What Is It?
Where one stands on an issue of tax law may depend upon context and perspective, including the facts and circumstances one finds relevant, and whom one is counseling or representing.[i]
Tax advisers often find themselves in situations in which they must ascertain either the “true” nature of a transfer of property between taxpayers[ii] – what they intended – or the character of the property that is the subject of the transfer. The determination of one may influence the outcome as to the other.
Ordinary Income?
The IRS Office of Chief Counsel(“OCC”) recently issued advice[iii] on whether the gain from a taxpayer’s sales of LLC interests should be treated as ordinary income because the taxpayer held the LLC interests primarily for sale to customers in the ordinary course of a trade or business.[iv]
At the same time, the OCC also considered whether the Code’s “hot asset” rules for partnerships[v] should be applied collectively to treat the taxpayer’s gain on the above sales as ordinary income because the taxpayer was engaged in a trade or business of selling land.
Sale of LLC Interests
During the taxable years in question, Taxpayer directly, and indirectly through entities owned and managed by Taxpayer (the “Managed LLCs”), engaged in the promotion and sale of interests in limited liability companies (“Transaction LLCs”). The only assets owned by these Transaction LLCs were undeveloped parcels of land. Taxpayer held interests in the Managed LLCs with persons A and B and reported the activities of the Managed LLCs as partnerships for federal tax purposes.
Each of the Transaction LLCs engaged in transactions that involved the donation of an easement with respect to the land “in exchange for” a charitable contribution deduction,[vi] and/or the donation of a fee simple interest in the land in exchange for such a deduction (the “Transactions”).[vii]
According to information provided by Taxpayer, Taxpayer was previously engaged in a variety of business activities, including real estate management, acquisition, and investment activities. Taxpayer also represented that Taxpayer and the Managed LLCs did not sell real property and were not engaged in a trade or business of selling real property.
The promotional materials for the Transactions described certain principals of Managed LLCs (presumably including Taxpayer) as “only providing additional information regarding the potential acquisition of membership interests to prospective members and are not acting as a real estate broker nor are they acting as a broker or dealer in securities.”
Transaction Steps
Taxpayer, or Taxpayer through a Managed LLC, managed, marketed, and negotiated all Transaction steps. During the relevant periods, Taxpayer generally undertook the following steps[viii] to promote and sell the Transaction LLC interests:
- Identified a third-party owner of an undeveloped piece of land who held the land for more than one year (Landowner). Landowner formed an LLC (Land LLC) and contributed the undeveloped land to Land LLC.
- Formed a Managed LLC that purchased a percentage of the interests in the Land LLC from Landowner in exchange for cash.
- Directed Land LLC to subdivide the undeveloped land into parcels, contribute one parcel each to several newly formed LLCs (each a Transaction LLC), and distribute the Transaction LLC interests b% to Landowner and a% to Managed LLC (which were the same ownership percentages each held in Land LLC). Land LLC continued to hold one of the parcels.[ix]
- Directed Managed LLC to either continue to hold a% interest in each Transaction LLC, or distribute the interest to its partners – Taxpayer, A, and B.
- Managed LLC, or Taxpayer, A, and B, then sold c% of the Transaction LLC interests to a newly formed LLC (Investor LLC) of which Managed LLC or Taxpayer was the managing member. Taxpayer used a different newly formed Managed LLC to sell the Transaction LLC interests every year. Individual investors contributed tens of thousands of dollars into the Investor LLC to purchase Transaction LLC interests. Managed LLC, or Taxpayer, A, and B, continued to hold d% interest in, and act as the managing member of, Transaction LLC.
Charitable Easement
Typically, within one to four months from the date of Land LLC’s formation, Transaction LLC donated an easement and/or the land to a tax-exempt organization described in Section 501(c)(3) of the Code. Transaction LLC reported the donation as a charitable contribution[x] on its federal tax return. Taxpayer and the investors, through Investor LLC, claimed a deduction for their respective distributive shares of such charitable contribution deduction.[xi]
Taxpayer, through Investor LLC, made oral and written promises to the investors that they would receive a charitable contribution deduction with respect to the donation of the easement and/or the land many times the amount the investors contributed to Investor LLC.[xii]
Although the promotional materials for the Investor LLCs offered the investors several investment options, Taxpayer, acting as managing member of the Transaction LLCs, caused all the Transaction LLCs to donate easements and/or the land to charitable organizations. Taxpayer, through Investor LLC, received a promotional fee or other consideration in connection with the sales of the Transaction LLC interests to the investors.
IRS Exam
During the years in question. Taxpayer and the Managed LLCs, collectively, reported about $e of gain on the sales of their interests in f Transaction LLCs to the Investor LLCs. Other than in the last of these years, Taxpayer reported the gain from the sales of the Transaction LLC interests as long-term capital gain.
In this final year, Taxpayer sold Transaction LLC interests directly and reported the gain from these sales as long-term capital gain. Also during that year, Taxpayer formed an entity that elected to be treated as an S corporation for federal tax purposes. Taxpayer contributed Transaction LLC interests to the S corporation, which then sold these interests. Taxpayer reported gain on the sales of the Transaction LLC interests sold by the S corporation as ordinary income.
On Taxpayer’s personal tax return, Taxpayer reported no other source of income other than the income generated by Taxpayer from the promotion and sale of the Transaction LLC interests.
On examination of Taxpayer’s tax returns, the IRS challenged the character of the gain Taxpayer recognized on the sales of the Transaction LLCs. The IRS examiners asked the OCC to weigh in on the issue.
Some Basics
The gain recognized by an individual taxpayer from the sale of a capital asset that the taxpayer has held for more than one year is treated as long-term capital gain the tax on which is determined using a preferential federal rate of 20 percent.[xiii]
According to the Code, the term “capital asset” means property held by a taxpayer (whether or not connected with the taxpayer’s trade or business), but does not include “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”[xiv]
The purpose of the foregoing “definition-by-exclusion” is to differentiate between the profits that arise from the everyday operation of a business, on the one hand, and the realization of appreciation in the value of property accrued over a substantial period of time, on the other.
The following factors generally indicate whether property is held primarily for sale to customers in the ordinary course of a trade or business:
(1) the frequency and regularity of sales;
(2) the substantiality of sales;
(3) duration of ownership;
(4) whether the property held for sale and the property held for investment were
separately identified;
(5) the purpose for acquiring the property;
(6) sales and advertising efforts;
(7) the time and effort devoted to the sales activity; and
(8) how the sales proceeds were used.
Of these, the frequency and regularity of sales are among the most important factors in determining whether an asset is held for investment or as inventory.
The CCA
Applying these factors, the OCC found that the Transaction LLC interests were held primarily for sale to Taxpayer’s customers – i.e., the investors. In support of this finding, the OCC relied upon the following:
(1) From Year 1 through Year 4, Taxpayer sold interests in f Transaction LLCs to the Investor LLCs, the sales took place every year, and there were multiple investors in each
Investor LLC.
(2) From Year 1 through Year 4, Taxpayer recognized gain of about $e from selling the Transaction LLC interests to the Investor LLCs.
(3) The length of time from the acquisition of the Land LLC interests to the sale of Taxpayer’s interests in the Transaction LLCs was usually less than a year.
(4) Taxpayer did not separately identify property held for sale versus property held for investment with respect to the Transaction LLC interests.
(5) Taxpayer directed Managed LLC to acquire an interest in the Land LLC from Landowners to create the Transaction LLCs and sell interests in these Transaction LLCs quickly, usually within a year.
(6) Each year from Year 1 through Year 4, Taxpayer vigorously advertised the
Transactions, through promotional and other written materials and verbal
communications, to attract investors who would contribute a minimum of tens of thousands of dollars to an Investor LLC. Taxpayer also engaged in significant sales activities, resulting in sales of interests in f Transaction LLCs with multiple investors buying interests in Investor LLCs every year.
(7) Taxpayer devoted a substantial amount of time to the Transaction. Taxpayer found Landowner with whom Taxpayer negotiated a land purchase price, convinced the Landowner to structure the land sale as a sale of a% interest in Land LLC with Landowner keeping b% in Land LLC. Taxpayer determined the scope and nature of the Transactions and arranged financing. Taxpayer directed the subdivision of land in Land LLC, the creation of Transaction LLCs and placement of the subdivided land parcels
into them, hired appraisers and other professionals, directed the creation of Investor LLC and the promotion and sale of interests therein to investors. As managing member of Investor LLC and in other ways, Taxpayer caused the Transaction LLCs to donate the easement and/or the land. Taxpayer repeated these steps every year from Year 1 through Year 4.
(8) Taxpayer clearly intended to replace the Transaction LLC interests being sold. From Year 1 through Year 4, Taxpayer created new Transaction LLCs and sold Taxpayer’s interests in them. The frequency and size of these transactions supported the finding that Taxpayer used the proceeds from the sales of the Transaction LLC interests to purchase replacement properties – basically, to replenish its inventory – for subsequent similar transactions.
Sale In The Ordinary Course
In selling the Transaction LLC interests, Taxpayer met each factor relevant to whether property was held primarily for sale to customers in the ordinary course of a trade or business. This confirmed that Taxpayer held the Transaction LLC interests as inventory “or property held… primarily for sale to customers in the ordinary course of Taxpayer’s trade or business,” not as capital assets.
In addition, Taxpayer sold the Transaction LLC interests quickly, generally within a year, and did not hold them on a long-term basis.
Thus, Taxpayer realized income “from the everyday operation of a business” and not “the realization of appreciation in value accrued over a substantial period of time.” Therefore, Taxpayer’s gain on the sales of the Transaction LLC interests was ordinary income.[xv]
Partnership Interest As Capital Asset
The CCA then turned to Taxpayer’s contention that the Code’s partnership tax rules require the sale of a partnership interest be treated as the sale of a capital asset and preempt application of the Code’s definition of what constitutes a “capital asset.”
According to the Code, in the case of a sale or exchange of an interest in a partnership, the gain recognized to the transferor partner is considered as gain from the sale or exchange of a capital asset,[xvi] except to the extent the value of the interest is attributable to unrealized receivables or inventory items held by the partnership.[xvii]
The OCC responded that, while the partnership tax rules generally treat the sale of a partnership interest as a sale of a capital asset, one must still determine whether the interest is a capital asset in the hands of the selling taxpayer. The legislative history, the CCA continued, indicates that Congress intended to grant capital asset treatment only to the sale of partnership interests that are in fact held as capital assets. Moreover, Congress intended that the sale of a partnership interest generally be considered a sale of a capital asset, leaving open the possibility for ordinary treatment on the sale of a partnership interest when the facts and circumstances were appropriate.
Here, because the substance of the sales of the Transaction LLC interests by the Taxpayer were necessary steps in the Transactions in the ordinary course of Taxpayer’s trade or business of selling Transaction LLC interests, the Code’s general asset classification rules[xviii] applied to determine the character of the gain on such sales.
The CCA added that the IRS was not challenging the Code’s entity approach that the sale of a partnership interest is treated as the sale of a single asset.[xix] Under the present set of facts, however, capital gain treatment did not apply because Taxpayer’s gain arose from the everyday operation of a trade or business. The Transaction LLC interests were pre-arranged “products frequently created and sold to customers”; i.e., investors. Thus, the gain on such sale should be treated as ordinary income.
Hot Assets
Next, the OCC considered the IRS examiner’s inquiry whether the Code’s partnership “hot asset rules,”[xx] applied collectively, may treat Taxpayer’s gain on the sales of LLC interests as ordinary income.
These rules[xxi] collectively apply to characterize as ordinary income the gain recognized from the sale of a partnership interest attributable to a partnership asset that is inventory to the partnership, or when a partnership asset is held by the partnership primarily for sale to customers in the ordinary course of the partnership’s trade or business.[xxii]
According to the CCA, the facts presented did not support a finding that the land was included in the inventory of the Transaction LLCs or held by such LLCs primarily for sale to customers. Additionally, there were no facts to support that the Transaction LLCs were engaged in the trade or business of selling land. Each Transaction LLC donated the easement, and/or the land, to an organization described in Section 501(c)(3) of the Code on behalf of the investors. Therefore, the hot asset rules collectively would not apply to characterize the gain recognized by Taxpayer as ordinary income.
However, the rules would apply to characterize the gain recognized by Taxpayer as ordinary income if the facts supported that the Transaction LLCs were engaged in the trade or business of selling land and that the land held by these LLCs was either inventory or held primarily for sale to customers by the Transaction LLCs.
Collectively, the rules apply to characterize as ordinary the gain recognized from the sale of a partnership interest attributable to partnership property which, if held by the selling partner, would be considered property other than a capital asset to the selling partner, inventory to the selling partner, or held by the selling partner primarily for sale to customers in the ordinary course of the selling partner’s trade or business.
The CCA pointed out that the facts presented did not support that Taxpayer was in the trade or business of selling land. Promotional materials for the Transactions described Taxpayer as not acting as a real estate broker with respect to the Transactions. Additionally, in at least one year Taxpayer stated that neither Taxpayer, nor the Managed LLCs, sold land and was not engaged in the business of selling land. Accordingly, the land in the Transaction LLCs, if held by Taxpayer, would have been a capital asset to Taxpayer because there was no indication that the land was inventory to the Taxpayer or held by Taxpayer primarily for sale to customers in the ordinary course of the Taxpayer’s trade or business.
Assessment
Was the CCA correct in its conclusion that the Transaction LLC interests were held for sale to customers in the ordinary course? I think so.
When there is a sale of a partnership interest, the entity theory is the underlying concept, meaning that a partner’s ownership interest in the partnership is treated as a separate asset that can be purchased and sold.
As a general rule, the selling partner treats the gain from the sale of the partnership interest as the sale of a capital asset. However, if the partnership holds certain types of the assets – say, hot assets – the aggregate rule comes into play and the look-through concept is applied, pursuant to which the partner may have to characterize part of the gain from the sale of the interest as ordinary income, base upon the partner’s “share” of such assets.
The CCA rightly points out that the foregoing analysis depends upon the partnership interest being treated as a capital asset in the hands of the selling partner. Where the seller is effectively acting as a dealer, the nature of the underlying assets never comes into play in determining the nature of the gain from the sale.
[i] Not to be confused with Miles’s Law: “Where you stand depends on where you sit.”
[ii] Does it represent a loan, a contribution to capital, a distribution, payment for services, a gift, etc.
[iii] IRS CCA 202309015, Chief Counsel Advisory March 3, 2023.
A Chief Counsel Advisory (CCA) is written advice prepared by the Office of Chief Counsel and issued to field or service center employees of the IRS. It is intended to convey a legal interpretation of the Code. It is not intended to be precedential.
[iv] IRC Sec. 1221.
[v] IRC Sec. 751.
[vi] See Notice 2017-10 in which the IRS identified certain “syndicated conservation easement (“SCE”) transactions as listed (tax evasion) transactions. See also IRC Sec. 170(h); Reg. Sec. 1.170A-14.
[vii] Syndicated conservation easements.
[viii] In general, the transaction steps were the same when a Transaction LLC donated easements and/or the land.
[ix] Taxpayer reported the activities of the LLCs as partnerships for federal tax purposes.
[x] IRC Sec. 170.
[xi] As reflected on their respective Schedules K-1.
[xii] The Consolidated Appropriations Act of 2023 (P.L. 117-328) amended IRC Sec. 170(h) to limit what Congress and the IRS determined was the abuse of syndicated conservation easements.
Specifically, it provides that a contribution by a partnership (whether directly or as a distributive share of a contribution of another partnership) will not be treated as a qualified conservation contribution for purposes of IRC Sec. 170(h) if the amount of such contribution exceeds 2.5 times the sum of each partner’s “relevant basis” (as defined therein) in such partnership.
However, this limitation will not apply to any contribution which is made at least 3 years after the latest of: (i) the last date on which the partnership that made such contribution acquired any portion of the real property with respect to which such contribution is made, and (ii) the last date on which any partner in the partnership that made such contribution acquired any interest in such partnership.
Another exception is provided for family partnerships.
[xiii] IRC Sec. 1221, Sec. 1222, Sec. 1223, and Sec. 1(h).
[xiv] IRC Sec. 1221(a).
[xv] In addition, the OCC argued that the Transaction LLC interests sold by Taxpayer were also excepted from the capital asset definition under Corn Products, as the Transaction LLC interests were not “separate and apart from” Taxpayer’s operations but were rather “closely geared to” Taxpayer’s business, promoting Transaction LLC interests, and were critically “important to its successful operation.”
[xvi] IRC Sec. 741.
[xvii] IRC Sec. 751, which is the exception to the general rule under IRC Sec. 741, which provides capital gain treatment for the sale of a partnership interest. Section 751(a) provides that on the sale or exchange of an interest in a partnership, the amount of any money, or the fair market value of any property, received by a transferor partner in exchange for all or a part of his interest in the partnership attributable to (1) unrealized receivables of the partnership, or (2) inventory items of the partnership, shall be considered as an amount realized from the sale or exchange of property other than a capital asset.
[xviii] IRC Sec. 1221(a), which excludes from the definition of capital asset: stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.
[xix] Like the sale of stock in a corporation.
[xx] Specifically, IRC Sec. 741, Sec. 751(a), and Sec. 751(d).
[xxi] IRC Sec. 751(a)(2) and (d)(1).
[xxii] IRC Sec. 751(d) provides that the term inventory items means: (1) property of the partnership of the kind described in IRC Sec. 1221(a)(1); (2) any other property of the partnership which, on sale or exchange by the partnership, would be considered property other than a capital asset and other than property described in IRC Sec. 1231; and (3) any other property held by the partnership which, if held by the selling partner, would be considered property of the type described in Sec. 751(d)(1) and Sec. 751(d)(2).
