Partnership taxation is one of the most interesting and complex areas of tax accounting that managers in both industry and public practice come across. The partnership “entity” is designed to provide for great flexibility for sharing profits, losses, capital contributions and distributions, and management responsibility. Of course, this flexibility also provides taxpayers with opportunities for tax avoidance, especially in terms of shifting the tax burden between taxpayers. As a result, there are many rules designed to prevent abuse.


Contentious areas include whether a partnership in fact exists (Internal Revenue Code (IRC) §761) and, where a partnership does exist, whether a payment to a partner is made in his or her capacity as a partner or if it’s more like a payment to a third party (IRC §707).  


While the check-the-box regulations of IRC §7701 minimize many of the issues about whether an entity was a partnership, there are still many instances in which it’s unclear whether a partnership has been established.




This tension is illustrated in Alexander C. Deitch; Jonathan D. Barry and Susan S. Barry (TC Memo 2022-86, 124 TCM 101). The case explores the nature of whether a partnership existed for tax purposes between a “lender” and two individual partners in an LLC and, as a result, whether or not a payment of “interest” was in fact a deductible interest payment to the two individual partners. Ultimately, the Tax Court determined that a partnership didn’t exist between the LLC and lender and that the “appreciation interest” in question was a deductible interest payment and not a payment in respect of equity.


In this case, two individuals formed a state law LLC, taxed as a partnership, in Georgia to operate a commercial rental property. In order to acquire and improve the property, they needed to obtain additional financing. To be able to borrow a larger percentage of the value of the property, the LLC obtained the loan through a lender’s “participating loan program.” Under this program, the lender received a base amount of annual interest along with “additional interest” that included a percentage of the net cash flow and a percentage of appreciation in the value of the real estate.  


All of the documents related to the “loan” were characterized in a manner to treat the lender as just that—a lender rather than a partner. Some of the items related to the additional interest, particularly appreciation interest, had much more the appearance of an equity payment between partners in a partnership. For example, the lender would receive appreciation interest (50% of the gross proceeds) in the case of a sale or condemnation of the property.


The LLC rented the property to outside parties from 2008 to 2014, when the property was sold. During this period, the LLC made interest payments under the terms of the loan, which included principal repayment, interest, and additional interest (50% of net cash flow from the property). Upon sale of the property in 2014, the LLC reported a net gain (§1231) of slightly more than $2.6 million, which was split between the two individual owners. 


Since the property was sold, the LLC also made a payment of slightly more than $1 million to the lender as appreciation interest, which the LLC deducted as a rental real estate expense. This, in turn, resulted in each individual having half of this amount as a deduction, which effectively lowered their income by that amount.


While this type of payment to the lender appears to be more in the order of a special partnership allocation, the Tax Court noted that it isn’t possible to separate for analysis this feature of the loan from the other portions of the loan that did appear to reflect a true lender-borrower relationship. In fact, the parties to the trial had stipulated that the original note along with its modifications and security agreement were debt.




The Tax Court examined the eight factors found in earlier tax law related to whether a partnership had been formed: (1) the agreement of the parties and their conduct in executing its terms; (2) the contributions, if any, that each party has made to the venture; (3) the parties’ control over income and capital and the right of each to make withdrawals; (4) whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; (5) whether business was conducted in the joint names of the parties; (6) whether the parties filed federal partnership returns or otherwise represented to respondents or to persons with whom they dealt that they were joint venturers; (7) whether separate books of account were maintained for the venture; and (8) whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.


With respect to the first factor, the parties clearly labeled themselves in a way to appear as lender and borrower. The second factor is an interesting one: Had it not been stipulated that the base agreement was debt, the Internal Revenue Service (IRS) might have argued that the amounts from the lender were, in fact, equity contributions. In this case, however, because the base amount was agreed to have been a loan, it wasn’t possible for it to also be an equity interest.


With respect to the third factor, the “additional interest” did have the appearance of an equity investment with a preferred return. The fourth through eighth factors are all in line with a creditor relationship.


Note that the total income overall is effectively the same—it’s a matter of how the income is allocated between the individual partners and the lender. If the deduction were disallowed, the income from real estate operations would be higher, but it would be split between three parties as partners. It’s understandable if this reallocation causes the individuals to have more ordinary income taxed as self-employment income. (But in real estate rentals, the individuals might be able to avoid having the income classified as self-employment income.) It would also be understandable if the reallocation would cause there to be more ordinary income and less capital gain, the latter being taxed at a more favorable rate.  


What does seem clear is that in situations in which it appears to the IRS that income is shifted in a way that creates an inappropriate deduction to other taxpayers, it may attempt to reclassify the structure in a way to nullify the deduction.

© 2023 A.P. Curatola

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