While having to identify the most complex area of the Internal Revenue Code is akin to being asked to choose the most annoying member of the Miami Heat, in my opinion, there’s no more complicated jumble of rules than those governing partnership taxation. Subchapter K, which spans from Sections 701 through 777, is rife with cumbersome language, exceptions to exceptions, and seemingly endless cross-references, with the “substantial economic effect” rules of the Section 704 regulations enough to send even the most brazen of tax advisors running for the relative simplicity of subchapter S.
Sadly, I’ve spent the better part of the past decade trying to understand the finer points of the partnership rules, and it seems that whenever I think I’m finally comfortable with a specific provision, something comes along and throws me for a loop.
Consider the Tax Court’s decision yesterday in Brennan v. Commissioner, T.C. Memo 2012-158. Brennan dealt with Section 736, which governs partner retirements, a provision that could — and certainly should — read much simpler than currently constructed.
One might logically conclude that when a partner in a partnership retires, they cease to be treated as a partner on the retirement date, and should receive no further allocation of income, gain, loss or deduction from that point forward. Stephen Brennan certainly believed so.
Brennan was a partner in Cutler & Company (Cutler), an LLC taxed as a partnership. In 2002, Brennan apparently “retired” from Cutler just as Cutler was preparing to sell a large portion of its assets pursuant to a restructuring agreement. As part of the restructuring agreement, Cutler was to distribute 44% of the sales proceeds — after paying off any Cutler liabilities — to Brennan in liquidation of his interest. This relationship was described by the Tax Court as an “economic interest” held by Brennan in Cutler, one that conferred upon Brennan a continuing right to share in the income or loss of Cutler while also securing Cutler’s obligation to make liquidating payments to Brennan.
Cutler apparently sold its assets on the installment method, receiving large chunks of cash and recognizing the related capital gains in 2003 and 2004. No cash was ever distributed to Brennan before Cutler went bankrupt in late 2004. While Cutler properly reported the capital gains resulting from the asset sale on its 2003 and 2004 Forms 1065, Brennan did not recognize his share of any of the gains, operating under the theory that since he had retired as a partner at the end of 2002 and did not receive any of the sale proceeds, he was not required to recognize his share of the gain.
And this is where the confusion sets in. In general, Section 736 — like much of subchapter K — contains a trap for the unwary. Treas. Reg. §1.736-1(a)(1)(ii) provides that while a partner “retires” when he ceases to be a partner under local law, for the purposes of subchapter K, a retired partner will be treated as a partner until his interest in the partnership has been completely liquidated. This regulation is further clarified by Treas. Reg. §1.761-1(d), which provides that a partner is not completely liquidated until they have received the final distribution owed to them.
Now, until yesterday, I had always believed that these regulations only served the administrative purpose of continuing to require the partnership to issue a K-1 to the retired partners until they were fully redeemed, but importantly, the retired partner would not be allocated any additional income, gain, loss or deduction during the period of time spanning from his retirement date until the day he receives his final liquidating distribution. In other words, while the retired partner would continue to receive K-1s until he was fully redeemed, they would be blank K-1s.
The McKee, Nelson & Whitmore treatise on the subject only confirmed my belief:
For tax purposes, a retired partner is treated as a continuing partner until the § 736 liquidation process is complete.Accordingly, the taxable year of a partnership does not terminate prematurely with respect to a retired partner until such time as all § 736 payments have been received.Furthermore, even though a retired partner is entitled to receive only fixed liquidating distributions and is not entitled to any distributive share of partnership income, the fact that the retiree is still treated as a partner means that certain provisions, such as § 704 and § 751, continue to apply to him.
Yesterday, however, the Tax Court forced me to revisit this approach, as it concluded that Brennan had to recognize his share of Cutler’s capital gain recognized during 2003 and 2004, even though he “retired” at the end of 2002, because he had not yet received his final liquidating payment from Cutler and was thus still a partner. Here’s the court’s explanation:
Here, Mr. Brennan was entitled to receive 44.985% of the net IA sale proceeds in complete liquidation of his partnership interest in Cutler after the IA sale. Cutler received proceeds from the IA sale in 2003 and 2004, yet never distributed any amount of the net IA sale proceeds to Mr. Brennan. Nor did Cutler make any other distribution of cash or property in complete liquidation of Mr. Brennan’s partnership interest in Cutler before the end of 2004. Accordingly, Mr. Brennan remained a Cutler partner for tax purposes for 2003 and 2004. Consequently, Mr. Brennan must take into account his distributive shares of the capital gains income from the IA sale for 2003 and 2004 as set forth in the restructuring agreement, along with various other partnership items as required under section 702(a).
The decision is largely bereft of facts analysis, leaving readers wanting for clarification. For example, the opinion does not stipulate Brennan’s state-law retirement date, but rather casually mentions that “the Brennans argue that Mr. Brennan’s status as a partner of Cutler for tax purposes terminated in 2002…” and “Mr. Brennan was to hold an economic interest in Cutler rather than a membership interest upon the [asset sale]”.
Further complicating matters, in reaching its conclusion, the court does not reference back to the specifics of Brennan’s “withdrawal,” but instead only addresses the general rules under Section 736 stating that a retired partner is still considered a partner for tax purposes until completely liquidated.
This ambiguity leaves several unanswered questions as to why the court concluded Brennan was required to recognize his share of Cutler’s income in 2003 and 2004, all of which I’d like an answer to:
- Does the lack of mention of a specific retirement date indicate that perhaps there was no state-law retirement date, meaning Brennan was unquestionably a partner through 2004? If so, why wasn’t this referenced in the opinion section?
- Could it be that because Brennan’s liquidating distributions were so inextricably tied to the asset sale, he was required to recognize the gain resulting from those sales, regardless of the fact that they occurred after his retirement date?
- Is this really just a matter of the “economic interest” Brennan held in Cutler after his retirement? If readers had access to the full restructuring agreement, would the language make clear that Brennan was to continue receiving allocations of income and loss until he received the final liquidating distribution even though he no longer owned a “membership interest” in the partnership?
- Or could I just have misunderstood Section 736 all along, and in all tax years beginning with the state-law retirement date and through the final liquidation payment, the retired partner is required to receive full allocations of income, gain, loss and deduction on Schedule K-1? I doubt that this is the case for a multitude of reasons, but this decision has certainly left me doubting my understanding of I.R.C. § 736.
I’ve got a call in with the IRS attorney assigned to Section 736, because I find the Brennan decision to be lacking in relevant details, and reaching a confusing conclusion, even by subchapter K standards. In the meantime, if you’ve got a grasp of Section 736 and an abundance of free time, please chime in. Updates forthcoming.
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