Senate Tax Proposal Would Reverse Tax Court Holding in Grecian Magnesite Case
Revenue Ruling 91-32 holds that the gain realized by a foreign partner on disposing of its interest in a U.S. partnership should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the departing partner’s pro rata share of such gain should be treated as effectively connected income. Commentators have generally been of the opinion that the IRS position is simply wrong.
The Tax Court in Grecian Magnesite invalidated Rev. Rul. 91-32 and observed:
“Rev. Rul. 91-32 is not simply an interpretation of the IRS’s own ambiguous regulations, and we find that it lacks the power to persuade. Its treatment of the partnership provisions discussed … is cursory in the extreme, not even citing section 731 (which, as we set out, yields a conclusion of “gain or loss from the sale or exchange of the partnership interest” (emphasis added)). The ruling’s subchapter K analysis essentially begins and ends with the observation that “[s]ubchapter K of the Code is a blend of aggregate and entity treatment for partners and partnerships.” We decline to defer to the ruling. We will instead follow the Code and the regulations to determine whether the disputed gain is effectively connected* income.”
Effective for transactions after December 31, 2017 the Senate proposal overrides the holding in Grecian Magnesite and imposes a 10% withholding tax on the amount realized on the sale or exchange of an interest in a partnership (that is engaged in a U.S. trade or business) unless the transferor certifies that it is not a nonresident alien individual or foreign corporation. If the transferee fails to withhold the correct amount, the partnership is required to deduct and withhold from distribution to the transferee partner an amount equal to the amount the transferee failed to withhold.
There are a number of issues that will have to be considered including:
- Possibility of structuring transactions between now and the end of the year to come under the current law as provided in Grecian Magnesite.
- Treatment of sales this year for installment notes.
- Separation of assets of a partnership attributable to a U.S. business.
- How does a partnership know that a non-resident has sold a partnership interest?
- It currently appears that the rule does not apply to U.S. tax exempt investors in partnerships.
- Often non-residents invest through multiple levels of partnerships offshore. In this case, how would a U.S. partnership ever know that an interest in the partnership has been sold?
- There is a possibility that the IRS will appeal the Grecian Magnesite case – although the outcome is unknown. The Tax Court case is very well reasoned, supported by the law and is generally believed to be the correct analysis.
*It is important to note that although the Tax Court invalidated Rev. Rul. 91-32, a non-resident individual or foreign corporation that sells an interest in a partnership (or LLC taxed as a partnership) is subject to U.S. tax on gain attributable to U.S. real property interests, under IRC Section 897(g).