Court Rejects IRS's Classification of Partnership Interest Expense as Investment Interest

(Parker Tax Publishing September 2019)

The Tax Court held that a taxpayer who acquired interests in partnerships by gift and bequest from his father did not receive the proceeds of any debt-financed distributions and did not use partnership distributions to acquire property for investment and therefore, none of the interest expense passed through to the taxpayer from the partnerships was investment interest under Code Sec. 163(d). The court found that the characterization of the interest expense as investment interest in the father's hands did not apply to the son; rather, under Reg. Sec. 1.163-8T and Notice 89-35, the son was deemed to have made a debt-financed acquisition of the partnership interests he acquired by gift and bequest, and the associated interest expense had to be allocated among the assets of the partnerships. Lipnick v. Comm'r, 153 T.C. No. 1 (2019).

Background

William Lipnick is the son of Maurice Lipnick, who died in October 2012 at age 95. For many years Maurice participated in three partnerships - Mar-Cal, Mayfair, and Brinkley - with real estate entrepreneur Calvin Cafritz. These partnerships owned and operated rental real estate in the Washington, D.C., area. In 2009 the partnerships borrowed money and distributed the proceeds to Maurice and Cafritz. The loans were secured by the partnerships' assets. Neither Maurice nor Cafritz were personally liable on the notes.

In 2009, the partnerships made debt-financed distributions out of the loan proceeds to Maurice totaling over $21 million. Maurice invested the funds in money market funds and other investment assets. During 2009-2011, the partnerships incurred interest expense on the loans. For each year, each partnership issued to Maurice a Schedule K-1 reporting his distributive shares of its rental real estate income and interest expense. On his tax return for each year, Maurice reported his distributive shares of the interest expense on the loans as investment interest on Schedule A.

On July 31, 2011, Maurice transferred to William, by inter vivos gift, 50 percent of his ownership interests in the partnerships. William did not become personally liable on any of the loans to the partnerships. On his 2011 tax return, Maurice treated the nonrecourse partnership liabilities of which he was relieved as a result of the gift as amounts realized and reported the amounts as capital gains.

Before his death, Maurice also owned an interest in another partnership, Claridge, which also owned and operated rental real estate. In February 2012, Claridge borrowed $20 million and distributed the proceeds to its partners. The loan was secured by the partnership's assets, but neither Maurice nor any of the other partners was personally liable on the note. From the debt proceeds Claridge distributed over $2 million to Maurice, who invested the cash in money market funds and other investment assets. Claridge incurred interest expense on the loan during 2012 and 2013 and reported the interest expense on Maurice's Schedules K-1. On his tax returns, Maurice reported his distributive share of the interest expense as investment interest on Schedule A. Maurice died on October 15, 2013. His will bequeathed to William a portion of his interest in Claridge. After the bequest, William did not become personally liable on the loan to Claridge.

The loans to the four partnerships remained outstanding during 2013 and 2014 and the four partnerships paid interest on them. William received Schedules K-1 from Mar-Cal, Mayfair, and Brinkley reporting his distributive shares of the partnerships' rental real estate income and interest expense attributable to the loan. For 2013 and 2014, William and his spouse jointly filed Forms 1040 attaching to each return a Schedule E. They took the position that the interest paid by the partnerships on the loans was not investment interest, as it had been in the hands of Maurice. Instead, they treated the interest as having been paid on indebtedness properly allocable to the partnerships' real estate assets, and hence treated William's distributive shares of the interest expense as fully deductible against his distributive shares of the partnerships' real estate income. Accordingly, on each Schedule E they netted against the income for each partnership the corresponding amount of interest expense and reported the resulting net income on their Forms 1040.

In 2017, the IRS issued a notice of deficiency for 2013 and 2014. It determined that William's distributive shares of the interest paid by the partnerships on the loans should have been reported on Schedules A as investment interest, which under Code Sec. 163(d) is deductible only to the extent of a taxpayer's net investment income. Because the Williams had insufficient investment income for both years, the IRS disallowed deductions for all of the passed-through interest attributable to the loans. It also determined accuracy-related penalties under Code Sec. 6662(a). The Lipnicks appealed the notice in the Tax Court.

Analysis

The Tax Court held that the interest expense passed through to William from the loans to the partnerships was not investment interest under Code Sec. 163(d) and that the Lipnicks correctly reported the passed through interest expense on Schedule E as allocable to the partnerships' real estate assets.

The court explained that investment interest is defined in Code Sec. 163(d)(3)(A) as interest paid on indebtedness that is properly allocable to property held for investment. The court noted that all of the four partnerships owned, operated, and actively managed rental real estate, and the loans on which the interest was paid were secured by these real estate assets. The operating assets held by the partnerships therefore did not, in the court's view, constitute property held for investment. The court further explained that Reg. Sec. 1.163-8T provides tracing rules to determine when debt is properly allocable to property held for investment, and Notice 89-35 provides guidance on how these tracing rules apply to partners and partnerships.

The court found that Maurice properly treated the partnerships' interest expense as investment interest reportable on Schedule A because he used the proceeds of the debt-financed distributions to acquire assets held for investment. However, the court found that, unlike Maurice, William did not receive the proceeds of any debt-financed distributions and did not use partnership distributions to acquire property held for investment. Rather, under Reg. Sec. 1.163-8T(c)(1) and Notice 89-35, William was deemed to have made a debt-financed acquisition of the partnership interests he acquired by gift and bequest, and the associated interest expense passed through to him was properly allocated among the assets of the partnerships. As the partnerships' assets were actively managed operating assets, those assets did not constitute property held for investment, and the interest paid on the loans was therefore not investment interest.

The court also rejected the IRS's contention that William did not take property subject to a debt when he acquired the partnership interests from his father because the loans were nonrecourse. The court found that William acquired the interests subject to the debts, even though he did not personally assume them. The court noted that, in general, any increase or decrease in a partner's shares of partnership liabilities is treated as a deemed contribution or distribution under Code Sec. 752, regardless of whether the debt is recourse or nonrecourse.

For a discussion of investment interest expense deductions, see Parker Tax ¶83,525. For a discussion of the interest allocation rules, see Parker Tax ¶83,580.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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