of a
general partnership were
held to be organizational
expenses and were required
to be amortized rather than
currently deducted.
Similarly, legal and
accounting fees incurred
shortly after formation were
nondeductible organization
and syndication expenses.
In Vandenhoff v.
Commissioner, 53
T.C.M. (CCH) 271, T.C. Memo.
1987-116 and Isenberg v.
Commissioner, 53 T.C.M.
(CCH) 946, T.C. Memo.
1987-269, it was found that
guaranteed payments by a
motion picture partnership
to the general partners were
in the nature of syndication
expenses and were required
to be capitalized.
In Schwartz v.
Commissioner, 54
T.C.M. (CCH) 11, T.C. Memo.
1987-381, aff'd without
opinion, 930 F.2d 920 (9th
Cir. 1991), it was found
that payments made to a
partner were syndication
expenses that must be
capitalized and were not
deductible as guaranteed
payments.
In Driggs v.
Commissioner, 87
T.C. 759 (1986), it was
found that amounts paid to a
general partner as
"sponsor's fees" were not
deductible because the
partnership failed to prove
whether the expenses were
for syndication fees or for
organization costs.
In Egolf v.
Commissioner, 87
T.C. 34 (1986), it was held
that a partnership could not
currently deduct
organization and syndication
costs by indirectly paying
them to a partner under the
guise of management fees.
Since no election was made
by the partnership, no
amortization of partnership
organization expenses was
allowed.
In Durkin v.
Commissioner, 87
T.C. 1329 (1986), the court
ruled that payments made by
a partnership to two general
partners for services were
for expenses in connection
with organizing the
partnership and the offering
and such payments were not
currently deductible as
guaranteed payments. The
partnership was entitled to
amortize the expenses.
In Finoli v.
Commissioner, 86
T.C. 697 (1986), it was
determined that amounts paid
for preparation of a tax
opinion, incurred to promote
or facilitate the sale of
partnership interests, and
commissions and consulting
fees constituted
non-deductible syndication
expenses.
In Tolwinsky v.
Commissioner, 86
T.C. 1009 (1986), and Law v.
Commissioner, 86 T.C. 1065
(1986), it was found that
organizational expenses for
a motion picture tax shelter
were amortizable only to the
extent that such expenses
were substantiated.
In Surloff v.
Commissioner, 81
T.C. 210 (1983), it was
found that fees paid to an
attorney by partnerships
mainly for the preparation
of a tax opinion letter that
was used in a prospectus
given to potential investors
were syndication expenses
and had to be capitalized.
In Flowers v.
Commissioner, 80
T.C. 914 (1983), it was
determined that expenditures
for tax advice were incurred
for purposes of obtaining
the tax opinion letter that
accompanied organization and
sales promotion of limited
partnership interests and
were non-deductible capital
expenditures.
In Wendland v.
Commissioner, 79
T.C. 355 (1982), aff'd, 739
F.2d 580 (11th Cir. 1984),
it was determined that legal
expenses paid to a law firm
by a coal mining tax shelter
partnership constituted
organizational expenses.
These expenses had to be
capitalized in the absence
of evidence allocating such
expenses between legal
advice and tax advice.
In Johnsen v.
Commissioner, 83
T.C. 103 (1984), motion
denied, 84 T.C. 344 (1985),
rev'd on other grounds, 794
F.2d 1157 (6th Cir. 1986),
it was found that a partner
could not deduct his share
of claimed expenses for
legal and tax advice. The
evidence showed that the
services concerned the
organization and promotion
of the partnership.
In Smith v.
Commissioner, 33 TC
465 (1960), aff'd in part
and rev'd in part, 313 F. 2d
724 (8t h Cir. 1963). The
Court of Appeals held that a
common fund, from which the
manager received a
percentage of the profits
from trading commodity
futures, was a partnership
but that the manager's share
of the profits was
compensation, not capital
gain. To the extent that
partners of the manager
invested cash in the common
fund, they were entitled to
treat the income from their
investment as capital gains
and losses.
Resources
CCH Standard Federal Tax
Reporter
IRS Publication 535 ─
Business Expenses
IRS Publication 541 ─
Partnerships
IRS Publication 583 ─
Starting a Business and
Keeping Records
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