Don’t Burn the Partnership AuditTechnique Guide

By Darryll K. Jones

The recent so-so movie ‘‘The Day After Tomorrow’’deals with the exigencies of life after the onset of a newice age caused by global warming. In one scene, threevery smart high school students are stranded with otherpatrons in a New York public library as the outsideclimate temperature drops to something like -150 degreesFahrenheit. The overachievers are forced to burn booksfor heat because there is neither electricity nor wood. Asone of them prepares to add a Friedrich Nietzsche pageturner to the fire, a librarian quietly but forcefully regis-ters her protest. In the face of their impending extinction,the librarian waxes eloquently that humanity will sufferan irreparable loss if Nietzsche burns. One of the morepragmatic students points out, of course, that Nietzsche’sabsence will mean nothing ‘‘if we are all popsicles.’’1 Adebate ensues but is abruptly concluded when one of thesnotnoses exclaims, ‘‘I found a whole section on federaltax law, we can burn that!’’2 Nobody protests. At thispoint, my wife — a budding librarian herself — howledwith such laughter one would have thought we werewatching a comedy rather than a sci-fi drama. I finallyhad to remind her of movie theater etiquette, althoughwe were sitting alone in our living room.

The IRS Partnership Audit Technique Guide will prob-ably not sell like Nietzsche or even a J.K. Rowling novel,but it shouldn’t be used for kindling just yet. It wasoriginally authored in December 2002, and then revisedand reissued on June 10, 2005. Ironically, the revisededition contains several sections that are or soon will beoutdated. The grant of capital or profit interests to servicepartners, mandatory basis adjustments, built-in lossproperty, disguised sales of partnership interests, andliabilities are some of the important areas about whichthe newly issued guide is already obsolete. Still, the

guide is quite useful in many other aspects. I’ve oftenwondered, for example, how firms and the IRS go aboutthe prodigious task of training new associates in partner-ship tax. I hope my students leave my class with anunderstanding of the purpose and jargon of subchapterK, if nothing else. Purpose and jargon allow us to putthings in context and proceed to application and, forsome, manipulation. But it takes more than one semesterof learning about purpose and jargon to fully or evententatively grasp subchapter K and its applications. Andyet associates and examiners can’t afford the time itwould take to leisurely stroll through the sub K thicketthe way professors can. They have to run with the bullsimmediately or suffer the consequences.

The Partnership Audit Technique Guide seems usefulas an orientation to the real world, particularly since itaddresses subchapter K from a viewpoint not very oftenpresented in law or accounting school. The flagship lawschool text, Lind, Schwarz, Lathrope, and Rosenberg’sFundamentals of Partnership Taxation, uses the sensible‘‘cradle to grave’’ approach whereby subchapter K pro-visions are presented in accordance with the lifecycle ofthe typical partnership — formation, operation (alloca-tions), and liquidation. The cradle to grave approach,though, is, well, quaint in the sense that it assumes thepeople wanting to know about sub K are mostly likeWard Cleaver. Ward Cleaver is not interested in themolding or manipulation of rules; he just wants to knowwhat those rules are so he can comply with the rules’broadest possible application as he proceeds through thelife of his business. The guide is more realistically, orperhaps cynically, written for Justice Holmes’s ‘‘badman’’ who ‘‘cares only for the material consequenceswhich such knowledge enables him to predict, not as agood man, who finds his reasons for conduct, whetherinside the law or outside of it, in the vaguer sanctions ofconscience.’’ Ward Cleaver is the good man the cradle tograve approach, by and large, assumes will use theknowledge presented. The guide teaches subchapter K tothe bad man and is therefore more useful if Holmes isright about how one should view the law.

Chapter 1, dealing with a partnership’s initial-yearreturn, provides an early example of that approach.Students of subchapter K would expect to find a basicdiscussion of sections 721 through 723, section 709, andsection 195. The guide adds a discussion, brief though itmay be, of section 707, pertaining to disguised paymentsfor services. In most standard teaching or training texts,section 707 is reserved until after the discussion ondistributions. That approach, while sensible, divorces thelaw from its most commonly associated context. Partnersare likely to first incur limits on current deductibility inthe partnership’s first year because sections 709 and 195

1I made that line up.2I didn’t make that line up. That is exactly what the character

said.

Darryll K. Jones is associate dean and associateprofessor of law at the University of Pittsburgh Schoolof Law. K Rations is a monthly column devoted topartnership tax issues.

edited by Robert J. Wells

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require amortization of organizational and start-up ex-penditures, and section 709 denies all deductions, currentor amortized, for syndication expenses. It is in responseto those provisions, encountered in the partnership’sformative year, that partners might make disguised pay-ments in an effort to achieve the equivalence of animmediate deduction. In a later section, the guide recitesthe disguised sale factors contained in the regulationsand legislative history, but in chapter 1 it provides a keypiece of practical advice not normally discussed in moreformal texts:

In the initial years of a partnership the ScheduleM-1 should have entries for startup and syndica-tion expenses which were deducted per books andhave been treated differently for tax purposes. Thelack of entries here will be an initial indication thatstart-up and syndication expenses may have beendeducted. Additionally, inspection of the partners’returns may indicate a deduction by the partnersfor these items. Sometimes these costs are paid bythe partner and deducted as a miscellaneous item-ized deduction, etc. Therefore, review the partners’returns.

If Holmes’s bad man wants to deduct capital expen-ditures before their time, he would be better off disguis-ing the Form 1065 rather than studying that long list ofregulatory factors. Chapter 2 provides a fairly straight-forward discussion of inside and outside basis, as well ascapital accounts. Its brevity causes it to gloss over thesupreme importance of capital accounts to the whole goalof subchapter K — preventing the presence of the part-nership from distorting tax outcomes to individuals whoengage in transactions via the partnership. Its listing ofthe three instances in which section 754 is relevant — (1)an acquisition of a partnership interest at fair marketvalue, (2) death of a partner causing a basis adjustment tofair market value, and (3) a distribution of cash orproperty — omits any discussion of recent legislationmaking basis adjustments mandatory in certain in-stances. Another piece of practical advice, though, per-tains to the necessity to review a distributee partner’ssubsequent 1040s. A partner who received a distributionof appreciated property and took a substituted basisunder section 732 should be prepared to account for theproperty or show that the gain was recognized on a laterdisposition. Knowing that the examiner may inquireabout the whereabouts of distributed property will, inturn, prompt an adviser to review partners’ 1040s.

Obviously, then, Holmes’s bad man would appreciatethe guide because, by pointing to ‘‘red flags,’’ the guidesuggests planning opportunities by which to stretchsubchapter K to its maximum material benefit. Thediscussion of section 752’s allocation of liabilities isparticularly good from a substantive standpoint, and atthe same time it suggests opportunities for legitimate andillegitimate tax planning. The guide advises that tothwart basis shifting, examiners should ‘‘analyze alldirect loan documents by a partner to the partnership.Determine if these represent arms length liabilities to thepartnership or capital contributions because loans thatshould be classified as capital contributions may beclassified as loans in order to give other partners outside

basis to deduct losses.’’ The general difficulty of distin-guishing debt from equity suggests, of course, that‘‘loans’’ made solely for basis-shifting purposes shouldgenerally pass muster.

One complaint about the guide involves the sort ofimprecision that fairly characterizes the guide’s entirety.There are many instances of over- or understatement,and a few instances when substance is explained inpotentially erroneous shorthand. The following exampleof the effects of a 754 election demonstrates that point:

A and B share in profits, losses, and capital, 50percent each. The partnership’s only asset is landwith an adjusted basis of $60 and a fair marketvalue of $100. A and B each have outside basis andcapital accounts of $30 each. B sells his partnershipinterest to C for $50. C’s outside basis is now $50.C’s share of partner’s [sic] adjusted basis in thepartnership assets (inside basis) is $30. There is nowa discrepancy. Now, if the partnership sold the landfor its $100 fair market value there is a gain of $40.A $20 gain would be allocated to both A and C. Chas already in effect paid for his or her share of theunrealized gain at the time of the acquisition. Ifthere was no IRC section 754 election in effect, thiswill create a permanent difference until the partner-ship is liquidated. If there was an IRC section 754election in effect then the $20 gain step-up is allattributable to C by virtue of increasing basis in theland to $80. The gain of $20 (100-80=20) on the saleof the land is allocated to A.

That, of course, is substantively correct but descriptivelyincorrect. The partnership’s basis in the land is notincreased to $80 nor is the gain only $20. The partner-ship’s basis remains $60, the gain is $40, and is allocatedequally. C’s $20 gain allocation is offset by the $20 basisadjustment and therefore only A recognizes $20 gain.Perhaps this is just a professor’s quibble, but one suspectsthat procedural precision is as important as substantiveprecision.

As mentioned above, and despite the shortcomingsalready noted, the guide seems most useful as a bridgefrom the largely theoretical, but nonetheless requisiteclassroom theory to the practical world. There is, indeed,a dearth of written sources by which to bridge the verylarge gap between the fundamental theory of partnershiptax and its real-world application. I spoke to a fewpractitioners in an effort to ascertain how they wentabout bridging that gap. Matthew Hawes is a second-year associate in a large New York law firm whosepartners have no doubt come across nearly every wrinkleand ambiguity in partnership tax. John Taylor is a veteransub K warrior, having done time in a big accounting firmand now as the sub K partner in a smaller Los Angelesaccounting firm. Though one might be described as ‘‘wetbehind the ears’’ and the other ‘‘long in the tooth’’ inpartnership tax years, they gave nearly identical answersto my query regarding how associates are trained torealistically apply sub K. ‘‘There is a presumption ofcompetence with regard to the basics,’’ according toHawes, ‘‘but associates and partners are not usuallystumped by a question the answer to which is a matter of

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fundamental basics.’’ Hawes noted that more experi-enced associates and partners are always willing to guidea younger associate through a more complex problem,‘‘but there comes a point when one has to figure thingsout alone.’’ Taylor agrees with the idea that masteringsub K is ultimately a solitary task. Like Hawes, heascribed only limited value to formal training that manyfirms provide new associates. Taylor describes himself asa ‘‘self-taught’’ sub K practitioner who has ‘‘read andre-read the 704 examples until my eyes hurt. I’ve tried todo formal training programs but most people don’t seemto learn well that way. Therefore, the preparation of thetax return becomes the training ground. Having staffhelp me prepare aggregate method computations, 734adjustment computations and the like is the best way tohelp them visualize how this stuff actually works.’’

The problem, of course, with all of the partnershipstatutes and regulations is that they leave the reader withthe impression that she is tuning in to the middle of aconversation that has been going on for a long time, andperhaps even on top of an isolated mountain. The regs, inparticular, seem divorced from context and as a resultmost formal texts and training sources seem equallyunmoored. The guide, on the other hand, is rather leanon theoretical substance and long on contextual, real-world manipulations. In that sense, it seems a superiortraining source but only for those who already under-stand the fundamentals. Its practical bad man focus,though, seems particularly useful for collaborative train-ing — perhaps by an associate assigned to summarizeand critique (that is, study) its content for the benefit ofpartners and other associates.

A final point concerning the guide actually returns usto an earlier point. Mastering partnership tax, as withmost any discipline, is made easier by the mastery of newjargon. ‘‘Qualified income offset’’ means nothing outsidesub K but is communicative to the likes of Hawes andTaylor. The guide explains a few cool words and phrases.The ‘‘dumb but lucky rule,’’ for example, is used inreference to the economic effect equivalency rule con-tained in reg. section 1.704-1(b)(2)(ii)(i). The ‘‘some help,no hurt’’ test refers to the overall tax effect test containedin reg. section 1.704-1(b)(2)(iii). My favorite one though isthe ‘‘zombie partnership,’’ which the guide defines as‘‘partnerships which are no longer actively engaged inbusiness but which still wander aimlessly about shed-ding tax benefits or postponing gain.’’ The guide explainsthat zombie partnerships are used to defer Tufts gain onthe sale or abandonment of encumbered property. In-stead of liquidating, the partners maintain the shell andassert that the liability remains with the partnership untilsome later time, apparently when the IRS has stoppedmonitoring it. I suppose knowing the slang assists therecall of underlying substance but the only other place Icould find a reference to zombie partnerships was in a1992 Jane Bryant Quinn column in The Washington Postand in that instance it was used in an entirely differentcontext. The less interesting but more important point isthat the guide contains a nice glossary of terms necessaryto an understanding of sub K.

Now, I might admit that tax materials might be thefirst thing many people would suggest be burned oncethe heat and lights go out. But even in the movies, the

heat and lights come on again. When they do, we willhave to figure out ways to pay for it all over again, so let’snot burn the tax stuff just yet, and certainly let’s not burnthe stuff that shows us how the tax laws really work. ThePartnership Audit Technique Guide is one of those dustyold books we ought to keep around for awhile.

CORRECTIONIn a report in brief on AMT reform (Tax Notes, July,

18, 2005, p. 371), author Linda M. Beale is incorrectlylisted as a professor at the University of IllinoisCollege of Law; Beale is an assistant professor at thatuniversity. Tax Analysts regrets the error.

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