Likely, either the partnership or limited liability company is the most flexible of entities now available for business-or investment-related ventures. Whether either such entity is a partnership for tax purposes is the subject of this note.
Checking the box is not all that is necessary to assure partnership status. Recognition of the entity for federal tax purposes is a prerequisite, meaning that there must be business purpose and economic substance to the entity. See 26 CFR Sections 301.7701-2 and 301.7701-3. See also IRS Form 8832 entitled Entity Classification Election.
If partnership characterization fails, the parties may lose certain tax benefits such as pass through deductions, losses or credits. Timing may matter. Tax benefits may be lost due to the failure of the proper person to make certain tax elections.
Be that as it may, partnership status requires that the parties, acting in good faith, undertake their venture for profit or for some other legitimate non-tax business purposes, and that each of them has a meaningful stake in the venture’s success or failure. See, Commissioner v. Culbertson, 337 U.S. 733 (1949) (“Culbertson”).
Estate planners would do well to remember the importance of establishing business purpose. For without a legitimate business purpose, there is no guarantee of partnership tax status, notwithstanding carefully abiding the “check‑the-box” rules and the lawful creation under applicable state law of a partnership, limited liability company or business trust entity.
Totality of Facts and Circumstances
Underlying partnership tax treatment are the fundamental admonitions of the U.S. Supreme Court in Commissioner v. Tower, 327 U.S. 280 (1946) (“Tower”) and Culbertson that look to the parties’ intention to be partners and their demonstration of the successful carrying out of such intention. Analyzing the bona fides, Culbertson provides the test for partnership status as follows:
… whether, considering all the facts – the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent – the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.
Paraphrasing the recent opinion in Cross Refined Coal et.al., v. Commissioner, 45 F.4th 150 (DC Cir. 2022) (Cross Refined Coal), partnership status requires the parties to have intended their venture to constitute the carrying on of business for profit or other legitimate nontax business purpose, and objectively that each has a meaningful stake in the success or failure of the partnership (i.e., each partner having some “skin in the game”).
Cross Refined Coal
Looking closer at Cross Refined Coal, circa 2008, Cross Refined Coal (the “LLC”) was formed as a subsidiary of AJG Coal (“AJG”). AJG desired to build and operate a coal-refining facility through the LLC to take advantage of the statutory refined-coal tax credit, using technology developed by AJG. 26 USC Section 45(c)(7)(A). It was clear from an economic perspective that it only made sense to pursue this activity because of the availability of the tax credit.
Additional investors were sought in order to spread the financial risk of building and operating the coal-refining facility. Neither AJG nor its parent would have been able to take advantage of all of the resulting credits in a timely fashion.
Fidelity Investments and Schneider Electric joined AJG as members in the LLC and contributed capital for their respective interests. The members all actively participated in the operations of the LLC. The LLC technically became a partnership due to having more than a single member. However, the underlying question was whether it met the requirements of Tower and Culbertson.
Not to get sidetracked, but an interesting question arose in the Castle Harbor litigation regarding whether the Culbertson requirements of business purpose and profit sharing were overruled by 26 USC Section 704(e). The argument is that under the Treasury Regulations, one who purchases, or receives as a gift, a capital interest in a partnership where capital is a material income-producing factor, is a partner irrespective of said requirements. See 26 CFR section 1.704-1(e). The U.S. Court of Appeals for the Second Circuit, reversing the district court, held that since the Dutch banks did not own capital interests in the purported partnership there was no need to decide the issue. See, TIFD v. United States, 666 F3d 836 (2d Cir. 2012).
Without digging too deeply into the coal refining activity, it was clear to all that the economic substance of the LLC’s activity and its ability to derive a profit depended solely upon the availability of the tax credit. Suffice it to say the D.C. Circuit, affirming the Tax Court, did find the necessary profit motive for partnership tax status after examining profit projections, the active participation of the members in the LLC’s activity and their continued proportional contributions to cover the costs of operations. The commissioner’s contrary view was that the LLC was not a bona fide partnership for tax purposes since there would have been no profit without the application of the tax credit.
The D.C. Circuit upheld the argument that a profit based upon the availability of the tax credit (i.e., a post-tax profit) was sufficient for establishing profitability for purpose of Culbertson. Furthermore, the attraction of additional investors by the LLC so as spread the overall risk of the coal-refining project was a valid business purpose, and together they met the bona fides of partnership status. The LLC “… sought to produce a post‑tax profit, and it did so by pursuing the congressionally encouraged business purpose of producing refined coal. Moreover, its use of the partnership form furthered that purpose by enabling AJG to raise more capital and spread its investment risk across multiple coal-refining projects.”
Clearly, it is appropriate to consider tax credits provided by Congress, in this case to incentivize the refining of coal, to establish the necessary profit motivation for the recognition of partnership status, even if there would be no profit without the tax credit. Things become murkier where Congressional tax incentives are not directly involved. Generally, there has to be a reasonable expectation of profits at the pre-tax stage.
Are cases like Cross Refined Coal, and there are many, that concern partnership characterization matters in the context of providing tax shelter‑like structures to investors, applicable to a so-called family partnership structured to operate a family business, family office or as a holding company for family investments? In this regard, it is notable that Tower and Culbertson concerned family partnerships. Tower involved whether a husband and wife were partners in a family-owned manufacturing business and Culbertson involved whether a father and his sons were partners in a family-owned cattle-breeding business.
Cross Refined Coal reinforces the notion that factors demonstrating a business purpose actually depend on the needs of the particular business or investment activity. Attracting investment capital and spreading the business risks were important factors.
Family Business Context
In connection with structuring entities for family-owned businesses or investment activities or other privately held enterprises, the entity, whether a partnership or limited liability company treated as partnership, should play a significant role in the succession process, which in itself would clearly be a valid business purpose. Using the entity to facilitate succession planning for the business or investment activity would be most meaningful, especially if it is part of the larger endeavor of planning for leadership changes in succeeding generations.
Of course, the picture is not complete without the implementation of the necessary estate planning and asset protection planning strategies to assure that ownership and control end up in the appropriate hands and that the business or investment activity is safe from the interference of the creditors of individual family members or investors.
Reprinted with permission from the New York Law Journal, An ALM Publication