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Upon audit, the IRS determined that the taxpayers had
purchased an interest in a partnership that owned the property,
not a direct interest in the property itself.

was formed to facilitate the prohibited the partnership claimed an interest In a case23 decided in 2022, three
transaction of monetizing the refined deduction for the payment of the ap- single-member entities were partners
coal tax credits. Since the LLC was not preciation interest. The partnership also in an accounting firm organized as a
a partnership, only the original owner reported a Sec. 1231 gain on the sale of partnership. The partners negotiated
could claim the tax credits. The tax- the property. a buyout of one of the partners in
payer petitioned the Tax Court, which A partner in the partnership reported anticipation of the retirement of that
ruled that the LLC was a bona fide his distributive share of the appreciation partner’s principal owner. The buyout
partnership because all three members interest and the gain on his individual was added to a restated partnership
made substantial contributions to the return. The IRS audited his return and agreement. The partnership agreement
LLC, participated in its management, disallowed the deduction for the ap- also included provisions governing
and shared in its profits and losses.21 preciation interest but did not adjust the allocations of income and distributions
The IRS appealed the ruling to the gain on the sale of the property. The IRS (both liquidating and nonliquidating)
D.C. Circuit, which agreed with the argued that the lender and the partner- to the partners and a qualified income
Tax Court. Factors that the appellate ship were a joint venture, making the offset provision. The partnership
court held showed that the entity met appreciation interest a nondeductible agreement anticipated that a partner
the definition of a partnership included return on equity. The Tax Court rejected could receive a distribution of clients
that the founder had legitimate nontax that argument and found that, based on from the partnership and provided a
motives for forming it and for recruit- the facts, it was clear the partnership method for valuing such a distribution.
ing other partners, such as spreading and the lender did not enter into a joint Shortly after finalizing the restated
investment risk over a larger number of venture. The facts the court relied on partnership agreement, the other two
projects; that there was nothing wrong included that there was no contribution partners withdrew from the partnership
with the founder’s seeking partners who by the lender, the parties stipulated that and formed a new partnership. Some
could apply the tax credits immediately all funds provided to the partnership of the old partnership’s clients moved
rather than carrying them forward were loans, the lender did not have a to the new partnership. The old
to future tax years; and that all of the “single equity interest” in its dealings partnership reported on its tax return
partners shared in the partnership’s po- with the partnership, and the records that the two partners that withdrew
tential for profit and risk of loss. showed the partnership payments were received distributions in amounts equal
In another case,22 a partnership income to the lender for the use of funds to the value of the clients (as determined
purchased a commercial rental property it had advanced. under the restated partnership
by financing the property with the agreement) that followed them to the
proceeds of a loan. The loan document Income included on new partnership. The partnership also
included an “additional interest agree- partner’s return decreased the withdrawing partners’
ment” that entitled the lender to ad- Partnerships are not subject to federal capital accounts by the value of the
ditional interest of two types — “NCF income tax under Sec. 701. After items reported distributions, which reduced
[net cash flow] interest” and “apprecia- of income and expense are determined their capital accounts below zero. To
tion interest.” The partnership made at the partnership level, each partner is restore their capital accounts to zero,
regular loan payments that included the required to take into account separately the partnership allocated all of the
NCF interest. Later, the partnership in the partner’s return a distributive partnership’s ordinary income to the
sold the property and, in accordance share, whether or not distributed, of each withdrawing partners pursuant to the
with the loan documents, paid the ap- class or item of partnership income, gain, qualified income offset provision in the
preciation interest. On its tax return, loss, deduction, or credit under Sec. 702. partnership agreement.

21. Cross Refined Coal, LLC, No. 19502-17 (bench opinion, decision entered, 22. Deitch, T.C. Memo. 2022-86.
Tax Ct. 10/16/19). 23. Clark Raymond & Co., T.C. Memo. 2022-105.

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