In this episode of Tax Notes Talk, the first of a three-part series, Damien Martin and Tony Nitti of EY discuss their top tax cases from 2024, focusing on two partnership cases: Denham Capital Management LP v. Commissioner and Surk LLC v. Commissioner.
Tax Notes Talk is a podcast produced by Tax Notes. This transcript has been edited for clarity.
David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: top 2024 tax cases, part 1.
We’re switching things up this week as we host a special series from EY practitioners Damien Martin and Tony Nitti. They’ll be highlighting their top tax cases of 2024, and that’s not all we’re switching up. If you’d like a more multimedia experience, you can head over to our YouTube page to see me and our guests this week on video. This will be part of a three-part series, so keep an eye out on our feed for parts two and three.
For now, let’s hand it over to Damien and Tony.
Damien Martin: Well, hello everyone. This is Damien Martin. I’m a tax partner at EY, and I’m joined by my esteemed colleague, Tony Nitti, also a tax partner at EY. Tony, we’re here to do what we love to do best, right? And that’s the top tax cases of the year, and we’re excited to be here on Tax Notes to be doing that, right?
Tony Nitti: Oh man, absolutely buddy. I could not be more excited for today. You know I love this conversation every year. I do think, however, before we get going, we need to address the elephant in the room. And what I mean, there is, look, for about the last half decade, you and I have gotten together every year and we’ve talked through the most interesting, the most impactful, the most entertaining cases that have been decided over the last 12 months, but last year rolls around, doesn’t happen. Now, I know why we didn’t do the podcast last year. But Damien, the people, the listening public, they don’t know. And I think you’ve probably figured this out by now, but in this day and age when people don’t have answers, do you know what follows?
Damien Martin: What’s that?
Tony Nitti: Conspiracy theories. Conspiracy theories, Damien. And there have been conspiracy theories about why this podcast didn’t happen last year. And I’m going to tell you, and this might be hard for you to hear, most of them revolve around you.
What people are saying out there on the streets is that you got a little bit too big for your britches. Right? You let the commercial success of your podcast and career get to your head a little bit, and you effectively, you priced us out of any potential podcasting platform by insisting on what could only be described as a diva-like set of demands. Now, I don’t know if you even want to understand some of the things that people were saying about you in terms of these demands, but if you’re curious, I could share a couple of them.
Damien Martin: You know, Tony, I’m a tax guy. I’m pretty curious to get into the weeds. Let’s hear these, because this is a little bit news to me. So let’s hear it.
Tony Nitti: The most common one I was getting, it was fairly innocuous, right? Someone came up to me at AICPA National Tax, I heard it again via LinkedIn or someone said, “I heard that you guys couldn’t find a post last year because Damien wanted it written in his contract that during the recording nobody on the production staff could make eye contact with him.” And listen, you know me. I know you well. And I said, “You don’t know Damien the way I know Damien. That’s not him. At the very least, he’s not going to have that put in writing. He may berate some people for looking at him, but he is never going to insist that that be in the contract.” And so, I don’t know if you’re going to want to respond to that one, but that is not the worst one.
The worst one, and the one I may have been partially responsible for starting, is somebody reached out to me via email and said, “Hey, is there any truth to the rumor that you guys couldn’t do the podcast last year because Damien was demanding that on the morning of the recording he be provided an omelet made from the eggs of endangered condors?” I don’t even know where someone comes up with something like that. What kind of monster would insist upon something like that?
And so, I didn’t want to share this stuff with you, but this is what’s out there on the streets. And so, I wanted to give you a platform, should you choose to take it, to confirm or deny or address these rumors, put them to bed once and for all. And so, I put it to you, man. Why didn’t this podcast happen last year? And is it because of these diva-like demands or are people just really missing the boat out there?
Damien Martin: All right, well, I guess I can neither confirm nor deny if I’m currently sitting in a studio setting that’s all black decorated with fresh roses that were demanded as part of the provisions of doing this. But more seriously, last year, I actually did, around the end of the year, when we would typically be going through the list, right, Tony, and figuring out what were those cases. And I always love it because that’s such a great process. It’s not necessarily the top ones that make everyone’s list, but the top ones that make the list of, hey, what’s going to be interesting and helpful to people and some good learning nuggets? Right?
But actually, I’ll say it to you: To this day, it’s a bit of a medical mystery, but I found myself actually for the better part of December in the neuro ICU, had a complication from meningitis. And thankfully, after taking some time off and regrouping and really giving you just a gut check on what’s important in life and what you’re doing, so coming back with a fresh perspective, I’m back. Back in action and glad to be here talking tax cases with you again this year.
So without further ado, let’s jump into our top tax cases of ’24. You’ve got a good strong one here to lead off with, I think. Denham Capital Management LP. It’s TC Memo 2024-114. Got this one right before the Christmas holiday there on December 23. So set it up for us here. What was the issue and why is it significant? Why are we talking about it now?
Tony Nitti: Sure. I mean, as you said, it was a bit of a gift. It was a gift, not in the sense that it was good for taxpayers because it certainly isn’t, it’s going to shake up our industry, but it was a gift in the sense that it came right before the holidays and it was fantastic fodder for this podcast. We couldn’t really lead off with any one other than this. Although I do want to quickly address a second elephant in the room where we know we had some big Supreme Court cases settled in 2024, but we’re not going to address those on this particular podcast. Right, D? Because Moore and Loper Bright, I mean, they’ve been beaten up and beaten up and there’s not much left to say. Tax Notes has discussed it. I’ve done some writing about it and discussed it with the AICPA. We’re just going to leave those aside.
We always like to pick cases that have more practical implications anyway. And boy, Denham Capital certainly fits into that category. So yeah, just was a clear-cut leader here for the list that we have because where we go from here is anybody’s guess, but as we roll through these cases, we tend to do things a little differently sometimes. Sometimes we set up the facts first and then we lay out the relevant law.
I think for this one, what makes more sense, D, is to lay out the law and then we’ll layer on top of the facts. But Denham Capital LP, it’s clearly a state law limited partnership. So we’re dealing with a partnership issue and partnerships are a state law construct, and we need to appreciate the different types of partners and partnerships under state law and what they mean from a tax perspective. So if we just lay down some background here on the relevant legal authority, we start with the classic form of a partner in a partnership and that’s a general partner.
And the critical state law characteristic of a general partner is that they have unlimited liabilities for the debts of the partnership. So things go bad and there’s a general partner around, it’s the general partner who’s left holding the bag, so to speak. From a tax law perspective, we move over to section 1402 because we know that as individuals, we don’t just pay income taxes. We may have to pay self-employment tax, right, at a 15.3 percent rate.
And what 1402 does is say that we’re going to pay that self-employment tax on our income from conducting a trade or business. And included in the definition of that is our distributive share under section 702 from any partnership that conducts a trade of business. And so, stated another way, Damien, it’s just like if you’re a partner in a partnership that’s conducting a business, you are treated as conducting the business of that partnership. And so you should be including that income in your self-employment tax. Fair enough.
But then of course under state law, we can have a limited partner because not everybody wants to be on the hook for the debts of a partnership. And the key characteristic of a limited partner is that an LP is not responsible for the debts of the partnership. So if there’s an LP and a GP and things go bad in the partnership, the lender can come after the GP but not the LP. Now of course, if everybody could just limit their liability, everybody would choose to go that way. So you would expect that there’s a trade-off and there is. The trade-off is under state law if you want that limited partner status, you’re generally limited, for lack of a better word, in how involved you can get in the operations and management of that limited partnership.
And so, then we have to take that concept over to section 1402 because we just established earlier that well, under 1402, a partner is treated as conducting the business of a partnership. But now we’re saying that a limited partner by definition really isn’t allowed to be too heavily involved in the activity of a partnership. And so, when they were crafting exceptions to self-employment income under 1402, they said, “Well, we don’t want limited partners, these partners who really aren’t involved in the activity of the partnership, who more kind of invest their money and sit on their hands and wait for an allocation. We don’t want them getting credits towards Social Security.” And so, what they did was they carved out this exception in 1402(a)(13) that we think of as being friendly to a limited partner, but its original genesis was to not be friendly, to avoid them from improperly getting Social Security credits.
And so 1402(a)(13) says, “Self-employment income does not include the distributive share of a limited partner, as such.” And you and I know that “as such” language becomes really important here. Who knew? But all of a sudden we have to focus on that “, as such.” But it does include, self-employment income, does include any guaranteed payment paid to a limited partner. And so, we end up with this exception that has existed for decades under 1402(a)(13) that just says, “A limited partner, because they can’t really participate in the operations and management, is not treated as conducting the business of the partnership, doesn’t have to pay self-employment tax on their share of the partnership’s income unless they get a guaranteed payment for services, and then they’ll just pay the self-employment tax on that guaranteed payment.” All right? So we got all that baseline established.
But then in the late 1970s, out of the state of Wyoming this new vehicle appeared: limited liability companies, LLCs. And LLC members, they’re a hybrid of general partners and limited partners. Like a limited partner, an LLC member has limited liability for the debts of the partnership. So that’s good. But a general partner, an LLC member can and often does, to varying degrees under state law, participate in the operations and management of the LLC. So they get kind of the best of both worlds. What do we do with them from a self-employment tax perspective? And the answer is, I don’t know. Do you know Damien? I don’t think anybody knows, right?
Damien Martin: Right.
Tony Nitti: Because taxpayers are generally going to think is, “Hey, I don’t want to overthink this.” Right? “LLC, I got ‘limited’ in my name, the first letter there, so I must be akin to a state-law limited partner, and as a result, I shouldn’t be paying self-employment tax on my share of the LLC’s income. I’m a limited partner. Under state law, that’s good enough for me.”
But that’s not how the IRS views it. And this all kind of started and this history becomes very relevant to Denham Capital. It all started back in 2011 in the Renkemeyer case, and Renkemeyer did not even have to do with an LLC. It had to do with an LLP, but it’s a very similar creation under state law. And in Renkemeyer, this LLP was a law firm and the majority of the legal services were being provided by the LLP’s partners. And those partners were getting allocations of income from the law firm, and they were saying, “I’m a limited partner. I don’t have to pay self-employment tax.”
And the IRS came in and said, “Well, slow down. You’re not a state law LP that clearly can avail themselves the exception of 1402(a)(13). You’re this new hybrid-type entity, an LLP. We need to figure out: Are you behaving the way we want our limited partners to behave under state law in order to enjoy this exclusion?” And what they did was they established this concept that really became important in the last couple weeks. They said under 1402(a)(13), when we’re talking about a limited partner, we mean kind of a passive partner. And I hesitate to use the word “passive” because in tax law, we’re going to immediately think of passive activities and whether we materially participate. Let’s not do that here. Right?
Damien Martin: Different kind of passive in this context. That’s right. Different standard. Yeah.
Tony Nitti: Yeah. Colloquial, right? Passive. You’re not really doing a whole heck of a lot.
Damien Martin: Sitting on the couch collecting your check as an investor. Right?
Tony Nitti: Exactly. Sitting on that couch. And so, what they did in Renkemeyer is they said, “What type of business is this?” It’s a law firm. A law firm doesn’t require a bunch of capital. You don’t have to go build out a warehouse and an assembly line. You’re not selling widgets. Right? You’re providing legal services. And those legal services in this instance are, the most significant ones are being provided by these limited liability partners. And so these allocations of income that you’re getting, they’re not a return on capital of some passive partner who’s just been sitting on their couch, like you said, waiting for a check. These are returns on your efforts, returns on your services, and returns on services should be subject to self-employment tax. And so, that is what Renkemeyer established back in 2011, this passive investor standard. If you’re not, as you said, just sitting on the couch, if you get more heavily involved than that, we’re going to have some issues.
And so, all of that background, I think, is necessary to set the stage for what would eventually happen here in 2023. And that was the Soroban case. In the Soroban case, what we saw was that, wait a minute, the IRS is not only taking this approach with LLPs and LLCs, they are now expanding this argument about this potential exclusion to state law LPs, like your classic limited partner. And it kind of shook up the industry when we saw that case because what happened is they said 1402(a)(13), as we said, excludes from self-employment income “distributive share of a limited partner, as such.” And that “as such” language means you only get this exclusion to the extent your distributive share is attributable to you behaving as a limited partner. And we think that the Tax Court needs to come up with a functional analysis, a functional test to measure whether a state law LP that has always enjoyed this protection from self-employment income deserves it, whether they’re behaving as a limited partner.
What they didn’t do in Soroban, which kind of left us hanging, it is a situation where they didn’t give us that functional analysis. They just said to the Tax Court, “You need to do this. In a future decision, you need to tell us: How do we decide if a limited partner is acting as a limited partner and can enjoy this exception from self-employment income?” That case that we’ve been waiting for, right, D? That was Denham Capital.
Damien Martin: Yeah, I mean that really was, you said, didn’t say what that was, that functional analysis would be, and obviously motion for summary judgment, so didn’t get into it, but they got into it with Denham. So yeah, what did we have there with Denham?
Tony Nitti: I don’t think it’s a particularly complicated set of facts. So we can lay them out, and I think it’s a pretty common structure. So obviously, Denham was an LP, a limited partnership or we wouldn’t be talking about this. And it had, on the GP side, it had as its general partner an LLC. We can just cast that half of the equation aside for our purposes. But it also had five limited partners, five individuals who were LPs. Right? Now, one of those individuals invested $8 million in exchange for their interest. The other four, not a penny went in. They got their interest in exchange for services. What Denham did, Damien, is Denham was in the business of providing investment management and advisory services to a bunch of related private equity funds. So you got your funds over here investing in PortCos, but who’s deciding where those funds make their investment and when they exit and at what value? That’s all coming from Denham Capital. So they’re doing the steering, they’re doing the management, they’re doing the advisory work.
And so, the LP agreement gave these limited partners the ability to negotiate and execute contracts on behalf of the limited partnership. So all right. That’s worthy of note here. Right? They’ve got some authority to kind of guide the operations of the limited partnership, but beyond that, the limited partnership agreement also says, “You five limited partners, we need you to devote substantially all of your time to this limited partnership.” And just knowing what we’ve already established about what it means to be a limited partner, that’s probably not ideal. And devote substantially all of their time, they did. Right? These five LPs. Number one, three of the five made up the management committee. And so, they’re deciding who makes partner, who doesn’t, who stays, right? Who goes. So they’re making those big personnel decisions on the management committee.
Then, from just an investor relations perspective, these funds on the other side that were raising money to go out and acquire PortCos. They made no bones about the fact that these five LPs over there in the advisory company, these guys are big deals. They’re all in charge of different sectors of the industry, and they’re kind of steering the ship for where we’re ultimately going to invest from a permanent establishment perspective based on their industry. And these LPs, their names were all over the marketing materials. And in fact, the arrangement was such that if these LPs stopped being involved with the Denham Capital, then investors could withdraw their money from the private equity fund. So you could see they were a big deal in terms of what they were being held out to the public as far as steering the decision-making of this management company.
And then, within the management company, within their sector of expertise, these five LPs, they were on what was called the investment committee, where they would decide in their sector, is this a good choice? Is this not a good choice? They would make the recommendations over to the private equity company. They were on the valuation committees, so they would decide what value do we come in, what value do we exit? Like I mentioned before.
And so, you get the idea. Right? I’m just trying to lay out what the IRS laid out, which is that these LPs, boy, they were doing an awful lot from a management perspective, from an investment perspective, from an investor relations perspective, they were so heavily involved, D, that Denham Capital had a $90 million life insurance policy on one of them for one of the years. So that tells you how important somebody is to your operations. Right?
Damien Martin: Right.
Tony Nitti: And so, when it comes time to compensate these guys for all these efforts, what they did was Denham Capital kicked out about a $325,000 guaranteed payment to each one. Nothing to sneeze at, obviously, but the reality is 23 rank-and-file employees of Denham Capital earned more money than that $325,000 guaranteed payment. So if you’re these LPs, you get a $325,000 guaranteed payment and you say, “I’m going to pay self-employment tax on that.” But then you get this allocation of income and the distributions that come with it, and it ranges anywhere from about $1.5 all the way up to $8 million. And you say, “I am a state law LP and a state law LP has always enjoyed this exception from self-employment income for my distributive share, and so I’m not going to pay self-employment tax on it.”
And what the IRS did is they said, “This is our opportunity, Tax Court. This is our fact pattern where you are going to now do what we directed you to do in Soroban and give us this functional analysis. Tell us how we’re supposed to decide if these five LPs, who are LPs in name at least, are they behaving as LPs from a tax law perspective?” And what’s interesting is the LPs kind of stopped one of their arguments right there, and they said, “All that should matter to you is that whatever we’ve done, we haven’t blown our LP status under state law. And so if we’re still LPs under state law, that should be good enough for you.” And the Tax Court quickly said, “Federal law is going to trump state law here, so we’re going to decide from a tax law perspective what we think and not worry about your characterization under state law.”
And so, from there, it was really up to the court to give us what we’ve all been waiting for. And that is how do we know if we’re acting as a limited partner, what is this functional analysis, this functional test? And what they did, buddy, and the reason we went through this history earlier is they went back to that Renkemeyer case in 2011 and they said, “We kind of agree here. We like this standard, this idea of a passive investor. We really don’t want you doing much here in this LP if you’re going to maintain this exception.”
And that is where the taxpayer made what I thought was a really good argument. And I think we’ve talked about this doctrine before, maybe we have, maybe we haven’t. But I know you, you’re a guy who likes his paper code and regs and you’ve got your paper code somewhere and it’s two huge volumes. There is a doctrine in the law that says every word that’s in that code has to be given significance. There’s nothing in there that was written that was superfluous, that was unnecessary.
And so, what they argued under that doctrine was, “Hey, in 1402(a)(13), it says a limited partner doesn’t have to pay self-employment tax on their share of income, but they do have to pay it on guaranteed payments in exchange for services. But now you’re telling us we have to be a purely passive investor, we can’t really do much. Well, clearly the code contemplates an LP being able to provide services because it says if you get a guaranteed payment for those services, you should pay self-employment tax. And so, the code seems to be very clear that we are allowed to provide services, and as long as we’re an LP, anything other than our guaranteed payment’s not going to be subject.” And the court, to my satisfaction didn’t really address it. But they just kind of said, “No, you can provide some services. The question is how much is too much.”
But I thought that was an interesting argument. Like, if 1402(a)(13) anticipates you’re going to get a guaranteed payment potentially as an LP, it seems to indicate that you can provide the services necessary to get that guaranteed payment.
Damien Martin: Right. Right. Dual status. Right? You’re wearing two hats essentially. Yeah, yeah, yeah.
Tony Nitti: Well, then they go to the functional analysis and they say, “Here’s how we’re going to do it under Renkemeyer to see if you’ve been passing, kind of three parts.” And I don’t know if this is going to become a formal three-part test or what have you, but this is what they laid out in the case. They said, “Test number one, how is the LP partnership generating its revenue? Test number two, what is the relationship between that revenue and the services being provided by the LPs? And then test number three, what’s the relationship between the allocations of income to the LPs and the capital that they’ve invested?”
And so, when you look at test one, how did the partnership generate its revenue? You know what they’re getting at there. If it’s from the sale of widgets, that’s going to be a good fact. If it’s all personal services and it’s the LPs providing those services, going back to Renkemeyer and Ryther, that’s not going to be a good fact for the taxpayer.
And what they said is, “Yeah, look pretty clearly here, $130 million in revenue was generated in two years by this partnership all from personal services, investment management and advisory services.” And so, none of that’s from the sale of widgets. So the question we have to ask is who’s providing those services?
So that kicks you over to step two. What’s the relationship between that $130 million in revenue and whatever services that these LPs are providing? We’ve already laid all this out. It’s not good for the taxpayer. They’re all over the marketing material. They’re on the management committee, the investment committee, the valuation committee. They were required to devote substantially all of their time to the LP. And so, they were able to draw this connection between the revenue of the partnership and the services provided by the partners. So when might we not be able to draw that connection?
Well, like I said, if it’s not a service partnership, if you’ve got an assembly line and you’re selling widgets, you can call in sick as a limited partner. Widgets are still going to get manufactured and sent out the door, but when it’s a service partnership and the key services are being provided by the limited partners, there’s that direct correlation between the revenue and the services. And when you have that direct correlation, then you have to really expect that the allocations to those partners are going to reflect a return on those services, compensation, if you will. Unless you can move to the third test and say, “Well, boy, we put in so much capital that maybe we can treat these allocations as being return of capital.”
But in this fact pattern here you have five LPs, only one put in cash. The other four got it for profits interest. And so, how can you argue that you’re getting a return on your capital investment when you didn’t make a capital investment? So when you connect the three dots, you’ve got revenue generated for personal services. The partners are the ones providing the personal services, and they didn’t invest any capital.
Really wasn’t a difficult decision for the Tax Court here. They said under this Renkemeyer standard, you’re not behaving like a passive investor. You are way too heavily involved for our liking. And so, you shouldn’t enjoy this exclusion under 1402(a)(13). And I put it back to you now, right? Because you probably work in this space more than I do, but this is a big deal, right? This shakes up the industry a little bit. I mean, what’s your takeaway there?
Damien Martin: Yeah, no, I think that’s well said, Tony. And to your point, yeah, I sit with what we call our financial services practice and work with a lot of asset managers. To your point, it all started from a campaign 2016, ’17, back in those years, and it’s mostly Northeast Corridor asset managers like your Denhams. So certainly ears really perked up when we had Soroban because it was the first time that the statute doesn’t, to your point, there is no definition of what a limited partnership is. So the first time we’re hearing that and then this actually with Denham takes it to the next step further. So maybe a couple things.
First thing I’ll just mention is I think this is certainly not taxpayer favorable in looking at the facts and whatnot, but I also think it’s not the end of the road, so to speak. I mean, Denham just picked up with Soroban and just said, “Hey, we’re not actually going to look at those issues.” Like you said, maybe the legislative history and looking at all 60 words of the statute there and in the context of that legislative history, and I think there’s more to come there to say that there’s Sirius Solutions case that’s before the Fifth Circuit. See what happens there. Maybe we will get into some of those issues because like I said, really they just sort of in Denham said, “Look, we’ve already got a Tax Court. The Tax Court’s already ruled on this. We’re just going to pick up there and then now we’re going to get into this functional analysis that was required.” Right? So basically to say there’s uncertainty, we wouldn’t be talking about it, I guess, Tony. We like our uncertainty and our lack of definition. That’s what makes these things so interesting.
But secondarily then you say, “Okay, well now let’s look at Denham.” They said functional analysis, they look at Renkemeyer, that passive investor and looking at it in that context. So what do you do if you are like the Denhams of the world? And again, we’re talking about the management company that is managing, and again, this is where the visual here sometimes of you shaking, moving our hands. So you’ve got the management company over here that has the management company relationship with the PortCos that are underneath the, or I guess with the funds that invest in the portfolio companies underneath. So we’re talking about the management company. So what do you do? Well, you look at your facts and are there ways — it’s really coming into this dual status situation, and are there things that you can do in revisiting your facts?
And these are the conversations that I think many are having now to look at it and say, “How do we delineate maybe better between those two?” You mentioned that fact that 23 of what the 80 employees at Denham, they’d cited in the case their compensation component for their services was greater than that of the five limited partners. Maybe you’re looking at that, right? Again, there’s no reasonable comp standard in the sub-K arena like maybe we do in other areas of the law. It makes it harder, I’ll say, to make an argument about reasonable — what you were getting compensated for your services when you’ve got others, such a significant portion that are getting paid more.
Looking at things like the LPA in the agreement language saying you have to dedicate what percentage of time, or even in this case I think the case referenced or the decision referenced a language in the audit report that identified them as being active. So things like that, so to boil it down, it’s to look at your facts and if Denham were to do it again, would there be things that you would maybe do different and then you look at it in that case. So I think the community is still just sort of taking this all in the context to say it is not the last shoe to drop because there is going to be more here and see what happens, like I said, with Sirius. And there’s others that are docketed as well.
So again, developing area, we know where we’re at with the Tax Court right now, that remains to be seen. The last point to make is I suppose there always could be a legislative effort to better define this. Right? If the IRS doesn’t like the answer they get in the courts, there’s always, let’s go back to Congress and maybe we define this in the statute so we could look at that as well, but again, that’s all the directions this could go, but in the meantime there’s uncertainty, and how do we get comfortable with that?
And then given that uncertainty, whether we agree with it or not, the functional analysis being necessary, maybe we want to do things to improve our lie, so to speak from a golf perspective, your lie, when your fact pattern maybe would appear before a court.
And I guess with that, maybe let’s get to our next case. I mean honestly, we could probably sit here and I do, I spent a large portion of my day because I work with so many asset managers around this case, but let’s talk about this next one we have teed up. It’s Surk LLC vs. Commissioner. That’s TC Memo 2024-99, got this one in October, late October. What was the basis for getting this one added to the list here this year?
Tony Nitti: I see your little play on words that you did just there.
Damien Martin: Can’t help myself, Tony. It’s just like the dad tax jokes. That’s what I’m known for.
Tony Nitti: I noticed something last night purely by coincidence of the six cases we really want to get into today just by happenstance two partnerships, two S corps, two C corps. So Surk, again, another one of our partnership cases. Surk itself was a partnership, but that’s not the focus here. What the focus is, is that Surk was a partner in a partnership. So the fact that Surk itself was a partnership not really relevant to this particular case.
Damien Martin: Just that timing-wise, so it was a 1982 Tax Equity and Fiscal Responsibility Act partnership and TEFRA is still there. Right? That was under the ’82 act. Right? But then there’s the bipartisan budget or the 2015 adjustment, the Bipartisan Budget Act that changed the audit regime. So it’d be kind of interesting to see, but maybe again, one of those unknown things, Tony, right, of just an interesting query of what would happen under the new regime, but I do believe this one fell under our old TEFRA partnership regime.
Tony Nitti: Got it. So as a partner in a partnership, nothing here that we don’t encounter all the time. What this has to do with is utilizing losses allocated to you from a partnership that you invest in, so your basis limitations under 704(d). What I find fascinating about this case is I think they get to the right answer through some really interesting reasoning, but you’ve got Surk, partner in a partnership. Before we get into those facts, we know that when we are dealing with a taxpayer who is a partner in a partnership, maintaining basis, kind of a pain in the butt. If we invest in Facebook stock, Amazon, it’s just a C corporation; our basis, it doesn’t go anywhere. We put a $100,000 in, whether it makes $1 billion, lose $1 billion, it’s not moving.
But when we invest in a flow-through entity, a partnership, an S corporation, maintaining basis is hard because every year it’s required to be increased for income, decreased for distributions, decreased for losses, and sometimes we lose sight of why we have to go through all of that, why we have to make the adjustments, but it’s for a very, very good reason. Right, D? We want to preserve a single level of tax, and so if we get taxed on income that flows through to us and we don’t increase our basis for that income, the value of the company is now increased as we’ve earned income. If we sell that stock, don’t drive up our basis, we’re going to recognize gain on the sale of stock that we already pay tax on when we allocated the income. And so we have to maintain our basis to preserve that single level of tax, but that doesn’t make it any less onerous when we have to do all these additions and subtractions every year. And sometimes things can go wrong.
But we keep our basis for a variety of reasons when we sell our interest, when we get distributions, but when we’re going to most frequently encounter it is 704(d). 704(d) says we can only utilize a loss from a partnership to the extent we have basis in the partnership. Any loss in excess of our basis is going to get suspended. Carried forward to the new year, the next year, sorry, where it’s kind of treated as springing to life again in the next year and going into that computation again. And so these are rules and limitations that we work in all day, every day. Nothing shocking there. If we take, though, that concept over to the Surk case, very simple set of facts, buddy.
You’ve got the years of 2014 and 2015 I believe, if I have my years correct, where Surk is getting losses allocated to them from this partnership. And I don’t know, either through indifference or bad math, they end up deducting and passing through to their partners $3.3 million of losses in excess of their basis they had in the partnership. And that’s a no-no. Right? We just said under 704(d), we’re not allowed to do that. We can only take losses up to our basis. Any additional amount has to get suspended. Well, that’s not what happened here. Never got suspended. It got used even though there was no basis. Then at some point subsequent in the future, the IRS decides to take a look at this partnership, and they can see what happened in 2014 and 2015. They can see that $3.3 million of loss were taken in excess basis. They’re not happy about that. But guess what happened to those years, Damien, by the time the IRS looked at it?
Damien Martin: I’m going to guess they were closed.
Tony Nitti: They were closed.
Damien Martin: Statute had closed. Yeah.
Tony Nitti: Yeah, they were closed. And so the IRS goes, “Okay, can’t touch those years. What can I do here?” Well, in 2017, Surk had a situation where its basis was dramatically increased in this partnership. Imagine the basis suddenly skyrocketing up to a positive degree in 2017, and now Surk has losses that it uses again against that basis, but it’s got basis left over. And so, the IRS comes in and they look at this full landscape, 2014, 2015, 2017. And they say, “You got away with one in 2014 and 2015. You took $3.3 million of losses in excess of basis. But in 2017 basis ratcheted back up. We are going to require that you now reduce your 2017 basis by those excess losses you took in 2014 and 2015.” And the taxpayer, they’re saying, “That’s not how this works. You had one chance at this and that was to deny the losses in 2014 and 2015. Those years, as Damien just told us, are closed by statute and so we won. Right? We got away with one here. We don’t have to do anything. We certainly don’t have to adjust our basis in 2017 for those losses we took.”
And the Tax Court ultimately sided with the IRS, but boy, they did it in an interesting way, D. What they did is they tried to deconstruct the basis adjustment rules for partnerships, which is no easy task. Just the way the rules are laid out in sub-K, a lot harder to keep track of.
Damien Martin: That’s right.
Tony Nitti: The basis adjustment rules, like the pure items that increase and decrease basis, they’re all found in section 705, and basically 705(a)(1)-(a)(2) says, “Look, to preserve a single level of tax,” as we talked about, “every year you increase your basis for items of income and contribution, you decrease basis for distributions.” And then, under (a)(2)i, “You decrease for non-deductible expenses.” And then (a)(2)ii, “You decrease for your losses.” Right? So it’s the last thing that kind of comes out, and so it’s helpful to know what items adjust basis, but if you’re talking about limiting losses, you really have to drill into what is the ordering rule? In what order do we adjust basis because that is ultimately going to decide how much basis is left over when we want to take our losses. And the ordering rules, people will run into a wall trying to find the ordering rules somewhere in 705.
They’re not in 705. Right? They’re in 704, specifically under the 1.704-1(d)(2) regulations that gives us kind of our ordering rule. And the Tax Court looked at these ordering rules, and they interpreted them in a way that I have never interpreted them, but I think they get to the right answer. If you look at those regs, they say, “Okay, when you adjust your basis, first, increase basis for all those positive adjustments under 705(a)(1), and then do it for your decreases under 705(a)(2) except for losses of the taxable year and losses previously disallowed.” The way I have always interpreted that is that when losses are previously disallowed, as I said before, they get suspended, and they just kind of spring to life in the next year and they get put on equal footing with losses from the current year.
And so, it’s just like as a last bucket, you’ve got your losses for the current year, any losses that were previously suspended, take those as the last items out, but not necessarily prescribing a specific ordering rule between, hey, we take our current year losses first and then our suspended losses. Because again, I never thought of it as mattering. Right? There’s no vintage for suspended losses. They’re not like net operating losses.
But what the Tax Court did is they keyed in on that language and said, “The last reduction for basis is for losses for the year and then losses previously disallowed.” They broke that into two pieces and said, “There’s an ordering rule. First, we reduced for losses for the year and then second losses previously disallowed.” Then they said, “If in the second part we’re reducing for losses previously disallowed, that must mean that in the first part we must reduce for all previously allowed losses.”
What they said was an allowed loss is defined as, it’s different than allowable loss. Right? An allowed loss is a loss that was claimed on a tax return and taken. An allowable loss is something you were entitled to take. Right? But in this case, they had taken losses in ’14 and ’15 that weren’t allowable, but ultimately were allowed because they got away with one. And the Tax Court interpreted this final requirement of the 704 regs to say, “If the very last step is to reduce by all losses previously disallowed, the step before that must be to reduce by all losses previously allowed.” And that was the avenue that was the door they opened up to say, “We are required when adjusting basis at the end of the year to figure out how much loss you can use to kind of make sure that all loss that was previously allowed reduces that basis. And only then will we reduce for any previously suspended losses that are rolling forward.”
Is it the right answer? Again, I think it’s the right answer because otherwise you really end up with an abusive situation where you take $3.3 million of excess loss in a given year, and then if you never adjust your basis for that, well obviously when you sell your partnership interest, for example, your gain is going to be $3.3 million less than it would’ve been, or your loss will be $3.3 million more than it should have been. And that obviously shouldn’t be the consequence.
But the way they interpreted this, D, to say that the way we’re going to look at this language here is that if the last half of the language requires a reduction in basis for all losses previously disallowed, the first half must mean all losses previously allowed. It’s an interpretation. I don’t know. I don’t know that that’s what I would’ve necessarily used, but that’s where we get to and it’s an important decision. Right? Because they’re saying that you don’t get away with one. If you take losses in excess of basis, even in a closed year, the IRS can go to that first open year with positive basis and reduce your basis in that year to make sure you don’t get away with one. And so, I think that’s a significant case.
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