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:: Partnership - Audit Technique Guide - Chapter 12
- Syndicated Investment Partnerships (12-2002)
Chapter
12 - Table of Contents
OVERVIEW
Syndicated
Investment Partnerships as
used in this guide are pools
or syndicates formed,
marketed, and managed by
professional money
managers. Since minimum
investments start at $50,000
and it is not unusual for
them to be higher than
$500,000, the investor
partners are generally
wealthy individuals or
families. Foundations and
other tax-exempt
organizations are also
frequently investors.
Investment
partnerships invest in
stocks and bonds, both
domestic and foreign, but
sometimes concentrate on
more exotic securities such
as options, futures, forward
contracts and other
derivatives. Foreign
currencies and related
instruments are used and
many are involved in
arbitrage and straddles.
The
partnership agreements
generally provide that
contributions and
distributions can only be
made as of year-end,
although some funds provide
quarterly valuations.
ORGANIZATION AND
OPERATIONS
The most
common type of organization
involves an Investment
Partnership where
investments are made, the
Managing Partner which is
frequently a partnership
composed of the Manager, Key
Employees, family members,
and the Management Company
as illustrated in Exhibit
12-1.
The
partnership agreement
provides that the Investment
Partnership shall pay a fee
of 1 percent of assets to
the Management Company for
administrative expenses. In
addition, the partnership
pays an incentive fee to the
Managing Partner that is
generally 20 percent of net
profits determined on the
accrual basis using
mark-to-market. (For
Mark-to-Market, unrealized
gains and losses are booked
by adjusting the value of
securities to FMV at
year-end.) In the event of
a loss, that amount is
carried over and reduces
profits in the next year for
the purpose of determining
the incentive fee.
Generally
partners are admitted, and
existing partners may make
additional contributions or
take distributions, only as
of the first of the year.
For example, a new partner
would submit his or her cash
contribution in December in
order to be admitted as a
partner as of January 1 of
the following year; the
percentage interest they
acquired is not determined
until after the books are
closed and net income for
the year is computed. If
the partner redeems his or
her interest, the effective
date is December 31, but he
or she will probably not
receive the proceeds until
late January or early
February of the following
year when the actual amount
of the capital account is
determined. The partner
will get a final Schedule
K-1 for the year and report
gain or loss on disposition
in the next year, the year
in which he or she received
the cash proceeds from the
disposition of his or her
partnership interest.
back to the top
ISSUE: SECURITIES
TRADERS- ENGAGED IN A TRADE OR
BUSINESS?
Since
Investment Partnerships
engage in substantial buying
and selling of intangible
assets, some partnerships
claim that their activity
constitutes “securities
trading” such that they are
engaged in a trade or
business and not
“investing.” The
distinctions between a
“trader” and an “investor”
for tax purposes are very
significant and arose more
than 50 years ago as a
result of the Supreme Court
decision in Higgins
v. Commissioner, 61
S Ct. 475 (1941). There the
Court stated that
“No matter how large the
estate or how continuous or
extended the work required
may be, managerial attention
to your own investments does
not constitute a trade or
business.”
At the time
of Higgins,
only trade or business
deductions were deductible
and as a result taxpayers
were denied any
tax benefit for investment
expenses. Congress
considered that it was
inequitable to deny any
deduction for expenses that
might increase taxable
income, but were not willing
to provide the same
beneficial treatment as
trade or business expenses.
The result was the enactment
of the predecessor to IRC
section 212, which provided
an itemized deduction for
expenses incurred for the
production or collection of
income, or for the
management, conservation or
maintenance of property held
for the production of
income. The enactment of
IRC section 67 in 1986,
combined with changes in the
computation of Alternative
Minimum Tax, made these
deductions much less
attractive to investors.
The higher your income, the
less attractive they are.
By claiming
to be engaged in a trade or
business, the Investment
Partnership is entitled to
claim their expenses as
“Other Deductions” on
Schedule K. (Some
partnerships claim all
expenses as Other Deductions
on page 1 of Form 1065.
This results in a large
ordinary loss on line 1 of
Schedule K since none of the
income is on page 1.)
Prior court
cases have held that traders
on the floor of the
Commodity Futures Trading
Commission are entitled to
capital gain or loss
treatment on their trades.
The courts reasoned that
since the traders were
required to buy and sell at
“open outcry,” the futures
were not held for sale to
customers in the ordinary
course of business; that is,
without the ability to “mark
up” futures, they did not
meet the definition of
inventory and, therefore,
must be treated as capital
assets.
Although
the floor traders had only
capital gain or loss and no
ordinary business income,
the courts have consistently
found that their activity
rises to the level of a
trade or business. As a
result, floor traders file
Schedules C with only their
expenses; all their income
is on Schedule D. Congress
has endorsed this treatment
by enacting special
legislation for these
traders to provide them with
Social Security coverage,
special capital loss
carrybacks, and pension plan
deductions.
What Is a
Securities Trader?
“Although
the Supreme Court has yet to
find a taxpayer properly
characterized as a
‘securities trader,’ it is
clear that such a
‘businessman’ exists, given
the proper facts.” (Levin
v. United States,
79-1 U.S.T.C. 9331) The
standard applied by the
lower courts to distinguish
between an investor and a
trader was first enunciated
by the Tax Court in
Liang v. Commissioner
(23 T.C. 1040): “In the
former, securities are
purchased to be held for
capital appreciation and
income, usually without
regard to short-term
developments that would
influence the price of
securities on the daily
market. In a trading
account, securities are
bought and sold with
reasonable frequency in an
endeavor to catch the swings
in the daily market
movements and profit thereby
on a short-term basis.
There is general agreement
amongst the courts (Moeller
v. United States,
83-2 U.S.T.C. 9698 and
Purvis v.
Commissioner, 76-1
U.S.T.C. 9270) that the
following factors are to be
considered in determining
whether a taxpayer is an
investor or engaged in the
trade or business of
securities trading:
-
The
taxpayer’s intent-
investment negates
trader status.
-
Nature of the income
from the activity-
only short term
gains qualify as
trading income.
-
Frequency, extent
and regularity of
transaction- holding
period can be
critical.
Items 2 and
3 are objective (and
quantitative) indicators of
intent which are principally
relied on. Taxpayers who
mention “capital
appreciation” or even
“conservation of capital” do
not prevail. Significant
long term capital gains, and
even dividends and interest,
are strong indications of an
investor and not a trader.
In one
instance, the Court of
Claims (Mayer v.
United States, 94-2
U.S.T.C. 50,509) took the
position that a taxpayer who
carefully selected money
managers and farmed out a
portion of his funds to each
could not be considered a
securities trader since he
did not actually make any
purchase or sale decisions
himself; “To claim a trade
or business deduction,
taxpayer must himself
perform the activity
characterizing the ‘trade or
business’ citing
Groetzinger (87-1
U.S.T.C. 9191). The Tax
Court considered the same
taxpayer for subsequent
years and came to the same
result based on holding
period and frequency of
trading. (Mayer v.
Commissioner, TCM
1994-209)
The Supreme Court provided
in Higgins that expenses
related to real estate
rental were deductible and
that office and salary
expenses could reasonably be
allocated between investment
and trade or business.
Accordingly, even where it
has been determined that a
partnership is engaged in
the trade or business of
securities trading, care
must taken to ensure that
any portion of the
partnership’s activity or
expenses that are properly
allocable to investment
should be separately stated.
ISSUE: INVESTMENT
INTEREST EXPENSE DEDUCTIBLE ON
SCHEDULE E?
Syndicated
Investment Partnerships
invariably advise their
partners to adhere to the
limitations on Investment
Interest. Where the
partnership has taken the
position that they are
engaged in the trade or
business of securities
trading, the partnership
will advise the partners to
claim the deductible portion
of the interest expense on
Schedule E. As explained
below, this is not correct.
All
investors in syndicated
investment partnerships are
limited partners since they
do not wish to place their
entire net worth at-risk.
IRC section 163(d)(5)(A)(ii)
provides that “property held
for investment” includes any
interest held by a taxpayer
in an activity involving the
conduct of a trade or
business that is not a
passive activity and with
respect to which the
taxpayer does not materially
participate. Treas. Reg.
section 1.469-1T(e)(6)
provides that securities
trading is not a passive
activity, regardless of
whether it rises to the
level of a trade or
business. Thus, the
interest expense is
deductible only to the
extent permitted by IRC
section 163(d).
Since the
treatment of non-corporate
partners is dependent on the
degree of participation of
such partners, IRC section
163(d) could limit the
deductibility of the
interest expense associated
with the partnership’s
trading activity for some
partners and not others.
Treas. Reg. section
1.702-1(a)(8)(ii) requires
that each partner must take
into account separately his
or her distributive share of
any partnership items that,
if taken into account, would
result in an income tax
liability for that partner
different from that which
would otherwise result.
This is why the partnerships
are not permitted to deduct
interest expense on page 1
of Form 1065 in
computing ordinary net
income. In addition, a
partnership engaged in the
trade or business of
securities trading may not
treat portfolio interest
expense allocated from
another partnership as a
trade or business expense,
since the character of the
item is determined at the
partnership level.
NOTE:
Although the instructions
for Investment Interest on
Form 4952 provide that for
“any portion (which) is
attributable to a trade or
business in which you did
not materially participate
and that is not a passive
activity, enter that part of
the interest expense on the
schedule where you report
other expenses for that
trade or business,” there
does not appear to be any
statutory authority for that
position.
Examination
Techniques
The
starting point for an
examination of a Syndicated
Investment Partnership is to
obtain a copy of the
“Offering Memorandum” which
is required by the
Securities Exchange
Commission to be provided to
investors. This document
should contain a complete
description of the
management fees, objectives,
the principals and other
useful information. A
discussion of the tax
treatments and risks is
usually included. A copy of
the original Partnership
Agreement will be included
as an exhibit, but the
examiner should request
copies of any Amendments.
Where the
partnership reports little
long-term capital gain, or
where it is attributable
entirely to IRC section 1256
straddles, trade or business
is not likely to be an
issue. In determining
whether the partnership is
engaged in the trade or
business of securities
trading, the Investment
Objectives portion of the
Offering is of paramount
importance. Objectives
other than taking advantage
of short-term market
movements negate securities
trader status.
Where the
managing partner is a
flow-through entity, request
a copy of the return. The
managing partner is
performing personal
services, although the
income received may be
characterized as interest,
dividends, and capital
gains. If family members or
trusts have an interest in
the managing entity, see
FAMILY PARTNERSHIPS above to
ensure that proper allowance
has been made for personal
services performed.
Issue Identification
Does the
partnership claim long-term
capital gains and expenses
deducted as business
expenses, either on page 1
or as “Other Deductions” on
line 11 of Schedule K?
Is there a
substantial amount of
interest expense? Is it
separately stated as
Investment Interest Expense
on line 14a of Schedule K?
Is profit
and loss allocated based on
something other than
capital; that is, are the
profit and loss ratios on
the Schedules K-1 different
than the capital
percentage? This indicates
that the managing partner
gets a special allocation of
profits for services. Is
this income allocated only
to those performing
services?
Documents to Request
-
Offering Memorandum
or Private Placement
Memorandum
-
Partnership
Agreement and any
Amendments thereto
(“Articles of
Organization” in the
case of LLCs)
-
Copies of manager’s
return if the
managing partner is
a flow-through
entity
-
Sample
correspondence
provided to partners
with their Schedules
K-1
-
A calculation of
partnership tax
basis if the
partnership is using
accrual/mark-to-market
for book and cash
for tax.
Supporting Law
Higgins v. Commissioner
61 S Ct. 475 (1941) ─ There
the Court stated that
“No matter how large
the estate or how continuous
or extended the work
required may be, managerial
attention to your own
investments does not
constitute a trade or
business.” In
addition, the decision
provides the basis for
allocating expenses between
investment and trade or
business.
Levin v. United States,
79-1 U.S.T.C. 9331 ─
“Although the Supreme Court
has yet to find a taxpayer
properly characterized as a
‘securities trader,’ it is
clear that such a
‘businessman’ exists, given
the proper facts.”
Liang v. Commissioner
(23 T.C. 1040) ─ “(with an
investor), securities are
purchased to be held for
capital appreciation and
income, usually without
regard to short-term
developments that would
influence the price of
securities on the daily
market. In a trading
account, securities are
bought and sold with
reasonable frequency in an
endeavor to catch the swings
in the daily market
movements and profit thereby
on a short-term basis.”
Mayer v. United States,
94-2 U.S.T.C. 50,509 ─ “To
claim a trade or business
deduction, taxpayer must
himself perform the activity
characterizing the ‘trade or
business’ citing Groetzinger
(87-1 U.S.T.C. 9191).
Partnership - Audit Technique Guide - Chapter 12 - Syndicated Investment Partnerships (12-2002)ships (12-2002)ships (12-2002)ships (12-2002)iv>
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