Published Tax Court decisions look at new and novel issues that have not previously been decided by the Court—and, in the case of Lipnick v. Commissioner, 153 TC No. 1, the Court was looking at just such case.
The issue was fairly simple. A partner received a debt-financed distribution from a partnership. He used those funds to buy investment assets and, under Reg. §1.163-8T and Notice 89-35, he treated the debt-financed distribution interest expense reported to him by the partnership as investment interest. However, later he gifted a portion of his interest in the partnership to his son who, of course, was now seeing such debt-financed distribution interest show up on his K-1.
How does the son report this interest expense on his return? Does it retain its status as investment interest (the position of the IRS in this case), or is it instead more properly treated as interest on debt incurred to obtain his interest in the partnership (the taxpayer’s position regarding this interest)? Interestingly enough, this particular issue had not come before the courts in the 30 plus years since the revised interest rules under the Tax Reform Act of 1986 entered the law.
The Court notes that, generally, the use of proceeds of a debt determines its tax treatment (the tracing rule). Temporary Regulation §1.163-8T(c)(1) provides:
(c) Allocation of debt and interest expense -
(1) Allocation in accordance with use of proceeds. Debt is allocated to expenditures in accordance with the use of the debt proceeds and, except as provided in paragraph (m) of this section, interest expense accruing on a debt during any period is allocated to expenditures in the same manner as the debt is allocated from time to time during such period. Except as provided in paragraph (m) of this section, debt proceeds and related interest expense are allocated solely by reference to the use of such proceeds, and the allocation is not affected by the use of an interest in any property to secure the repayment of such debt or interest.
Notice 89-35 was issued to clarify, among other things, how the tracing rule would work in the context of a partnership that borrowed funds to make a distribution to its partners. Section V.A. of the Notice provides:
In general, when debt proceeds of a passthrough entity are allocated under section 1.163-8T to distributions to owners of the entity, the debt proceeds distributed to any owner and the associated interest expense shall be allocated under section 1.163-8T in accordance with such owner’s use of such debt proceeds. For example, if the owner uses distributed debt proceeds to purchase an interest in a passive activity, the owner’s share of the interest expense on such debt proceeds is allocated to a passive activity expenditure (within the meaning of section 1.163- 8T(b)(4)).
But nothing in either the regulation nor the Notice directly addresses the situation where the partner transfers his interest via a gift in a later year.
The IRS has an answer, though the Tax Court didn’t agree with its view: the son steps into the shoes of his father, resulting in the interest being investment interest, just as it had been in his father’s hands.
The Tax Court notes one problem with the IRS’s theory: it found “no support for this theory in the statute, the regulations, or the decided cases.”
The Court notes the son did not receive, either directly or indirectly, any debt-financed distribution from the partnership, thus did not make any traceable investment expenditure with the funds. With no investment asset having been acquired with the funds, the interest cannot be investment interest.
Rather, the Court finds the situation is described in Reg. §1.163-8T(c)(3)(ii) which provides:
(ii) Debt assumptions not involving cash disbursements. If a taxpayer incurs or assumes a debt in consideration for the sale or use of property, for services, or for any other purpose, or takes property subject to a debt, and no debt proceeds are disbursed to the taxpayer, the debt is treated for purposes of this section as if the taxpayer used an amount of the debt proceeds equal to the balance of the debt outstanding at such time to make an expenditure for such property, services, or other purpose.
The Court notes that when the interests were gifted to the son, the debts that were generating this interest were are on the books of the partnership—thus, the son’s partnership interest was effectively burdened with these debts. Thus, the Court concludes that the son acquired the interest subject to the debt in accordance with Reg. §1.163-8T(c)(3)(ii).
And now the Court returns to Notice 89-35 which also covers the use of borrowed funds to acquire an interest in a passthrough entity. Section IV.A. of the Notice provides:
In the case of debt proceeds allocated under section 1.163-8T to the purchase of an interest in a passthrough entity (other than by way of a contribution to the capital of the entity), the debt proceeds and the associated interest expense shall be allocated among all the assets of the entity using any reasonable method.
The Court applied these rules as follows:
In short, whereas Maurice received a debt-financed distribution, William is treated as having made a debt-financed acquisition of the partnership interests he acquired from Maurice. See ibid. For section 163(d) purposes, therefore, the debt proceeds are allocated among all of the partnerships’ real estate assets using a reasonable method, and the interest paid on the debt is allocated to those assets in the same way. Sec. 1.163-8T(c)(1), Temporary Income Tax Regs., supra.
The partnerships’ real estate assets were actively managed operating assets. Respondent agrees that those assets did not constitute “property held for investment.” See sec. 163(d)(3)(A). The interest paid on the M&T and W&D loans therefore was not “investment interest.”
The Court also rejected the IRS’s claim that this couldn’t be acquisition debt because it was nonrecourse debt. The Court ruled that he had acquired his interest subject to those debts even though he did not personally assume those debts.