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PARTNERS & PARTNERSHIPS

representative that the IRS had com- income, according to a district court careful review, affirmed the Tax Court’s
pleted its work and specifically stated opinion in earlier, related proceed- decision.18
that the results could change before ings.15 An essential component of
the examination officially concluded. the scheme was a series of offsetting Partnership definition
In addition, neither the agenda nor foreign currency exchange forward Sec. 761 defines a partnership as an en-
the telephone conference informed the contracts, or straddles. The IRS au- tity including any syndicate, group, pool,
partnership of any unequivocal decision dited the partnerships and determined joint venture, or other unincorporated
by the IRS to assert penalties. that they were an abusive tax shelter organization through or by which a
and, thus, disallowed the losses gener- business, financial operation, or venture
Economic substance ated. The partnerships filed suit in is carried on and that is not by defini-
A basic principle of tax law is that district court, which found the scheme tion a corporation or a trust or estate.
taxpayers are entitled to structure their to be an abusive tax shelter and in a During 2022, the question of whether
business transactions in a manner that partnership-level proceeding upheld an entity was a partnership was raised
produces the least amount of tax.13 the IRS’s disallowance of the benefits in two cases. In one case,19 shortly after
However, business transactions must of the losses. The partnership appealed Congress expanded the refined coal tax
have economic substance. For a trans- to the Eleventh Circuit, which af- credit,20 a corporation began developing
action to have economic substance, it firmed the district court’s ruling.16 coal refining technology and set out to
must have a reasonable possibility of As a result of the partnership-level launch a coal refining facility. To do so, it
a profit, and the transaction should proceeding, the IRS issued a notice of formed a new single-member LLC.
have a business purpose independent deficiency to the married taxpayers in The corporation anticipated that
of reducing taxes. The IRS has been Sarma, disallowing the loss deduction the LLC would be able to claim the tax
diligent in examining transactions that they reported on their joint tax return credit but would produce tax losses. The
it considers to lack economic substance from the husband’s participation in LLC brought in additional investors to
or that are shams. The IRS generally the scheme as a partner. The taxpayers allow the original owner to spread its
has prevailed on the issue. To help sought review by the Tax Court. The own investment over a larger number
clarify the rules, Congress codified the taxpayers argued that the statute of of projects and to reduce its overall
economic substance doctrine in 2010.14 limitation expired prior to the IRS’s risk. A secondary reason to expand the
Several cases during the update period issuance of the notice to them. ownership was that the original owner
considered whether a partnership The resolution of this issue hinged could claim only a portion of the refined
transaction had economic substance. on whether the partner’s outside coal tax credits in any given year; the
basis in the partnership was an item rest would have to be carried forward.
Sham partnerships affected by a partnership item (an “af- Because money has a time value, it made
In some court cases, partnership struc- fected item”) under TEFRA’s former sense to have partners who could claim
tures were found to be abusive arrange- Sec. 6229. The Tax Court determined the credits sooner. All of the members
ments or shams. that it was and found the notice to be of the LLC were actively involved in its
In Sarma, the taxpayer participated both timely and valid.17 In addition, operation and financed any operating
in a tax-avoidance scheme to avoid the Tax Court determined that the shortfall. For the years in question, the
paying tax on the gain he expected on outside basis of the partnership inter- LLC had ordinary business losses and
the sale of his business. This scheme est was zero because a partner cannot claimed more than $25.8 million in re-
required the creation of a set of three- have any basis in a sham partnership. fined coal tax credits. The LLC distrib-
tiered partnerships with upper, middle, Thus, the taxpayers were not entitled uted the credits and losses proportionally
and lower tiers. The partnerships were to the passthrough loss. The taxpay- among its members.
designed to generate significant artifi- ers appealed on both issues to the On audit, the IRS concluded that the
cial losses to offset legitimate taxable Eleventh Circuit, which in 2022, after LLC was not a partnership because it

13. See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935). 17. Sarma, T.C. Memo. 2018-201.
14. Including under Secs. 6662(b)(6) and 7701(o), as enacted by §1409 of the 18. Sarma, 45 F.4th 1312 (11th Cir. 2022).
Health Care and Education Reconciliation Act of 2010, P.L. 111-152. 19. Cross Refined Coal, LLC, No. 20-1015 (D.C. Cir. 8/5/22).
15. Kearney Partners Fund, LLC, No. 2:10-cv-153-FtM-37CM (M.D. Fla. 20. By the Energy Improvement and Extension Act of 2008, P.L. 110-343,
3/6/14), aff’d, 803 F.3d 1280 (11th Cir. 2015). which repealed a requirement that the taxpayer’s sale price of refined coal
16. Id. be at least 50% more than the market value of unrefined coal.

32 February 2023 The Tax Adviser