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Partnership - Audit Technique Guide - Chapter 2 - Initial Year Return Issues (Published 12-2002)

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

 

Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to either return to the Table of Contents or proceed to the next chapter.

Chapter 1|Table of Contents | Chapter 2

Chapter 2 - Table of Contents

Introduction         


INTRODUCTION

 

In the initial year of a partnership, several Code sections limit or preclude a current deduction for costs incurred prior to the actual operation of a business.

This chapter deals with three specific types of expenses:

  • Organizational Expenses
  • Syndication Expenses
  • Start Up Expenses.

Other issues covered in this chapter include the tax implications of payments made to partners:

  • IRC section 707(a) ─ Partner or Non-Partner
  • Receipt of a Capital or Profits Interest
  • Payments Capitalized, Deducted, or Distributed?
  • Guaranteed Payments

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ISSUE:  INITIAL YEAR EXPENSES

Under prior law, organization, syndication, and start up costs were not deductible.  Through a series of litigation, it became firmly established that these were capital costs and were recovered as a part of the partner's basis on disposal of the partnership interest.  Subsequently, Congress enacted IRC section 709 and IRC section 195, which provide guidance for these expenses.

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Section 709 ─ Organization and Syndication Expenses

Applicable after 1975, IRC section 709 provides for the tax treatment of the costs of organizing a partnership and promoting the sale of a partnership interest.

Under IRC section 709(a) a current deduction is not allowed for the cost of organizing a partnership and promoting the sale of partnership interests.

Subsequently, IRC section 709(b) provides that organization expenses may be amortized over a period of not less than 60 months.  The partnership must capitalize these costs and timely elect the 60 month rule.  The partnership is not allowed to elect amortization treatment after the return has been filed, such as during the audit process.

Syndication expenses are not included in IRC section 709(b).  They cannot be deducted or amortized.

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Syndication Costs

These are the costs of syndicating a partnership and its related investment units.  Syndication costs are normally items incurred for the packaging of the investment unit (the partnership unit), and the promotion of it.  These include marketing costs as well as the production of any offering memorandums or promotional materials.  Included is the training of any brokers/dealers who will sell the partnership units, plus the actual sales commissions paid to the sellers of the partnership (whether they are unrelated third parties or the individuals who promoted the investment).  Other costs normally incurred as a part of syndication could include legal costs associated with the offering, tax opinions, due diligence, costs of transferring assets to the partnership, printing and preparation of offerings/prospectus, etc.

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Organization Costs

Organization costs include the legal and accounting costs necessary to organize the partnership, facilitate the filings of the necessary legal documents, and other regulatory paperwork required at the state and national levels.

There is a fine line which exists between syndication costs and organization costs.  Generally, syndication represents those costs associated with the sale of the actual investment units, while organization costs are those costs necessary to legally create the partnership.

Election to Amortize Organization Expenses

The election to amortize organization expenses is made on the return for the year in which business commenced.  It is made by completing Part VI of Form 4562, Depreciation and Amortization.  A separate statement must be attached to the return containing the following information:

  • A description of each cost
  • The amount of each cost (costs of less than $10 may be aggregated)
  • The month the active business began, (or the month the business was acquired)
  • The number of months in the amortization period (not less than 60).

An amended return cannot be filed to subsequently elect amortization of organization expenses.  However, an amended return can be filed, including additional organization expenses, when a timely election has previously been made.

IRC section 195   Start-Up Expenditures

IRC section 195(a), added in 1980, denies a deduction for start-up costs.

IRC section 195(b) however, specifically allows the taxpayer to elect to treat these costs as deferred expenses and amortize them over a period of not less than 60 months.

IRC section 195(c) provides the definition of the terms "start-up costs" and "beginning of trade or business".

Start-up costs are costs for creating an active trade or business or investigating the creation or acquisition of an active trade or business.  Start-up costs include any amounts paid or incurred in connection with any activity engaged in for profit or for the production of income before the trade or business begins, in anticipation of the activity becoming an active trade or business.  The expenditures must be of such a nature that they would be deductible if they had been incurred in the operation of an existing business.

When an active trade or business is purchased, start-up costs include only costs incurred in the course of the general search for or preliminary investigation of the business.  Costs incurred in the attempt to actually purchase a specific business are capital expenses and are not amortizable under IRC section 195.

Investigatory expenses are those incurred in the review of a prospective business before a decision to acquire the business has been made.  See Revenue Ruling 99-23 for a definition of allowable investigatory expenses.

Start-up expenses and pre-opening expenses include costs incurred after a decision has been made to acquire or enter into a business.  These would include salaries and wages for training employees, travel for obtaining prospective distributors, suppliers, or customers.  Generally this term is given to expenses that would be deductible currently if they had been incurred after actual business operations had begun.

Expenses specifically not included in start-up costs are those costs allowable under IRC section 163(a), interest expense; IRC section 164, taxes; or IRC section 174, research and experimental costs.

Election to Amortize Start Up Expenses

The election to amortize start up expenses must be made no later than the due date of the return (including extensions).  It is made by completing Part VI of Form 4562.  A separate statement must be attached to the return containing the following information:

  • A description of the business to which the start-up costs relate
  • A description of each start-up cost incurred
  • The month the active business began, (or the month the business was acquired)
  • The number of months in the amortization period (not less than 60).

If a revised statement is required, it cannot include any costs treated on a return as other than a start up cost.  Accordingly, the only costs that can be added to the original statement are costs incurred in a subsequent year that are added to the total start up costs to be amortized.  An amended return cannot be filed to reclassify costs to start up costs.

Cash Basis Taxpayers and Start Up Costs

A partnership using the cash basis cannot take an amortization deduction until the organization or start-up cost has been paid.  If paid in a year after the business has begun, they can deduct an amount equal to the number of months beginning with the effective date of the IRC section 709(b) election.  This will catch up the amount of amortization on items paid in subsequent years with the amortization on costs paid in the initial election year.

Dispositions before the End of the Amortization Period

If a business is completely disposed of before the end of the amortization period, the remaining unamortized balance of properly elected organization and start-up expense is deductible as an ordinary loss under IRC section 165.  Syndication expenses paid outside the partnership by the partner, must be added to the partner's basis and will affect gain/loss on disposition or increase the basis in distributed assets on liquidation.

GAAP versus Tax Accounting   Start Up and Organization Costs

Under generally accepted accounting principles, organization costs and start up costs are expensed as incurred.

Specifically, the AICPA, in Statement of Position (SOP) 98-5 defines in broad terms what are start up costs and requires that such costs be expensed.  This broad definition would include most of the expenditures that are required to be capitalized for tax purposes.  Therefore, GAAP versus tax differences generally exist and should be reflected on the partnership Schedule M-1.

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Payments To A Partner:  IRC section 707(A) ─ Partner Or Non-Partner

IRC sections 702 and 704 provide that a partner includes in income his or her "distributive share" of partnership income or loss, and the amount of that distributive share is usually determined by the partnership agreement.  IRC section 731 provides that no gain is to be recognized as a result of distributions by the partnership so long as those distributions do not exceed the partner's basis in his or her partnership interest.  While these provisions represent logical and equitable approaches to the taxation of businesses operated in partnership form, they have been used by some taxpayers to circumvent capitalization requirements and to avoid reporting income.

By treating various payments to a partner as a deduction or a distribution of profits, a partnership may attempt to change the nature of a payment.  Examples of these recharacterizations would include transforming capital items to deductible expense and fee income into portfolio income.

IRC section 707 (a) was enacted to prevent such potential abuses.

IRC section 707(a)

IRC section 707(a) was originally intended to prevent misuse of IRC sections 702, 704 and 731.  It requires that transactions between a partnership and a partner, who is not acting in his or her capacity as a member of the partnership, to be considered as occurring between the partnership and one who is not a partner.  That is, an outsider or unrelated party.  IRC section 707(a)(1) can encompass loans, leases, sales, and employment relationships.

The wording of IRC section 707(a)(1) is very brief, and the regulations for this subsection provide very little explanation except to state in the last sentence of Treas. Reg. section 1.707-1(a):  "In all cases, the substance of the transaction will govern rather than its form."  In general, services involving a partner's particular technical expertise are considered "non-partner."

Apparently the law and regulations were not specific enough to accomplish the desired effect, so, as part of the Tax Reform Act of 1984, a second paragraph was added to IRC section 707(a) which is reflected as IRC section 707(a)(2).

The law specifically provides that payments to a partner for either services or property will be treated as a transaction between the partnership and an outsider so long as he is acting other than in his or her capacity as a member of the partnership.  This forces the partnership to treat the payment as if it were paid to an unrelated third party and removes any option to treat the payment as a partner's distributive share as shown in the Examples 1 through 4 in this chapter.

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Payments To A Partner:  Receipt of a Capital or Profits Interest

During the course of partnership formation, it is not uncommon for the partner who is to manage the partnership’s affairs to receive an interest in partnership profits in exchange for the performance of past or future services.  Since it is the combination of labor and capital that creates a business, this is to be expected.  Over the years, taxpayers, the Service, and the courts have struggled with the tax consequences of the many variations of these partnership agreements.

A “Bare” Profits Interest ─  An interest in partnership profits with no interest in partnership capital is a “bare” profits interest.  Generally, the receipt of a partnership interest in exchange for services is taxable under IRC section 61(a)(1) and Treas. Reg. section 1.61-2(d)(1) as property received for services.

However, Treas. Reg. section 1.61-2(d)(6) provides an exception in the case of property subject to a restriction that has a significant effect on its fair market value under IRC section 83.

A capital interest in a partnership is generally not subject to a substantial risk of forfeiture under IRC section 83 and will not meet the exception.  Therefore, it will be included in the income of the recipient at its fair market value (Treas. Reg. section 1.721-1(b)(1)).

Since the value of a profits interest is contingent on the realization of profits in the future, it is difficult to value and is generally considered to be IRC section 83 property.  Under IRC section 83, at the time the profit is determined and added to the service partner’s capital account, it is taxable to the partner and deductible by the partnership.

To provide further guidance, the Service announced in Rev. Proc. 93-27 that they would not attempt to tax the receipt of a profits interest except where the income is fairly certain, the interest is disposed of within 2 years of receipt, or it is publicly traded.

When is a Partner not a Partner? ─  Rev. Proc. 93-27 did not put an end to all of the controversy regarding receipt of a profits interest.  The receipt of a profits interest does not automatically make one a partner.  A similar agreement could be made with an independent contractor.  Someone who receives a “guaranteed payment” of so much a month plus a percentage of the profits may in fact be an employee with profit -sharing.

Pursuant to Rev. Proc. 93-27, the receipt of a profits interest in exchange for future services should generally be accepted.  However, if the partnership appears to be designed primarily to provide tax benefits to one or both parties, careful analysis should be applied to ensure that partner status for tax purposes is warranted.

Regulations regarding performance of services have not yet been issued, but the Section 707 Committee Reports contain significant guidance.  The Committee was concerned with transactions that avoid capitalization requirements.  Other concerns were situations where a service partner received a portion of partnership capital gains in lieu of a fee, the effect of which converted ordinary income into capital gain.  The Committee was not concerned with non-abusive allocations that reflect the various economic contributions of the partners.  The rules apply both to one- time transactions and continuing arrangements that utilize purported partnership allocations and distributions in place of direct payments.

The Committee believed that the following factors should be considered in determining if the purported allocation is received by the partner in his or her capacity as a partner.

Generally, the most important factor is whether the payment is subject to an appreciable risk as to amount.  An allocation and distribution provided for a service partner which subjects the partner to significant entrepreneurial risk as to both amount and payment generally would be recognized.  Other factors indicating that the payment may be a fee include:

  • Transitory (temporary or short-term) partner status
  • The payment is made close in time to the performance of the services
  • Whether, under all the facts and circumstances, it appears that the recipient became a partner primarily to obtain tax benefits for himself or the partnership which would not have been available had the services been rendered in a third party capacity.  The fact that a partner has significant non-tax motives is of no particular significance
  • The recipient's interest in continuing partnership profits is small in relation to the allocation

In applying these factors, one should be careful not to be misled by self-serving assertions in the partnership agreement, but should look to the substance of the transaction.

In cases where allocations are only partly related to the performance of services, the above provisions will apply to the portion related to services.  Even where the service partner has contributed some capital, the “profits interest” may still be carved out and treated as compensation.

In Smith Est. et. al. (63-1 U.S.T.C. 9268), the Eighth Circuit Court of Appeals held that a common fund, from which the manager received a percentage of the profits from trading commodities futures, was a partnership but that the manager's share of the profits was compensation, not capital gain.  To the extent that partners of the manager invested cash in the common fund, they were entitled to treat the income from their investment as capital gains and losses.

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Payments to Partners ─ Payments Capitalized, Deducted, or Distributed?

Capital Item Shown as a Deduction or Distribution

In the early years of a partnership, it is common to see payments or reimbursements to partners that are properly capital in nature.

Examples are payments to partners for the following:

  • Organization Expenses, IRC section 709
  • Syndication Expenses, IRC section 709
  • Start-up costs, IRC section 195
  • Capital Assets, IRC section 263
  • Uniform Capitalization Rules, IRC section 263A

 Example 2-1

Assume that a broker is a 25 percent interest owner in a partnership that plans to construct a building.  She provides services including packaging and promotion of the investment units, resulting in the sale of all the planned partnership units.  For her services she is paid a fee of $40,000.  Assume that partnership income for the year of payment amounted to $100,000 before considering the $40,000 payment to broker partner.  Proper treatment of this $40,000 expenditure would be to capitalize it as a nondeductible syndication expense, with no direct effect on the partnership's total income of $100,000.  Of course, the broker partner would also include the $40,000 fee in her income, probably on a Schedule C.  The total effect on the partners' returns would be as follows:

 

 

 25% Partner 

 75% Partner

Total

 Partnership Income

$ 25,000

 $ 75,000

 $ 100,000

 Broker's Fee

   40,000

             0

      40,000

 Total Income Reported 

$ 65,000 

 $ 75,000

 $ 140,000

 

 

 

This is the proper treatment of this item.  It has been shown as a payment to a person who is not a partner.  This is correct under Section 707(a).

If the partnership had improperly deducted this capital expenditure, taxable income would have been reported as follows:

 Example 2-2

 

      

 25%
Partner

 75%
Partner

 Total

Original Partnership Income 

$25,000 

$75,000

$100,000

Deduction for Broker's Fee 

(10,000)

 (30,000)

  (40,000)

Net Partnership Income 

$15,000

$45,000

$  60,000

Broker's Fee 

 40,000

           0

    40,000

Total Income Reportable  

$55,000

$45,000

$100,000

 

 

 

 


 

By deducting an otherwise capital expense, the partnership has effectively reduced its net ordinary taxable income by $40,000.  Since we would disallow this deduction because it is a non-deductible syndication expense, the partnership may try to achieve the same result by treating the broker's fee as part of the broker's distributive share.  In this case, the allocation between the partners would be slightly different, but the incorrect net taxable amount remains $100,000 as follows:

 Example 2-3

 

   

25%
Partner 

75%
Partner 

Total 

Original Partnership Income 

$ 25,000

$ 75,000

$100,000

Special Allocation 

40,000

(40,000)

0

Total Income Reportable  

$ 65,000

$ 35,000

$100,000

 

 

 

 

By treating the $ 40,000 fee as a part of the broker's distributive share, the partnership has managed to deduct an expenditure that any other taxpayer would be required to capitalize.  Section 707(a) would require treatment as a payment to a person not a partner in the partnership, changing the reporting to the $140,000 result shown in Example 1-1.

Conversion of Fee Income into a Capital Gain

Another abuse that IRC section 707(a) was intended to prevent relates to the shifting of the nature of income.  An example of this is the shifting of fee income to a distributive share of a partnership's capital gain, portfolio income, etc. as shown in the following example.

Example 2-4

Mr. A is a financial advisor.  He has a contract with Investor B to manage $20 million of Investor B's assets.  The contract requires Investor B to pay 20 percent of profits annually to Mr. A as a fee for managing the assets.

In Year 1, the $20 million is invested and earns a total of $4 million in capital gain, dividend, and interest income.  Accordingly, Mr. A earns a fee of $800,000 (20 percent of the $4 million).  Mr. A reports this as income subject to employment tax.  On his Form 1040, Investor B includes the $4 million in income and deducts the $800,000 fee as a miscellaneous itemized deduction subject to alternative minimum tax.

In Year 2, Mr. A and Investor B form Partnership AB.  Investor B contributes his $20 million in assets.  Mr. A contributes no capital and receives a 20 percent profits interest in exchange for managing the assets.

Assume the earnings in Year 2 are equal to Year 1 earnings.

Mr. A now receives the $800,000 of income as a distributive share of partnership capital gain and portfolio income, not subject to self-employment tax.  Investor B now includes $3.2 million into income ($4 million @ 80 percent).

Although the economic relationship between Mr. A and Investor B has not changed, the tax treatment of their activity has changed significantly.

In general, the provisions of IRC section 707(a) would require the payment to Mr. A to be treated as paid to a non-partner.  This would require the tax treatment to be reported as it was in Year 1.

Guidance on the issue of payments to service providers who receive a profits interest in a partnership is set forth in Luna, 42 T.C. 1067 (1964) and includes:

  1. The intent of the parties to create a partnership
  2. The ability of the service provider to control the income or capital
  3. Whether the parties share a mutual proprietary interest in the net profits of the venture
  4. Whether the service provider has an obligation to share in losses
  5. Whether the venture was conducted in the joint names of the parties
  6. Whether the partners filed a partnership return
  7. Whether the parties held themselves out as joint venturers
  8. Whether separate books were maintained for the partnership
  9. Whether the parties exercised mutual control over and assumed mutual responsibilities for the business of the partnership.

Of all of the factors enumerated in Luna, the most important is entrepreneurial risk.  Does the partner have the risk of loss if the venture is unsuccessful?  In the example above, Mr. A has no risk of loss since he has no capital at-risk.  All losses will be allocated to Investor B.

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Guaranteed Payments ─ IRC section 707(c)

A guaranteed payment is deducted in the computation of partnership income.  Accordingly, it is considered a payment made to one who is not a member of the partnership and is deducted in full, just as if it were an ordinary expense under IRC section 162.  A guaranteed payment is an amount paid to a partner that is determined without regard to the partnership income and is made to a partner acting in his or her capacity as a partner.  Additionally, the amount paid must be deductible under IRC section 162 as an ordinary business expense.  Thus, illegal payments or payments that are capitalizable are not deductible under IRC section 707(c).

Prior to 1976 many taxpayers interpreted the law as providing that guaranteed payments were automatically deductible.  In 1976 IRC section 707(c) was amended to specifically hold that if the payment is a capital expense under IRC section 263 it must be considered as made to one who is not a member of the partnership.  Accordingly, it must be capitalized and is not automatically deductible.  At the same time, IRC section 709 was added and it became evident that a taxpayer cannot convert organization and syndication expenses into a current deduction by casting the payment as a guaranteed payment.

It is sometimes difficult to distinguish between payments to partners which fall under IRC section 707(a)(partner not acting in capacity as partner), and those which are governed by IRC section 707(c) (guaranteed payments).

  • The determining factor is whether the partner is acting other than in his or her capacity as a member of the partnership.
  • Generally, if the partner performs a service for the partnership that he/she also performs for others (such as an attorney, architect, stockbroker, etc.), payments will be deducted or capitalized by the partnership under IRC section 707(a).
  • However, if he or she works exclusively or primarily for the partnership, payments are more likely to be treated as guaranteed payments per IRC section 707(c) (if not based on partnership income) or as his or her distributive share under IRC section 702(a) (if based on partnership income).

Whether the payment is under IRC section 707(a) (payment to a partner not acting in his or her capacity as a partner), or under IRC section 707(c) (guaranteed payment), it cannot be treated as a distribution of partnership profits.  Also, if it is paid for any capital item, it cannot be expensed.

So why even make the distinction between IRC section 707(a) and IRC section 707(c)?  One of the most important reasons is the timing of receipt of income by the partner.  Guaranteed payments are always includable in the partner's taxable income as of the end of the tax year in which the partnership deducts or capitalizes the payment.  On the other hand, payments made under IRC section 707(a), and considered paid to a non-partner, retain their character and timing based on the nature of the payment and the accounting method of the partner as previously shown in Example 2-4.

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Examination Techniques

Start up costs, organization costs, and syndication expenses of partnerships may not have been properly classified.  Areas to consider during examination are:

  1. Did any partners claim an itemized deduction for a legal fee, tax advice fee, surety fee, etc., incurred in connection with the partnership?  If no organization or syndication costs are apparent from the records of the partnership, it may be necessary to examine the general partner or other entity that established the partnership to determine what costs were incurred.  IRC section 709 states that such costs are not deductible by a partner.
  2. Is there a first year management fee, or a guarantee of a set amount of profit, for the organizing partner in the early years of the partnership that is designed to compensate him/her for organization costs?
  3. A detailed examination of the organizing partner's records will be required if you see any indication that syndication fees have been amortized under the guise of organization costs.
  4. Partnerships often attempt to deduct large syndication payments in the year of organization that are either paid to the general partner or to outsiders and are actually capital in nature.  Sales commissions, a proper IRC section 263 capital item, may be labeled as management fees, interest, or another classification that would make it appear to be a deductible expense.  When the commission is substantial, it is often fractionalized into any number of classifications and amounts and spread out to appear deductible.
  5. Other payments to partners may require capitalization.  Examples would include certain legal, accounting, and architectural fees.
  6. Partnerships with a large number of partners should have significant syndication costs on the balance sheet and a large amount of organizational expense being amortized.
  7. You should note that the classification given to a payment is often misleading.  Thus, a strict analysis is needed.  Since the payments may require a different tax treatment, Rev. Rul. 75 214, Rev. Rul. 85 32, as well as IRC sections 195, 248 and 709 should be consulted for guidance.
  8. Secure written description of duties performed by the promoter/partner.  Determine what portion of promoter/partner fees is related to syndication costs, organizational costs, start-up costs, and asset acquisition.  Ask the promoter/partner for contemporaneous records to verify the amount of time spent on initial activities.  In instances where the taxpayer refuses to provide records, the agent should consider disallowing the entire developer fee.  (Carp & Zuckerman v. Commissioner, T.C. Memo. 1991 436).
  9. If any partner receives an interest in the entity in exchange for services rendered, the facts must be considered to insure proper treatment.  At the partnership level, this will include the determination of when and how the partnership reflects the allocation of profits and/or capital.  At the partner level, it will be a determination as to the proper timing and nature of the inclusion of income by the partner receiving the interest.

Issue Identification

In the initial years of a partnership the Schedule M-1 should have entries for start-up and syndication expenses which were deducted per book and have been treated differently for tax purposes.  The lack of entries here will be an initial indication that start-up and syndication expenses may have been deducted.

Additionally, inspection of the partners' returns may indicate a deduction by the partner for these items.  Sometimes these costs are paid by the partner and deducted as a miscellaneous itemized deduction, etc.  Therefore, review the partners' returns.

Any changes to the capital accounts may reflect items that could be subject to capitalization.

Inspection of Schedules K-1 may reflect changes to partnership interests.  Analysis should reflect if any interests were provided for services rendered to the partnership.

Documents to Request

  1. Partnership agreement and all amendments
  2. Articles of Organization (LLC's) and all amendments
  3. Private Placement Memorandum, prospectus, or any similar documents
  4. Any agreements with brokers or sales agents

 Interview Questions

Interview questions will vary based on the information presented and will be contingent on how clear a picture is presented, specifically:

  1. Who organized the entity and how was he/she compensated?
  2. Were brokers or agents used to sell partnership interests?
  3. When did the business begin?
  4. What expenses were incurred prior to the opening?

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Supporting Law

IRC section 709
IRC section 707
IRC section 195
IRC section 263
IRC section 263A
IRC section 61
IRC section 83

Rev Rul 99-23, 1999-20 C.B. 3, provides guidance on the type of expenditures that will qualify as investigatory costs that are eligible for amortization as start-up expenditures under Section 195 when a taxpayer acquires the assets of an active trade or business.

Rev. Rul. 88-4, 1988-1 C.B. 264, states that the fee paid by a syndicated limited partnership for the tax opinion used in the partnership prospectus is a syndication expense chargeable by the partnership to a capital account and cannot be amortized.

Rev. Rul. 85-32, 1985-1 C.B. 186, states the following:  Syndication costs incurred in connection with the sale of limited partnership interests are chargeable by the partnership to a capital account and cannot be amortized.

Rev. Rul. 81-153, 1981-1 C.B. 387, states the following:  An investor in a limited partnership may not deduct that part of the purchase price that is paid, through a rebate or discount arrangement, by the investor to a tax advisor on behalf of the partnership for services related to the sale of the partnership interest.  The partnership may not amortize this amount under IRC section 709(b).  The investor's basis in the partnership is the amount of cash contributed.

In Carp & Zuckerman v. Commissioner, 62 T.C.M. (CCH) 658, T.C. Memo. 1991-436, the court allowed no part of a purported development fee as the taxpayer failed to establish the purpose and nature of the expenditure.

In Diamond v. Commissioner, 92 T.C. 423 (1989), guaranteed payments were made to partners which they contended were for management services.  The court required the payments to be capitalized.  The taxpayer did not provide a basis for estimating what portion was for management services under Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).

In Collins v. Commissioner, 53 T.C.M. (CCH) 873, T.C. Memo.  1987-259, it was found that management and consulting fees paid shortly after the formation of a general partnership were held to be organizational expenses and were required to be amortized rather than currently deducted.  Similarly, legal and accounting fees incurred shortly after formation were nondeductible organization and syndication expenses.

In Vandenhoff v. Commissioner, 53 T.C.M. (CCH) 271, T.C. Memo. 1987-116 and Isenberg v. Commissioner, 53 T.C.M. (CCH) 946, T.C. Memo. 1987-269, it was found that guaranteed payments by a motion picture partnership to the general partners were in the nature of syndication expenses and were required to be capitalized.

In Schwartz v. Commissioner, 54 T.C.M. (CCH) 11, T.C. Memo.  1987-381, aff'd without opinion, 930 F.2d 920 (9th Cir. 1991), it was found that payments made to a partner were syndication expenses that must be capitalized and were not deductible as guaranteed payments.

In Driggs v. Commissioner, 87 T.C. 759 (1986), it was found that amounts paid to a general partner as "sponsor's fees" were not deductible because the partnership failed to prove whether the expenses were for syndication fees or for organization costs.

In Egolf v. Commissioner, 87 T.C. 34 (1986), it was held that a partnership could not currently deduct organization and syndication costs by indirectly paying them to a partner under the guise of management fees.  Since no election was made by the partnership, no amortization of partnership organization expenses was allowed.

In Durkin v. Commissioner, 87 T.C. 1329 (1986), the court ruled that payments made by a partnership to two general partners for services were for expenses in connection with organizing the partnership and the offering and such payments were not currently deductible as guaranteed payments.  The partnership was entitled to amortize the expenses.

In Finoli v. Commissioner, 86 T.C. 697 (1986), it was determined that amounts paid for preparation of a tax opinion, incurred to promote or facilitate the sale of partnership interests, and commissions and consulting fees constituted non-deductible syndication expenses.

In Tolwinsky v. Commissioner, 86 T.C. 1009 (1986), and Law v. Commissioner, 86 T.C. 1065 (1986), it was found that organizational expenses for a motion picture tax shelter were amortizable only to the extent that such expenses were substantiated.

In Surloff v. Commissioner, 81 T.C. 210 (1983), it was found that fees paid to an attorney by partnerships mainly for the preparation of a tax opinion letter that was used in a prospectus given to potential investors were syndication expenses and had to be capitalized.

In Flowers v. Commissioner, 80 T.C. 914 (1983), it was determined that expenditures for tax advice were incurred for purposes of obtaining the tax opinion letter that accompanied organization and sales promotion of limited partnership interests and were non-deductible capital expenditures.

In Wendland v. Commissioner, 79 T.C. 355 (1982), aff'd, 739 F.2d 580 (11th Cir. 1984), it was determined that legal expenses paid to a law firm by a coal mining tax shelter partnership constituted organizational expenses.  These expenses had to be capitalized in the absence of evidence allocating such expenses between legal advice and tax advice.

In Johnsen v. Commissioner, 83 T.C. 103 (1984), motion denied, 84 T.C. 344 (1985), rev'd on other grounds, 794 F.2d 1157 (6th Cir. 1986), it was found that a partner could not deduct his share of claimed expenses for legal and tax advice.  The evidence showed that the services concerned the organization and promotion of the partnership.

In Smith v. Commissioner, 33 TC 465 (1960), aff'd in part and rev'd in part, 313 F. 2d 724 (8t h Cir. 1963).  The Court of Appeals held that a common fund, from which the manager received a percentage of the profits from trading commodity futures, was a partnership but that the manager's share of the profits was compensation, not capital gain.  To the extent that partners of the manager invested cash in the common fund, they were entitled to treat the income from their investment as capital gains and losses.

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Resources

CCH Standard Federal Tax Reporter
IRS Publication 535 ─ Business Expenses
IRS Publication 541 ─ Partnerships
IRS Publication 583 ─ Starting a Business and Keeping Records

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Page Last Reviewed or Updated: 24-Oct-2014